Client Alert March 26, 2024 Curtis Underwood

Pitfalls of Unwary Private Investment Arrangements in Michigan Business and Real Estate

‘Investor’ is a common word in business circles, but one with nuance that can easily be missed. For example, it is common to hear parties in their initial communications about investing in a deal or acquisition using terms like “equity,” “promissory note,” “security,” and “debt” all when talking about the same arrangement.

However, the distinction between debt and equity, while often conceptual, is a sharp divide that must be well considered.  While a deal may be financed by both debt and equity, each portion of the arrangement is only one or the other – debt or equity.  This distinction has many implications, including taxation considerations, security, return on investment, and control rights.

A legal entity, like a corporation or limited liability company, can be thought of like a boat.  There are two types of investors, those on the boat and those remaining on shore.  An equity-investor is a party that puts their money directly into the boat itself.  If the venture is successful, the boat becomes more profitable and the investor’s percent interest in the boat is more valuable.  However, if the boat sinks, the equity-investor has lost everything with no recourse.  Finally, because the investor is on the boat, Michigan law will give the equity-investor a greater interest and connection to the decision-making about where the boat goes and what it does.

On the other hand, a debt-investor stays on shore.  Rather than investing in the boat, the debt-investor gives funds to the boat or captain in return for repayment at a particular rate. The debt-investor can never get any more than that amount back in return.  However, the debt-investor is owed that money regardless of how the boat’s voyage turns out.  Finally, the debt-investor has no say over decision-making on the boat, so long as the debt-investor is paid, the boat has met its obligations.

While this distinction is often understood to some degree, majority owners of businesses often run into lawsuits or other issues when they forget to consider if anyone else is on the boat with them – if so, it is not just their business.  Further, parties entering into investment arrangements, often caught up in the excitement, forget to clarify this important distinction.  Are funds being given to be on the boat, or in return for repayment at certain terms? Moreover, does the investor get any say in decision making? Failure to address these concerns in a prudent manner can result in unexpected consequences come tax season, when expectations are not met, or when served with a lawsuit.

Our attorneys at Mika Meyers are knowledgeable and experienced in the laws and other issues related to mergers and acquisitions, as well as setting up businesses and related business investment arrangements.  Please feel free to reach out to our firm at 616-632-8000 and ask for Curtis Underwood if you have any questions.

Let’s start a partnership worth keeping.