Key Takeaways

  • Investment contracts are legally binding agreements where funds are exchanged for future returns, often regulated under securities laws.
  • These contracts typically include terms on ROI, control rights, transferability, and reporting obligations.
  • Various types of investment contracts exist, such as equity, debt, convertible notes, and SAFE agreements.
  • The SEC regulates investment contracts under the Securities Act of 1933, especially when they meet the Howey Test criteria.
  • Real estate, startups, annuities, and private placements often use these agreements.
  • Legal consultation is essential when drafting or entering into an investment contract.

Investment contracts are agreements wherein one party invests money with the expectation of receiving a return on investment (ROI). These contracts are used in various industries, including real estate.

Basic Terms of an Investment Contract

Small business owners may use investment contracts if they have an interest in investing in other businesses or bringing outside investors into their business. When a person invests money as part of the investment contract, he or she expects to receive profits based on the efforts of a third party.

Real estate contracts can fall under the definition of investment contracts. Some specific fields of real estate purchases — namely the hotel condominium, or “condotel” — are fighting to be included in the investment contract definition.

If a transaction qualifies as an investment contract, it's possibly going to be subject to the following: 

  • Registration
  • Reporting
  • Disclosure requirements as laid out by the SEC

In an investment contract, the basics describe the terms of the investment as well as how and when the investor should expect a return on the investment. Basic information that should be included in an investment contract includes the following: 

  • Names and addresses of participating parties
  • Basic structure of the investment
  • Purpose of the investment
  • Date of agreement
  • Signatures of participating parties 

If you want your investment to be ownership shares in a company, look into any relevant business documents. This includes the operating agreement or articles of organization. You must make sure you issue shares in a way that adheres to company guidelines. In addition, you may be required to notify your business partners that you plan to issue ownership shares. 

A solid investment contract clearly details the following: 

  • How much the investor provides
  • The form of the investment
  • When the investment will be transferred

Most investments are provided in check, cash, or wire transfer. Some investments, however, are provided as tangible assets. The contract should state whether this is the case. In the case of tangible asset investments, you'll have to figure out how to continue business operations in the event the investor asks that those assets be returned.

Types of Investment Contracts

Investment contracts can take several forms, depending on the structure of the deal and the parties involved. Common types include:

  • Equity Investment Contracts: These give the investor ownership interest in the business, typically in exchange for capital.
  • Debt Investment Contracts: The investor acts as a lender and expects repayment with interest. These are often structured as promissory notes or bonds.
  • Convertible Notes: Initially debt instruments, they convert into equity under predefined conditions—commonly used in startup funding.
  • SAFE Agreements (Simple Agreement for Future Equity): These are agreements where investors receive equity at a later financing round without setting a specific valuation at the time of investment.
  • Real Estate Investment Contracts: These may involve pooled real estate investments or fractional ownership with shared returns.

Each type carries unique rights, obligations, and risk exposures for both the investor and the recipient of funds.

Return on Investment

Your contract must state when an investor can expect an ROI. If he or she doesn't receive a return, the investor can ask that you return the investment.

Think about how the investor will be paid. Will it be a flat interest rate, or do you both agree to a rate of return based on the investment's success? The contract should also take into account what happens if your company is dissolved or enters into bankruptcy. What will happen to the investment in those circumstances?

Any risks associated with the investment need to be disclosed in the contract as well. This makes the investor aware that a return isn't guaranteed.

Legal Framework and the Howey Test

The legal status of an investment contract in the U.S. is primarily determined by the Securities Act of 1933 and interpreted through the Howey Test, established by the Supreme Court. According to the Howey Test, a contract is considered an investment contract if it involves:

  1. An investment of money,
  2. In a common enterprise,
  3. With an expectation of profits,
  4. Derived primarily from the efforts of others.

If these conditions are met, the contract may be classified as a security and must adhere to SEC regulations. This includes registration, disclosure, and reporting requirements unless an exemption applies (e.g., Regulation D private placement).

This classification ensures that investors are protected from fraud and that issuers provide adequate information.

