Alter Ego Liability Through Undercapitalization
Many businesses are incorporated, or are formed as limited liability companies, in part because the owners want to avoid personal liability for business debts. These forms of business entity shield the owners from personal liability. If the business fails, the owners lose their capital investment, but not their personal bank accounts, homes, and so forth. The law, though, permits an exception to the usual exemption from personal liability if the owners abuse the corporate or company form. This exception, the alter ego doctrine, can be applied in appropriate situations to attach the corporation’s liability, or the company’s liability, onto its owners.
Courts, in deciding whether to apply the alter ego doctrine, whether to “pierce the corporate veil,” and attach liability to owners, begin by reciting a two prong test that looks for an improperly close relationship between the owners and entity, and some element of unfairness, or injustice, to the creditor beyond the failure to pay a debt owing. The test, the prongs, are proven by showing that various alter ego factors exist, and the list of possible factors is long, including such abuses as the failure to issue stock to the commingling of entity and personal funds. Thus, in practice, the two-prong test cited by courts for imposition of the alter ego doctrine breaks down into a hunt for the presence of two or more factors from the list. Once an ownership interest in the questioned entity is established, then the number of alter ego factors is toted up and, depending upon how unfair the court thinks that the creditor’s situation is, imposes the doctrine or not.
Of the various factors cited by California courts in support of invoking the alter ego doctrine, undercapitalization is frequently the key factor. Adequate capital has been described as having:
“… [C]orporate assets sufficient for the conduct of the business. Inadequate assets or excessive debt or liability financing at the time of formation may suggest insufficient protection of creditors or tort victims. Adequate capitalization can be supplied through a mix of equity, indebtedness, insurance, or otherwise.” 
Yet assessing the adequacy of capital is complex, and raises two more questions:
How should the assets of the entity be analyzed?
Is capitalization measured only upon entity formation, or is it an ongoing concern after?
Capitalization Analysis – California courts often use descriptive terms to describe inadequate capitalization such as "grossly undercapitalized," "illusory," and "trifling." But these do not help business owners determine how much capital is adequate. Unfortunately, neither California statutory nor case law offers a bright line test or safe harbor for measuring the adequacy of capital. Courts say that the question is based in fact and is determined based upon the peculiar set of circumstances facing the business. They may rely upon testimony from financial experts and statistics comparing similar businesses.
Ongoing Adequacy of Capitalization – Whether a company in California has a duty to maintain a certain level of capitalization over the life of the business is unclear. So far there are no California cases directly ruling on this issue, although one court suggested that grace be given to shareholders of a corporation formed with adequate capital only to suffer financial hardship later.
Ensuring Adequate Capital - How, then, may a business owner defuse claims of undercapitalization, particularly given the lack of clear guidance from the courts which have wrestled with the issue?
We suggest developing and following a business plan, including a budget. Assess the size, nature and hazards of the business, particularly in comparison with similar businesses, and incorporate those considerations into the plan. Obtain liability insurance where feasible. Find capital through contributions or debt sufficient to meet the projected needs in the plan, and continue to watch those needs as the business operates.
Having a reasoned plan, and following it, should assist greatly if ever a creditor seeks to hold the owners liable for the debts of a corporation or limited liability company.
 2 Ballantine & Sterling, California Corporation Laws §298.02 (4th ed 1962).