3 Reasons NOT to Do a Joint Venture with Investors When Raising Capital

The following question was recently asked of our firm: “If I’m raising less than $1 million, do I still have to follow securities laws? Can’t I just do a joint venture?” The amount of money you are raising doesn’t matter. What determines whether something is a joint venture or a security is whether the investors are actively involved (joint venture) or if they are relying on you to generate a profit for them (security). Here are 3 reasons a joint venture may not be the best choice when dealing with investors:

1. Tax Issues: Having investors in a joint venture doesn’t give them (or you) the same tax advantages you and your investors can enjoy in a properly structured securities offering with passive investors. When your deal is properly structured to allow management and passive investors, earnings the members receive from cash flow will be taxed at ordinary income rates, but earnings from equity (i.e., profits, which will be the bulk of your earnings) can be taxed at capital gains rates for both the investors and the management team. In a joint venture, all member earnings may be taxed at ordinary income rates, which could cause everyone to pay an additional 15% self-employment tax from equity earned at sale of the asset. While a securities offering might be more involved and cost more in upfront legal fees, the wrong structure may cost you far more in taxes later on.
2. Securities Compliance Issues: Legal fees are reimbursable by your investors. You just have to build the legal fees into your raise. Further, a securities offering can protect you from investor lawsuits if the deal fails for reasons beyond your control, as all of the risks will be spelled out in the private placement memorandum. By showing it to your investors, they assume the risks. Additionally, many joint ventures are really securities offerings with 1-2 people running the deal and all other members acting as “passive investors.” If scrutinized by a securities regulator, most of these deals get re-characterized as securities offerings. If you didn’t follow securities laws when you raised the money, you could be prosecuted, fined, or labeled a “bad actor” who is prohibited from ever raising money from investors again.
3. Control: Additionally, if you have too many joint venture partners, it will be difficult to make decisions (3-4 members is ideal for a joint venture). Based on our experience with past clients, more than 5 members becomes problematic and management dissension often occurs.

Bottom Line

You should have a free consultation with a securities attorney before structuring a deal with investors, as there may be control, tax, and securities compliance reasons that determine the best choice for your deal structure with investors.