Securities and Your Business: An Overview for Beginners

As an entrepreneur with a great new idea, probably one of the last things you want to hear when you’re raising money is: “Oh, and we also need to make sure you’re compliant with securities laws.” It’s yet another hurdle to clear on your way to bringing your idea to market. You know you’re supposed to care about it, but you may wonder how it really has anything to do with your business. 

Let’s break it down: Does your business use other people’s money? If the answer is yes, then securities laws likely apply. 

What is a “security” anyway? This is actually a complicated question that courts have grappled with over the years. 

A good place to start is to figure out why we even have securities laws. An overly simplistic (but still basically correct) answer is this: the stock market crash of 1929. Securities laws were written essentially to protect investors so we wouldn’t ever have to see those days of long lines at the soup kitchen again. Lawmakers in the 1930s believed that if companies were forced to be transparent about their business when raising money, investors would have better information to determine whether investing was a wise decision. “Disclosure” became the name of the game. However, the lawmakers failed to give us a concrete answer on what constitutes a security. Why, you ask? Well, if the public policy behind securities laws is to protect investors, the laws have to remain flexible enough to account for all the creative ways people come up with for accessing other people’s money. 

Nevertheless, we had to have some parameters, and to that end, in 1946 (in a little case called SEC v. Howey), the Supreme Court came up with the basic test we still use in most places (including Minnesota) to determine whether an investment is considered a “security”:

1. Is there any investment of money (or some other valuable asset)?
2. Does the investor expect a profit from that investment?
3. Is the investment being made in a “common enterprise”?
4. Will the profits be gained through the efforts of a promoter or third party?

Here’s an example: Founder needs money to fund the continued development costs of her product and to pay her employees. Founder tells her family and friends about her great new idea and asks if they’d be interested in investing in her company. She tells them that if they do so, they’d have the opportunity to see their money multiply in the future once her company is successful. Even if this investment is not called a “stock” or a “bond” or a “note,” securities laws would apply here because the answer to all of the above questions is yes: her family and friends are investing in a common enterprise (aka the company) and are being led to expect a profit due to the efforts of the Founder and her employees.

Having established that the investment is a “security” subject to securities laws means that the company must either a) register under applicable state and federal (yes, multiple sets with which to comply) securities laws or b) find an exemption to such laws. Due to the public policy behind securities laws, most of you entrepreneurs will be able (with the help of skilled counsel) to use an exemption. Here’s why (again, this is the simplistic version): because you have offered it to very few people (read: even if they lost all their money, there wouldn’t be enough of them to create the blocks-long soup kitchen line) and/or you have offered it to people who are considered sophisticated enough to know what they’re getting into and who have enough money to bear the loss of their entire investment without needing to fall back on the soup kitchen. 

The tricky part is that securities laws are fairly black and white in that you are either in compliance or you are not. Noncompliance has potentially dire consequences. Along with potential civil and criminal penalties, your investors may have rescission rights for noncompliance. As a practical matter, the biggest impact may be that your failure to comply will make it more difficult to sell your company (because you won’t be able to represent compliance with securities law and/or get an opinion from a lawyer that you have). 

Like a lot of laws, securities laws are not known for being an “easy read.” So if your business is raising money, work with your trusted legal advisor (in advance) to ensure that you are in compliance.