Issuing an ownership equity in a small business is a common means to garner capital, but such an initiative poses legal risks.
Entrepreneurs seeking capital by way of conveying ownership interests to investors need to be aware of the legal ramifications of such transactions.
1. Giving Equity Away Can Expose a Small Business to Securities Law Risks
We are used to hearing about insider trading and the application of the securities laws to big companies, but the securities laws also apply to small businesses. Indeed, anytime an enterprise issues equity to third parties, in the form of stock, or member or partnership interests, one needs to consider whether a security is being issued.
The touchstone for the definition of a “security” can be found in the 1946, U.S. Supreme Court case, SEC v. Howey.
In that case, the Supreme Court laid out a three-part test for determining if the issuance of an ownership interest in a business is a “security:
(1) the investment involves money, which has since been interpreted broadly to include other types of consideration, like services.
(2) there is an expectation of profit from the investment.
(3) the profit is expected to be generated on the basis of a promoter’s or third-party’s efforts, meaning that the investor is, essentially, a “passive” investor and thus leaves the management of the company to others.
Although there have been refinements in the law over the years, the Howey Test continues to serve as the foundational definition of a “security” under U.S. law.
The practical implications of the Howey Test are that if a business is conveying a security, it may be obliged to make comprehensive disclosure to the prospective investor.
The idea behind disclosure is to ensure that investors understand the risks of their prospective investment and have the financial wherewithal to bear its risks.
Disclosure is, generally, made by way of an offering memorandum, which is supposed to affirmatively disclose many aspects of the business, including who is going to run it, its prospects for success, and the competitive landscape, etc.
If material disclosures are not made to investors and the business, ultimately, fails, business owners could well end up being personally responsible for reimbursing investors for their losses.
In sum, once the security laws are triggered, businesses issuing stock, member interests, or partnership interests to investors, are charged with the obligation of coming forward with material information about their businesses. The general principle–Caveat Emptor — “Let the buyer beware “– is stood on its head in the securities context.
It bears reiterating that offerings of securities do not just implicate transactions with strangers, but could also cover transactions even with family, friends, and patrons.
Finally, not only should entrepreneurs be cognizant of the Federal securities laws, they also should be aware that each state has its own securities laws, called Blue Sky laws, which should also be consulted.
Next page- Taxes and the Issurance of Equity and The Takeaway