12 Mar A Note is a Note, Except When it’s Not Just a Note
In a recent article (œGive Your Mom a Note: A Few Words on Friends & Family Financing), we suggested that startups in their very early stages would do well to issue simple promissory notes to friends and family, rather than more complicated convertible notes or other instruments that are more clearly securities. That advice hasn’t changed, but it’s worth pointing out that companies should be careful to ensure that the instrument they’re using to raise money “ in this case, a promissory note “ is actually evidence of a loan, and not a security in debt’s clothing, so to speak.
Federal and state authorities have historically included œnotes in the definition of œsecurities, and courts across the United States have weighed in on the question of whether a promissory note is, in fact, a security, and therefore subject to the relevant statutes and regulations. In 1990, the United States Supreme Court laid out a test to determine whether a note is a security in Reves v. Ernst & Young, 494 U.S. 56 (1990).
Since then, the test has evolved from a confusing, multi-step process to a more essential inquiry into whether a note in question bears a œfamily resemblance to one or more of a list of instruments that are NOT securities. For a more in-depth examination of this issue, see œIs a Note a Security? by Doug Cornelius, http://www.compliancebuilding.com/2012/05/31/is-a-note-a-security/.
For example (among many possible iterations of the œNote or Security? question), a promissory note is more likely to be construed as a security if its repayment terms are somehow tied to performance of the company or some metric other than a simple, time-based schedule at a set interest rate. For example, a note holder is entitled to a variable return on investment based on the company’s profits, then the note itself is more likely to be a security than a simple debt instrument. In that scenario, the thing purporting to be a loan is functionally more like an equity investment, whose value is linked to the rise and fall of the company.
In short, even the most seemingly straightforward fundraising strategies (i.e., giving your mom a promissory note in exchange for $5,000 in seed money and unlimited moral support) can be fraught with potential pitfalls. Wisconsin companies can and should refer to the Wisconsin Department of Financial Institution’s online resources regarding securities, and entrepreneurs in general must be thoughtful in their approach to potential securities issues.