Angel investment sounds like a great deal upfront.  Investors with available capital put money in a growing business with the expectation of a return. Start-up entrepreneurs without capital can get their dreams off the ground. But there are potential legal ramifications of failing as a start-up when you’ve taken other people’s money to get it running.

So, can an angel investor sue you? Whether an angel investor can sue depends on the investment. A straight investment in equity makes a lawsuit difficult; there may be more risk of a suit with loan or note investments, especially if the terms are vague.   But it is unusual: investors want a return from a company, not a lawsuit.

There are ways for entrepreneurs to protect themselves from investors in the case of a business failure,  Really, the threat of a lawsuit shouldn’t scare anyone away from entrepreneurship with investment capital. Keep reading to learn out more about angel investors and what kind of legal liability they are.

What is an Angel Investor, and Why Would They Sue?

An angel investor (like a venture capitalist) is someone—typically a wealthy individual or family—that uses their funds to invest in business start-ups.  They become part-owner and get a return mostly through an exit, sometimes through dividends or other relationships.

In many cases, this is a symbiotic relationship between investor and entrepreneur for a few reasons:

  • The investor can participate in the business and share its profits without being bogged down by the company’s day-to-day runnings. It is a way for people to participate in business without having to operate one themselves. This allows the investor to be involved in industries that he or she may not have enough experience to participate in directly.
  • Investors often want to mentor and help businesses to grow – part of their motivation is the desire to share their experience, see other businesses thrive, and earn a reward in the process.
  • The entrepreneur can get a business going even if they don’t have the cash necessary to purchase equipment, salary employees, or rent brick-and-mortar storefronts. Since many would-be business owners lack the necessary capital to start up a business on their own, this allows people to start successful businesses that might otherwise never be able to afford one.

It sounds like a match made in heaven—so why would an angel investor end up taking their chosen entrepreneurial champion to court?

The main reason an angel investor would sue entrepreneurs is to recover their financial investment from entrepreneurs who commit fraud. 

It is important to remember that most businesses fail.  One in five companies fail in the first year, but even when angel investors are 100% certain that a business will return 30 times what they invest, the failure rate is 50%.

Investors caught without a return can sometimes get their money back through a lawsuit.

The truth is that most venture capitalists can afford to lose the money that they may potentially lose in a lousy start-up investment, and they’re prepared for the chance that the business might fail—that’s why it’s a “venture.” So, the chances of being sued aren’t high.

However, many entrepreneurs can’t afford to be casual about burning bridges in the investment world.

So What Can Lead to a Lawsuit in Angel Investment?

An American investor can sue pretty much at any time for anything—that’s not saying that they’ll win, but they have the right to sue. However, a few specific issues involving an angel investment might cause a court to side in favor of the investor over the entrepreneur.

Here are some of the reasons why angel investors win in court against the founders of the companies they invested in:

  • Documented mismanagement of the company
  • Falsification of business records or fraud
  • Diversion of proceeds
  • Cash misappropriation or embezzling
  • Breach of specific clauses of the Shareholders’ Agreement

Except for the most flagrant cases, many instances of mismanagement or business failure are difficult to prove in court.  Also, lengthy, expensive lawsuits are not something that most professional investors are interested in pursuing.

That means that,  in an angel investment where the investor invests capital in exchange for stock in the company, it isn’t likely that you’ll get sued.

Also, keep in mind that the whole reason that an investor finances an entrepreneur is that they don’t have sufficient funds. The investor is free to sue to get it back, but if the entrepreneur is financially broke, they’re not likely to get it.

Lawsuits are a poor way to get a return on investment. 

How Entrepreneurs Can Protect Themselves from Angel Investor lawsuits (and Vice Versa)

There are several steps that both entrepreneurs and angel investors can take to make the process of angel investment more financially secure for everyone involved. Here are some ways to protect yourself in an angel investment:

  • Make sure the business thrives. The best way to avoid getting sued by investors is to make sure that the business being invested in grows and delivers on its promises. That may mean a dedication to execution and attention to the details of operations, supply chains, and marketing.
  • Be transparent. Communicate with your investors, highlight issues you are having, and be clear on the business state.  The investor wants to succeed as much as the entrepreneur wants to succeed. If you are facing issues let the investors know.  They may be able to help you get back on track.
  • Get it in writing. The best way to prevent hurt feelings, subpoenas, and nasty days in civil court when dealing with investors is to make sure that everything in your investment is documented.  Clear documents that define objective, easy-to-understand, terms that both the entrepreneur and investor understand and agree to will help.   Invest in the legal paperwork – it will help.
  • Keep Good Records. Document what you do, keep clear books and provide investors with the information they need.  Keep investors informed, make sure they know how your business is doing.
  • Be ethical. This isn’t hard.  The few cases where we have seen investors sue it is because the management team stole or misappropriated funds.  Don’t give yourself ridiculous raises, don’t engage in nepotistic services, and don’t spend money stupidly.  Don’t buy yourself a house or a car.  Be ethical.  And it bears repeating: be transparent.

In many ways, angel investment is a partnership, and the best way to keep it that way is to keep everything on the up and up.  An entrepreneur who fails to live up to expectations may not be sued.  There is a much worse fate though: a damaged reputation and nobody ever willing to take a chance on them again.

Avoiding Lawsuits in Angel Investment Isn’t Hard.

Transparency, organization, and clear-cut contracts not only make investors more confident in their start-ups, but they are also a huge key to running an efficient business. Engaging in sound business practices for ethical reasons can benefit entrepreneurs financially in the long run, so it’s a win-win.

Angel investors can sue in some cases, but lawsuits in the investment world are much better off avoided altogether through ethical business practices.