In this blog oust, Hitender Sharma, who is the member of the Bar of the District Court Mandi Town, Himachal Pradesh and is currently pursuing a  Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, discusses the points that one should keep in mind before investing in a friend’s business.

The following points should be kept in mind while investing in a friend’s business:

It is important to know as to what is the business

What type of business my friend is doing?

Is he in the manufacturing sector?

Is he in trading business?

Is he in import & export business?

Is he involved in service sector?.

Or any other?

There are different compliance for different sectors. The manufacturing goods will attract excise duty. If the sale of manufactured products is made within the State itself, it will attract VAT, while CST is payable if products manufactured are sold outside the state. Service sector business will attract Service Tax. In the case of Import and Export business, he is required to comply with various provisions of Foreign Trade (Development & Regulation) Act, 1992 and Foreign Trade policy announced every 5 years.

An investor must know about the regulatory requirements of the business to assess the capabilities of the business organization and to comply with it before making an investment in the business. This will ensure the future safety of his investment.

It is important to know what legal structure has been adopted for carrying on business

Before committing funds for investment, it is also important to know the type of legal structure adopted to carry on business. Which of the following structure has been adopted:

1. Sole-Proprietorship
2. Partnership
3. Limited liability partnerships
4. Company under the Companies Act, 2013

The sole-proprietorship model is adopted in small business requiring small capital and has a small market. So it will not be advisable to invest in such business where the sole proprietor is responsible for all activities and controls. The profitability of the business will depend on his capabilities and is a risky investment area. Returns from the business are also small. However, if one still wants to invest in the sole-proprietorship business, the loan may be given to the proprietor at interest against first charge on some tangible security. In the case of a start-up, a written agreement to secure investment is advisable.

In the case of Partnership or Limited Liability Partnership concerns, investment can be made by joining the concern as a partner in case the investor is prepared to bear the risk of unlimited liability. In that case, one should insist on a written partnership deed duly registered with the registrar of firm clearly spelling out the profit ratios, responsibilities of each partner, etc.

In case you only want to invest in Partnership or LLP’s, then give loans secured against the guarantee of business as well as personal guarantees of all the partners. Partnerships concerns/LLP’s like sole proprietorship concerns are not run on professional basis as they are small businesses with small capital. In the event of business failure, all the partners will be personally liable to repay the loan.

If the business is such that it requires sufficient capital, huge funds/loans domestic or foreign, and professionally run management to control the business, the investment would be advisable only if the legal structure adopted is that of a company incorporated under the Companies Act, 2013. The company can be Private Ltd. or Public Ltd. Depending on the need and the size of the business.

If it is an existing business, it is important to check their financial statements profit & loss accounts, balance sheets, statement of retained earnings, Auditors reports and notes on the accounts. This statement will reveal the state of health of the business concerned with regard to any adverse feature, debts repayments positions, guarantees, etc. Analysis of these statements will help in making an investment decision.

From investor’s point of view, It will be advisable to insist on contract with indemnity clause for safeguarding investment in the equity of the company.