The Pitfalls of Starting a Business with Friends and Family
Business advisors give their adviceBy David Levine | Last updated on October 11, 2022
Here’s the first thing most business attorneys say when asked about starting a small business with a friend or family member: Don’t.
“It brings financial struggles and doesn’t always bring out the best in people,” says John A. Benemerito at Benemerito Attorneys at Law. “My advice is: Never go into business with anyone you want to speak to all the time.”
But many would-be entrepreneurs still partner with family or friends for that sure-fire venture. And then they make a bigger mistake: They don’t plan for failure. “They think nothing will go wrong, and they tend to avoid contracts, when in fact they should be more cautious,” Benemerito says. “You have to contemplate these things and consider what would happen if things go south. If you were doing it with a stranger, you’d be on top of everything.”
After being in business with his father for 15 years, he knows some of these difficulties firsthand. “The relationship turned into a partner relationship, sometimes an employer-employee relationship; so, speaking from experience, it really changes things,” he says.
That’s key: You go into business because of the relationship, but the family business will change the relationship. “Whether the business fails or succeeds, the relationship you currently have with the person is unlikely to ever be the same,” says Shahrina Ankhi-Krol, of Ankhi-Krol Law.
She advises making sure there are safeguards in place, such as a partnership agreement, operating agreement, or bylaws that determine each person’s rights and responsibilities, before a conflict arises. In addition to these documents, it may be a good idea to have non-disclosure and non-compete agreements signed by both parties to prepare for a possible termination of the relationship, she says. “Think of these documents as insurance. You should have them before something bad happens.”
Steven W. Gold, of Mintz & Gold, often gets hired to resolve corporate family disputes, sometimes among the original partners but more often among the descendants. “You need to spend time and money at the beginning,” he says.
“It’s really no different than a pre-nup. Going into business is like getting married. You think everything’s going to be peachy, and often it is. But you need to deal with things up front.”
Among the questions:
- What type of business entity will it be—a limited liability corporation (LLC), an S-Corporation, or something else?
- How will ownership be divided?
- Where is the seed money coming from?
“If one guy puts in more money than the other, was it a loan, was it equity? No one thinks about it, and it carries forward for years, and then results in a fight later,” Gold says.
If more than two people are involved, he adds, they need to discuss what issues involve democratic solutions and which need unanimous consent—such as, say, selling the business. And if the business partnership does dissolve, owners need to determine how that will happen, who will own the various accounts and whether non-compete clauses are warranted. Succession is also a major concern.
“Many problems are family disputes, usually the result of one child being more involved than the others,” Gold says. “I have three kids, he has two, so how do you distribute ownership, who is working and who is not. There is a big difference between distributing money to shareholders and getting salaries. A contract can provide for succession, employment arrangements and salaries, and the more specific, the better.”
Often, Ankhi-Krol says, clients come to her only after a dispute arises with a business partner. “By the time they reach me, they are often no longer capable of a friendly negotiation and require a mediator to do it for them.” Sometimes, things become so ugly that the dispute can only be resolved in court, causing irreparable harm to the relationship and costing each party a lot more money.
“The most common pitfall,” she says, “is thinking nothing can go wrong.”
For more information on this area of the law, see our overviews of closely held business, business organizations and business and corporate law.
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