Nic McGrue is a tenured Professor of Law and an attorney at Polymath Legal PC.
Scaling a business or engaging in a large project often requires capital. Financing is one way to obtain some of that capital, but in most cases, you will not be able to obtain 100% financing for your project. Thus, you’ll need to bring equity to the table. You can bring your own personal capital to the table, or you can solicit investors to bring the financial equity, while you bring the sweat equity.
As a securities attorney, I’ve helped clients raise capital through private offerings. If you find partners to bring equity capital while you do the work, those equity partners are likely passive investors. Passive investors typically mean that your investors pay money and expect to share in the profit without doing the work that brings in that profit.
When you have passive investors, in many cases, you are selling a security. If you are selling a security, you must register the security or find and comply with an exemption from registration. There are multiple capital-raising exemptions, including but not limited to Regulation D, Regulation A and Regulation Crowdfunding, according to the Securities and Exchange Commission.
Securities exemptions require certain disclosures of nonpublic information. Whether registered or not, you, the issuer of the security, will need to provide each potential investor with information that allows them to adequately review the risks and merits of that deal so they can make an informed decision on whether the investment opportunity fits their financial goals and risk tolerance.
Unlike registered securities, which require extensive public disclosure of information, exempt securities are typically only required to disclose minimal information publicly. While exempt securities typically do not require extensive public disclosure, disclosure of pertinent information, even if privately, is still required before taking investors’ capital.
One way to meet the disclosure requirements of an exempt securities offering is to provide investors with a private placement memorandum.
What is a private placement memorandum?
A PPM is a disclosure document. Sometimes these disclosure documents are called an “offering circular” or “prospectus.”
Regardless of the name, they will generally disclose a lot of the same information, which typically includes: the name and contact information of the company or issuer; the name, title, biography and background information of the management team; the business plan; the investor suitability and requirements; the general offering terms; the method in which distributions will be made and how any profits would be shared; fees paid to company executives; the use of proceeds; financial projections; restrictions on transfer; and risk factors of the investment, among many other things.
If you are saying to yourself, “That sounds like a lot of information,” you are correct. Why do we need all of this?
First, disclosures are required by law. As stated before, exempt securities offerings do not have a lot of public information disclosure requirements. This contrasts significantly with registered securities. With a registered security, investors can typically search EDGAR, the SEC’s reporting database, and find all sorts of information about a company, even down to executive salaries. Because exempt securities lack that public transparency, the SEC compels exempt security issuers to provide this information privately to potential investors.
Second, outside of it being the issuer’s legal duty to disclose, the disclosures that take place in a PPM serve a practical protection purpose as well. Investors typically want to trust the company and operators of the company they invest in. From my perspective, it is much better for an investor to be scared away from a risk factor that you have disclosed while you do not have their money versus hiding a risk factor and having the undisclosed, worst-case scenario happen while you have their money.
In the first scenario, you miss out on investment capital that could have helped your deal. In the second scenario, there is a chance the investor could seek legal remedies against you, which would take time and resources away from you working on your deal. Additionally, you might also come under SEC scrutiny and be subject to any penalties it deems necessary.
Why can PPMs be useful?
Now, technically, all of these disclosures can be made in various one-off documents or other forms of communication; disclosure does not have to be specifically made in the form of a PPM.
However, I’ve found a PPM can be useful if you ever needed to substantiate that disclosures indeed were made and received. The receipt of PPMs is usually signed by the investor. If the issuer was ever questioned as to whether it provided certain disclosures, having a document, the PPM, that has those disclosures with the investor’s acknowledgment of receipt can go a long way in substantiating that the issuer provided the required disclosures. The issuer could piecemeal various documents together, but it could cause confusion, allow for errors or failed disclosures and create some uncertainty as to when and if a disclosure was made. A PPM can help eliminate or drastically mitigate these issues.
As you decide how you want to raise capital for a project or to scale a business, remember these key takeaways: There are several exemptions that can be used, but they all require certain levels of information disclosure. And, a PPM can be used to meet those disclosure requirements and allow potential investors to make an informed decision about participating and investing in an exempt security offering.
The information provided here is not legal advice and does not purport to be a substitute for advice of counsel on any specific matter. For legal advice, you should consult with an attorney concerning your specific situation.
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