Legal Framework for a Business Venture with an Investment from a Friend

Starting a new business venture is an exciting endeavor, especially when it comes with an investment from a trusted friend. However, to ensure that the venture is legally sound and smoothly run, careful consideration of the business structure and profit-sharing arrangement is essential. This article explores the advantages and disadvantages of different business structures and provides a detailed guide on how to establish a fair and legally binding profit-sharing agreement.

Choosing the Right Business Structure

When considering the structure of your business, two common options are a sole proprietorship and a private limited company. Each has its own set of advantages and disadvantages, which will help you determine which is best for your venture.

Sole Proprietorship

A sole proprietorship is a simple business structure that is easy to start and manage, but it also comes with its own set of limitations. Here are some of the key points:

Advantages

Less compliance: A sole proprietorship requires minimal paperwork and compliance. Economical: It is less expensive to start compared to a private limited company or a limited liability partnership (LLP). Control: The sole proprietor has full control over the business, ensuring secrecy and maintaining business strategies confidentially. Quick decision making: As the business is run by a single individual, decisions can be made swiftly and without consulting others.

Disadvantages

Unlimited liability: The sole proprietor is personally liable for all business transactions and any losses incurred. No perpetual succession: The business cannot continue if the sole proprietor dies or decides to exit. Difficult to raise funds: Because a sole proprietorship is managed by one person, it is challenging to secure external funding.

Private Limited Company

A private limited company is a more formal structure that allows greater flexibility and growth potential. Here are some of the key benefits:

Advantages

Separate legal entity: The company has its own legal status, protecting the owner's personal assets. Potential for perpetual succession: A company can continue to operate even if all shareholders leave. Easier to raise funds: A private limited company can issue shares to raise capital from external investors. Proper accounting and records: The company is required to maintain proper accounting records.

While a private limited company is more complex and costly to set up, it offers better protection and growth potential.

Setting Up a Profit-Sharing Agreement

Regardless of the business structure chosen, it is crucial to establish a clear and legally binding agreement for profit sharing. Here is a step-by-step guide on how to do so:

Profits-Based Structure

The profits-based structure allows for a percentage of earnings to be shared between you and your friend. This can be set up in two ways:

Scenario 1: High Base Salary, Low Profit Share

Example: You and your friend each earn a base salary of $40,000 per year. Any remaining profits after expenses are then split equally, each receiving 10% of the profits.

This structure is good for ensuring that both parties have a stable income, with additional bonuses based on performance.

Scenario 2: Low Base Salary, High Profit Share

Example: You and your friend each earn a base salary of $10,000 per year. Any remaining profits after expenses are distributed, with each receiving 30% of the profits.

This structure incentivizes both parties to maximize profits, as they will receive a larger share of any profits.

Important Considerations

When setting up a profit-sharing agreement, there are several important factors to consider:

What if the company is unprofitable?: Ensure the agreement includes a clause for handling negative profits. What if the company loses money?: The agreement should include provisions for re-evaluating the profit-sharing formula during financially challenging times. Buy-out provision: Include a buy-out clause in case one party wants to leave the business. Legal advice: Consult with a lawyer to draft the agreement and ensure it meets legal requirements.

Conclusion

Starting a business with a friend-investor requires careful planning to ensure a fair and legal profit-sharing arrangement. Whether opting for a sole proprietorship or a private limited company, the key is to establish a clear and binding profit-sharing agreement. Consulting with a lawyer is essential to navigate the complexities of these agreements and ensure the business venture runs smoothly.