Tips on Limiting Liability for Passive Investors in Private Companies
A client in the music industry called recently, saying he’d been asked to make an investment for a 10% passive stake in a new restaurant. The client said he didn’t want to become a member (equity owner) of the LLC formed to operate the restaurant, because he didn’t want any legal liability. He understood that he could potentially lose his investment if the restaurant fails (which, believe it or not, does happen from time to time!), but his fear, as someone with a more public profile than the other members, was being an individual target for a suit against the restaurant, being perceived as deep-pocketed.
I told him that the only way to guarantee no liability or at least not being named in a suit is to not make the investment at all, but assuming he does, he should want to be a member of the LLC, to properly document the financial arrangement, i.e., that he’d put in some cash in exchange for 10% of future profits, and also, through the documentation, to appropriately limit his liability.
Below are some tips/considerations for limiting liability in passive investments of this type:
- Limited Liability Entity – Ensure that the investment is made in a private company structured as an LLC or corporation. In these entities, investors are shielded from personal liability for the company’s debts and obligations. Their liability is generally limited to the amount of their investment. Investors can also make the investment through their own LLC for an additional layer of liability protection.
- Properly Drafted Investment Agreements – Investors should carefully review and negotiate investment agreements to ensure adequate protection. These agreements should clearly define the investor’s role as a passive participant, outlining their limited involvement in the company’s management and decision-making processes, and providing for indemnification or members/shareholders. By explicitly establishing their status as passive investors, they can minimize potential liability arising from the company’s actions.
- Due Diligence – Before investing in a private company, passive investors should conduct thorough due diligence. By investigating the company’s financials, operations and legal standing, investors can identify potential red flags and mitigate future risks. This proactive approach helps ensure that investors are aware of any potential liabilities the company may be exposed to, reducing the chance of unforeseen legal issues.
- Insurance Coverage – Investors should ensure that the company they’re investing in has an appropriate degree of insurance coverage, in amount and type, for the particular operations of the company. Even though the policy would directly cover the company, not the individual equity owners, the insurer would defend any suit that attempts to name passive investors as co-defendants.
- Legal Advice – Self-serving, but true: Be sure to engage a qualified corporate/securities attorney to assist with all of the above. In cases where the investment is for a small stake in the company and negotiation is not really possible, the attorney can at a minimum do a review of the documentation to summarize key issues and identify potential red flags.