What Legal Risk Is and Why It Matters
Indemnity clauses.
Just reading those words probably made your stomach drop a little, right?
Here's what usually happens: You're reviewing a client contract, you hit that indemnity section, and suddenly you're spiraling. You start researching "mutual indemnity vs one-way indemnity", convinced that fighting tooth and nail for mutual indemnity is the key to protecting yourself.
But there's a possibility you're fighting the wrong battle. Not that mutual indemnity is bad; it just may not be the most important change to fight for as it relates to that indemnity clause.
This my friend, is why legal risk matters. It helps you get clear about what to fight for in your contracts and in what priority.
When you understand legal risk, you can take a more strategic approach to contract negotiations because you'll know exactly what changes to ask for and stop wasting energy chasing contract changes that don't matter from a risk perspective.
If that sounds good to you, then let's get into what legal risk is and how it can change (and dramatically improve) your legal strategy.
What Legal Strategy Looks Like Without Understanding Legal Risk
To start, let's talk about what legal strategy looks like without incorporating legal risk. The way I like to think about is if your legal strategy is a tree, then legal risk is the roots. Without the roots the tree would die.
Legal strategy without legal risk doesn't quite look like death, but it's definitely not grounded in your business reality. Instead, without legal risk, most consultant's default legal strategy is protection.
Everything becomes about covering your ass, whether it actually matters for your business or not.
This protection-only approach shows up everywhere. You either become hyper-fixated on checking every legal box regardless of whether it's relevant to your business, or you avoid legal decisions entirely until you're forced into crisis mode.
Neither approach is effective. The "cover everything" strategy wastes money and energy on protections you don't need while potentially missing the ones you do. The avoidance strategy leaves you vulnerable to expensive problems that smart planning could have prevented.
But there's a third option - understanding legal risk so you can make strategic decisions about what actually matters for your business.
Let's talk about why the third option is the right fit for every business.
Understanding Legal Risk and the Four Management Strategies
What is Legal Risk?
Let's start by defining what legal risk is.
Legal risk is the potential for financial or reputational loss due to failure to comply with laws and regulations that apply to your business. This includes regulatory violations enforced by government agencies and potential lawsuits from customers, other businesses, or partners.
The key to understanding legal risk and using it to formulate your legal strategy is twofold:
Identify the risk and it's potential impact on your business
Decide how you want to manage it.
Since we already talked about indemnity, let's use it as an example.
Identify the Risk: I always tell people that an indemnity clause is like contractual insurance. It says that agree to defend your client against a lawsuit if the lawsuit brought against them is related to the work you did for them.
So what's the risk here? Well, that someone would sue your client and because the lawsuit relates to your work, you'd have to pay to defend against a lawsuit and you'd have to pay any potential judgment entered against your client in that same lawsuit.
And well, lawsuits are expensive. Most small businesses would struggle to survive one so this is definitely a risk we need to think about managing.
Decide How You Want to Manage the Risk: Once you know what the risk is, then you need to figure out how to manage it.
There are 4 traditional ways to manage risks. For brevity's sake, they are accept it, avoid it, transfer it, or reduce it.
When we go back to our example, we definitely don't want to just accept this risk as is. Even if there's a very small chance of an indemnity clause being triggered, its impact could be catastrophic on your business, so that's out.
Avoid it also isn't a great option since most corporate clients require some kind of indemnity. If you like making money, then it's unlikely you'll be able to avoid indemnity clauses in your contracts 100% of the time, but it's also worth a try to ask to have them removed.
That leaves reduce it or transfer it.
To reduce the risk, you would focus on narrowing the scope of the indemnity clauses itself so that it's only triggered in limited situation instead of *any* situation where your could potentially be involved.
Some examples are replacing the word "any" with "directly," stating specific causes of action or types of harm that you'll indemnify your client for, and or limiting the monetary amount of indemnity you'll provide (that's called an indemnity cap).
To transfer some or all of the risk, you could get a business insurance policy that would cover these types of situations, which would significantly reduce your potential financial exposure.
If you have lower risk tolerance, then getting an insurance policy AND narrowing the scope of the indemnity clause would be a great strategy.
Do you see how getting clear about the risk and how it impacts your business creates a clear management strategy?
You can do the same thing to analyze whether you need mutual indemnity by asking yourself who might sue you based on your client's actions as it relates to your work for them and then go through the same process.
The Three-Step Process for Identifying Legal Risk in Your Business
It's a bit easier to identify a risk when it's right in front of you like an indemnity clause in a contract, but figuring out how to identify risks across your business your business is another story. This is where lots of business owners get lost and default trying to check every legal box or ignoring the issue until there's a crisis.
Since we've decided not to do that (right?), let's talk about a 3-step process I use with folks who work with me to identify the legal risks in their business.
Whenever I start working with someone, I ask them the same three questions:
These questions may seem simple, but they do a great job of helping you wrap your arms around all the legal issues that impact your business.
I talk about them in greater detail in each of the blog posts linked above, but essentially, answering these questions will tell you the following, among other things:
Whether you need to register you business as a legal entity
Whether you need business insurance
Whether you need to work with an HR consultant
What website policies you need
What compliance rules you need to follow for marketing
What needs to be included in your contracts
How to approach IP protection for your business.
Why Legal Risk Management Matters for Your Business
Once you know what your legal risks are and how you're managing them, you can figure out how to take calculated risks to grow your business. Because the point of legal strategy isn't to ensure your business is protected; it's to put your business in a position make strategic decisions that create revenue generating opportunities.
Understand your business's legal risk and deciding how you want to manage them will help you:
You stop leaving money on the table in your contract negotiations because you'll be able to see where and how your business's assets come into play and charge your clients accordingly
You create alignment across your business operations. Your contracts, insurance, business structure, and policies all work together instead of against each other.
You build a foundation for sustainable growth. You know what legal protections you need now and what you'll need as you hit different milestones in your business.
You make strategic decisions instead of reactive ones. Legal questions become business decisions with clear frameworks for evaluation.
You allocate resources effectively. You spend money on the right legal at the right time instead of guessing up front or panicking in a crisis.
Most importantly, understanding legal risk stops legal from feeling like an obstacle to making money because you'll finally know how to use legal strategy to your advantage.
Ready to Identify Your Specific Legal Risks?
Understanding what legal risk is and why it matters is powerful. But here's what's even more powerful: knowing exactly which legal risks apply to YOUR specific business so you can manage them strategically.
Most business owners are flying blind and it's costing them money, energy, and time. But you don't need to be one of them.
To get started with your legal risk audit, check out Part 1: What Kind of Business Owner are You?