Family And Friends As Investors: Staying Friendly When Your Business Hits Hard Times

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.

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

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.

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 [email protected].

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