9 Ways to Fail as an Entrepreneur And how to counsel clients to avoid them

By Inti Martínez-Alemán

Conventional wisdom says that 80 percent of businesses fail within two years. The Small Business Administration (SBA) disagrees.¹ According to SBA statistics, from 2005 to 2017 nearly 80 percent of new establishments survived one year. “About half of all establishments survive five years or longer…. About one-third of establishments survive 10 years or longer.”

So the prospects for business startups are not as grim as presumed. What is grim is having to shut down a business because of poorly managed disagreements. Partner disputes, competitor animosity, disgruntled employees, and government compliance woes are among the common triggers for litigation that can kill a young enterprise—litigation that, in many cases, is entirely avoidable through attention to detail.

I started practicing law over 10 years ago in Honduras and spent the first five years of my career there. Yet despite the many differences between the two countries and their distinct legal systems, business owners in Honduras and the U.S. make very similar mistakes. Barring a few local nuances, I have seen at least nine recurring mistakes that entrepreneurs make in both nations.³

1. ICs = Employees

We all know those people who think that issuing a 1099 tax form to their workers automatically makes these workers independent contractors. And we all know those people who treat their employees as if they were independent contractors. When I advise clients on the subject, I tend to hear stories about a cousin or business associate who has been misclassifying their workers for 20 years and has never had a problem. Perhaps those stories are true and perhaps they aren’t, but the downside is just too great to take the risk. The penalties for misclassifying workers can be severe.

There are several tests to determine whether a worker is an independent contractor or an employee. The IRS, federal labor law, and state labor law use different multi-factor tests for different purposes.⁴ A common thread between these variegated tests is control. How workers get their orders, instructions, and supervision goes a long way toward determining whether a worker is an independent contractor or an employee. Simply issuing a 1099 does not settle the matter.

2. What insurance?

Not all insurance is created equal. Even within a particular class of coverage—workers’ compensation, general business liability, professional liability, product liability, business interruption, or personal property insurance—not all carriers and policies are created equal. I hate to see it when my clients come to me wanting to sue their insurance carrier over a denied claim, only to find out that their insurance policy explicitly excludes the type of risk or damage a business owner suffered. 

However much education there may be out there about insurance coverage, policies are very complex. And even when entrepreneurs clearly know the scope and contents of their insurance, they often accept whatever is offered to them as they are rushing to open or expand their business. Some insurance agents are not eager to tell potential customers about all the risks of cheap insurance policies, either.

For example, if your company plans to flip homes, make sure there is not a townhome & condo exclusion in your commercial general liability insurance policy. If you plan to innovate in your hiring and compensation structure for your workers, make sure to obtain an employment-related practices endorsement, if you are able.

Owning a business is risky business. Not having a tailored insurance policy for your specific type of enterprise can be dangerous. Investing the time and money to know what is covered, and what is not covered, could save your business from failure.

3. Just put it all on my AMEX

If I am the sole owner of a coffee shop, then it’s okay to use the business to support my lifestyle, right? Not quite. If you are running your shop under an entity offering limited liability, then you had better steer clear from commingling funds. Otherwise, a court could find in favor of a business creditor after piercing the limited liability veil. That means your creditor could likely snatch up your family boat or cabin. 

Using your personal credit card to pay for business expenses is allowed if the business in turn reimburses you for that use. If there is no reimbursement or equivalent, then you are setting yourself up for misfortune. 

4. Who even reads the fine print? 

The haste to open your doors and start making money can trip you up if you do not know what you are signing and getting yourself into. More than legal advice, this is life advice. It applies to almost everything we do.

If you do not know what your rental lease or your loan agreement says, how will you know your rights? Most laypersons will not understand the terms of their lease or loan without actually reading the agreement—and even then, the dense legalese will be impenetrable to anyone unfamiliar with the terminology.⁵ Without proper legal counsel, you might be out of luck when your relations with your landlord or lender go south.

