In one paragraph, a private placement means that a company
solicits investment from accredited individuals or institutions on the basis of
a document called a Private Placement Memorandum (PPM). The solicitation is private because it is
narrow in scope, targeting only known potential investors. Because it is not a broad, public
solicitation, it is not bound by the same disclosure rules (and expenses) such
as quarterly and annual reports and independent financial audits filed with the
SEC by companies listed on the public stock exchanges. Should a company blur the distinction
between targeted approaches and public solicitations, (such as advertising on
its website that it wants investors) it could lose its private placement
exemption and have to pay the six figures per year charged public
companies.
The primary document used in private placements is the PPM. It is a business plan plus other
documentation on which investors should be able to make an informed decision
about the merits of the management, industry, company and its prospects. The PPM also includes pages that outline how
the company plans to use the money it hopes to raise. Often it lists the contact information for
service providers, such the escrow agent at the bank or the investment bankers
or attorneys involved in writing the document or the experts whose research is
included.
By knowing what the investor will want to learn before investing
(their due diligence), entrepreneurs can make sure that they are able to write
and defend an informative and persuasive document.
1) The Investor Reviews the issuer (the company offering the Private Placement):
a) What do the company’s governing
documents indicate about its right to authorize stock? Any restrictions?
b) What do the historical financial statements
indicate? Any trends? Any independent
audits?
c) Any affiliates, subsidiaries or other
relationships with supplies, landlords, contracts, that might impact the
financial picture of stock issuance?
d) Has the company previously offered
securities? What form? What result for the company and investors?
e) Is there any history of litigation and
liens/judgments or any current or pending ones? Any taint of securities
malfeasance?
f) Does the PPM indicate a brand new
business venture or one based on past success/failure?
g) What’s the potential for this
industry? If the company is making the
best buggy whip ever, is there a market opportunity or not?
h) If the company claims assets, such as
patents or land leases or contracts, review ownership and valuation documents,
particularly if the investor wants to collateralize his/her investment.
a) Any indication that the stock the PPM
purports to offer may be tied up in prior offerings or by other parties?
b) Any historical trends or litigation or
liens/judgments that indicate that future investment will be used to pay
salaries of people who have not succeeded in turning a profit or to pay for
litigation, liens/judgments that current management has incurred?
c) Any prior securities offerings that
did not meet the minimum raise, or that spent the money without a return to the
prior investors? Any indication that
prior investors have chosen not to participate in this round? Why?
d) A brand new venture by successful
serial entrepreneurs is not necessarily a bad thing. They may have learned a great deal from past
successes and failures. Key question:
have these leaders surrounded themselves with others who do have deep
knowledge/experience in the industry?
e) Look for statements where the wording
may be misleading. For examples, are
patents actually filed or pending or just potential? Are lucrative contracts actually signed or
just letters of intent or a sales list?
Are management, profit, and expenses listed actually current or only
true after investment is secured? Has
market potential been borne out in any market, and if not, what does that mean
about the profit margin on the proforma financial statements?
f)
Examples:
a. Many entrepreneurs have the skills and
personality that make them terrific at starting companies but not as effective
as others at managing them long term.
When they realize this, they become well regarded as serial
entrepreneurs, who have a knack for seeing a trend or opportunity before others
and may have learned from both successes and mistakes. For this reason, many investment bankers
respect repeat entrepreneurs more than first timers who may be experts in one aspect
of a business (such as the intellectual property that launched the business)
but not running a business while finding funding or customers for it.
b. A business spent a great deal of time
and press hailing patents, only to discover that its patents were so narrowly
written that a competitor could sweep in after the initial learning curve.
c. Most investors have little interest in
paying off past debts or the salaries of management with poor financial or
managerial track records. They tend to
be more interested in leveraging their investment toward endeavors they
perceive to be money makers or cost reducers.
A PPM that pays for fancy offices and sales staff and no production or
sales is likely to raise some eyebrows.
3)
Investors Review Management
a. Review resume, compensation,
“sweetheart” arrangements, and securities record of management and board. For example, do their resumes indicate
expertise in this industry or some relevant aspect of it pertinent to future
success?
