Tips when investing in a friend’s business

It can be tempting when a friend asks you to invest in his private business venture. But before saying “yes,” consider all the implications, and ensure your decision is not based on emotion.

Here’s one hypothetical case that outlines what you need to consider.

Case study

Mary’s friend Winston has offered her the opportunity to invest in his specialty candy store. She would be a silent partner in the business, which is structured as a limited partnership. If she invests $5,000 into Winston’s business, she’ll be paid up to 10% of the business’ after-tax profit over the next five years, starting from year two of operations.

Before investing as a silent partner, what should Mary consider? How would she gauge whether she’s getting a fair deal? What risks should she weigh, and how would her investment be accounted for in her taxes?

The experts

• Abby Kassar, vice-president, High Net Worth Planning Services, RBC Wealth Management Services, Toronto
• Jonathan Kleiman, corporate law and litigation lawyer, Kleiman Law, Toronto

What they say

Abby Kassar:

As a limited partner, Mary’s exposure to the debts and obligations are limited to the amount she has contributed. A limited partnership must have at least one general partner who has unlimited liability; in this case, Winston. Mary should ensure the agreement would identify her as a limited partner, not a general partner. The agreement should also outline:

• capital contribution of each partner;
• salaries;
• distribution of profits;
• winding up of partnership;
• withdrawal from partnership;
• death of a partner;
• arbitration of any dispute.

Regarding her payout over the next five years, she’ll need to define 10% profit after taxes. Will it include a deduction for Winston’s salary, and the salary of any other active partners, or not? Her friend’s salary could eat up profits, and Mary could find herself not getting any payout.

After five years, Mary needs to find out if she’d get her capital back, or if she’d continue to get a 10% share of the company’s profits. And, would she continue to be a partner after five years? If Mary wanted to be part of the business long-term, she and Winston could agree that she would continue as a limited partner until she’s ready to leave.

If Mary views this as a short-term investment, she could lend to the business and earn interest instead. If she extends a loan, she’ll receive interest payments, not income distributions. The agreement will ensure that her capital is returned after five years and that she’s earning a rate of return that she thinks is appropriate based on the level of risk associated with the business. If that’s the case, she may no longer be a limited partner. She would need to create a proper loan agreement to ensure that her capital is returned after five years. She may get a lower return as a lender, but her risk is lower and she may get a higher return than she would by buying a GIC.

As for taxes, the partnership itself is not a taxable entity. It operates as a flow-through vehicle: the taxable income is computed at the partnership level and allocated to the partners. The agreement will spell out in what proportion that income would be allocated; then, Mary would report her share of the income of the partnership on her tax return. Since the candy shop is a start-up, it will likely incur losses in the first few years. Those losses will also be allocated to the partners and Mary’s share could be reported on her tax return. She could deduct those losses against her other sources of income, which would result in tax savings.

Mary’s main risk is loss of capital, and the upside is she could generate a positive rate of return. She may not get the same rate of return as a stable investment. If the business has to wind up, she would lose her capital and the general partner will be liable for any additional obligations.

Jonathan Kleiman:

As a silent partner, Mary wouldn’t have any input on how the company’s run, but she should have a mechanism to hold the company accountable for its expenses, revenues, and business strategy. At least, the partners should come together periodically to go over what’s happening in the business. It may not be reasonable to do that every month, so a quarterly review should be fine.

Also, Winston might want to raise more money in the future and issue shares to a third party. This could dilute Mary’s shareholder ownership. So she should encourage Winston to incorporate and offer shares to the investors instead of maintaining this current partnership. This would give Mary her more protection under a shareholders agreement and generally more protection under the law.

Mary should request that the partnership agreement include exit terms, including a shotgun clause. In such a clause, either party can force the other to accept a certain offer to buy their shares, or sell their shares at that same price.

If Mary wants to be a private lender instead of a silent partner to ensure the return of her capital, the amount of interest to charge can be negotiated. It depends on how badly the business needs the money, and how many other options it has to raise funds, and the interest rates associated with the other options. Mary doesn’t need this investment, so she can push on the terms she wants.

What you learn

Investing in a friend’s business involves business and relational risks. That’s why it’s important to have a partnership agreement to ensure both parties understand what’s expected of them. The agreement should spell out the terms, including mechanisms to review the company’s financial status, and include an exit clause, such as a shotgun clause outlining how a partner may exit the business prior to five years.