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The anatomy of a private placement memorandum
A Private Placement Memorandum (or PPM) is one of the documents that a company prepares for investors in a private placement (which is also known as a private or non-public offering). A private placement or private offering is when a company sells equity to investors privately.
Of all the documents involved in the private placement process, the PPM is often the most time-consuming to develop, but with some preparation, research and an open mind it can be an enjoyable process that leaves the management with a better understanding of its company. Although this two-part article is written for an audience of managers of a company making a private offering, potential investors can also benefit from seeing how the sausage is made.
A PPM is to a private placement what a prospectus is to a public offering. Because private placements are regulated differently than public ones, PPMs will come in a greater variety of forms and styles than a prospectus. Although I always advocate substance over form, and I say this for better or worse, a well-formatted, professionally styled PPM will immediately set a positive tone with a potential investor, regardless of the PPM’s contents.
Not always, but often, the legal and business needs of a company are in tension. This can become especially apparent when a company seeks out money from investors. Excitement and the desire for funding can make discussions with lawyers unpalatable to management, to be honest. The best relationships between management and its lawyers are developed when the lawyers have practical experience and never forget to consider the business impacts of their legal advice, and when management trusts its lawyers to not only identify issues but to come up with practical solutions together. When it comes to financing, business executives often think that hiding bad facts and exaggerating good points about the company will attract better investors with deeper pockets. Only once your investor becomes your partner they reason, will the truth come out.
But the truth is that honesty should be a policy in order to get the best investors. If a company is in its first serious round of financing, it can be easy for management to get distracted by just getting the deal done. However, whether you are seeking an investor for debt or equity, you are going to be linked to the person or company, not only to the dollars. That investor is going to have a say in what your company does, whether the law gives them that say or not.
As a manager, founder or owner, you are privy to the ins and outs of the entire company; but investors are not going to have the same day-to-day exposure to the full risks (and opportunities) of the company. The PPM must contain all of the material information that the potential investor will need to make an informed decision to invest or not to invest. What is or is not material information is a complicated question with a lot of different answers. In short, it is information that a reasonable investor would want to have before making an investment.
With a little practice and guidance, a reasonable investor can know what to look for in a PPM, and a prudent businessperson can provide balanced, well-reasoned disclosures to potential investors. Keep in mind that disclosures are fluid, and need to reflect the company right now, not in the past. Also remember that the shifting sands of the legal system mean that the disclosures that were hot yesterday might not be enough to fully satisfy the requirements of ever-tougher financial regulators or to paint a complete picture for potential investors.
The answer is that a PPM needs to be tailored for each deal, because it must address specific risks (both of the company and the offering). These change from deal to deal. The right check list for one deal, or from a deal completed in the past, is probably obsolete. Discussions with management, the investor and the company’s key employees always turn up a unique set of challenges that need to find their expression in the PPM, so that investors know what they’re buying. The first part of this article provides an introductory look at the PPM and some of the lesser-known sections of the PPM, and the second part of the article will cover exclusively the section of the PPM that covers the risk factors.
What Your PPM Is
Your PPM needs to be well-drafted, thought out, and tailored to your business. Once it is finished, a well-drafted, well-organized PPM is a beautiful thing. As briefly mentioned above, PPMs can fall victim to the clichéd idea that 80% of the value in what you say is in how you say it, and only 20% in what you are actually saying. A PPM that is polished, tabulated, properly-formatted and has a thickness that is just right will immediately excite many potential investors, before they have even turned the first page. If you are an investor reading this, do not be one of these investors. If you are a company looking for investors, do not take money from these types of investors. You need to find (and be) someone who takes time to understand the contents of the PPM.
Failing to read and understand the PPM is bad on both sides. There are many investment opportunities available; if you do not have the attention span to read and understand a PPM then it may be better to find somewhere else to stash your money.
What a PPM is Not
A PPM is not a business plan or a marketing brochure. It is also not something to write at the last minute. A PPM should be drafted with the goal of providing objective and material information to potential investors.
Target Audience: The Need for a Confidential PPM
If you have ever read a PPM, you might note on the cover page both the word “CONFIDENTIAL” and a unique number. These are both tools that the company will use to try to control the distribution of your PPM.
The way in which you make people aware that you are raising money is critical to the process. Many exemptions to federal and state securities regulations require that the offering is not offered to the public and that certain restrictions on advertising or distribution of offering materials be respected. If you number each copy of the PPM, that makes it easier to keep track of which potential investor received which copy. If the contents are marked confidential, they are less likely to be passed along. You can also protect the PDF with a password for an extra layer of security.
This is the point in reading this article where you may find yourself saying out loud that no system is perfect. You’re right. So know who you are (attempting to) get into business with. If a potential investor ignores your instructions that the offering is made to them and them alone, future problems are likely to come up. And by then, you will not be able to get rid of them so simply. Moreover, if you don’t take steps to limit the distribution of your PPM, then you face regulators concluding that your offering was a public one, not a private one.
