This is an important question and one I get asked often by startup entrepreneurs: Can I sell top positions in my prelaunch business to fund it? To quote my least favorite answer from law school, the answer is:
On multiple occasions, I’ve been asked about the legality of three different methods. The first method is the most common: the selling of top positions i.e. pay $50,000 in exchange for a master position in the pay plan. In a nutshell, this arrangement would be categorized as a security. See below for more info on what constitutes a “security.” If something is a “security” it needs to be registered or fit within some sort of exception. If it’s not registered, a regulator can pursue a company for selling unregistered securities.
The second method is a little more elaborate and involves selling “revenue shares” in the compensation plan for x dollars. As an example, suppose Company ABC wants to create a revenue sharing pool whereby 1% of all company revenue gets skimmed into a separate revenue pool. Company ABC thereby makes available 3 spots to share in the revenue at a $50,000 charge per spot. Do the simple math and Company ABC can conceivably “raise” $150,000 with this method. Again, this would be considered a security.
The third option is the least common. It involves the charging of enrollment fees to give users an early enrollment option and access to a “beta” version of the product or service. With a successful “prelaunch” phase, the company can generate early interest and adequate revenue to scale out the business. Unless the core product is actually sold in these early days, commissions should never be cut. However, true value can still be provided in exchange for the enrollment fee; thus, bolstering the argument that it’s not a security.
What is a “Security?”
In the Securities and Exchange Act, the term “security” is defined broadly. If you want the full definition, click here. Warning: it’s boring beyond belief. Basically, for purposes of this analysis, the important question should be: what’s an investment contract? The U.S. Supreme Court addressed this issue a long time ago in 1946. The Court held an investment contract to be:
“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 third party.”
In the SEC’s case against MLM great, Glenn Turner, the court ignored the plain meaning of the word “solely” and held, “We adopt a more realistic test, whether the efforts made by people in the organization other than the investor are the undeniably significant ones, those essentially managerial efforts which affect the failure or success of the enterprise.”
Confused yet? But wait, there’s more!
Although the Howey Test represents the position of the Supreme Court and the Securities and Exchange Commission as well as a majority of the states, there are some states that apply an additional test. This is known as the “risk capital” test set forth by the California Supreme Court. There are only a few states that use this test; however, according to a colleague of mine, it’s worth knowing. The Hawaiian state supreme court provided the following factors to help clarify this test. Those factors are:
(1) An offeree furnishes money; and (2) a portion of this money is subjected to the risks of the enterprise (i.e. we’ll take this money and build the business with it); and, (3) the investor is promised a return on the investment as a result of the the enterprise (i.e. the investment will grow without the investor doing anything); and (4) the offeree does not receive the right to exercise practical and actual control over the decisions of the business.
Using the risk capital test, a classic example of a “security” would be the “sale” of membership dues for the development of a country club. If the club is simply an idea, the collection of membership fees on the promise of having a country club eventually might be considered a security. However, as pointed out in an American Bar Association article, timing is everything as to when the funds are collected. The article states,
Start quote The risk capital test looks at whether the money being put to work in a given venture will be used to develop or acquire the business or enterprise in which the interest is offered. If that test is satisfied, then such interest is deemed to be a security. Thus, a key factor under the risk capital test in determining whether what is offered and sold constitutes a security can be the extent of the development of the business at the time the interest is purchased.. . . [W]hen analyzing the purchase of a country club membership, it is possible that otherwise identical club memberships may be a security in the hands of one member and not in the hands of another member depending on the time the member acquired the membership and the maturity of the club itself at such time.” End quote
Again, the risk capital test is not used by the SEC and is only used in a few states. But when it’s a factor, it’s a factor when people collect funds in anticipation of fleshing out a concept. If there’s a little development behind the business, it might be a different outcome. In the MLM world, it could potentially be an issue if a company collected fees from participants (in the few states that actually use the test) without providing any value in return.
Translated in English
Can a company hypothetically sell top positions for $50,000 to help fund development?
Yes, but it would likely be illegal (unless they registered the security). Applying the Howey test (developed by the Supreme Court) referenced above, ask the following question: Is there a transaction where the person expects a return based on the efforts of other people? Using the looser standard published in the Glenn Turner case, the answer would undoubtedly be an emphatic “yes.” With a $50,000 payment, even if the investor intended on building the business, the payment would be considered a security assuming the business owner promised a lucrative return on the value of the position.
Can a company create a revenue pot to be divided between investors?
Same answer as above. In this scenario, there’s no fudging. When a top position is sold, there’s at least a tiny argument that the outcome of the investment will be largely influenced by the payor’s performance. In this scenario, the money is driven 100% by the performance of the company, not by the skill or talent of the investor. In this scenario, the business owner selling the hypothetical spots would undoubtedly show financial projections demonstrating the value of those spots i.e. “if we earn $15,000,000 in revenue, you would earn $x for your $50,000 payment” Clearly, this arrangement would be considered a security.
Can a company run a prelaunch and charge enrollment fees with the hopes of raising enough money to flesh out a business?
It depends. This is where the “risk capital” test might come into play. Again, the SEC does not use this, so if it’s a concern for someone, it should only be a concern at the state level (in the states that use it). Using the traditional Howey test, the answer would likely be “no, it’s not a security.” The Howey test involves an investment whereby the person expects a return based on the efforts of other people. Charging an enrollment fee would unlikely be considered an “investment contract” under Howey. Distributors would undoubtedly understand that the enrollment fee would not appreciate in value and entitle them to future earnings. However, if they live in a jurisdiction that goes a little farther and uses the risk capital test, the question then becomes: Is the enrollment fee being used to develop the business? If yes, what’s the stage of development at the time the enrollment fee was collected? If the business was in early stages at the time the fee was collected, was the payor induced by the business owner’s promise that a benefit of some kind, over and above the initial value, will accrue as a result of the enterprise? In my opinion, based on what I’ve read, the risk capital test is rarely a factor and when it is, the investments are usually substantial. The solution: be sure to offer something of value in exchange for the enrollment fee. Instead of treating it as an enrollment fee, treat it more like a sale. If there’s a beta version of the product or service, use the prelaunch phase to test it with early adopters. Throw in some free training, perhaps give them early access to future products or give them various discounts. And be sure to wait to pay commissions until the service is fleshed out. With this scenario, the moral of the story: do not sell the enrollment as an investment opportunity and add value in exchange for the money. And ideally, get the cash before you embark on the arduous journey.
It’s always a challenge for MLMs to get their businesses funded. Traditional angel investors are skeptical of the models and usually want a large chunk of equity in exchange of their investment. Due to these challenges to raise funds via traditional means, many executives rely on creative methods to get the cash they need. Some of these methods are legal, some are not. The methods discussed in this post are some of the most common that I see on a monthly basis. I hope you’ve found this article informative. I’d love to know your thoughts about all of this. What do you think?