Buying into a business can be an exciting next step in your career and present uncapped opportunities for growth. It can be especially lucrative from a financial perspective, as well as the professional allure of working for yourself. For example, if you are a doctor working for a clinic, you may be given an opportunity to buy into as a partner. Or, as an employee you may be presented with an option agreement that lets you purchase a membership stake in your employer. Note that this discussion is limited to privately held companies – if you are buying stock in a publicly-traded company (or receiving stock options as part of your compensation) or otherwise investing in an SEC-registered security, you may encounter different issues.
Here are 5 key considerations when faced with a (private) buy-in opportunity:
1. Retain an attorney to represent you. Buy-in options often come from a boss or trusted partner with whom you have an existing relationship. You may even be friends outside of work, which may make you reluctant to involve an attorney. However, you owe it to yourself to treat this as a business deal – because it is a business deal – and it is better to get professional advice now, rather than try to undo something years down the road. There are countless court cases that develop from one person trusting the other too much, people taking advantage of each other, or even a fundamental miscommunication or difference in expectations.
2. Review the operating agreement or the bylaws of the business. As part of your fundamental due diligence, you must ask for the basic formation documents. For a corporation, the foundational document is called the bylaws and for a limited liability company (LLC) the document is called the operating agreement. This document describes the rights and obligations of members, distributions, voting, buy-sell rights, mandatory offers to sell in situations like death, divorce, or insolvency of a member, and other important provisions. Be especially careful if you are buying a minority stake, which does not give you voting control If the company is governed by a majority vote and one person owns the majority, it is effectively at the control of that majority shareholder. Make sure you know what your rights are as a minority shareholder before you invest – you certainly want to avoid a situation where you are “frozen out” or otherwise oppressed, with no remedy other than potentially going to court.
3. Do not assume that you will receive distributions just because you are now part owner. As a shareholder or equity owner, you are also sharing in the losses of the business, as well as its gains. Just because you paid $50,000 into the business, you are not guaranteed a return or any profit at all. Again, it is important to understand the operating agreement or bylaws of the business. When are distributions paid? Monthly? Yearly? Who decides how the gross income of the business is allocated? What happens if the business loses money? Are the owners required to contribute additional capital? Can the majority owner issue additional shares and introduce new members?
Additionally, when you buy into a private company, you cannot cash out your investment very easily. Even if an operating agreement or bylaws include a mandatory sale clause, there is a matter of determining the sale price and the company may very well not have the assets to buy out your shares, even if you try to sell them back. Further, private companies restrict the ability of its owners to sell their shares to third parties or on the open market. In other words, an investment in a privately-held company is an investment for the long-haul, and you should be financially and psychologically prepared for that fact.
4. Get familiar with your new tax status and obligations. If you were a W-2 employee, your tax situation is relatively simple. But if you switch to partnership status, suddenly you will be responsible for paying your own taxes (quarterly), calculating the right amount of self-employment tax, and setting aside sufficient funds for future tax obligations. You will likely receive a new document from the business – a K-1 form – which will change the way you do taxes. Also, any retirement contributions (401k, IRA, etc.) will need to be reassessed in light of your new partnership status. It may be a good time to consult with an accountant as well.
5. Take the time to do your due diligence. Because you are likely dealing with a familiar person when buying in, you may feel pressure to act quickly or forgo asking the tough questions. Again, this is a business deal and a significant financial obligation that you are assuming. Just because your boss assures you that “this is a great opportunity and we will be millionaires” does not make it so. In addition to reviewing the business forms, you should ask for and review (with your lawyer and/or accountant) the financial documents like profit and loss statements, assets and liabilities, projections, and the business plan. After all, you would not buy a house without an inspection and a walkthrough, nor would you buy a car without test driving it first. Even if you think you know the business from working there as an employee, ownership is a different game and it is in your best interest to gather as much information as you can before making a significant financial investment.
Business ownership presents an exciting opportunity. As long as you are proceeding patiently and consulting outside professionals, you will be able to make a fully informed decision. And remember, even if presented with an option to buy-in, it does not mean you have to take it now or even take it at all. It is called an “option” because it optional and should be exercised only if it is in your best interest.
Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.
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