There comes a time in the lifespan of just about every business where the potential for growth (maybe substantial growth) is there, but additional capital will be necessary to make that growth happen. It’s at these moments that you’ll probably start thinking hard about finding other people to invest in your business.

Some potential investors will want to become “partners” in the venture and have some measure of control or voting rights in making decisions for the business. They may also want to take ‘risk’ for a greater reward. Other partners, may want a fixed rate of return on their investment, and less risk or even some sort of ‘security’ for their investment.

When raising capital from others, I feel all of the options boil down to three types of ‘labels’ or ‘approaches’ for these individuals or entities.

INVESTORS – LENDERS – PARTNERS

A party to your business can rarely fit into more than one of these categories. This is a critical point!! Only with careful planning could a party be BOTH a partner and a lender…or an investor and a lender. Each ‘hat’ comes with a different set of documents, benefits, duties, and responsibilities.

If you have a party lending you money for a project wherein they receive a fixed rate of return (let’s say an interest rate, and maybe even points), but then they ALSO receive a share of the profit when the property or business sells, THEN they are a partner…NOT a lender. I can’t emphasize this enough!! If your money party looks like a partner at the end of the day when it comes to profit, there are now sucked into the ‘partnership’ for tax and personal liability exposure. You can’t call them a partner when it’s convenient and lender when it’s not.

However, a lender could be a great fit for both you and your money party. The positives include a fixed rate of return for your lender, and they have much less risk in the venture. Moreover, as a lender, you don’t have to listen to their complaints on how you run the business or answer to their recommendations or advice. If you are looking for a silent partner, the lender classification could be the perfect fit.

Yet, it’s important to know, as a lender they CANNOT share in the profits of the business with some sort of percentage of ownership or ‘back door’ payment based on the success of the business. This will drag you back into a claim from them under the SEC if you lose their money, and it can drag them into a lawsuit in your business if a creditor gets wind of your ‘creative’ relationship and knows there’s some ‘money bags’ partner behind the scenes.   Remember, if they quack like a duck, look like a duck, and act like a duck…then they’re a duck!!

We often work with real estate investors who are looking to raise money to purchase, rehab, and flip residential real estate. When this kind of fix & flip business takes a loan from a silent partner evidenced by a solid promissory note, and secures that loan with a first position deed of trust on the property being flipped, it has taken the note out of the realm of being a security because the note is “secured by a lien on a small business or some of its assets.” This approach works best when the small business actually has some assets (such as real estate). Don’t expect to avoid SEC scrutiny if you take a loan and give the lender no more security than a lien on the assets of a business that has little or nothing in the way of assets.

When documenting the lender’s relationship, it is absolutely imperative that the loan to the business be evidenced by a promissory note. In truth, this is simply good business practice to be using anyway, but at a bare minimum, the Note and terms should include the following information:

  1. The party making the loan, the party responsible to pay it back
  2. The amount loaned and interest rate
  3. How and when payments are to be made
  4. Whether there is a penalty for repaying the loan early
  5. The consequences of a default in the repayment of the loan
  6. If at all possible, secure the note with a first-position deed of trust on the real estate that is the subject of the deal or a personal guarantee at the least
  7. Do not give the lender a piece of the profits

Having a solid promissory note is great start. However, it really is just the start. A promissory note is still considered a security under federal law. Nevertheless, a landmark 1990 Supreme Court case called Reves v. Ernst & Young, helped clarify when a note is a security and when it is not. In that decision, the Supreme Court listed several categories of transactions that do not implicate federal securities laws. Among these categories are promissory notes “secured by a lien on a small business or some of its assets.”

Bottom line, when taking money from others to fund your business, make sure you understand their classification.  Are they lenders, investors or partners in your business?  If they are a lender, make sure to follow the proper procedures to make sure they stay classified as a lender if they lose their money.

Mark J. Kohler is a CPA, Attorney, Radio Show host and author of the new book “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”  and “What Your CPA Isn’t Telling You- Life Changing Tax Strategies”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP. For more information visit him at www.markjkohler.com.