Business Law

Investing Directly in a Business

There are a lot of ways to invest money in a company. Generally speaking, though, you can divide investment vehicles into two different categories: direct and indirect investments. With a direct investment, you actually acquire an ownership interest in the company, for example, as a stockholder or a partner.

If you are making a direct investment in a business, whether it is a public company or a mom-and-pop grocery store, it is extremely important to understand the nature of your investment. Otherwise, you may be setting yourself up for personal liability exposure.

The terms and conditions of any paperwork that you sign (or don't sign) most likely will determine whether you ever get some or all of your money back on your investment. For example, if the company is sold or liquidates, who gets their money back first?

Direct Investments

The primary legal vehicles through which you can make direct investment in a business are:

The Corporation

A corporation is the tried-and-true business entity through which investments are made, as a corporation could serve as a shield to help insulate investors from personal liability exposure. There may also be tax benefits to incorporating, even if the business fails.

A corporation is a legal entity that the law treats as a "person" in the sense that the corporation has its own name and identity separate from the owners. A corporation:

  • Pays taxes
  • Has the ability to enter into contracts
  • Can own property
  • Can sue and be sued
  • Can sometimes be charged with and convicted of crimes

As a separate legal entity, a corporation serves as a shield between the owners and third parties doing business with the organization. So long as corporate formalities are observed, the corporate shield makes it difficult for third parties to go after the owners personally. In other words, if the corporation is sued, the only thing that's usually at risk is the assets of the corporation. A lawsuit could not reach into the pockets of the individual owners. Instead, creditors and other third parties can be limited to going after assets of the corporation.

The Sole Proprietorship

Although maybe not the best alternative in the long run, the simplest and cheapest way to start up a business is as a sole proprietorship. A sole proprietorship means that someone is doing business in an individual capacity and not through any type of business entity.

You can invest in a sole proprietorship by loaning money to the business. But if your investment is something more than a loan, the business may be deemed to be taking on another owner and would no longer be a sole proprietorship. Instead, there is a good chance that it would be labeled a partnership between you and the original owner.

The Partnership

A partnership involves two or more people undertaking a business venture as co-owners, with an intent to make a profit.

The General Partnership

Forming a general partnership is easiest way to go into business with another person. But the simplicity of a partnership can be its downfall, so careful planning is important. One of the principal drawbacks of a general partnership is that a general partner can be held responsible for all debts and liabilities of the partnership. For example, a general partner with only a 1% interest in a business could still be held liable for 100% of the debts and liabilities of the partnership.

The Limited Partnership

From a tax standpoint, it's sometimes better to invest in a partnership rather than a corporation. But in order to address the issue of potentially unlimited personal liability, most states recognize another type of business entity that is called a "limited partnership." A limited partnership must have at least one general partner, but all of the other investors can be limited partners whose potential liability exposure can usually be limited to the extent of that partner's investment. One of the resulting tradeoffs, though, is that an investor must take a passive role in the operation of the business in order to maintain the status of a limited partner.

In many regards, being a limited partner is comparable to a shareholder in a corporation.

The Limited liability Company

A limited liability company is perhaps best described a hybrid of a corporation and a general partnership. It's treated as a corporation for limited liability purposes, but is treated as a general partnership for tax purposes. The owners are called "members." Unlike a shareholder or a limited partner, they don't have to take a passive role in the business. A variation is the limited liability partnership, which can be formed in certain instances by professionals such as lawyers, accountants or engineers.

The Nonprofit Corporation

Just because a business is called nonprofit doesn't mean that it can't make money. One significant limitation for nonprofit corporations, though, is that they cannot take on investors in the traditional sense, because they do not have shareholders. So the only way a person may be able to invest in a nonprofit would be through a loan or some other non-equity investment means.

Questions for Your Attorney

Before creating or investing in a company, it's important to make sure you understand the company's structure and how that structure can potentially affect you.

Among the questions to consider asking your attorney:

  • Do you have prior experience working with different corporate structures?
  • What are the advantages and disadvantages of the corporate structure I'm considering?
  • How much personal protection do I have if the company is sued?
  • How much money could I potentially lose if the company goes out of business?
  • How much do you charge for your services?
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