Legal Considerations For Investing in a Friend or Family Business
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Updated on June 12th, 2022
When it comes to raising capital for a startup or seeking investment for a business, there are always multiple avenues that business owners can explore. These options include taking out a business loan from a bank, getting in touch with venture capitalists, or asking a friend or family member to invest in your business. Out of these three, asking your friends and family seems like the easiest option.
Even from the friend and family’s point of view, it can be a benefit to support their loved one and invest money into a venture operated by someone they trust.
Although it may seem like a simple transaction, there are a lot of things involved when you invest in a friend or family member’s business. Therefore, it is best to evaluate the legal considerations before you sign a check and commit a chunk of your savings on the basis of trust. In this article, we will discuss the legal aspects of investing in a friend or family member’s business.
Questions to Ask Before Investing in a Friend or Family Member’s Business
Whether your friend or family member has asked you to invest money in their business, or you have made the decision out of your free will, there are certain things that you should go over with them.
What You Are Getting in Return for Your Investment?
First and foremost, you should ask the business owner the terms of the investment deal. Since you are investing in their business, you need something in exchange for it. This can be a return of your capital with interest, percentage profit, company stocks or shares, equity interest, or something else. This can be sorted out by requesting or creating with them a terms and conditions sheet. Your expectations to each other should be conveyed clearly from the beginning.
Will You Receive Dividends or a Value Increase in the Investment?
Another thing you should ask from the person whose business you will be investing in is whether they will offer you dividends or interest payments in exchange for your investment over time or if you will receive an equity stake that will increase in value over a certain period of time. You might negotiate both.
If you agree on dividends, receiving a portion of the company’s profits regularly will ensure confidence throughout your investment period. Remember, dividends don’t lie.
What Happens to Your Capital When the Company Brings in New Investors?
Usually, businesses raise capital at different stages of their timeline, which means that there may be multiple investors involved in the business you are investing into. If you are given company shares in return for your investment, the new capital will increase the total number of shares and may also cause the dilution of your shares. Therefore, it is important for you to ask your friend or family member how the company dynamics will change once there are new investors.
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Legal Aspects You Should Consider Before Investing in a Friend or Family Member’s Business
Nearly a third of all startups have gotten their friends and family members to invest in their business, mainly because they are easier to convince and bring onboard, as compared to venture capitalists or angel investors, who focus on more established or promising companies. Although raising money through relatives or investing in a relative’s business is advantageous, there are several things you need to be cautious about.
Valuation and Company Structure
At the early stages, companies often give their friends and family large equity in the business for a smaller investment, which drives the company valuation through the roof and makes it difficult for angel investors or venture capitalists to get in on the action. The equity structure of the company won’t only cause problems for the company owners, but also their friends and family members.
If you have more than one friend and family investor, there might be bad feelings between them because some of them might have much higher equity than the others. Plus, the highly inflated valuation may lead to taxation issues for the investors.
Like all other types of investments, those made by friends and family members are also covered by the Securities Law of the US. However, there is always an exception that may apply when you invest in a friend or family member’s business. Therefore, it is very important for you to find out the rules and regulation that govern the way you can invest money into the business.
It is crucial to find out everything about the Securities Law and how it applies to your investment because any violations can put you in front of sanctions and heavy fines. For this purpose, you should also check the financial information and SEC licensing for the business, so that you know you are investing into a legitimate business.
The shareholder agreement is the most crucial part of the investment process, and it provides you with a set of rules that define your relationship with the business owner. Once you sign the agreement, both you and your friend or a family member have to adhere to it. Some of the common components of a shareholder agreement include the decision-making roles, the protocol for issuing new shares, the issuance of dividends, and the protocol in case a shareholder is incapacitated or dies.
When the shareholder agreement is being drafted, you should make sure that your interests and rights are properly represented in it. This would make it easier for you to understand how the investment process works, and also that you are secured from any kind of issues that may arise in the company’s operations.
Type of Business Plan
Even though you are investing in a business that is owned and managed by a friend or family member, you shouldn’t make the mistake of not having a look at their business plan. Granted, you may trust them enough and have confidence in their abilities, but this shouldn’t stop you from seeing if they have a solid business plan or not.
