Inadequate Capitalization: Courts Know it When They See it

In corporate law, “capitalization” refers to a corporation’s funding. Every corporation must be capitalized, at the time of formation and on an ongoing basis. And not just any capitalization will do: all corporations must be “adequately” capitalized to avoid piercing the corporate veil.  A corporation may be capitalized through an initial investment of money or other assets. Other forms of capitalization that may be considered include liability insurance coverage, loans to the corporation, and other equity.

What is Adequate Capitalization?

In a landmark 1964 United States Supreme Court case, Justice Potter Stewart famously said of obscenity: “I know it when I see it.” Determining what the proper capitalization is for a new corporation is a lot like Stewart’s obscenity test: there’s no bright-line rule for either one.

Courts generally consider a corporation’s capitalization to be inadequate if it is very small in relation to the nature of the corporation’s business and the risks attendant to the business. The bigger and riskier the business, the greater the capitalization requirement will be. A corporation that has one employee who manufactures and sells hand-made baskets will require much less in the way of capitalization than a construction company with 50 employees.

Why Should You Care About Adequate Capitalization?

One of the primary advantages of incorporating a small business is the protection that the corporate form gives to shareholders’ personal assets. When a corporation is a defendant in a lawsuit, the plaintiff may seek to “pierce the corporate veil” to reach the shareholders’ personal assets. Courts often cite inadequate capitalization as one factor that supports piercing the corporate veil: in fact, some corporate law experts believe that inadequate capitalization is the single most important factor courts consider when determining whether to pierce the corporate veil.