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Entrepreneurs raise money in various ways and from various sources. One method frequently discussed is a Private Placement. As an investment banker, I think entrepreneurs can be better prepared to embark on this expensive and time consuming step, if appropriate, or choose to delay it until success is likely, if they “put on the shoes” of the potential investor first. What do they look for in a worthy Private Placement candidate for their dollars? What “red flags” would thwart an investment? Are you ready?
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.
2) Red flags for Potential Investors from Reviewing the Issuer:
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:
f.i. 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.
f.ii. 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.
f.iii. 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
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:
c.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?
c.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.
c.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.
Examples:
a) 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?
b) 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.