4)
Red flags from reviewing management
a. Any conflicts of interest with
potential investors? Is the potential
investment subsidizing management who are not invested, are not experts in the
field, have not performed well for prior investors or who are financially
invested in suppliers that will make money selling to this company until it
goes under?
b. If any senior managers have a record
of defrauding investors, run don’t walk.
It is rarely a one time “oops.” (See www.sec.gov, search companies and disciplinary
actions, or www.finra.org and
search Broker Check or check the relevant state website corporations and/or
securities boards).
c. Examples:
i.
Don’t
rely on verbal assurances. Due diligence
on a Florida company started by calling board members who reported the CEO to
be a great guy who had been successful in running and selling a number of
public and private companies. Deeper due
diligence, using public SEC and FL corporate and court websites, revealed
sweetheart deals amongst some of the 11 companies the CEO had registered in the
state, two corporate bankruptcies, no successful sales, and 7 personal
judgments/liens, from the IRS, the state of FL, and local clubs and service providers. Did the board members not know or had they
not done their due diligence?
ii.
A CEO
for a company in CA, where he lived, registered a new company and PPM for it in
MD. Why?
Due diligence revealed that he had a cease and desist order in CA as
well as having been banned from the securities industry for defrauding prior
investors. Yet a law firm in Maryland
wrote the PPM without revealing this.
iii.
A CEO
for a pink sheet company in Washington was, upon due diligence, found to be a
featured case study for securities manipulation in some law schools and he lied
in SEC filings about his background.
5)
Investors Review Experts
a)
Are experts independent or not? How were
they compensated?
b) Do
experts have the expertise to make the pronouncements they do? Are their licenses or degrees pertinent to
their pronouncements? How recent?
c)
Are the comments worded in such a way that seems evasive or off-point?
d) If
intermediaries are selling the company (such as agent-only investment bankers
or “finders” or business brokers) have they done their own due diligence or are
they just prattling on with the party line?
6)
Red flags from reviewing experts
a)
Has the company changed accountants?
Does it have a “going concern” letter from the one (or two) who
left?
b) How
independent are the auditors and experts?
Are there any sweetheart deals, like payment in stock?
c)
FINRA registered investment bankers are required to undertake their own due
diligence before representing a client to potential investors who can ask to
see the due diligence file. Other
financial service providers don’t have requirements to do due diligence
themselves or even to reveal any vested interest in the company. So ask if the intermediary is licensed and
double check, at www.finra.org. Follow links to Broker Check.
7)
After due diligence, decision time
Until an investor has completed
his/her due diligence, any offer may change.
Most letters of interest include a “subject to due diligence” clause and
unfortunately, some offers can be yanked at the closing table, so never spend
money before you have the check in hand! In fact, many contracts have a right of
rescission, meaning that if an investor discovers after closing that an issuer
has been misleading it can get its money back!
If two potential offers represent widely varying valuations, don’t
disregard the low one; engage both through the due diligence process. The high offer may be part of a “bait and
switch” strategy or a naïve trust that will or won’t pass the scrutiny of the
knowledgeable experts the investor will hire before parting with money. The low
offer may be from “smart money” that knows the industry well. Or it may be the offer of ‘bottom fishers”
who presume the seller is desperate.
Either way, the process of due diligence is likely to be longer than the
entrepreneur hopes, and more humbling in this financial climate, but if you are
likely to be a serial entrepreneur, take notes.
You will learn a lot.
a. Examples:
i.
A
medical device company sought $1 mm from angel investors, for which they
offered 20% of the company. A year
later, they finally got a term sheet for $1 mm.
Due diligence dragged on. No new
investors appeared. The company was
ready to spend the money on necessary next steps to take them to the next
level. A week before the closing, the
company shifted the terms. They still
offered $1 mm, but for half the company.
What do you think the company did?
ii.
An
oil and gas services company wanted to be acquired for about $20 mm. Investment bankers brought two offers, but
both were much lower. The company
rejected both. How much money did the
company pay for investment bankers, lawyers, and other service providers to get
what amounts to a market valuation? It
could have paid less to quietly get a valuation and determine what milestones
it needed to reach before achieving a $20 mm valuation or internally determine
whether a lower price was acceptable.
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