Risks That Haunt Private Placements

Source: Jim Verdonik

Jim Verdonik is an attorney with Ward and Smith, P.A. in Raleigh and operator of www.eLearnSuccess.com and www.YouTube.com/eLearnSuccess. He can be reached at jfv@wardandsmith.com

More businesses are raising capital through private placements, because the venture capital industry has shrunk. “Public Private Placements” with or without advertising (soon to be augmented by crowd funding) have begun replacing venture capital as a primary financing mechanism for growing companies. In private placements you cobble together your own deal with multiple investors instead of negotiating with one lead VC. Instead of one or two VC funds writing checks for multiple millions, in private placements a dozen or more investors write checks. New rules that allow advertising, general solicitation and crowd funding will increase the number of private placements over time.

Let’s talk about Risks and Fears.

How do you warn investors about investment risk without scaring them away?

It’s an art form to protect clients from liability without scaring investors away. That’s a big part of what I do every day.

Why do we disclose risks?

Isn’t it good enough to tell investors facts and let investors figure out the risks themselves?

That approach usually works in venture capital deals. VC funds conduct due diligence. You respond to questions. After several weeks or months, the VC fund paints its own investment risk picture. VC Funds that specialize in specific industries often know more about industry risks than young businesses raising capital know.

But private placements are a different world. You have obligations to paint risk pictures that investors understand. How you do that usually depends on how sophisticated your investors are. Some are better than others at painting risk pictures with the facts you give them.

Now, let’s examine several approaches to painting risk pictures.

Private Placement Memoranda often include ten pages that describe risks. Do long Risk Factors scare away investors? Usually not. Disclosing many generic risks often numbs investors to individual risks.

The SEC actually encourages businesses to avoid discussing generic risks that apply to entire industries or generally to all early-stage businesses. The SEC wants you to focus investors on risks that pose the most danger to your particular business.

But then why are most disclosure documents full of generic risk disclosures? Your defense against personal liability to investors is that you disclosed the risk that killed your business. So, the more risks you disclose, the more potential defenses you have. Unless you lie about material facts, it’s like having a Get Out of Jail Free Card in Monopoly.

The best way to tell investors about risks is to build it into how you describe your business. Tell investors the value milestones story of your business. Each value milestone represents a challenge your particular business has to overcome. Challenges are risks. When you successfully deal with challenges, you achieve value milestones because you reduced risk. Tell investors your business’ challenges and how you plan to deal with each challenge. Also remind investors that your strategy isn’t guaranteed to succeed, give concrete examples of things that could go wrong and what may happen to your business if your strategy fails.

Securities lawyers like me spend our careers studying risk and people’s reaction to risk. That reaction is often unpredictable.

Several decades ago, the SEC required Prospectuses in certain public offerings to have warnings on the first page that said: “This investment is SPECULATIVE and involves HIGH RISK.” The SEC revoked this rule after investor surveys revealed that many investors are attracted to Speculative investments that involve High Risks. These investors associated high risk with high reward. So, the scary warning helped to sell securities.

What’s your risk tolerance profile?

About Scale Finance

Scale Finance LLC (www.scalefinance.com) provides contract CFO services, Controller solutions, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, business valuations, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance LLC has offices throughout the southeast including Charlotte, Raleigh/Durham, Greensboro, Wilmington, Washington D.C. and South Florida with a team of more than 40 professionals serving more than 100 companies throughout the region.