What Is a Security?
What Is a Security?
When you’re raising capital for your business - whether you have a pre-revenue startup or are a well-established and growing enterprise, one of the first - and most important questions to ask is: “Am I dealing with a security?”
The answer determines whether your company must comply with complex federal and state securities laws. Getting it wrong can lead to regulatory headaches, investor lawsuits, and enforcement actions from the SEC or state agencies.
This post breaks down the essentials every founder, CEO and business should understand about what counts as a security as well as why it matters.
The Legal Definition: Broad by Design
The starting point is Section 2(a)(1) of the Securities Act of 1933, which defines “security” to include a long list of instruments: stocks, bonds, notes, investment contracts (see below), and many more. Congress drafted the definition intentionally broad, in the words of Supreme Court Justice Thurgood Marshall, “to regulate investments, in whatever form they are made and by whatever name they are called.”
In practice, this means the term “security” covers not only traditional shares of stock but also many creative or nontraditional financing instruments that businesses use to raise funds, regardless of whether the business is a corporation, a limited liability company (“LLC”) or a partnership.
The Howey Test: The Heart of the Definition
The U.S. Supreme Court’s 1946 decision in SEC v. W.J. Howey Co. established the key test still used today.
Under the Howey Test, an “investment contract” (and therefore a security) exists when there is:
An investment of money
In a common enterprise
With an expectation of profits
To be derived from the efforts of others
If your fundraising arrangement meets these four elements, it’s likely a security—even if you call it something else.
Applying the Howey Test
Investment of money: Any contribution of value—cash, crypto, services—counts.
Common enterprise: Usually satisfied when multiple investors’ fortunes rise and fall together with the success of the business.
Expectation of profits: If investors expect to make money from the company’s success (not merely to consume a product), this box is checked.
Efforts of others: If those profits depend primarily on your team’s managerial or entrepreneurial efforts, the test is met.
So when an entity issues stock, membership interests, convertible notes, SAFEs, options, warrants or even some types of tokens, it’s almost always offering securities.
Even friends and family rounds count. Nothing says that just because it is your friend or family member giving you money that you can ignore the law!
Calling a fundraising round a “loan” or a “membership” or saying someone is a “silent partner” doesn’t remove it from securities regulation if investors expect profit from your work.
Why It Matters: Compliance Obligations
If you’re offering or selling a security, you must either:
Register the offering with the SEC (an expensive, public process); or
Qualify for an exemption (such as Regulation D, Regulation CF, or Regulation S).
Failing to comply can result in:
Investor rescission rights (they can demand their money back),
Civil or criminal penalties, and
Barriers to future fundraising or M&A transactions.
Founders and even seasoned business owners often underestimate these risks. Even a small, private round among acquaintances should be documented carefully and structured under a valid exemption.
Practical Tips
Work with counsel early. A short consultation can prevent costly missteps later.
Document everything. Keep clear records of who invested, how much, and under what exemption.
Educate your investors. Ensure they understand what they’re buying and the risks involved.
Watch your communications. Publicly advertising investment opportunities can destroy your exemption eligibility.
Revisit as you grow. Each fundraising stage—seed, Series A, or token issuance—may trigger different compliance obligations.
Key Takeaways
If someone is giving you money with the expectation that you and your team will make them a return, you are likely dealing with a security.
Similarly, if you are giving someone an interest in your business in exchange for services, you are likely dealing with a security.
These facts do not change even if the investor or service provider is a friend or family member.
Understanding this early helps you raise capital legally, attract credible investors, and avoid enforcement pitfalls.
When in doubt, assume it’s a security—and reach out for legal advice BEFORE moving forward.
Disclaimer: This blog post is provided for general informational purposes only and does not constitute legal, tax, or financial advice. Reading this post does not create an attorney-client relationship with me or my law firm. Reach out for a consultation and to obtain advice specific to your individual legal needs.