Pre-Formation Contracts

April 13, 2006

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Ideally, the small business owner will sign a contract solely as an agent of his or her limited liability company (LLC) or corporation. If an agent does this properly, only the principal is liable on the contract. The agent will have no liability at all on the contract. Thus, if the owner of a business properly signs a contract as an agent of the LLC or corporation, only the principal (i.e., the LLC or corporation) will be liable on the contract.

The most the owner could lose on the contract will be what the LLC or corporation can lose. This amounts to the owner's investment in the business (the business's assets to the extent they are vulnerable). In other words, the owner will enjoy limited liability for the contract.

One of the contract exceptions to limited liability involves a pre-formation contract (i.e., a contract formed by the owner before his LLC or corporation legally came into existence). An individual can act as an agent only if there is a principal. With a pre-formation contract, there is no principal, as the entity has yet to legally come into existence. Thus, with a pre-formation contract, the owner is acting in his personal capacity. Accordingly, he has unlimited, personal liability on the contract.

The way to avoid this outcome is simple: The business owner should avoid forming any contracts until after the LLC or corporation legally comes into existence. Each entity is created formally under state law, by filing articles of organization with the state along with the appropriate fee. The state will approve the articles and send back a written acknowledgment indicating the date the entity came into existence. Only after this date can the owner act as an agent for the entity.

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When the owner mistakenly signs a pre-formation contract (without a novation clause), the owner has two choices:

The owner should first attempt to have the creditor sign a novation, which will release the owner from personal liability, and substitute the LLC or corporation in his place.
Failing this, he should carefully consider an indemnification agreement from the LLC or corporation. This agreement allows the owner to seek reimbursement from the LLC or corporation, in the event the owner is called on personally to honor the contract. However, this agreement has disadvantages: this agreement does not actually release the owner from personal liability as it is not signed by the creditor, and the agreement will make the LLC or corporation liable on the contract and, thus, expose the business's assets to liability, in addition to the owner's personal assets.

Again, the best course, obviously, is to avoid signing any pre-formation contracts.

In short, it is wise to wait until this written acknowledgment is received before forming any business contracts. Unfortunately, many small business owners form business contracts first and then form the business entity. It is easy to understand how this can happen. As the owner surveys the market for his business, many times contracts are signed to lease space, buy equipment and furniture, hire employees, etc. Somewhere in the middle or at the end of this process, the entity is formed.

Of course, it does make sense to survey the market before the entity is formed. A well-researched business plan is an essential ingredient in any new business's success. The business plan will include projected costs of doing business. Obviously, this requires that the business owner survey the market to document these projected costs.

The business plan will allow the owner to determine whether the idea is feasible. Thus, usually the owner should create the business plan and, accordingly, survey the market for the costs of doing business before forming the business entity. After all, why form an LLC or corporation first, and then find out that the idea for the business will not work?

However, the owner should make inquiries about the costs of leasing space, purchasing equipment and furniture, hiring employees, etc., just do not execute any contracts until after the entity is formed.