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Why you should record sources of startup capital

You should make the effort to document investments
By Entrepreneur Staff |

To ensure harmony and stability in a business, there should be a proper documentation of investment or any other interest each investor has taken

A purchase of an interest in a business should be properly documented so the parties involved will have a clear understanding of the relationship they have entered into.

It’s not unusual to hear of an entrepreneur calling on friends or relatives to invest in a venture that he or she has already started. The arrangements are often arrived at informally, after which money changes hands and expectations are raised. The entrepreneur is able to raise additional capital, the investor becomes a participant in a going concern, and both parties in the transaction start off in high spirits.

Things go well until one of the parties realizes that there are no clear guidelines as to what his or her participation in the business means. In particular, the investor may begin to wonder if he or she is entitled to get some of the income of the business directly from the cash register. On the other hand, the entrepreneur may well wonder if the investor needs to contribute further to the expenses of the business. After some time, and more situations like these, serious disagreements erupt between the parties.

Although it’s possible for businesses capitalized by friends and relatives to flourish without a hitch, confusion and discord can arise under two situations: when the investment arrangements are not properly documented, and when the rights and responsibilities of the parties involved are not properly spelled out.

The most important distinction to consider at the start of the relationship is, of course, whether the so-called investment was intended as a loan or as a stake in the venture. If the money was intended as a loan, then the primary obligation of the entrepreneur would be to repay it. The parties should then have agreed beforehand on the conditions of the loan, such as the interest and payment terms, and this agreement should have been put in writing so as to leave no doubt as to the obligations created. For the entrepreneur, this means that those payments need to be made even if the business doesn’t earn profits.

That’s the downside. The upside is that those payments should be in fixed or computable amounts; that is, once the loan payments are covered, whatever excess funds belong to the business alone. Once the loan is fully repaid, in fact, the creditor-debtor relationship comes to an end and there will be no further obligations between the parties. During all this time, the lender had not become part of the business and had no right to claim participation in its management.

On the other hand, if an actual purchase of an interest in the business was contemplated, then the investor would have wanted to become a part-owner of the business. As such, that investor would have assumed certain risks in the success or failure of the business and, because of this, would have been entitled to a role in its management. In the strict sense, however, the investor should expect to get a return on his or her investment only if the venture earns profits. Also, it should have been clear to both parties at the very beginning that the investor would risk losing all of his investment if the business fails.

Now, to properly document an investment or a purchase of an interest in a business, the entrepreneur should first determine the kind of business structure the company has.

In the case of a corporation where ownership is quantified through ownership of its shares of stock, documenting such investments is much simpler. The shares of stock purchased by an investor will represent the exact percentage of his or her ownership over the corporation. This percentage is very material because it also determines the investor’s share in the income of the corporation.

In the case of a business partnership, the parties should set the precise terms of their relationship in a partnership agreement. The agreement should cover not only such matters as the sharing in the profits and losses of the business but also the exercise of management and decision-making. It should be noted that articles of partnership are required to be filed and registered with the Securities and Exchange Commission.  

People’s memories are fallible and can’t be relied upon several years after a transaction has taken place, so writing down a business agreement is always a good idea. An agreement in black and white makes the arrangement clear to the parties, which minimizes the ever-present risk of misunderstandings.

An agreement in writing makes the arrangement clear to the parties, minimizing the risk of misunderstandings

This article was originally published in the August 2007 issue of Entrepreneur Philippines.

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