NFIB

Family And Friends As Investors: Staying Friendly When Your Business Hits Hard Times
10/ 29/ 2002

by Briar L. McNutt, Esq., Eckert Seamans Cherin & Mellott, LLC

Raising capital from family and friends has many advantages over other types of financing. Venture capitalists are typically unwilling to invest at the initial financing stage and generally demand hefty concessions in exchange for their investments, e.g., seats on the board or veto authority over business decisions. Family members, friends and acquaintances, however, will often invest early on and without insisting on control provisions.

Before you talk with family and friends about investing, you should make sure that your business is ready for outside investors. You should have a viable business plan backed by financial statements that have been certified or reviewed by an accountant. Your legal counsel should determine whether the entity under which the business was initially organized will accommodate investors, whether the business has a sufficient number of authorized shares or other investment units that it may offer to investors and whether corporate documents are in order. You, other officers and key employees should understand the legal obligations that the business will have to outside investors, such as providing annual financial statements and holding annual stockholders' meetings.

One disadvantage of soliciting investments from family, friends and acquaintances is the risk of family feuds or spoiled friendships if your business hits hard times. It may be impossible to avoid disappointment and hard feelings when your business goes sour, but the best way to reduce the likelihood that disappointment will lead to dispute, and dispute to litigation - and to put your business in a better legal position if it does -- is to create an "arm's length" relationship between your business and friendly investors. That means making sure that your investors understand and acknowledge the risks involved in investing in your business and adhering to all the formalities that a private securities offering to outside investors entails:

Be realistic about your prospects for success.

Avoid making overly optimistic predictions--either in writing or orally--to potential investors or the public about the prospects of the business or the return on investments in the business.

Screen your investors.

Be reasonably certain that potential investors have some business sophistication. At least make certain that they can afford to lose whatever money they are investing in your business. To be safe, many small businesses limit the pool of potential investors to "accredited investors." An accredited investor is a person with a net worth of at least $1 million or a person whose income in each of the two most recent years exceeded $200,000 or whose joint income with a spouse for those years exceeded $300,000 and who has a reasonable expectation of the same income level in the current year.

Provide full disclosure to investors.

"Full disclosure" means providing investors with written materials describing your business's operations, assets, liabilities, competition and risks -- all the information that investors need to know to make an informed decision about investing in the business. The disclosure materials also should describe investors' rights (if any) to have a say in the management of your business. They should clearly state that: (a) investors might receive no return on their investments; (b) investors might lose the full amount of their investments; (c) there is no market for the securities that investors will receive; and (d) the securities cannot be freely sold without compliance with federal and state securities laws.

Each potential investor should receive the disclosure materials.

Full disclosure to investors is important because the antifraud provisions of federal and state securities laws apply even if you qualify for an exemption from federal and state registration requirements. This means that you and your business may be liable for any false or misleading statements (oral or written) that you make to potential investors.

Enter into written agreements with all investors.

In the written agreements, investors should acknowledge that they have received and read the disclosure materials described above. The written agreements should also contain representations from investors that they have sufficient business sophistication to evaluate the risks of their investments or that they fall within the definition of an accredited investor. You should ensure that all signature pages are returned promptly and that the signed agreements are carefully maintained.

Raising money from friends and family creates emotional issues that can jeopardize both the personal and the business relationship when tough times come. The safest way to stay on friendly terms is to keep the business relationship strictly formal and make sure that investors understand and acknowledge the risks of their investments.

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Briar L. McNutt is an associate in the Business Division of Eckert Seamans Cherin & Mellott, LLC focusing her practice on corporate and securities law. She may be contacted at 412.566.2014 or blm@escm.com.

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