Protect your outside investments

If you're investing in an outside company, make sure you follow a proper respect for the process.

By Bruce D. Armon, Craig F. Zappetti | Legal Matters | Spring 2012

 

Throughout your career, you will likely be presented with opportunities to invest in businesses that are separate from your medical practice. These opportunities can present the chance to participate in a business as an investor while allowing you to maintain focus on patients and growing your practice. Though these opportunities can be lucrative building blocks for wealth generation, they can also present significant risks that, if realized, can be extremely costly and detrimental to your reputation.

These risks may be present even if the promoter of the investment opportunity is a relative or friend. For purposes of this article, we are not focusing on health care ventures. For those opportunities (such as an ambulatory surgery center, medical office building, etc.), in addition to the tips below, you must ensure compliance with all federal (e.g., Anti-kickback and Stark) and state health care fraud and abuse provisions.

When presented with an investment opportunity, you can protect yourself by taking the following steps:

1. Do not write a check until legal documentation of the investment is finalized. Though this seems like simple advice, quite often in smaller investment opportunities, this step is not followed. You know the promoter, the opportunity is immediate, and the need to commit funds is presented in a high-pressure manner. You are likely too busy with your practice to focus on the details, and you write a check to either get this issue off your desk or to appease the promoter so that he or she stops bothering you. Follow-up is critical. Legal documentation for the deal cannot be set aside as the promoter focuses on running the business or raising additional funds. If these important documents are never completed, the physician-investor’s rights are not documented and the interests are severely impaired throughout the life of the investment.

2. Only invest in an entity, and respect corporate formalities. When making an investment in a business opportunity, only invest funds in a properly formed legal entity. Never invest funds directly with an individual, as this is the most common vehicle for fraud. The typical forms of legal entity include a general partnership, a limited partnership, a limited liability company and a corporation, each of which have different advantages and disadvantages. The major advantages that a legal entity provides are protection from individual liability and preferred tax status. Accordingly, you should understand the liability protection and tax advantages and disadvantages of the form of entity that constitutes the business opportunity. Once an investment is made, all business activity should be conducted through the entity and not in an individual capacity. You should never sign anything in an individual capacity on behalf of the business, as this may result in a personal liability. Likewise, the owners of the entity should limit its activities to the specific business of the entity and not commingle other businesses or individual matters in this entity. Good corporate practices must be followed.

3. Understand the business and ensure that the promoter understands its risks. Though it is not necessary for you to understand all technical aspects of the business, it is essential for you to understand the general premise of the business. Does it make sense to a layperson? Is there a significant market opportunity for the business? If the answer to either of these questions is “no,” then you should probably reconsider this investment. When you review the business plan and related materials, look for a balanced presentation that identifies and addresses major risks to the success of the business. If these risks are not identified in the business plan, then the promoter is either unsure of how to address these risks or, even worse, has not properly identified the risks to the business plan.

4. Understand your investment rights. You do not need to memorize every fact in the investment documents, but you should understand your general rights and responsibilities as an owner of the company. Do you have voting rights? Are you entitled to receive cash distributions? Do you have the right to make additional investments? Do you have an obligation to respond to capital calls by making additional investments? Do you have consent rights to any sale or merger of the company? These issues should all be addressed in the executive summary section of the business plan. You should maintain a full set of the investment documents as executed, and get updates whenever they are amended.

5. Negotiate “blocking” and consent rights. You should attempt to negotiate blocking rights with regards to major transactions. The promoters of the business should not be able to sell the business or engage in any change of control transaction without ensuring that you receive the return of your investment and a pro rata share of the net proceeds of this transaction. Blocking rights will obligate the promoter to present the terms of any such transaction to you for your consent and approval prior to consummating the transaction.

6. Identify and protect all intellectual property. Often, the most important assets of an early-stage business are its ideas and its brand. Institutional investors will only invest in a business if the business owns all rights to these ideas and this brand. A business needs to patent its proprietary processes, trademark its name and logo, reserve rights to its website domain name and copyright all written material on its website or material otherwise used to sell its products. Prior to committing to an investment, you should ensure that these steps have been completed or are in the budget for near-term completion or you run the risk of owning a business that loses its most valuable rights to a third party just as it is becoming successful.

7. Consider requesting a board seat. A corporation is managed by a board of directors, and a limited liability company is managed by a board of managers. When making an investment in such an entity, consider requesting a seat on the board. A board seat provides you with legal responsibility for managing the company. The advantage to such an appointment is that you have a seat at the table and are entitled to receive all information regarding and participate in all major decisions. However, with these rights come responsibilities, as all board members have a fiduciary duty to all other owners of the company. This duty will require a time commitment.

8. Keep tabs on your investment. Many times an investor loses sight of the progress of the business after the investment is made. As part of your investment decision, you should ensure that you have the right to receive financial information on a regular basis—quarterly or even monthly reports. Once you make your investment, you should maintain an active relationship with the promoter and meet with him or her on an informal basis. This will provide you with the opportunity to learn as much as you can about the business straight from the source, and you will be aware of emerging problems that the business faces before they become insurmountable disasters that are impossible to address.

9. Understand your likely exit events. Like a practice breakup, a business breakup can be a costly and difficult endeavor. Before you commit to an investment, you need to understand the proposed exit events that will return your investment (hopefully with a profit). With the initial public offering market for venture capital backed investments in a state of very limited activity, one of the historically significant avenues for exit has been cut off. This means that you will likely be relying on a sale or merger of the company to either a strategic or economic acquirer or the business will need to find a subsequent investor that is capable of redeeming your investment. You need to have a clear understanding of how the promoter plans to ensure that you realize one of these exit events and the general timing of such an event. This will ensure that the promoter has a clear understanding of your expected timing for the return of your investment and gives you a gauge with which you can measure the progress of the business against this goal. Always remember that the major reason you make any investment is to sell it in order to realize a gain.

10. Consult with your lawyer and accountant regarding these items. Each of the items listed above has its own complexities and needs to be assessed differently with respect to each investment opportunity. Your lawyer and accountant have the benefit of vast experience in evaluating and advising both successful and unsuccessful businesses. Their experiences can be invaluable as you try to assess your business opportunity and try to reach an investment decision. Your accountant will be able to guide you through any tax aspects of the deal, another major benefit.
By taking these precautionary steps, a physician can greatly reduce the risks associated with investing in businesses outside of the medical practice.

Bruce D. Armon, Esquire (barmon@saul.com) is a partner in Saul Ewing LLP’s health care group. He assists physicians, physician groups, health care entrepreneurs and hospitals with regulatory, corporate and transactional matters. Craig F. Zappetti (czappetti@saul.com) is a partner in the business department of Saul Ewing, LLP. As a corporate and securities attorney, he counsels venture capital funds, angel investors and individuals regarding investments in early-stage and emerging-growth companies.

 

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