So You Want to Invest in Your Friend’s Business (Part One)

At least once a week I get contacted by someone who is looking to “invest in a friend’s business”.  The call or e-mail usually goes something along these lines:

“I want to invest in my friend’s business”
“My friend actually owns X% of the business with other partners”
“I will be purchasing [some amount]% of my friend’s X%”
“It’s not a large amount of money, just $[insert dollar amount that is usually a large amount of money to most people]”
“I want to be protected”

Because this is a question that comes up frequently enough, I figured I would give my faithful readers a freebie and highlight some of the main (but by no means only) issues that come with sinking your money into a friend’s company, hopefully helping avoid potential friendship strains, misunderstandings, and pitfalls that often come with.   In Part One, I’ll talk about some of the questions you want to make sure you get answered and/or fully think through before taking the next step of hiring an attorney.  In Part Two, I discuss some of the main documents used in the purchase of an equity interest in an existing business.   Before I get into it, though, let me make clear what neither of these two articles will do:  I will NOT be discussing whether or not your friend’s business is financially sound or a worthwhile investment or if you should just take whatever you were planning on investing and light it on fire–that is outside the scope of my expertise and is strictly between you, your CPA or financial advisor, and your god.

In the excitement of a planned buy-in of a buddy’s business, it is important to take a breath, pump the brakes and make sure you know, find out, or understand the following:

  • Business Structure –  Is the business you’re looking to invest in operated as a corporation, an LLC, partnership, some other form (or none of the above)?   Not only is this question important from the standpoint of making sure your investment doesn’t turn into a potential personal liability, it is also an important first step in letting you (and your attorney) know what your options are and what will be required in order to make your stake in the business legally enforceable.
  • Equity vs. Loan – Are you actually interested in owning a piece of the business or are you just looking to help out (and perhaps make a better return than what you could get elsewhere)?  If it’s the former, read on; you will need to do certain things to make sure your ownership position in the business is memorialized and that everyone is on the same page.  If it’s the latter, consider a loan to the company, preferably secured by assets of the business (for example: equipment, accounts receivable, intellectual property, etc.) or even convertible into an equity position at a later date.  Generally, a loan tends to be more straightforward and, in most cases, as a creditor of the business (as opposed to just an investor) you will have preference for getting paid back if the business goes under (which, let’s face it; most businesses do).
  • Role in Business – Do you truly want to be a just a “silent” partner or will you insist on some a more active role or say-so in how the business is run?   Either way, to avoid potential misunderstandings and raw feelings (or, worse yet, an actual legal dispute), the operational documents for the business (for example: its ByLaws if it is formed as a corporation, or its operating agreement if it is formed as an LLC) will need to be evaluated, amended, and signed by all of the owners to reflect your new role, as well as your rights in and obligations to the business and your fellow owners.
  • Exit Strategy – What happens if you want out (or need out)?  How do you go about this under the rules and guidelines by which the business is run?  Can you freely sell your interest to another person or group or are you bound to sell only to your other partners?   Will the price for your stake be set by open negotiation or some other means, like a formal appraisal or set formula based upon pre-established criteria.  To get even darker (but no less probable) what happens if the company actually takes off and something happens to you?  How do you make sure your ownership interest is preserved for your surviving loved ones?  The short answer is, the business’ ByLaws, shareholder agreement, operating agreement, etc. (depending again on, you guessed it, the formal structure of the business) will shed a lot of light on these and other questions.  And if the business does not have such an agreement in place?  Although it may not necessarily be a deal-breaker from the business aspect, from an attorney perspective, it’s pretty darn close.

Although the above questions are not all of the issues you should consider before stroking a check to your good friend, going through each of these questions openly and honestly with your friend (and, heck, even yourself) first will help to head off future disagreements and might even save you time and money when you will have a lot of this already thought through and your attorney does not have to try and read your mind or waste precious billable time guessing your and your friend’s intentions and objectives.

In Part Two, we get to the fun stuff (well, for us attorneys anyway) and talk about the types of agreements commonly required for a proper and legal purchase of an ownership stake in an existing business.   If you can’t wait for Part Two, consider using the form at the right to schedule an initial consultation.  While it will cost something, an actual face-to-face consultation will always be more relevant to your specific facts and situation, and give you a far more tailored picture of your legal options, than what can be addressed in a general blog article.

Ben Bhandhusavee is the Managing Attorney for BhandLaw, a Phoenix corporate and technology law firm that works with start-up companies, creative intellectual property matters, and complex business and technology transactions.  Ben can be reached at (602) 678-2970 or by e-mail at bbhand@bhandlaw.com