You would still expect them to make you a profit and also use your funds in the right manner. If the business plan is weak or not fully thought out, you should probably reconsider if you plan on getting your money back.
If it is a product they are selling and they have a prototype to show you, then you are in a better position to invest in their business since they have already put in some leg work on their product and it is not only a theoretical idea.
Over-Promising from Friends and Family
While you are deciding whether to invest in your friend or family member’s business or startup, you have to be realistic and prepared for the possibility that their business might fail or it might not gain enough traction to make a substantial profit. Naturally, the person running the business will be highly optimistic and encouraged to paint the prospects larger than they actually are.
But when things won’t materialize as they were supposed to, not only will you lose your hard-earned money, but it would also fracture your relationship with them. Therefore, it is best to keep realistic expectations, and also protect yourself legally. Otherwise, you may think that you have been defrauded or deceived by a person you trusted with your life’s savings.
Involvement of a Lawyer
Most people make the mistake of not hiring a lawyer when it comes to friends and family investments, usually due to it being an over the table handshake agreement. This can lead to complicated expectations of the business and return objectives and potentially problems with legal ownership of the business.
By hiring a lawyer, you’ll not only have an extra set of eyes to review the shareholder agreement and other documentation, but they will also be able to guide you regarding the legal considerations to keep in mind when making such an investment.
Types of Security
There are several types of securities that you can choose from when you are investing into a business. Some of the common options include equity securities, which are also known and offered as stocks, and debt, otherwise known as a loan. There is a tradeoff between the security of your principal and the upside you get to capture in the business’ success.
With equity you will do very well if the business is successful, but cashing out requires finding a buyer for your equity stake. With a debt position, you only get your principal and interest payments and the business owner can pay off the loan themselves, if they have the capital.
Sometimes business owners can get in over their heads with too many debt investments from friend and family members and the cash flow from the business just isn’t available to service the debt requirements. In that case they might ask is debt consolidation a good idea? And it of course the answer depends on the specifics of their business arrangement and how much debt they need to consolidate.
Another option that is the best of both worlds from an investor’s standpoint is a convertible note, which represents a loan that later transforms into equity for the company you are investing it. You get both the downside protection and upside potential.
Becoming an Equity Investor for a Friend or Family Member’s Business
How Equity Investments Work
Equity refers to the allocation of stocks and shares of a company. You should also know that in this investment, you get a certain portion of the company ownership. For instance, your friend or relative may offer you 10% equity for a $50,000 investment, which means that you are the owner of 10% of the company.
The best thing about equity investments is that your investment valuation will grow with the company valuation, especially after new investors have also joined.
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Documents Needed for an Equity Investment
There are several essential documents required when you have an equity investment agreement with your friend or family member whose business you are investing it. These documents govern your right of investing in the company, and also declare the terms and conditions of the investment. Moreover, they denote the transfer of shares to your name. Here are some of the documents that you should know about:
Certificate of Incorporation
The certificate of incorporation denotes the distribution of shares for a company. The business owners will have the certificate amended after the investment to include the revised ownership structure, as well as any provisions that may have put forward by the new investors.
Stock Purchase Agreement
The stock purchase agreement contains all the details of the distribution of stock. It comes after the term sheet, which contains all of the agreed upon terms between the investor and their friend or family member who owns the business. The agreement would also include legalities about the company status and composition.
Investors Rights Agreement
This document contains details of various rights given to investors, especially the participation rights, information rights, registration rights, and other details. It may also contain any conversion rights; in case the shares are meant to be converted into a future investment round.
The term sheet reflects the agreement between the company and the investor, and it includes all of the terms that both parties have agreed upon. Plus, it may also have terms that might not go into the final agreement.
Apart from these documents, there are several others that might or might not be a part of the investment agreement, particularly due to the nature of the friends and family investment. These documents may include the management rights letter, employment agreements, right of first refusal, voting agreement, and several others.
To protect your interests, you should also discuss with your friend or family member about what happens if you want to opt out of the investment at any point in time. Do you get all of your invested money upfront or through dividends, or is there a specific deduction that will be done from your money when you decide to leave the business.
