Resources / How Do You Know If What You’re Doing Is Considered a Security?

So how do you know if what you’re doing is considered a security, or whether it’s regulated by a securities law? It all comes down to a little story.

Once upon a time, a couple decades ago, there was a guy named Howey. He lived in Florida, he was an orange farmer, and so he owned a ton of land on which he would farm oranges. One day, he came up with a bright idea that he was going to basically sell his land to investors. He would then put into place a lease-back on the land, so he would basically be leasing back that land so that he could grow his oranges on it, and then he could basically go sell his oranges as produce.

However, in selling this land, he went to areas where there were a lot of tourists who didn’t know anything about agriculture and got a lot of those people as investors. Regulators weren’t too happy with this arrangement and so, after lots of legal wrangling, they came out with the Howey Test.

The Howey Test is a four-factor test that basically tells you whether you are selling a security, or an investment contract? So those four factors are as follows:

First, there must be an investment of money. Money can be cash, it can be a check, a wire, cryptocurrency. The SEC tends to have an expansive definition of what money is.

Secondly, there must be a common enterprise or a common scheme. The questions here is, is this just, you know, two guys going off and doing a tiny thing, or do we really have a wider audience here, right? Is it more than a couple people who are participating in some common manner? If there is a common scheme or a common plan, that meets this prong of the Howey Test.

Thirdly, there has to be an expectation of profits. What does it mean to have an expectation of profits? There are certain types of crowdfunding, for example, GoFundMe, in which, if I give you five dollars for whatever project you are working on, you don’t give me anything back, and the only thing I really get is good, happy feelings. That’s not an expectation of profit. GoFundMe is a good example of donation-based crowdfunding.

In a Kickstarter or Indiegogo project, if I give you five dollars to basically invent a widget, hopefully I’ll get something back. Maybe I’ll get a shout-out on Twitter, maybe for ten dollars I get the first version of this widget. Is the widget an expectation of profits? No, because I’m not getting profit back. An expectation of profits is what you would expect—money back.

And the fourth and most important factor is that these profits must be derived solely from the efforts of another. So, if it’s you and your business partner, and you guys are both active in the business day-to-day, if your business partner invests some money in the company, you likely don’t have a security offering here because the profits would not be based off of the efforts of another person, but based off the efforts of you and your business partner. But if you and your business partner are working really hard, and investors A, B, and C give you $5,000 each and do nothing else, they’re expecting you to be able to make sure that this project performs and that they get profit. That means that they’re relying on your efforts.

So, if you meet all those four factors, then it’s probably a security and investment contract.