Updated: Jun 23
Starting a business with your best friend sounds like an exciting prospect. Imagine sharing the exhilaration of success and the lessons of failure with someone you trust and respect. But before you leap, I recommend you consider how to safeguard your stake in the venture so that your business has the best possible chance to succeed and your friendship continues to flourish.
Let's explore the steps you should take to protect your investment.
The first step would be to consider the advantages and disadvantages of owning a business with a friend; here is a general list of factors to consider:
Mutual Trust: You know each other's strengths, weaknesses, and work ethics.
Shared Risk: The financial risk of starting a business is divided.
Support System: You have someone to share the stresses and joys of entrepreneurship.
Conflict: Business decisions could lead to disagreements and strain the friendship.
Unequal Investment: Differences in capital, time, and effort contributions can cause friction.
Personal Liability: In some legal business structures, you could be liable for your friend's business-related debts.
Taking into consideration that all new business ventures come with risks, I recommend allocating some time and effort to complete this task before you decide to launch a business with a friend:
Each friend should write a list detailing what they believe the advantages and disadvantages could be if they decide to launch a business venture with their friend. You should be as thorough and honest as possible when writing your list, even if you are afraid that something you note as a disadvantage may offend your friend. After all, if you cannot be honest with your friend about the potential issues you foresee, how can you possibly expect to manage a successful business with them? After completing the list, review it together and develop a plan of action to address the disadvantages. Suppose you agree the venture could succeed despite the identified issues after appropriately addressing them. In that case, you are ready to take the next step in your journey to entrepreneurship.
But remember that taking this first step seriously can be the difference between launching a successful business and losing your entire investment.
A real-world example of business failure and the loss of a lifelong friendship
Early in my career, I worked for a successful start-up that ultimately failed because two best friends' expectations changed, and they could not agree on how to resolve their grievances. The friends decided to start a business together after working at a company for several years without opportunity for advancement. At first, all was great since they saw each other as equals and agreed on splitting the profits equally. The business grew significantly over the first three years generating over thirty million in yearly revenues. Over time, it became evident that one of the friends was a talented salesman, a deal closer, while the other was better at managing the jobs. As a result, they decided to change their roles in the company so each could focus on what they did best. Shortly after, the friend who was the deal closer chose to receive more of the company’s profit since he was bringing in the contracts and felt his contribution to the business was more valuable. The other friend disagreed, and within six months, the company was shuttered, and a lifelong friendship was destroyed.
If you are ready for the next step.
The next step is to choose a legal business structure best suited for the business. Entrepreneurs launching a new business often consider a general partnership, a limited liability company (LLC), or a corporation as a potential business structure. Each structure has unique legal, personal liability, and tax implications, so seek the advice of an attorney and Certified Public Accountant to help you choose the most beneficial structure. Here is an introduction to some key factors to consider when selecting a legal business structure:
A general partnership is the simplest form of business for two or more owners; the simple act of operating a business owned by two or more people creates a general partnership when the owners have yet to establish another business entity structure. Some states, like Massachusetts and Florida, do not formally require general partnerships to register the partnership with the state. General partnerships are most common with spouses-owned businesses, companies with very low litigation risks, or entrepreneurs looking for a low-cost-to-entry option.
Profit and Losses
In a general partnership, the partners will share the profits and losses of the business. The profits and losses are generally shared equally.
As partners, you will need to decide how to manage the company and how decisions will be made when there is a difference of opinion. However, it is essential to note that any partner can engage in a transaction, on behalf of the partnership, which legally binds the partnership without getting the express consent of other partners; this is a legal concept known as agency.
Partners are personally liable for the business's debts in a general partnership. However, selecting a limited liability partnership will limit the amount of liability exposure. But it is important to note that a partner may not be able to be protected from personal liability for harm caused by their actions; for example, a partner at a certified public accounting firm may not be released from personal liability for acts such as errors committed by that partner.
Limited Liability Company (LLC)
Operating a business under the limited liability company entity structure requires formal registration with a state. State laws regulating limited liability companies can differ, so it is essential to research the laws of the particular state being considered the domestic state of registry for the LLC.
Profit and Losses
In an LLC, the owners, known as members, will share the profits and losses of the business. Profits and losses may be shared equally, based on capital ownership or by agreement of the members.
In a small business, members generally share responsibility and authority in managing the business. However, members may choose to elect a managing member who will lead the company, while other members have less power in making decisions or are simply silent investors.
Owners of a limited liability company are also protected from personal liability. However, the protections afforded a limited liability company owner vary from state to state; in some states, owners may still be responsible for business debts up to their invested capital.
Operating a business under the corporate entity structure requires formal registration with a state. The corporate structure is considered a more complex choice as it comes with procedures that must be followed to maintain the corporate status—for example, filing annual reports with the state, holding annual meetings with shareholders, and maintaining certain types of corporate records.
Profit and Losses
Owners of a Subchapter C Corporation, known as shareholders, do not share in the company's profits. Corporations are not legally required to make any form of distribution to their shareholders. Instead, the owners receive income in the form of dividend payments generally paid from the corporation's earnings and profits only when the corporation’s board of directors votes to issue a dividend distribution. Shareholders who are also employees of a corporation receive additional income as compensation.
Shareholders of a Subchapter S Corporation generally will share in the profit and losses based on their agreed-upon allocations.
In larger corporations, a board of directors oversees the companies, but the day-to-day management is the responsibility of the corporations’ officers, such as the Chief Executive Officer. In closed corporations, companies owned by a small group of shareholders, generally, decisions are made by the shareholders without a board of directors' oversight.
Shareholders’ personal assets are generally protected from collection efforts by other stakeholders in the corporation, such as vendors, creditors, and taxing authorities. Their personal assets are also shielded from litigation arising from the corporation's acts. However, it is important to note that if you own a small corporation and seek bank financing, in most cases, the bank expects a personal guarantee from at least one shareholder who will assume responsibility for paying the loan should the business default.
Steps to safeguard your stake once the structure is decided:
1. Draft a Comprehensive Business Agreement
The document details ownership percentage, capital contributions, distribution of profits and losses, roles and responsibilities, dispute resolution procedures, and the process for dissolving the business if necessary. The execution of the agreement is a pivotal step in protecting your investment. The agreement should be prepared or reviewed by an attorney and signed by all owners before a notary public.
2. Consider a Buy-Sell Agreement
This prearranged plan outlines what happens if an owner wants to leave the business, dies, or is forced to leave. The buy-sell agreement is especially useful in helping control who can purchase an owner’s interest in the company. For example, if you do not want your mother-in-law to become your business partner, you can stipulate that the owner’s interests cannot be sold to specified parties.
3. Separate Personal and Business Finances
Separating personal and business finances is good financial practice. It also reinforces your company's legal standing as a separate entity, which will impact a determination of the validity of your personal liability protection if it were to be challenged in a lawsuit.
4. Get Proper Insurance
Depending on the nature of your business, different types of insurance (like liability insurance, property insurance, workers' compensation insurance, etc.) can provide added protection. Life insurance should also be considered when the death of an owner in the business could result in the failure of the business. The life insurance policy could be used to protect the investment of the surviving owner.
5. Seek Ongoing Legal and Financial Advice
Regular check-ins with your attorney and accountant will help you stay on top of any legal changes and make sure you are optimizing your tax planning.
Remember, seeking legal and tax advice tailored to your situation is essential. What works for one business might not work for another. Be clear, be open, be honest, and make sure you put everything in writing. Protecting your investment and your friendship will take work, but it can be worth the effort if you approach it thoughtfully and carefully.