August 30, 2010
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Raising Money: The Private Placement Memorandum
Millions of dollars are raised every year by highly motivated small business entrepreneurs. Most of that money doesn’t come from the bank. Banks are very conservative and risk averse when it comes to lending money to small businesses. Bank wants to see your business generating money before they will make a loan. As we all know, it takes money to make money. Many small business entrepreneurs turn to family, friends, savings accounts, retirement accounts or private angel investors for funding. Whenever you raise money from friends, family or other private investors you need to be give them a document called a private placement memorandum. A private placement memorandum, commonly called a PPM, is a disclosure document given to investors. Usually when a company wants to raise money they will offer to sell a piece of the company to private investors rather than to the public at-large. Investing in a company always involves a certain element of risk. Investment risks, business objectives, management and capital structure are commonly disclosed in a PPM. For entrepreneurs, the PPM is a critical piece of documentation because it provides a safety back-drop against potential claims by investors. By way of simplistic illustration, imagine you started a lemonade stand and your neighbor gave you $100,000 in exchange for 50% of the profits (notice this isn’t a loan). After years of buying lemons and making lemonade you still haven’t been able to sell any lemonade. Your neighbor might get anxious and ask for his money back. Unfortunately, the money has all been spent on lemons. Now what do you do? Hopefully, you gave your neighbor a PPM so he was aware of the risks. It is a simple fact that businesses fail. When businesses fail, investors usually lose money. On the flip side, when businesses succeed investors usually reap enormous windfalls.
BORING (but important) LEGAL STUFF ABOUT FEDERAL SECURITIES REGULATIONS
When you sell a piece of your company typically you sell shares of stock in your corporation. This intangible is also referred to as equity in a company. It basically means you are an owner of the company. This intangible ownership interest is called a security. When you offer to sell securities to family, friends or investors it is called a securities offering. The offering is subject to regulation under the Securities Act of 1933, which are designed to prevent fraud by requiring complex and extensive disclosure and registration of offerings. Complying with the registration requirements of the Act can be time consuming and quite expensive. However, there are exemptions to the registration requirements for some private offerings. Rules 504, 505, and 506 of Regulation D allow for an exemption from registration if certain conditions are met. In addition to federal laws, state laws also regulate the sale of securities by companies. These laws are typically referred to as “Blue Sky” laws. Compliance with these laws in your offering is a necessary part of raising capital for your company. The private placement memorandum gives a company the chance to make some of the same disclosures that are required in a public offering.
DISCLOSE, DISCLOSE, DISCLOSE
Sales people everywhere live and die by the phrase “under sell and over deliver.” The same concept applies when you are raising money. Appropriate disclosures in a PPM are a way of “under selling” your business and setting the right expectation with investors. Equally important is providing investors with the right type of information. Most PPMs will have the following sections:
- Summary of the Investment
- Risk Factors
- Use of Proceeds
- Capitalization
- Business Plan
- Management
- Description of the Securities
- Terms of the Offering
- Legal and Tax Matters
