What is a security?

Tex. Rev. Civ. Stat. Art. 581-4 defines a "security" or "securities" as the following:

The term "security" or "securities" shall include any limited partner interest in a limited partnership, share, stock, treasury stock, stock certificate under a voting trust agreement, collateral trust certificate, equipment trust certificate, preorganization certificate or receipt, subscription or reorganization certificate, note, bond, debenture, mortgage certificate or other evidence of indebtedness, any form of commercial paper, certificate in or under a profit sharing or participation agreement, certificate or any instrument representing any interest in or under an oil, gas or mining lease, fee or title, or any certificate or instrument representing or secured by an interest in any or all of the capital, property, assets, profits or earnings of any company, investment contract, or any other instrument commonly known as a security, whether similar to those herein referred to or not. The term applies regardless of whether the "security" or "securities" are evidenced by a written instrument. Provided, however, that this definition shall not apply to any insurance policy, endowment policy, annuity contract, optional annuity contract, or any contract or agreement in relation to and in consequence of any such policy or contract, issued by an insurance company subject to the supervision or control of the Texas Department of Insurance when the form of such policy or contract has been duly filed with the Department as now or hereafter required by law.

That's a pretty exhaustive list. The federal definitions are similarly detailed. So we know for certain a limited partnership interest is a security for sure. But what about an LLC member's interest?

An "investment contract" tends to be the most broad term in the definition, so we look at what it means: an investment contract is a scheme that involves:

  1. the investment of money in a common enterprise
  2. with the profits to come solely from the efforts of others.

We call this the Howey test from the case SEC v. W. J. Howey Co., 328 US 293 (1946). Texas courts have adopted this federal reasoning behind an investment contract. The modern approach to the "solely from the efforts of other" prong is that the courts have modified it to something akin to

"whether the efforts made by those other than investor are undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise". Searsy v. Commercial Trading Corp., 560 S.W.2d 637, 41 (Tex. 1977).

So, this means that LLC interests may or may not be securities. For example, an LLC structured like a partnership, with every partner participating in management almost certainly won't be a security. While, a manager-managed LLC, with operating documents similar to a limited partnership may cause the non-manager members' LLC interests to be securities. Manager-member interests may not be securities since they will pass the Howey test.

If any interest is a security, then you must find an applicable state(s) and federal exemptions. If you can't find applicable exemptions, you must register the security with either the state and or federal regimes, which is a crushingly expensive ordeal. Because of this expense, startups rarely register their securities at their intial round of funding, and instead structure their funding to make sure that an exemption from registration exists for them.

Also, failure to register a security without meeting an applicable exemption may result in state and federal criminal charges, civil fines, rescission of the investment years later, etc.. Usually no owner cares if the investment is working out; but, if the investment goes south, the plaintiff lawyers emerge.