Telling Your Story: Describing Your Business
Here is where you get to tell your story (mostly) your way. This is about painting a picture for your investor about what your company does (and what it can do!). Depending on your business, this section might include details of strategic partnerships, competitors, sales and marketing techniques and/or challenges, relevant existing or anticipated government regulation and your specific human capital. Your business is also covered in part 2 of this article, “Risk Factors,”, so feel free to keep this introductory text more light and to the point. You do not need to identify all of the potential pitfalls to your business in the beginning. Instead, tell your story of where you have been, where you are now and where you are going.
Lawyers can make these documents start to sound generic and, even worse, incomprehensible. But remember that first and foremost this is your company and your story. Make sure your voice comes through, whether it is the single voice of a company’s founder or the collective spirit of a Fortune 500 company.
The Human Component: Management, Affiliations and Compensation
Many companies are heavily dependent on their human capital. It is essential that you accurately describe the key persons within your company and any potential conflicts of interest. It is typical for small companies or startups to be family businesses, but it is crucial that you explain all connections between the management if they are relevant.
Over time, focuses and priorities can shift. Because there is so much flexibility about what is in a PPM, and because it depends so much on the individual company, what a company should prioritize changes over time. One example is the renewed focus and scrutiny over executive compensation. Although also a priority under the Sarbanes-Oxley Act in 2002, we really saw an uptick in critical review of executive compensation in light of the 2008 financial crisis. Although always important, I stress that disclosures in the PPM on executive compensation have become absolutely critical, and they must be handled in a smart way. If you are a startup, investors want to know how much you plan to pay yourself (since you probably are not already paying yourself). If the PPM is for a special purpose vehicle for a real estate investment, then the investors likely want to know how much the overall management compensation amounts to and make sure that key people in the company sufficiently compensated. That’s right. Executive compensation is about looking both at whether they are overcompensated as well as if they are under-compensated. A key person who is underpaid may be looking for opportunities elsewhere. If the founder is not taking a salary, then that is likely to change once there is a fresh infusion of cash, even if that is not apparent in the PPM.
Every data point can be material in the right context. One important value you get from hiring an attorney who also understands business is that the attorney can help you look at your business in a different light, and even help inspire changes unrelated to their mandate. The right connection can be a win-win for both sides.
Money: The Finances, Financial Summary and Investment Objectives
An entire article could be written just on the financial aspects of the PPM. At a minimum, you need to present the basic offering financial information at the start of the PPM in a clear and concise manner (ideally in a table format). This tabular summary should include, at a minimum, the size of the offering (i.e., how much money you want to raise), the offering costs (including how much you are paying your lawyer to write your PPM), and then the offering size less the costs for the net proceeds from the offering. There can be much debate about what the ratio should be between the size of the offering and the costs of the offering. Legal costs, for example, may not rise one to one with the size of the offering. However, at a minimum, you need to keep these costs in mind when deciding the size of the offering because if you are not careful, the costs can increase significantly over time.
Other factors here will include the use of the proceeds, the average price per share that the current shareholders paid for their shares, disclosure of debt and your policy about dividend payments or other distributions. The use of proceeds is vital. It may seem easy, but you need to take your time with it. This is where a potential investor can become a future nightmare if you are not careful. You need to be honest and thorough about what the money is being used for. If you are raising $100,000 but intend to use $20,000 to pay yourself back for a loan to the company, that absolutely must be disclosed (and is also a bad idea in general unless it is part of a larger, strategic plan).
Also do not forget to say that the proceeds are also potentially to be used for “general corporate purposes.” You don’t want to say that you are spending all of the money on marketing and brand awareness and then go and spend $5,000 hiring an auditor for the taxes. Although that might seem innocuous, that is $5,000 that is not being spent on the purpose of the fundraiser, and there might be an assumption that you already had the $5,000 to pay the auditor, otherwise you would have told the investor about the auditor. Investors will often look at these projections and also consider whether or not management is expecting to enjoy a share of these profits by increases in executive compensation that come with the offering. Or maybe some of the existing shareholders are going to try to use the offering as a chance to cash out some of their equity.
Again, these are not inherently bad scenarios. But they are absolutely material when it comes to deciding whether or not to invest. Be respectful of the investor’s time and money and don’t assume that they are okay with something. When you are drafting the PPM, it is also important to remember that what is not included could also be a problem. In theory, if you did not describe the use of proceeds at all and then used those proceeds for general corporate purposes that would be better than if you said you were going to use the money for marketing and end up using it to pay your accountant. But both are bad, neither should be done in practice and either can lead to a claim by an investor that they were misled or that you defrauded them.
