I recently spoke with someone who started a small, one-person business in a creative field. One of his friends has some good ideas and contacts within the industry and wants to invest. What are some things the business owner should be aware of (or beware of) before accepting the investment and bringing his friend into the company?
“Both parties need to understand that business is inherently risky and should commit to separating any business failure from personal friendship,” says David Waring, CEO and co-founder of Fit Small Business. That advice sums up what every expert I reached out to said about going into business with a friend.
And it is important advice to consider, as Scott Hasting, co-founder of Betworthy LLC, stresses. “Adding a partner to your business is perhaps one of the most critical decisions that can spell success or failure for any budding enterprise,” he says.
Yet, in spite of the business world being littered with bits of relationships broken apart by partners who have gone (or been forced to go) their separate ways, there always will be entrepreneurs who opt to bring a friend in.
“The best way to avoid this is to not mix business and pleasure, and keep your personal friendships separate from your business partnerships,” says Waring. “But if the friends want to move forward with an investment, it’s better to be honest and clear about what the opportunity is, and about all of the potential risks that come with pursuing the opportunity.”
If you or someone you know is intent on partnering with a friend in a new business venture, asking these questions before taking the plunge can help avoid some of the most common pitfalls of partnership endeavors.
Does the partner bring a unique benefit? “The main thing to consider is whether the new addition will actually bring any benefit to the company that could not be attained without bringing them in as an owner,” Hasting says.
Are you willing to risk the friendship? As many former business partners can attest, going into business as friends ultimately can shatter the friendship. “He should be aware that by accepting the investment and bringing on his friend, that person is no longer just a friend, he’s now a business partner — the friendship dynamic is forever changed,” cautions Steve Waters, founder of CONTRACE Public Health Corps.
“Regardless of the legal agreement between them, the practical reality is that he is now a guardian of a financial investment from his friend. He should ask himself if he’s comfortable with the potential fallout to his relationship with the friend if the business fails.”
Is there a business strategy in place? This should include a description of each owner’s role and plans for handling any conflict resolution — and it should be in place before taking any outside investment.
“Many times, when it is a friend or relative, there is a trust factor that leads to overlooking key details,” says Mark Painter, CFA and founder of EverGuide Financial Group, who has been advising small businesses for more than 17 years. “Write everything down when it comes to strategy and roles and make a conscious effort to revisit this on a regular basis to make sure that things stay on track.”
Are you protecting your stake in the startup? “Giving up equity stakes can be a real trap if the other party has intentions of taking over or changing the direction of the business,” Hasting says. “Make sure there’s a healthy relationship maintained on trust, and even then, sign a legal contract spelling out the rights, obligations and responsibilities of the owners.”
Are you prepared to lose your business independence? Gaining a business partner means losing the biggest benefit of being what Waters calls “a solopreneur.” That benefit: “He only answers to himself,” Waters says. “Does he really want a partner? Does he need a partner? Does the friend bring enough to the table that it’s worth giving up his independence?”
Have you discussed what you don’t agree on? As Waters notes, most small business partnerships begin with a conversation about all the things they agree on. “It should be focused on what you disagree on, and if those disagreements are workable or are a bridge too far,” he says. Potential partners should have a long, in-depth conversation about where their viewpoints differ.
“For instance, what do they each think of the idea that ‘the ends justify the means’? Is one of them willing to do anything it takes to see the company succeed, and the other isn’t comfortable with that?” Waters asks. “You would be surprised at the philosophical differences that come up with that question, even between close friends.”
Discovering differences in mindset — strategic, ethical, or even political — is imperative. “All of those differences will come to the surface when things aren’t going well, and by that point it’s often too late — you’re stuck with that person,” Waters warns.
Will the new partner’s role depend on continued involvement? “Often, business owners have a need for a service provider and think it would be cost-effective to make them an owner rather than an employee,” explains business attorney Shushan Barsegyan, owner of Full Circle Business Law.
“Not only is that potentially an ineffective way to get around labor laws, depending on the state, it’s also risky if done without safeguards. What happens if the partner stops providing those services? Or the quality drops below expectations? It’s important to know whether the ownership will be contingent on any continuing obligation.
“This is true with an investment, as well. Will there be a continuing obligation to contribute funds? Many of the disputes we see arise out of one partner dropping below expectations and there being no mechanism to address it.”
Have you considered voting rights? That is another often-overlooked area, Barsegyan notes. “It should be clear whether or not that person will have the same voting rights as the business owner,” she says. “If not, then the owner may want to reconsider the entity type — corporation versus LLC, for example. Some entity types provide more flexibility with investment versus voting rights [than others].”
What will the repayment obligations be? Barsegyan says this is an important point that must be clarified from the outset of the partnership. “Is the investor expecting to be paid out before the original owner? Will the owner be able to bring on additional investors and dilute everyone’s interest equally or will there be restrictions?” she asks.
All of these things, of course, are “easier said than done,” Waring admits. But they’re necessary when considering bringing on a friend as a business partner.
“Both parties need to understand that business is inherently risky,” he concludes, “and they should commit to separating any business failure from personal friendship.”