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

In Part One, I talked about some of the more important questions overlooked (or usually glossed over) by people looking to invest in a friend’s existing business. In this part, I’ll delve into some of the key documents used to formalize the purchase of an interest in a business, what they are for and why they are important. For purposes of this article, we are going to assume that the business being invested in is formed and operated as a Limited Liability Company (LLC), although the concepts here are applicable to a corporation or partnership, too:

  • Operating Agreement –  As I touched on in Part One, this is a document that hopefully already exists. You should insist upon a complete copy of the version executed by your friend and his partners in the business, as well as any attachments and exhibits and amendments to it. Investing in a business without knowing with the operating agreement says is like buying an existing home without doing an inspection. The operating agreement should be carefully read by you or, if you are too busy to do it, by an attorney experienced in these matters and familiar with state LLC laws. Doing so will help confirm (or reveal potential problems with) such critical things as: Are new members even allowed? What is the process for admission of a new member? What, if any, are the restrictions on your rights as a newly admitted member? One of the dangers is you stroke the check to your buddy only to later have it revealed that new members are not allowed or can only be admitted with the consent of all current members (which was never obtained), making the transaction void and leaving you out the amount of your investment. So you may be saying, “I can just get my money back right?” Maybe. That will depend on your friend. As you can imagine, it’s always easier to get your money back when it’s still in your bank, as opposed to in the hands of someone else. If your friend is unwilling or unable to refund you, you would have to sue her, which will cost you time and money in legal fees and court costs, not to mention plenty of aggravation. I cannot stress enough how important it is to have a solid understanding of the business’ operating agreement and its provisions.
  • Letter of Intent (LOI) – Assuming the operating agreement gets your and your legal counsel’s seal of approval, the next step is often an LOI (sometimes referred to as a “term sheet”). Frankly, the LOI is not always necessary, particularly where the cost of having an LOI prepared may not make sense given the value and complexity of the deal. Think of the LOI as the parties’ outline or “cheat sheet” of the key business terms of the deal itself. It can be a good thing to consider with your attorney if the deal (or the personalities involved) are complex, constantly shifting, or certain problems are anticipated or need to be fleshed out. Simply put, the LOI helps to put all of the parties on the same page as to the essential deal points. Although it sounds counter-intuitive, a well-crafted LOI can actually save time and money in that it can highlight where the problems areas are with the investment almost right away and allow you to cut the deal short and walk away before the full cost and expense of having an attorney draw up the purchase agreement and amending the operating agreement (See below). If the deal proceeds, a good LOI can greatly help your attorney in the drafting process by cutting down on the guessing on how the parties want to handle important issues, as well as eliminating a lot of and back and forth on issues on which the parties have already agreed.
  • Membership Interest Purchase Agreement –  Provided you and your friend are ready to proceed with the deal, the membership interest purchase agreement is where the key business terms (as well as all of the other protective legal-ese) are actually fleshed out. Unlike the LOI which is usually non-binding, the purchase agreement is where things “get real” and once executed, is binding upon all parties who signed. It is in the purchase agreement that you and your friend (and her partners) put to paper what is actually being purchased by you, what the cost (and any terms) of such purchase will be, rights of access to the business’ financials and business operations, how much time you have to do your due diligence on the business, what specific promises or inducements were made to you by your friend and her partners, and what, if any, pre-conditions you need met before you are required to close on the purchase. In short, the purchase agreement takes the concept of you buying into your friend’s business and turns that into an actual event.
  • Amendment to Operating Agreement –  Once the parties have agreed upon the terms and conditions of your investment in the business, the operating agreement must be amended to reflect what you and your friend (and her fellow members) have agreed upon in the purchase agreement. It bears repeating that the operating agreement should be fully reviewed and understood BEFORE you get anywhere close to this far in the process. Amending or modifying the operating agreement will address such important topics to you as: what your ownership interest in the LLC and its profits and losses is, what your class of membership (if there are different classes) is, record what your initial capital contribution to the LLC is, what your role in the company will be, what, if any, and what voting rights you may have as a new member, among other issues. The amended operating agreement will then have to be signed by you and all of the other members. To summarize, the amended operating agreement is the contract between you and your new partners after you have bought in, providing the lanes for each of you to operate within in the operation of the business. It is what you will hold your friend (and any other partners) accountable to.

Corporation Commission Filings – Finally, once all of the above has been completed, as a new member you will want to make sure you’re formally “on the LLC” in the records of the Corporation Commission. Not only is this one of the things which you dropped your “not much” money investment for, but doing so also helps to make sure you’re covered under the legal protections of the LLC form in case anything goes wrong with the business (such as a contractual lawsuit or catastrophic judgment against the business) and not potentially exposed to personal liability. Of all of the above documents, this is probably the easiest action to take, and can generally be handled without an attorney.

Investing in any business, let alone one whole or partially owned by a friend, is not something to be taken lightly and should be done only after the deal has been carefully evaluated and properly documented. If you are interested in learning more or having legal counsel represent you in your proposed investment, consider using the form at the right to schedule an initial consultation.  While it will cost you 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