protect yourself financially by building 3 layers of protection

When you run a business, you need to protect yourself financially by building 3 layers of protection:

1. Prevent people from suing you by using contracts.

2. If you get sued, make sure you are covered with insurance.

3. If you are not covered, make sure you are not personally liable.

1. Contracts

When you do business, you have relationships with clients, vendors, and the general public.

Because of your business' affect on the world, good or bad, someone might sue you.

Therefore, your risk of being sued in business cannot be prevented entirely. However, you can decrease this risk substantially using contracts.

Specifically, your contracts can give you two things that will decrease your litigation risk: (1) limitation of liability and (2) indemnification.

Limitation of Liability (Use For Client Contracts)

Your contracts should say that the other person's ability to sue you is limited in the following ways:

1. They can only sue you for up to a certain amount.

2. They can only sue you for certain types of damages but not others.

3. They can only sue you for a certain period of time.

4. They can't sue you if the damage was partially or mostly their fault.

5. They can only sue you if you did something really bad, not a mere slip up.

Indemnification (Use For Vendor Contracts)

Your contracts should also say that if a third party sues you because of the contract, the other person signing the contract will cover your losses. This is called indemnification.

Indemnification doesn't prevent the other person signing the contract from suing you. But it means that if the person does something bad while performing a contract, and you get sued because of the bad thing they did, then they will cover the cost of fighting the suit and they will pay for the damages.

For example, imagine you hire a video editor, and they add copyrighted material to your videos, and then you get sued for copyright infringement. You would want your video editor to pay for your attorney fees in that case and also pay the damages if you lose. Therefore, if you're indemnified and you get sued, it's almost as if the other party to your contract is the one getting sued and not you.

2. Insurance

Even if your contracts are air tight, you still might get sued, and you might not be indemnified.

This could be a big problem if the cost of your case -- both damages and attorneys fees -- is enough to bankrupt or cripple your company.

What kind of insurance protection? It depends entirely on your industry. Most companies should have some form of a general liability policy that covers most things. But there are also more specific policies like cyber policies and policies to protect against IP infringements.

3. Legal entity

If you're planning to secure either contracts or insurance in the near future, or if you are already making significant money, it's probably time to get an LLC, corporation, or other legal entity.

The legal entity will not protect the liability of your business like insurance and contracts. But the legal entity will do something even more important: it will protect you personally.

So even if your business goes totally bankrupt, you should not owe a penny. The creditors of your business will only be able to recover their debts to the extent the business itself has assets to cover the debt.

This protection is called the liability shield or the corporate veil. In order to keep these protections as strong as possible, you need to do several things:

1. Keep your personal income and expenses in a personal bank account only and business income and expenses in a business bank account only.

2. Maintain reasonable insurance coverage.

3. Keep a reasonable amount of cash in your business bank account so you can pay all expenses timely.

4. Most important of all, do not commit fraud.

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Adam Yohanan represents entrepreneurs, investors, freelancers, startups, small businesses, artists, and entertainers in a wide variety of transactional and regulatory matters, with an emphasis on complex commercial contracts, business formations, corporate governance, M&A, finance, intellectual property, and entertainment law. His office can be reached at 212-859-5041.

This guide is meant for educational and informational purposes only and should not be considered legal advice. It is essential to consult with an attorney or other advisors regarding all legal and other important matters.