Another thing you should include in the term sheet is how the company, and each investor’s share, will be valued in the event of a buyout. This should also include the steps that will be taken for the company valuation, as well as whether the investors will have a say in the matter or not.
What to Do if the Business Fails?
You may invest in your friend and family member’s business with full zeal and passion, but there is no guarantee that it will succeed and flourish. Therefore, you should know what options you have in order to secure your financing if this unforeseen occurrence takes place. Let’s have a look at some of the possibilities.
If you invest in the business of your friend and it doesn’t pan out, there may not be a need to worry, provided that you have discussed all these things before investing in the business. Chances are that you might not have done so, however, considering that you trust your friend or family member.
One of the things you could do to recover your investment is to liquidate the inventory. Of course, it won’t bring you back every cent, but at least it would help you recover a fraction of your money, so that you aren’t in a complete loss.
However, there is another thing that needs to be considered in this regard. Usually businesses have multiple investors, which means that you aren’t the sole owner or beneficiary from the liquidation of the inventory.
Therefore, the wisest thing to do is to discuss who gets what and how the money from the liquidation will be divided in case the business crashes. This needs to be done before the shareholder’s agreement is signed and the money changes hands.
What if there is no inventory?
If there is no inventory to liquidate in order to cover the losses, then the investors are in a fix, because there appears to be no way to recover any of the money they have pooled into the business.
At such a time, the only thing you can do is to sell your shares to an investor or buyer who may help in turning the business around, if you can find one.
Alternatively, you can convince the business owner or majority shareholder to sell their shares to another business or entity that may help get the business back on its feet. If this plan works, you may be able to recover your investment, and also make a small profit off it. However, this plan will take time and you will have to be patient.
What to Do if the Owner Stops Complying With The Terms?
According to the shareholder’s agreement, the business owner is liable to pay all the shareholders their dividends and profits according to the agreed upon terms. However, there are some cases in which owners stop doing so after some time, and there can be a number of reasons for this. In such cases, there are a few options that you can take.
As an investor in your friend or family member’s business, you are well within your rights to sue them for not paying you the dividends as per the agreement. However, you might not want to do so, considering the relationship that you have with them. Therefore, you can talk it out with them and try to come to an arrangement before you take any formal action.
Of course, it’s always better to be proactive and have a plan of action agreed on in the term sheet before you pull out your checkbook to invest.
As we have reiterated throughout this guide, you should always iron out every detail and discuss it with the business owner before you invest in their company. After all, this is your hard earned money, and no matter how much you love or trust them, you can’t be certain that their business will be successful or that they will have enough sustaining capital to honor their agreement.
Advantages and Disadvantages of the Friends and Family Investment
Now that you have a clear idea of what you should consider before investing in a friend or family member’s business, let’s have a look at the pros and cons of the decision.
Pros of the FnF Investment
- You know the people you are investing in: The best thing about this type of investment is that you not only know the business owners, but you can also trust them to be truthful with you about the company’s ins and outs.
- They will be more comfortable with you: When the business owners know the people they are pitching their plan to, they will be more confident and comfortable while doing so.
- They will have more freedom and control: Your friend or family member will have more control over the business development, as compared to an angel investor or venture capitalist that also dictate their terms and suggest changes to their vision.
- You will become an early investor: There are several perks to becoming an early investor in a business, because you get higher stakes without investing a lot of money. The investors that come after you will also help in increasing your valuation.
Cons of the FnF Investment
- You might not understand their business: Simply having enough money to invest in a business doesn’t make you an investor. If your friend or family member has a tech startup, you can’t invest in it unless you know a thing or two about tech.
- You might trust them too much: Even if they are your family members or friends, trusting them too much would mean that you don’t look at their business plan or evaluate their finances before investing, and this could incur heavy losses.
- You might risk ruining the relationship: If you invest into a friend or family member’s business and things don’t work out as they should, you might also risk putting the relationship in jeopardy, especially if things don’t work out or the business fails.
As you can see, there is more to this avenue than just handing over the funds to your loved ones. Taking note of the legal considerations beforehand is important because it helps you not only protect your relationship with the person, but also your business partnership and your rights.