Are Founders Ever Liable When Their Startups Fail?

Last week saw the latest startup implosion. This was a company that tech media (and the company itself) hyped up as a future unicorn. The company was recognized by organizations that rank the top startups in the nation and everything looked great on the surface. This cautionary tale (no one will actually pay attention, so it’s not really “cautionary”) involves a startup that raised close to $200 million and, between what they did to themselves and coronavirus finishing them off by pulling out one Jenga piece at a time, just sold for $3 million.

Of course, in these situations, investors aren’t getting their money back. And aside from whatever money the founders took off the table (often more than they truly should have) during those fundraising rounds, the founders aren’t getting any money either.

And when this happens, there seems to be a belief that everything just goes away. This best case (and pretty unlikely) scenario being that the founders and investors cordially agree that they took a nice swing at the fence and while the ball looked like it was going to be a home run, sharply dipped into the outfielder’s glove as the uncertain footing of the warning track became a very hard wall. 

But is there really no situation where the founder of the startup can be held personally liable for some of the debts of the company?

Of course they can, explains New Jersey lawyer Michael Epstein

“Each startup is different. Assuming well-executed legal startup formation the startup itself is a legal entity responsible for its own debts. However, there are many circumstances where founders personally assure debts, particularly in the early days or even before the startup’s legal status was solidified.”

This happens all the time. The first problem is when founders do what so many founders need to do in the early days, which is use personal debt to fund their startup. There are companies out there now that are trying to fill the gap between the need for early stage startups to have access to a credit card and the danger of founder liability. Several new financial products, including Brex, seem to be trying to fill this gap, giving founders the ability to use credit card debt for the startup without being personally liable for it. None of these products comes without significant downsides, so read your fine print closely. 

But the much larger problem isn’t about the inevitable credit card debt in launching a startup, it’s about when founders essentially attach themselves to much more significant debt. They could (and absolutely should not) personally guarantee debt/investment into the business, not looking ahead to see that if the startup ends badly (and the vast, vast majority actually do) they they may not be able to walk away obligation-free. 

The danger may be more pronounced in startup verticals that scale quickly. Last week’s news that the startups in the electric vehicle space are in trouble should come as no surprise, nor should it if we find out that some of these companies took nontraditional funding routes that may involve personal obligation for company debts. 

Another type of founder liability that is far too rarely discussed is when founders are held liable for negligence and other wrongdoing. Imagine you had a startup that had terms of service with your users limiting what you could do with their data. And then you either chose to do some nefarious things with it or simply ignore inappropriate uses of their data that a reasonable startup founder should have caught. In a situation such as this there is the possibility that tort (and/or contractual) law comes into play and some liability attaches there. This could involve founders being named individually to a lawsuit, not simply the startup itself. 

This is all complicated territory, so the best advice is to always get your legal work done upfront in a reasonable, reliable way. Building new things is great for you personally and can have a huge benefit for our society. Yet founders are never going to fully eliminate personal exposure, so going into your new business with a solid legal foundation is the first think I teach my business school students and it’s what you should also always keep in mind in launching your new venture. 

About Aron Solomon

Aron Solomon is the Head of Strategy forEsquire Digital and an adjunct professor of business management at the Desautels Faculty of Management at McGill University. Since earning his law degree, Solomon has spent the last two decades advising law firms and attorneys. He founded LegalX, the world’s first legal technology accelerator and was elected to Fastcase 50, recognizing the world’s leading legal innovators. His work has been featured in TechCrunch, Fortune, Yahoo!, ABA Journal, Law.com, The Boston GlobeThe Hill, and many other popular publications.