Are you thinking about bringing on a silent partner? There comes a time in the lifespan of just about every business when the potential for substantial growth comes to fruition. Additional capital may be necessary to make that growth happen, and it’s at these moments you’ll probably start looking for people to invest in your business.
But before you take somebody’s money and start calling them your “silent partner,” be careful. How you structure that relationship can determine whether you’re dealing with a business partner, a lender, or an investor subject to federal and state securities laws.
Your first step? Understand the difference between investors and true business partners.
Silent partners generally want to “set it and forget it” when it comes to their investments. They want to invest money in an enterprise, but they don’t want to spend their time and effort helping the business make decisions. However, they still want to see a significant return on their investment.
The scary part here is the term “significant return.” Silent partners are taking a risk investing with you, so they usually want a bigger bang for their buck than stocks, bonds, and mutual funds might offer. But you may simply want someone who gives you money, sits back, doesn’t get involved, and doesn’t have a say in what you do or how you do it.
That’s where securities law can enter the picture.
The name you give the relationship isn’t what controls. Calling someone a “silent partner” doesn’t automatically prevent their investment from being treated as a security. Under the Supreme Court’s Howey test, an “investment contract” generally involves an investment of money in a common enterprise with a reasonable expectation of profits derived from the efforts of others. Whether a particular arrangement qualifies depends on the actual facts and circumstances.
Think about that. Someone gives you money, expects to make a profit, and relies on you to do the work necessary to generate that return. You need to know whether you’re offering a security before you start taking their money.
There are three structures you may want to consider when bringing money into your business:
Each has different legal, tax, and financial consequences.
Bringing on a money partner as an actual business partner has several pros and cons. Your partner can share in the profits, and you may even get the help, experience, and advice of an excellent partner.
But simply giving someone the title “partner” doesn’t automatically take the arrangement outside securities laws. The actual ownership rights, management responsibilities, decision-making authority, and economic reality of the relationship matter.
If you’re bringing someone on as a true business partner, treat them like one.
They should have the ownership, voting, management, or other rights established in your governing documents. The documentation from the beginning of the relationship needs to accurately reflect what they actually are.
The point is simple: Don’t call someone a partner on paper while treating them like a completely passive investor in practice and assume the label solves your securities problem.
If you want a real partner, structure the relationship as a real partnership and have an attorney determine whether the ownership interest or transaction creates securities-law requirements.
A lender relationship could be a great fit for you and your money partner. Rather than giving the person ownership in the business, you borrow their money and agree to repay it according to specific terms.
The positives can include a fixed rate of return for your lender and no ownership rights in the underlying business. Moreover, if they’re legitimately a lender, you generally don’t have to give them a vote on how you run the business or follow through with their recommendations or advice.
But don’t play games with the paperwork. If the person is supposedly a lender but the deal really gives them an equity-style participation in the success of the business, you need legal counsel to determine what you’ve actually created. Also remember that notes themselves can potentially fall within the securities laws depending on the facts and circumstances.
Having a solid promissory note is a great start. At a bare minimum, the promissory note and terms should address:
If it’s a loan, document it and treat it like a loan.
While bringing on a lender can be a great option, some silent partners want more than an interest rate return on their money. They want to share in the profits or growth of the business without worrying about how to run it.
Now we’re squarely in territory where securities laws need to be considered. Every offer and sale of securities must either be registered under the Securities Act or qualify for an exemption from registration. For many privately held businesses raising capital, one possible route is an exempt offering under Regulation D.
Regulation D isn't one single exemption. Current SEC rules include Rule 506(b), Rule 506(c), and Rule 504, and each has different requirements.
For example, Rule 506(b) generally prohibits general solicitation and permits an unlimited number of accredited investors and no more than 35 qualifying non-accredited investors. Rule 506(c), on the other hand, permits general solicitation, but all purchasers must be accredited investors and the issuer must take reasonable steps to verify their accredited status.
Here’s a short checklist if you’re considering bringing on an investor through a Regulation D offering:
A company relying on Regulation D generally must file Form D with the SEC within 15 days after the first sale of securities in the offering. States can also require notice filings and fees even when federal law preempts state registration requirements under Rule 506.
The path of a Regulation D offering needs to be followed carefully to make sure the applicable rules are being satisfied. This is a path that a small-business owner would be foolish to follow without the guidance of an experienced securities attorney.
I would remove the original statement that you should “expect to spend at least $15,000.” That's too specific and isn't something we can responsibly keep current without Mark giving us an updated figure.
BE CAREFUL using the words “investor” and especially “silent investor.” More importantly, don’t assume the terminology you use determines what you’ve created. Consider all of the options for a person or entity putting money into your business or project and use the right structure, terminology, and documents.
Whether they’re going to be a true business partner, a lender, or an investor, figure that out before you take a dime. The wrong structure can expose you to securities-law problems, disputes with the person funding the deal, and a legal mess that could have been avoided from day one. If you’re bringing outside money into your business or project, book a Comprehensive Tax and Business Consultation with my team at KKOS Lawyers before you make the deal. They can help you choose the right structure and put the proper agreements in place to protect you, your business, and the person putting up the money. Don’t wait until there’s a dispute, the investment goes south, or the SEC comes knocking to find out you structured it wrong.