The Importance of Corporate “Formalities”

A small business owner once questioned why I needed to draft bylaws for his sole-proprietorship, an LLC. After all, does a sole proprietor need a document that, on its face, addresses voting and management issues amongst multiple individuals? The question about the necessity of bylaws speaks to a larger issue among many small business owners who are attempting to control start-up costs. They legitimately question why they should incur legal costs to draft corporate governance documents, such as bylaws, annual meeting minutes, and resolutions, which many regard as mere “formalities.”

One of the key reasons business owners form a corporation or LLC is for the protection of their individual assets from the liabilities of the company. This protection is often referred to as a “liability shield.” Generally, a properly organized company is regarded as a separate legal entity under the law, and the owners of the company are shielded from the liabilities of the company.

However, this “shield” is not absolute. Small business owners – especially sole proprietors – can be particularly vulnerable to challenges by creditors, vendors, and customers who seek legal action against the owner as an individual. Potential plaintiffs can ask the court to “look through” the company as a separate legal entity and hold the owners liable for the liabilities of the company – a concept referred to as “piercing the corporate veil.”

Therefore, it is imperative for business owners to implement several best practices to maintain this separateness. Timely, comprehensive, and accurate corporate governance documents are one step in the process. Companies should document all important decisions, including loans, stock and membership interest issuances, stock option grants, major capital purchases, leases, and management and board elections and removals.

These corporate governance documents are more than mere formalities. They can show that the owners of the business took the necessary steps to maintain the legal line between the company and the individual owners. The temptation to postpone or ignore these documents is particularly alluring for the sole proprietor, but they remain important nonetheless.

Regarding bylaws, attorneys differ in opinion over the necessity of bylaws for a sole-proprietor LLC. I fall on the side of those who advise their clients to have a set of bylaws in place. A set of bylaws can provide further delineation between a company and its individual owners.

For those who postpone this task, your governance documents become more difficult to recreate as months and years pass. Situations that you may not be able to envision  – such as the sale of your company – can materialize and require a proper corporate “document trail.” With the assistance of an attorney, each company should implement procedures to draft and maintain proper corporate governance documentation.