Reporting and Control

The contract should specify if the investor will have any rights within the company, such as control or management rights. For instance, some investors may receive voting rights in a company that allows them to have a say in the management of the business. Investors may be allowed to vote for executives or directors. 

In a smaller company, an investor may be given rights that allow him or her to control day-to-day operations. 

The investment contract should specify any types of reports investors may expect to receive in relation to company finances. It should also detail any rights the investor has to audit company books.

Transferability and Exit Strategies

Investment contracts should outline terms related to the transfer of interests and potential exit strategies. These might include:

  • Right of First Refusal (ROFR): Existing investors may be granted the right to purchase shares before they are offered to third parties.
  • Tag-Along and Drag-Along Rights: Allow minority investors to participate in exit events or be compelled to sell under certain conditions.
  • Exit Scenarios: The agreement should address what happens in the event of:
    • A company sale or merger,
    • An initial public offering (IPO),
    • Bankruptcy or liquidation,
    • Voluntary withdrawal by the investor.

Clearly defining these mechanisms ensures smoother transitions and protects all parties' financial interests.

Contract Strategy

Investment contracts are very complex financial instruments. As with any investment, they're not risk-free.  They usually contain provisions limiting their ability to provide contract value payouts in certain circumstances. When evaluating investment options, it's very important to fully understand possible risks and circumstances.

Because contract terms are customized, it's helpful for a stable value manager to negotiate with the issuing parties on behalf of sponsors. In stable value investing, some skills are critical for a fixed income manager to have, such as contract negotiation and administrative expertise. 

Anyone who's familiar with investing knows that it's not a guaranteed process. Because investment contracts can be so complicated, you may consider consulting with an experienced professional before entering into one.

Risks and Disclosures in Investment Contracts

Transparency in risk disclosure is a cornerstone of any enforceable and ethical investment contract. Common risks that should be identified include:

  • Market Risk: Fluctuations in market conditions affecting returns.
  • Liquidity Risk: Difficulty in converting the investment into cash.
  • Operational Risk: Internal issues within the business that might affect performance.
  • Regulatory Risk: Potential legal or compliance changes that could impact the investment.

Full disclosure not only protects investors but also shields businesses from future liability. The SEC scrutinizes risk language to ensure that it is not misleading or overly vague.

Investment Contracts in Annuities and Insurance

Investment contracts are commonly used in insurance and annuity products. In this context, the "investment in the contract" refers to the principal amount the policyholder contributes. Key features include:

  • Tax Deferral: Growth within an annuity contract is typically tax-deferred until withdrawal.
  • Guaranteed Returns: Some annuities offer fixed returns, while others (variable annuities) fluctuate based on market performance.
  • Death Benefits: Many contracts offer payout guarantees to beneficiaries.

Understanding how investment contracts function in annuity products is essential for long-term financial planning, especially for retirement.

SEC Enforcement and Investment Contract Violations

The Securities and Exchange Commission (SEC) takes an active role in enforcing compliance when investment contracts are improperly issued or misrepresented. Violations may include:

  • Offering unregistered securities,
  • Omitting material facts from disclosures,
  • Making misleading statements to investors.

Penalties can include fines, restitution, bans from operating in the securities market, and even criminal charges. Companies must consult securities counsel when structuring offerings that may constitute investment contracts.

Frequently Asked Questions

  1. What is an investment contract under U.S. law?
    An investment contract is a type of security involving an investment of money in a common enterprise with the expectation of profits from others' efforts.
  2. Are investment contracts legally binding?
    Yes, when properly drafted and signed, investment contracts are enforceable legal agreements subject to contract and securities law.
  3. Do investment contracts have to be registered with the SEC?
    If they meet the criteria under the Howey Test and are not exempt, they must be registered with the SEC.
  4. What’s the difference between a SAFE and a convertible note?
    A SAFE offers equity at a future financing round without interest or maturity date, while a convertible note is debt that converts to equity and accrues interest.
  5. Can I sell my investment interest later?
    It depends on the terms of the contract. Many include clauses regarding transferability, exit events, and restrictions on resale.

If you need help with investment contracts, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.