As always, it is our mission to make sure startups understand everything they need to in order to be successful. Here, we are going to briefly navigate through the definition of a security in order to clarify one of the most frequently asked questions by founders. 

Defining “Security”

If you’re a startup seeking capital from outside investors, you’ve probably come across the word “Security”. A security is defined by the Securities Act of 1933 as:

any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate … transferable share, investment contract … or, in general, any interest or instrument commonly known as a ‘security’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. 15 U.S.C. §77b(a)(1).

Because of this broad definition, it is sometimes difficult to identify what a security is. In In the case SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the US Supreme Court set forth a test in order to determine whether an agreement constitutes an investment contract and therefore deemed a “security” under the Securities Act.  This ruling has been helpful in defining what may or may not be a security and it is still applied to this day. According to Howey, an investment contract meets the definition of “security” if there is:an investment of money in a common enterprise with the expectation of profits solely from the efforts of a third party. In order to be considered a security all factors must be met. 

Breaking down the Howey Test

An Investment of Money

An “investment of money” means that an investor must commit his assets to the enterprise in such a manner as to subject himself to financial loss. So for example, in the context of a startup, this part of the test would be satisfied whenever a person makes a financial contribution to the startup in a way they risk losing part or all of the money they have committed. (SEC v. Edwards,540 U.S. 389 (2004))

In a common enterprise

The definition of common enterprise has been interpreted in different ways by the different federal circuit courts. 

The Horizontal Commonality approach where a common enterprise exists when (i) the investor contributions are pooled and (ii) the success of any individual investor depends on the success of the business enterprise. 

The Broad Verticalapproach finds a common enterprise if the success of an investor depends on a promoter’s expertise. 

Under the Narrow Vertical Commonalityapproach it is not necessary that the funds of investors are pooled, what must be shown is that the results or returns obtained by the investors are linked with those seeking the investment (i.e. the startup company)

With the Expectation of profits 

The expectation of profits refers to any type of profit, regardless whether the venture is successful or not. The profitseither be in the form of capital appreciation; cash returns on investment or other earnings including dividends or interest.  

Solely from the efforts of a third party

This has been interpreted by the courts to mean that the failure or success of the business is predominantly or substantially dependent from the efforts of a third-party other than the investor. If an investor only has minor participation in the company and has no role as to the operation of the company, this factor is most likely to be satisfied.

Bottom Line:

If you are requesting or receiving any capital to fund your startup in exchange for profits, shares, tokens, etc. and all of the above-mentioned factors are satisfied, it is likely to be considered as an offer to sell a “security” and subject to securities regulations. Any offer or sale of securities must be either registered with the Securities Exchange Commission (SEC) or there must be an exemption for its registration. 

In a later blog post we will discuss the registration and the exemption from registration requirements and what can your startup do to be compliant and avoid any fines or penalties. 

If you still have questions on this topic, reaching out to a lawyer for advice is recommended. At Benemerito Attorneys at Law, we offer free consultations and would love to help guide you toward the right decision for your business. 

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This blog is for informative purposes only. This information does not constitute legal advice. You should consult with a licensed attorney that can advise you according to your particular circumstances.


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