Part 1 of a series about raising funds for startups: The family and friends round, where careful documentation is important to avoiding personal liability.

Entrepreneurs are full of ideas. After an entrepreneur comes up with an idea, the idea can turn into a startup. During this time, unless the entrepreneur is independently wealthy, the entrepreneur needs to raise a certain amount of money, to pay for things like computers, software, outside technical help, modest office space, lawyers, accountants and so forth. These expenses will not be huge, but they are necessary to get the startup off the ground. Often, the entrepreneur raises this money in the first round of fundraising, the family and friends round, before moving on to the next.

According to the Small Business Administration, about a third of new businesses survive for two years but fully half are out of business within five years. The entrepreneur, as well as any investors, lose their money. Although most family and friends will understand that one lends to a relative or friend with full understanding of the risk of nonpayment, others might want to try to collect something if the startup fails. Further, if the startup is not successful, the entrepreneur will want to do what is possible to protect family and friends from outside creditors. This blog post looks at some of the things an entrepreneur can do to minimize risk to the entrepreneur as well as to family and friends.

Personal Liability

When a person incurs a debt, yet is unable to repay it, a creditor can go to court to obtain a judgment against the person. A judgment is like a hunting license: The creditor can attempt to seize the debtor’s property and sell it to satisfy the debt. There are limitations on what property the creditor may seize; some of it is exempt from execution. But enough items of property are vulnerable to execution to make the entrepreneur want to avoid personal liability and potential liability for family and friends.

Organize as a Corporation or LLC

One way to reduce liability on the part of the entrepreneur, as well as family and friends, is to organize as a corporation or a limited liability company early in the life of the startup. The reason for organizing is that both corporations and LLCs provide protection against individual debt. If the entrepreneur’s startup becomes a corporation or an LLC, and debts for services rendered or goods purchased are in the name of the corporation or LLC, then the individual entrepreneur cannot be held liable for them unless the entrepreneur treats the corporation or LLC as a personal bank account rather than an independent entity under the law.

As an example, suppose the startup needs some furniture. The entrepreneur goes to an office supply store and opens an account in the name of the startup as a corporation or LLC. Unless the entrepreneur personally guarantees the debt, then if the startup suffers hard times and is unable to repay the debt, the entrepreneur will not be liable for it.

Avoid any Hint of Partnership with Family and Friends

A partnership is the worst form of business entity for a startup or, for that matter, any other kind of business. The reason is that under the law, each partner has the power to bind the partnership to a contract, even if the other partners know nothing about it. Partners can be held personally liable for partnership debts, including those incurred by their partners. Avoid partnerships at all costs.

By the same token, the entrepreneur should avoid any arrangement that might conceivably subject family and friends to liability as partners. For example, if an investor is merely a shareholder, the investor cannot be held liable for corporate debts. But if the investor takes an active role but informal role in running the corporation, it’s possible that an imaginative attorney could figure out a way to hold the investor liable as a partner, especially if the corporation does not keep good books and records.

Use Notes to Evidence Loans

Sometimes entrepreneurs make handshake deals. This is a good thing so long as the entrepreneur and the investor consider the handshake only as a broad outline of their agreement and a good faith promise to negotiate a final deal. Some people think documenting a loan is contrary to the idea of working together in good faith. To the contrary, when the parties write up their respective obligations, they often find that they disagree on minor details or that there are issues they have not yet considered. Putting the deal in writing helps to clarify things and avoid confusion and mistrust.

A written document also can help family and friends who have invested in the startup if the startup does not succeed but nevertheless has some liquidation value. A promissory note is proof that there really was a loan. Further, if the note is secured by a lien on corporate property or stock, family and friends might have a preferred position in bankruptcy court as secured creditors.

Recap for the Family and Friends Round

If an entrepreneur accepts investments from family and friends, then family and friends must understand that the loan is speculative and that, despite the entrepreneur’s best efforts to succeed with the startup, the loan might never be repaid. In addition, the parties should follow these rules:

  • The entrepreneur should either incorporate the startup or organize it as an LLC to avoid personal liability.

  • The startup should always do business as itself to make clear that it is a separate entity from the entrepreneur.

  • Family and friends should avoid becoming involved in the direction and management of the startup unless they formally take on such duties. Otherwise, there is potential liability as a partner.

  • Loans should be evidenced by a note. The parties should consider securing the note with a lien on the startup itself or its property.

Following these simple rules will avoid personal liability for the entrepreneur and family and friends if the startup is not successful. If the startup prospers, the rules will be no less important to how the startup is run and to the distribution of the eventual profits.