The best contracts I have read contain quick and precise executive summaries or a table of contents of the entire contract written in plain English. These summaries or tables help entrepreneurs understand what they are getting into—really—when signing that contract. Do not settle for less.

5. “I call the shots.” But do you, really?

Being a company owner should involve de jure and de facto ownership. Let’s discuss what this means in the context of limited liability companies (LLC), because that’s the most commonly chosen entity these days. (Nearly 87 percent of Minnesota business entities filed in 2018 were LLCs.)⁶ 

Minnesota’s new LLC Act allows for an LLC to be governed by an operating agreement that may be oral, recorded, or implied—or even a combination of these approaches.⁷ This means that the way members of an LLC run the company and treat each other may determine the actual terms of a valid operating agreement.⁸ This agreement may bind the company, too.⁹ Conversely, a written operating agreement may be deemed ineffective if the conduct of the company members implicitly disregards the written record. How you carry out your company affairs is indicative of the company members’ agreement, whether or not it is memorialized.

What’s the lesson here? Written governing documents matter a lot. But enforcing these documents is even more important. If operating agreements are not updated to reflect the current understanding and conduct of the partners, then why even have written governing documents anyway?

Because written operating agreements are private documents, I advise my business clients to file a statement of authority before the Secretary of State.¹⁰ This statement will tell the public the essential information about company leadership, without the details of the operating agreement. This filing enables third parties to find out who is authorized to sign contracts and bind the company, including their limitations and restrictions. 

Note that the doctrine of apparent authority is still applicable to, and intersects well with, the LLC Act. If an assistant manager does not have the power to bind the company but nonetheless makes purchases from a third party on behalf of the company, and the company readily pays for such purchases, then the assistant manager’s apparent authority before the third party is valid despite not having the actual authority to make the purchases.¹¹ Conduct and course of dealing matter!

Any real estate lawyers in the house? Note the statute’s provisions regarding real property belonging to the LLC. The statement of authority may reflect who in the company has the authority, or limitations to this authority, to “execute an instrument transferring real property held in the name of the company.” If a limitation on the authority to transfer real estate is recorded in the real property records, then “all persons are deemed to know of the limitation.”¹²

6. No paper trail, will surely fail

Similarly, if you are not documenting your business operations, chances are you will not be able to corroborate what really happened if a dispute arises a couple of years down the road. Keeping a daily log or journal of business operations, filtering your emails by categories, keeping digital copies of all physical mail, and backing up your electronic devices on the cloud are all examples of organizing your documents in ways that make it easy to retrieve them if a lawsuit commences. 

Google Vault is a formidable and low-maintenance product that “lets you retain, hold, search, and export data to support your organization’s archiving and eDiscovery needs.”¹³ With Vault you can seamlessly retrieve emails, chats, Google Drive files, etc. in anticipation of litigation. Legal holds and audit reports are a breeze!

A series of emails and text messages can become binding contracts under the right conditions. If you are keeping notes or journal entries for your business operations, chances are these would dissuade a potential plaintiff from litigating against you when your documentation is up to snuff. And if you do end up in court, a reasonable judge will give weight to your documented evidence.

We have all met people who do not like to put anything in writing. They only want to talk on the phone or in person about business matters. I tell my clients to take extra precautions with this type. What a savvy business person should do in these situations is to send the interlocutor a written summary of the conversation immediately afterward, giving them an opportunity to object to the summary within reasonable time, lest it be deemed accurate. For example: “Hey Jim, my takeaways from our talk were ABC. I will assume these are true for you as well, unless you tell me otherwise by 123.”

The point of documenting your business operations is primarily to prevent litigation from ever starting. If you are well documented, chances are a third party will not want to mess with you. But if they do, you can show the court what you’ve got. 

7. Mi IP es su IP

The saying Mi casa es su casa is a gesture of utmost hospitality—it invites others to enjoy what belongs to you. But a business that produces intellectual property of any kind should protect it. If a company has employment agreements with its workers, the agreements should have clauses stating that all intellectual property and its derivatives that were produced or improved by an employee belong to the employer and not to the employee. The last thing you want is an unhappy employee claiming the intellectual property they produced belongs to them. 

