Silence (Can Be, But) Is (Not Always) Deadly

When Investing In A Business, Make Sure You Are Protected From Personal Liablility

By Benjamin P. Michaelson

Historically, one of the largest funding sources for  entrepreneurial businesses has been American Express. Their open line of credit has funded many startups. Another source of capital for start up businesses is often family and friends. One of the many differences, aside from their balance sheets, is their potential liability. As a creditor, American Express is not liable for the debts and obligations of the start up company. Are you, as friends and family investors, liable?

The answer, of course, is, it depends. As investors you would generally become what is described as a “silent partner.” This means you invest significant capital but will have little to no role in the business’ operations, you will keep silent about how it is operated. However, if that start up business is not properly organized as a corporation, limited liability company, limited partnership, or the like; or if it is not properly operated after its creation, you can have unlimited liability for the debts and obligations of the company despite being a silent partner. You can bet that the silence will stop the moment you get sued. This personal liability exists even without signing personal guarantees, which you will hopefully not do anyway.

The practical implication of these realities is that you need to require the business to be properly established and operated to avoid putting your assets (such as your home, bank account, etc.) at risk. It is critical that there be agreements that require these actions and detail how they will be accomplished in addition to a limitation of your liability to no more than the amount of your investment (at worst). Do not overlook this back end risk when considering an investment in a privately held business, your risk is not necessarily limited to the amount of your investment, unless you structure it properly.