Do you ever turn on your TV and hear people speaking in Klingon, only to realize, “this isn’t Star Trek, that’s investments jargon!” We get it, and we’re telling you IT’S NORMAL TO FEEL CONFUSED BY INVESTOR LINGO. That’s why we’re bringing you a series of “vocabulary lessons,” with the ultimate goal of helping you feel a little more confident in your understanding of investments and business finance. In this lesson, we’re breaking down the term “security”.
So What IS a Security?
At its core, a security is equity, or ownership interest in something (typically a company). A security can be anything from a stock (think company shares) or a bond to basically any type of investment contract. What’s an investment contract? The Supreme Court decided a long time ago that this is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” We know, still sounds like Klingon. So let’s reduce this even more:
Investment of Money
This is pretty much what it sounds like. This element requires that the investor commit assets (typically money) to the project (typically a company), which means that the investor is subject to financial loss if things go south for that project (i.e. investor loses their money if the company fails). Pro-tip: sometimes offering services can be considered an investment.
This is where it gets trickier. Depending on which court has jurisdiction, this may be interpreted any number of ways. Different court circuits have decided that “Common Enterprise” can mean:
Any arrangement where there are multiple investors and funds are pooled. This can mean the common enterprise includes partnerships, real estate, or funds, not just investing in a company; OR
Some kind of business or company that is seeking funding where the investor’s profits are “totally dependent on the promoter,” or business owner. “Totally dependent” really comes down to how you invest– either actively or passively. So what makes someone an active investor v. a passive investor?
Active investors say “Wow, neat! I really believe in this project, let me give you some money and I also want to help with whatever you need.” As the name would suggest, they are active in running the business. They don’t just want to hand you money and sit back and relax.
Passive investors, on the other hand, basically says, “Deal me in. Take my money, do your thing, and only come bother me when you’ve made me a gajillionaire.” They don’t care what you do, as long as you make them that green $$$.
Okay so now that you have a basic idea of what an active investor v. a passive investor is, here’s how this fits into our rule: “totally dependent” means the investor is a passive investor, or not involved in running the company. So if your investors are passive, this requirement will likely be satisfied. In other words, if someone gives you money to help fund your company and you give them equity in return, but they don’t have any control over your company – the company is the common enterprise. This is important because this is a huge trigger for deciding whether something will be considered security.
Profits Dependent Solely on Third Party
The Supreme Court says profits are one of two things. Either:
“Capital appreciation” (an increase in value of the investment) resulting from the “development” (growth) of the initial investment. AKA if the investment value increased over time to the benefit of the investor; OR
A “participation in earnings” (dividends, or a piece of the leftover pie) resulting from the use of investors’ funds. AKA if the company the investment funded does well enough to distribute profits to the investor.
Even with these three guidelines spelled out, a lot of interpretation goes into deciding when something counts as a security. Unfortunately, there’s no clear picture on what a security looks like in every circumstance. But a good rule of thumb is that if you are offering things like soaring returns (that’s the profits part!) in exchange for money someone will contribute to your business (investment!) without that contributor being involved in the running of your business, courts will most likely decide you are offering a security / participating in an investment contract.
So Now That You Know What a Security Is, You’re an Expert on Business Finance!
HA, okay we’re good teachers but we’re not that good. Understanding the world of investing and finance takes a lot of time to master (and usually one or more advanced degrees, and the mountain of debt that comes with that.) But that’s okay, everyone has to start somewhere! So keep your eye out for more lessons– we’ll get through this together. Still have questions about securities? Give us a shout, we’re happy to help further translate!
By: Olivia Phillips – 11/29/17
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