It is also risky to use a business logo or slogan that is not protected with a registered trademark or copyright. Protecting your company’s intellectual property could prevent headaches down the road. Registering your intellectual property can also increase your company’s value and potential monetary claims against a third party if they infringe.

Smart business owners grow their business by protecting their intellectual property. Anything short of that is asking for trouble.

8. You’re fired! (Excuse to follow)

When I represent employees in wrongful termination cases, it always irks me when employers come up with phony explanations for firing. It is even worse when managers contradict themselves or there is documented evidence of seeking a pretext for firing. If a manager fires an employee because of her continuous poor performance, but every performance review in her personnel record is stellar, there is less wiggle room for an employer to come out clean.

I advise my business clients to hire and fire for the right reasons. Pursuing unfairly discriminatory or retaliatory practices can be costly for an employer. 

9. It’s safe. But is it cybersafe?

Although it varies according to industry, on average, human error is at the heart of nearly one in five data breaches.¹⁴ Last year alone, according to the 2018 Verizon Data Breach Investigations Report, there were 53,308 reported security incidents in 65 reporting countries, of which 2,216 were confirmed data breaches.¹⁵ It means that even if your staff makes no mistakes in how they handle sensitive data, there is a high chance that an external source could target your business to obtain confidential data.

There is no guaranteed solution to prevent data breaches, but you can significantly improve your odds by getting periodic cybersecurity assessments from a trusted vendor, implementing rigorous data policies, encrypting your data and storage, using a virtual private network when you are out of the office, and training staff to be more tech-savvy. And just in case, make you sure you get cybersecurity insurance to mitigate your losses.

You will find many free apps or services out there promising to protect your data or make your life easier. A rule of thumb in the tech world is that you are either a customer or a product. If you are paying, you are a customer and hopefully your data is protected. If the app is free, chances are that app is using you and your data as a product offered to third parties. Do not compromise your company’s data: Stay away from the free version and pay the extra dollars.

Conclusion

While there is no perfect way to avoid litigation, it is in a business owner’s best interest to keep a tight rein on their company. Putting into practice what I recommend here requires work and money, but it will pay off. Shuttering a business over legal disputes or costs is painful—and even more so if you could have avoided a protracted lawsuit.

Notes

¹ https://perma.cc/ESS7-RHLZ 

² Id.

³ Actual data on the incidence of particular kinds of litigation is hard to come by. The Minnesota Judicial Branch, for example, does not compile a practical breakdown of the types of civil cases filed. The current case typology is not very useful: If you want to know how many cases involve business disputes, generic descriptions like “Civil Other” or “Contract” are not helpful. https://perma.cc/AV6W-KWP9

⁴ My colleague Aaron Hall has a very good primer here: https://perma.cc/Q8ZY-HZ4T 

⁵ Boilerplate contracts are everywhere and it’s rare that anybody reads them or objects to them. Two scholars tackle the enforceability of pseudo-contracts and how shared-meaning analysis could help further consumer rights: https://perma.cc/5A2G-QLE8

⁶ https://perma.cc/436R-K2P5 

⁷ Minn. Stat. §322C.0102 subd. 17. Nevertheless, I would never recommend an oral or implied operating agreement.

⁸ Joan MacLeod Heminway, The Ties That Bind: LLC Operating Agreements as Binding Commitments, 68 SMU L. Rev. 811 (2015) https://perma.cc/R39L-F3FM 

⁹ Minn. Stat. §322C.0110 subd. 1; Elf Atochem N. Am., Inc. v. Jaffari, 727 A.2d 286 (Del. 1999) is persuasive.

¹⁰ Id. at §322C.0302

¹¹ See Comment for Section 301: https://perma.cc/NT5W-UX76 

¹² Id. at subd. 7.

¹³ https://perma.cc/875N-KC2F

¹⁴ https://perma.cc/WL8X-AGEL 

¹⁵ Id.