Business Entities – Dealing With Passive Investors

Let’s consider a common situation that arises with businesses, particularly start ups. You decide to start a business and have a few people investing. You want the money, but don’t want people constantly interfering with the running of the business and, frankly, they aren’t all that interested in being involved either. How do you deal with these passive investors? The answer may be a limited partnership.

What do we know about partnerships? Generally, you should avoid them like the plague because they don’t provide any liability protection against the debts of the business. While general partnerships are disfavored, limited partnerships are very much in favor. They provide the flexibility of a partnership, but with liability protection.

At its core, a limited liability partnership consists of one general partner and any number of limited partners. The general partner runs the day-to-day operations of the business. The limited partners contribute the capital needed to get the business up and running. The limited partners are prohibited from running or contributing to the running of the business. So long as they remain passive, their liability is limited to their contribution. If the company compiles debts in excess of that amount, the limited partners cannot be held liable for said debts. In short, the passive investors are protected.

So, how might this business entity be used in the real world? They are appropriate for situations where there is typically a lot of risk involved in the business, the proverbial bang or bust scenario. The classic business that fits this bill is restaurant. The vast majority of restaurants fail, but those that are a success usually are extremely profitable. Given the high risk, the limited partnership fits the bill perfectly for these entities. Let’s take a look.

You want to open a restaurant. You don’t have enough money to swing it. Your friends and family are willing to foot the bill, but don’t want to be dragged down if things go badly. A limited partnership would be created. Each investor would then buy a limited partnership interest. The general partner would run the business and distribute profits to the limited partners. If the restaurant went belly up, the limited partners would lose nothing more than their investment.

Is a limited partnership the best business entity for every situation? No. It is, however, a great way to deal with high risk and passive investor situations.

Richard A. Chapo is with SanDiegoBusinessLawFirm.com - forming limited partnership entities in California.