Investments in a Small Business

As a business lawyer, I receive this question from time to time:

“I started a small business and sold investments in it to my friends or family.  Now some of them want their investment back, but we are using the money for the business, and we are still building it up.  They say if they don’t get the money back they will sue.  I am in charge of the company and I am the only one who can run it.  What do I do?”

Whenever you take someone’s money to start an enterprise and that person does not have a significant role in running or managing the company, you may have sold him or her a security (such as equity in a company, stock in a corporation, a limited partnership interest, some convertible notes, or a variety of things that may not look like investments).

What is a security?

A security is broadly defined under federal and Texas law.  See 15 U.S.C. §77b(a)(l) and Tex. Rev. Civ. Stat. Art. 581-4.A.  Essentially, whenever a business owner seeks money or property from a person who is not intended to be involved in running the business, or intended to be less than minimally involved, the owner should be concerned about whether the investment is a security.  The most widely used test to determine whether an investment is a security is the Howey test from a 1946 U.S. Supreme Court opinion.  SEC v. W.J. Howey Co., 328 U.S. 293, 66 S. Ct. 1100, 90 L. Ed. 1244 (1946).  Under the Howey test, a security is (1) an investment of money (or any assets), (2) an expectation of profit from the investment, (3) the investment is in a common enterprise, and (4) the profit is to come from the efforts of another.

This test has been adopted in Texas and by other states under what are commonly called “blue sky laws.”  The definition of a security under Texas law and in other states’ blue sky laws is often broader than the federal definition.  Thus, if you are seeking money from people you expect to have little or no control over the enterprise, then you should look into compliance with applicable securities laws–federal and state.  You need to determine if the investments you are seeking need to be registered or if they are exempt from registration.  There have been cases where the sale of a single investment was found to not be exempt from securities laws.Further, even a general partnership interest, which one generally presumes to not be a security, can be a security when an investor partner has no power, is so inexperienced or lacks so much knowledge that he is unable to intelligently exercise powers, or is so dependent upon another manager that he cannot meaningfully exercise control. As a business owner, you must use caution when seeking investors.  If an investor is essentially unable to exercise any control, then you may be selling a security.

Registration requirements and exemptions

Failure to comply with securities laws can lead to criminal fines, imprisonment, and other penalties.  While we certainly recommend that you seek a competent business attorney to advise you, a business owner seeking investments should be aware of the registration requirements and exemptions under the federal securities laws.  Under federal securities laws, every offer and sale of securities, even if only to  one person, must either be registered with the SEC or conducted under an exemption from registration.  Most small business will seek investors under an exemption, but the business owner must meet all criteria for obtaining an exemption.  There are several different exemptions, and thus many questions that need to be answered in order to determine whether your attempt to raise capital is exempt.  If you decide to retain a Texas business lawyer, you may be asked any of the following questions: Are you seeking investments from people outside of Texas or in multiple states?   Does the business carry out significant operations in another state?  Are you using social media to seek investors?  Are you only seeking investments from your friends and family?  Are all of your investors “accredited investors”?  There are many more factors to look at to determine whether an exemption from registration is applicable.

You must also review state law to determine if it needs to be registered under state law.  Texas, like federal law and most states’ “blue sky laws,” require a sale of securities to be registered or exempt from registration.  Tex. Rev. Civ. Stat. Art. 581-7.  In Texas, there are several available exemptions that a small business can use when selling securities.  Tex. Rev. Civ. Stat. Art. 581-5.  There will generally be a cost to selling securities under an exemption, whether it be through the issuance of a Private Placement Memorandum, or through crowdfunding on an interstate or intrastate portal.  These costs pale in comparison to the costs that can be incurred for failure to comply with securities laws.  Unless you strictly comply with the exemption, you could face liability for selling an unregistered security.  This liability could result in fines, penalties, disgorgement of profits, return of the investment, receivership over the business, and even jail time.

Misrepresentation liability

Even if you met all the registration and exemption requirements, you can still be liable for misrepresentations made in the sale of the security.  Often a dispute arises when an investor believes he or she is not receiving the expected return from the business.  In these situations, written evidence, like a Private Placement Memorandum, showing the knowledge of the investor in the risk of the investment is critical to defend such an action.  Too many of these actions result in a “he said/she said” lawsuit, which are some of the most expensive and time-consuming types of lawsuits.

Such a lawsuit can bankrupt a small enterprise because the investor will usually seek disgorgement of any profits or rescission (i.e., return of the investment).  Many struggling enterprises that are unable to return the funds to the investor are required to defend the lawsuit and pay attorney’s fees.  These expenses are often too much for a small business to handle.  Worse still is when business owners and control persons face criminal liability.

While the formation of a business entity is designed to insulate the control persons of the company from legal liability, officers, directors and control persons do not have any insulation for violations of securities laws.  Instead, securities violation liability is strict, and there have been several cases where individuals have been bankrupted and financially ruined as a result of securities law violations.  Further, Texas law provides that someone who assists in a securities violation is also liable to the same extent as the control person as long as that person had knowledge of his role in the violation, rendered substantial assistance in the violation, and acted with reckless disregard for the truth of the representations to the investor or intended to deceive the investor.

If you have questions as to whether your investment complies with securities laws, or if you believe you were defrauded by a business, call the business law attorneys at Ritter Spencer Cheng PLLC at (214) 295-5070.