Limiting liability

Starting a business is an extremely creative process. Just think of the Internet with its cornucopia of Web sites, the astonishing range of goods on sale in every high street, the ingenuity behind the mobile phone, the laptop computer and the many life-saving drugs developed by the pharmaceutical industry, or the extraordinary mix of talents that can come together to create a big-screen movie. This is what motivates people to start a business. Without an idea to believe in, the drive to see it through to fruition, and a willingness to devote every waking moment to making it a success, no-one in their right mind would start a business.

Because starting a business is also very risky. In the UK, despite considerable government support, nearly one in three start-up companies fail within their first three years (Department for Business, Innovation & Skills). This is where the ‘hockey stick’ comes in. Draw a graph in which the horizontal axis represents time, moving into the future as you move right, and the vertical axis represents cash in the bank. The graph starts at zero and rapidly moves downward into negative territory as you make initial purchases of equipment and raw materials, pay the deposit on suitable premises, advertise for staff, and start paying rent and salaries. As time goes on, the business starts to generate income, slowing the graph’s decent. Eventually, perhaps some months later, sales start to exceed costs and the graph stops going down and turns upward. If the business is a success the graph will eventually cross the zero line, perhaps a year or two later, and continue upward as the business moves into profit. The reason it is described as a hockey stick is because that is what you hope will be the basic shape of the graph, starting with the blade and then moving on to the shaft as the graph turns upward.

For the entrepreneur, the important points on the graph are the turning point, where the graph stops moving downward, and the point when the graph finally crosses the zero line and moves into positive territory. The depth of the turning point represents the initial investment that he is going to have to raise if his business is not to go bankrupt before it gets going. The crossing point represents the time, if all goes to plan, at which he can expect his business to move into profit. If he does not have sufficient savings to make that initial investment himself then he will have to borrow, and few institutions will lend to an unproven start-up without some sort of surety. Alternatively he will need to seek investment from a venture capitalist or a ‘business angel’, but they will be expecting a substantial return within a specified period, and a substantial commitment from himself.

So the biggest danger faced by the entrepreneur is bankruptcy. If he gets into a situation where he cannot settle an outstanding bill or debt, then he must either file for bankruptcy or risk facing a bankruptcy petition filed by a creditor. If the court determines in favour of the petition then it will appoint a receiver with the power to seize and liquidate the debtor’s assets and use the proceeds to settle outstanding debts Nowadays such assets do exclude tools of trade, pension funds, and certain essentials such as clothing and bedding, but otherwise everything must go.

In addition the bankrupt risks facing criminal charges. Purchasing goods and services in the knowledge that you do not have the funds to pay for them amounts to fraud and has always been treated very seriously: after all, it is an affront to the trust that underwrites the market. It was only in the 18th century that courts began to accept that bankruptcy was not necessarily a criminal act, and were given the power to discharge a bankrupt after a suitable period of time. On the other hand, clear evidence of fraud could result in the death penalty, while imprisonment remained common until abolished by the Debtors Act 1869, except in cases where the debt involved a fine or payment ordered by a court, or there was clear evidence of fraud.

To be continued …

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