Building your business takes time and money. And, raising capital often feels like your biggest hurdle on your journey to success.
But before you start taking money from investors, whether it’s friends and family or a crowdfunding platform, it’s crucial to understand some legal concepts, specifically what counts as a security. Many people assume that only large corporations trading on Wall Street need to worry about securities regulations; however, even a small startup can violate the law without realizing it.
What is the Howey Test?
The term “security” doesn’t only apply to stocks and bonds. In SEC v. W.J. Howey Co., the U.S. Supreme Court established a test to determine whether a transaction qualifies as an investment contract and a security under federal law.
Under the Howey Test, a transaction is considered a security if it meets the following criteria:
- An investment of money
- In a common enterprise: the investor’s returns depend on your company’s success
- With an expectation of profits: the investor is expecting to make money
- From the efforts of others: the profits depend on the work you put into your startup
If your fundraising meets all four criteria, it’s considered a security and must comply with the Securities and Exchange Commission (SEC) regulations. To ensure compliance, you must either:
- Register the offering with the SEC, or
- Qualify for an exemption
Failure to comply could result in:
- Your investors suing you to get their money back
- SEC enforcement actions, such as fines and criminal prosecution by Florida’s attorney general
- Difficulties in future fundraising attempts
Even though you may have good intentions, there are serious legal risks if you don’t follow the correct procedures. Therefore, before accepting any money for your startup, you should speak with a legal representative. They can help you determine if your fundraising meets the criteria of a security and guide you through the process of registering with the SEC or applying for an exemption. This gives your startup the best protection as it grows and prospers.