This is the first part of our Securities Law 101 series. Because capital raising is such a critical function for emerging start-up companies, we designed this series to introduce their management teams to some of the fundamental concepts in securities law. We hope that this series will prevent some of the most common mistakes management teams of start-up companies make. We will periodically publish posts examining different aspects of securities law.
Contrary to popular perceptions, securities law is not just for large corporations and conglomerates. Too many start-up companies make the mistake of thinking securities law does not apply to them, though there is no de minimis exception to regulation. Practically, this means all entities, big and small, are required to comply with the applicable provisions of the Securities Act of 1933 (“1933 Act”). Each state has its own securities laws with similar requirements.
The general principle of the 1933 Act is that every offer and sale of securities must be registered with the SEC unless an offering exemption exists. You should keep in mind that a “security” is not limited to a share of stock either. In fact, securities also include what are known as “investment contracts.” Thus, courts have also applied the 1933 Act to interests bearing little resemblance to traditional securities transactions, including chinchillas, payphone packages, rare coins, live beavers, silver foxes, whiskey receipts, diamonds, and religious cults.
How is a beaver a security? Back in 1946, the U.S. Supreme Court in a case called SEC v. W.J. Howey Co. created this test for an investment contract: (1) an investment of money; (2) with the expectation of profits; (3) in a common enterprise; (4) coming mainly from the efforts of others. Under this test, for example, limited partnerships are securities because investors invest money and expect a profit which comes in part from the efforts of others (here, the general partners exercising essential managerial efforts).
What do we mean by the investment of money? Cash is not the only item that constitutes “money.” For example, “money” includes contributed services from employees in return for shares of stock.
Is the interest bought to obtain some kind of financial return? The “expectation of profit” prong is satisfied when investors provide the capital and share in the earnings. For example, the investment is a security when a company provides a fixed rate of return to investors.
Are investors included in a common enterprise? If a private company has multiple investors tied to the success of the overall venture, this will likely satisfy the “common enterprise” prong. For example, the offering of condominium units with a rental arrangement is usually considered an offering of securities because the success of the investor depends on the promoter’s expertise.
Do the investors participate in the venture to such a degree that they are largely dependent on the efforts of others for their profits? If an investor depends on the efforts of others for a return, then this prong is met. Under certain circumstances, even a general partnership or a joint venture can be designated a security when the agreement distributes power.
So, yes, securities law does likely apply to your company. While it is difficult to deal with all of these “legal issues” when you are just trying to get your company off the ground, it beats having to unwind a transaction or offer rescission rights later when your company is a success.