Imagine, for a moment, a worst-case scenario: Someone has an allergic reaction to one of your products. Or a major contract falls through and you can't pay one of your suppliers. Somehow you find yourself staring down the barrel of a lawsuit.

Your company, or its insurance carrier, is likely to be out a lot of money. But what about you personally? Can someone suing your company come after your house as well? Don't assume the answer is no. It all depends on decisions you made when setting up your company and running it day to day. "Respect the difference between yourself and your business," advises Nicholas Taylor, counsel in the Emerging Companies & Venture Capital practice at law firm Perkins Coie. "To the extent you don't, courts won't respect it either if you get sued."

Here's how to best protect yourself:

1. Don't skip the paperwork.

"A lot times, people have great ideas and are eager to get into business, and they don't take the time to form a separate entity," says Taylor. It's well worth the effort, he says, to set up an LLC (limited liability company). And it may not be as much effort as you think. "You can do the bare minimum to get the company formed, then as the business makes money and risks go up, you can start doing the things complex businesses do. You don't need them early on."

The bare minimum means filing your company as an LLC in your state and then creating a basic agreement or charter outlining the rights and responsibilities of each of the owners, Taylor says. And, he adds, if you've got more than one line of business--say, a restaurant and also a car wash--create a separate entity for each.

2. Make sure you're insured.

"Have good general liability, business interruption, and casualty insurance," Taylor says. "Find a broker you trust and discuss which policies are truly necessary." In fact, he says, smart entrepreneurs form a team of advisers to help them with these sorts of decisions. "You should have a team: a good lawyer; a good CPA; and someone who's done it before whom you can use as an informal advisor," Taylor says.

3. Document your loans to the business.

Your company needs materials now and there's no money in the account, so you just spend your own cash, figuring you'll sort it out later. That's fine, but it's a good idea to create documentation every time you put in money, and make sure that it's defined as a loan rather than an investment. "A loan gets paid back before stockholders get any money," Taylor explains. "You have the right to get paid the same as the company's other creditors. If it's an investment rather than a loan, you have to wait until after all other creditors are paid off."

4. Make sure the business has enough capital.

As its name implies, a limited liability company specifically protects you from legal responsibility for your company's debts. But that protection isn't absolute. Courts can choose to override the LLC and hold you personally liable for what the company owes if there's a good reason--what lawyers call "piercing the corporate veil."

The best way to keep your veil intact is to make sure it never appears that you were using the LLC to run up debts you had no intention of paying. "Don't do anything to make it look like you're trying to defraud creditors," Taylor says.

In general, he adds, judges do know about the challenges facing small businesses and won't penalize you if your company falls on hard times. "Courts understand the difference between trying to defraud creditors and a Mom and Pop business that ran out of money."