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. 2. Taxes and the Issurance of Equity While, generally, issuing equity interests in an enterprise does not become a taxable event until the interests are liquidated, this is not always the case. For example, where an investor has provided services in exchange for stock in a corporation, the exchange would be considered taxable to the investor unless the ability to transfer the stock were restricted or the stock were subject to forfeiture. In the context of a partnership or limited liability corporation, where an investor contributes services, such exchange would be taxable to the investor, unless the exchange is for a profit interest, i.e. exchanged for a percentage of an income stream derived, inter alia, from gross revenues or net profits. Where an investor contributes an appreciating asset to a business, again, complex tax rules can apply. With respect to businesses that are partnerships or limited liability companies, a contribution of appreciating property is not in itself a taxable event, although the later liquidation of that property and distribution of the resultant proceeds is likely to give rise to a range of tax consequences. On the other hand, contributing an appreciating asset to a corporation in exchange for stock may be considered taxable to the investor unless the investor and others who are parties to the same transaction collectively would control, after the transaction, at least 80% of the equity of that corporation.The take away:
- Business owners should vet proposed conveyances of equity interests to determine if the securities laws apply and, if they do, what, if any, disclosures need to be made and how;
- Ascertain the potential tax consequences of an offering of securities, including the tax consequences associated with contributions of property and/or services;
- Have a legal and financial team in place to make sure that you know what you should know about contemplated equity transactions.
