What Constitutes ‘Security’? Raising Capital and Private Placement Memorandums

Startup companies often need additional capital to grow and expand. During the capital raising process, when does it become important to have a private placement memorandum to provide to prospective investors so as to avoid being found guilty of committing securities fraud? The key question is whether the investment constitutes “securities” under Securities Exchange Act of 1934 (“Act”).

The US Supreme Court has determined that when a company is looking for a passive investor who would rely solely on the company to do all the work in producing a return on the investment, then the investment falls under the definition of “securities” under the Act.

Some companies have attempted to circumvent the rule by naming the “investor” as an officer of the company, implying active participation. The courts have ruled that even when the organizational documents were drafted to suggest active participation by the “investor”, if the “investor” plays no active role in the management and operation of the company, the investment constitutes securities.

It’s therefore vastly important to understand the legal ramifications and proper steps to take to protect the company from liability when raising capital whether it be friends, family or accredited investors. Consult with an experienced corporate and securities attorney before accepting any funds.

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