Newland's Business Notes

Investing (Coming Into a Business)

Volume 11 Issue 3 -- May/June 2007

According to some Biblical sources, the Apostle Paul allegedly said “Now abideth faith, hope and charity.”  While faith, hope and charity may be a foundation of the New Testament, they are a poor foundation on which to begin a business venture, but all too often, faith and hope are the driving forces behind investors in new businesses. 

Let’s look at the example of Dim Witt (“Dim”), Ebb Ulient (“Ebb”), and Gun Ho (“Gun”), who are going to start a new restaurant called DEGUS, INC.  Dim is to invest money, $120,000.  Ebb will contribute land.  Gun will manage the restaurant. 

What should have occurred prior to the business startup is that Dim, Ebb and Gun  entered into a pre-incorporation (or pre-formation) agreement that spelled out exactly what was expected of each and what percentage ownership each would have, as well as other matters such as compensation for Gun and other particulars relating to how the corporation would begin and operate. Incredibly, pre-incorporation agreements for operations such as DEGUS are often not entered into by the principals even when they’re investing substantial sums of money.

The following scenario is one of many that might evolve between these three individuals. After DEGUS is started, Gun, who has started many restaurants before, is very successful in running the restaurant.  Because of the phenomenal success of DEGUS, two of the principals, Ebb and Gun, begin to realize that they might be in a better position if they had treated Dim as a “lender” to the corporation.

That way, he would not be an owner for the indefinite future and Ebb and Gun would thus be able to split the ownership and profits between themselves, 50%-50%.  Dim had faith and hope that he would own a one-third interest in DEGUS; however, he relied upon the charity and good intentions of Ebb and Gun who were supposed to take care of all of the business formation particulars.

There is a body of law designed primarily to protect innocents under which they are deemed to be shareholders or have an equity interest in ventures such as DEGUS.  It would be possible for Dim to institute a lawsuit to force Ebb and Gun to recognize Dim as a one-third owner.  However, lawsuits are expensive and justice does not always prevail.  

To avoid such problems later, it would have been far better for Dim, Ebb and Gun to have entered into a pre-incorporation agreement.  In that agreement, the roles of each of the three would be detailed in writing and would be enforceable.  Should Ebb later decide that he doesn’t want to contribute the land to the venture, he could be forced to do so pursuant to the pre-incorporation agreement.  Similarly, if Dim decided there was a better use for his funds, he could be forced to advance the funds for his stock.  Perhaps more important, the pre-incorporation agreement would document how the ownership interests would be issued and many other operational factors.

As simplistic as this scenario seems, it happens over and over again.  That investors and would-be shareholders can contribute large sums of money based on faith and hope, and receive no charity, is amazing.

There are numerous situations in which investors place funds in the hands of those involved in the formation of a business, whether it’s a corporation or a limited liability company, with little or no documentation.  Should one of the parties prefer to take the position that the advancement of the funds is a loan, then it becomes the word of one against the other as to whether the person who advanced the funds (Dim, here) is a lender or an investor.

There are advantages and disadvantages of each position.  A lender has a reasonable assurance of being repaid and, if the loan is properly secured, could be able to take action against the others individually or against property which may perhaps be security for the loan.  On the other hand, an investor is “at risk.”  Stated differently, the investor’s funds do not have to be repaid and if the venture “tanks” because somebody put rat poisoning in the food at DEGUS, then the money of the investor (Dim, here) is lost. 

Perhaps the main message to be taken here is to have proper documentation.  Written agreements do not insure success but many of the problems concerning advancing funds to a business based on faith and hope may be avoided.  

Call Newland & Associates if you need help with regard to documenting a new business venture.

Copyright 2007

Published by the law firm of Newland & Associates, PLC
9835 Business Way
Manassas, VA 20110
Call us at (703) 330-0000 for a full range of business law and tax-related services.

While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.

Redistribution or other commercial use of the material contained in Newland's Business Notes is expressly prohibited without the written permission of Newland & Associates, PLC.

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