Limited Liability

What Is Limited Liability?

Limited liability is a legal arrangement under which the owners of a business, usually the shareholders of a corporation or the members of a limited liability company, are responsible for the company's debts only up to the amount they have invested or agreed to invest. If the business fails or is sued, creditors can generally claim the company's assets, but they usually cannot go after the personal savings, homes, or other property of the owners.

The idea is central to modern corporate finance because it separates the company as a legal person from the people who own it. The company can borrow money, sign contracts, and be sued in its own name.

How It Works

Suppose an investor buys shares in a corporation. If the company runs into serious financial trouble and cannot pay its bills, the investor can lose the full value of those shares, and that is usually the limit of the loss. Creditors cannot generally demand that the investor pay the company's debts from other income or assets.

There are important exceptions. Courts may "pierce the corporate veil" in cases involving fraud, misuse of a company to hide personal dealings, or a failure to follow basic legal formalities. Owners who personally sign a personal guarantee for a loan, a request lenders sometimes make of small business owners, are personally liable under that guarantee. Some professions and certain types of partnerships follow different liability rules.

Why It Matters to Investors

Limited liability allows people to invest in businesses they do not run, because their risk is capped at their stake. This makes it easier for companies to raise money from many shareholders, including through public stock markets.

For an individual investor, the practical meaning is that the most you can typically lose on a publicly traded stock is what you paid for it. That loss is capped, but it can still be total. Limited liability does not protect against falling share prices, and it does not guarantee that a company will repay its bonds or other debts. Because creditors bear more risk when owners are shielded, lenders often respond with higher interest rates, collateral requirements, or the bankruptcy process as a way to sort out what is owed when a company cannot pay.