I have included Investment Objectives in this part of the discussion because, depending on how management is developing their ideas, these objectives will skew more qualitative, quantitative or a good balance of both. Investment Objectives can take different forms in a PPM (e.g., business plan, investment policies). You will know it when you see it.
If you have a PPM that has a lot of description of the business plan but is light on the numbers, make sure you ask yourself why that is. The financial information from the other areas of the PPM should feed into the Investment Objectives in one way or another. If the investment is to be in series of single family homes in Dallas, for example, then you want to have some figures on the demographics of the people who are going to be renting them, as well perhaps some information about management’s experiences in both single family home rentals as well as the greater Dallas area. It is not mandatory that the Investment Objectives contain a bunch of statistics, figures and calculations, but it should give a complete picture of what the money is supposed to accomplish.
Which leads us to the projections. Inevitably, you will want to include in your PPM your projections for future success. You need to be careful with your projections. Be realistic, I would even argue that you should be conservative. You should also make sure that you are providing a complete and consistent narrative. You may think that it is okay to put conservative figures in your PPM and then espouse more colorful, exciting projections in a face to face. This is not wise. Even a newer investor will know to pay attention to the future projections. They are as interested in this area of the PPM as you are, even potentially more so. If you don’t already know, you need to quickly find out what is and what is not a “forward-looking statement.” This is securities jargon that has some serious, real-world consequences if you don’t understand the statements that you are making. For the most part, the forward-looking statements in a PPM can be disclaimed in such a way that they are not a problem. But this is a complicated area and you will need some sound advice on navigating it.
If you provide conflicting figures to the investor, they are very likely to see through that. And no one wants to give money to someone that he or she distrusts. And oftentimes, trust is the key. If they trust you, then their risk tolerance will typically be higher. But make sure you build that trust on something substantial and not just a gut feeling. Your lawyer will need to read over your projections and help you present them in the best way, coupled with relevant and thorough disclosures to provide the relevant context to the information.
The last comment in this section will be about dilution. Capitalization tables (or cap tables) take many, many different forms. Depending on what your company’s cap table looks like before your offering, it is possible that your potential investors will be paying in a large amount of cash but receiving only a minority interest. Let’s say that you are pricing this round at $10.00 per share and offering to sell 20% of the post-money equity. But if the remaining 80% of the equity was purchased at par value when the company began, that means that the 20% minority holders after the offering will have put in 99% of the actual cash into the company. Despite putting in 99% of the cash, they will only owe 20% of the company. Yes, we can have a discussion about assigned IP, sweat equity and the like. But in terms of the cash, that is the result. There is nothing wrong with this scenario. But it needs to be pointed out to the potential investors. Most PPMs will disclose this as part of the Risk Factors section in a subsection that specifically addressed risks inherent to this offering, not just risks to the company.
Ownership: Dilution, Offering Price, Ownership Structure
It might be easy to just focus on the per share price, the number of shares, and the total offering price. These are the most exciting numbers not only for the investor but also for the company. But equally important to understand are dilution and conversion factors (in the case of convertible debt or preferred stock).
Target Audience Redux: Qualifying Investors
Everyone wants something that is exclusive. The more exclusive it is, the more people will want it. If you did your legwork properly when you were targeting your audience, then you should have very little work to do there. At this stage, if you don’t know already, begin researching the difference between an accredited investor and a sophisticated one. This was also already mentioned above, but you need to know where you want to get your money from. It is possible to do a private placement for unaccredited investors, but many people will ask you the same question: Why would you? You create a lot of potential future headaches if you take money from unaccredited investors. But, bringing people into a company, now even more than ever, is as much about creating a community of like-minded individuals as it is about getting money together to fund a project, company or cause. Don’t turn away people you want to partner with just because they are unaccredited, but make sure that you understand the risks and not just the benefits.
You can’t just go with your gut on whether or not someone is accredited or sophisticated. You need to know for sure. What does “for sure” look like? It has become increasingly more complicated. This could be an entire article of its own, so suffice it here to say that – ideally before you send out your PPM! – each potential investor completes an Investor Questionnaire. This questionnaire will ask questions about the potential investor’s financial and investment history. Although the questions might seem quite personal, I assure you that any investor who has done this before has been asked these questions in one form or another repeatedly.
After your potential investor completes the Investor Questionnaire, please actually read the results. Enough people have come to me before with investor questionnaires that clearly show an accredited investor, even though the company swears all of their investors are accredited. Your investors do not always have to be accredited! But if you are operating as if they all are accredited when you have black and white evidence to the contrary, that is a problem. The threshold for sophistication versus unsophistication is of course not as clear-cut. This is when a lawyer can help you with a second set of eyes on the conclusion to draw from the questionnaires. But please don’t think that the line is gray when it comes to accreditation. You are setting yourself up for trouble, and doing so unnecessarily!
Written by Audrey Kravets