I spend a lot of my securities law practice advising savvy startup owners and seasoned entrepreneurs on the most effective methods for structuring their companies in a way that both satisfies the law and positions their businesses to successfully raise investment capital.
When raising capital, many of these owners and entrepreneurs decide they should (or need to) go the route of using a private placement memorandum (PPM) to inform potential investors about the structure of their business, the investment opportunity, and the risks associated with both.
If you aren’t certain if you want or need to use a PPM, start by reading Do I Need a Private Placement Memorandum (PPM) to Raise Startup Money?. The decision of whether you should use a PPM is rarely simple, although together we can figure out what makes sense given the context in which you are raising capital (i.e., the use of the capital, targeted investors, amount of money you are looking to raise, your budget, expectations of investors regarding documentation – what’s “typical”, etc.). There are certain industries and situations where PPMs are rare (e.g., technology startups – seed stage, Series A, even later stages that are raising money from angel investors and venture capitalists) and others where they are the norm and expected (e.g., restaurant and real estate offerings).
As you consider the value and need for a PPM in your specific situation, you may be asking yourself, “What goes in a PPM?” The information in this article is intended to help you understand more about the substance and purpose of private placement memorandums. This is helpful if you want to do some of the PPM work yourself or just to understand the type of information an investor ought to receive and information about which investors may have questions.
General Information About Creating PPMs
Private placement memorandums—or PPMs—serve a dual purpose. They are meant to act as both a compliance and marketing tool. You may recognize that compliance and marketing are very different goals. They are, which makes creating PPMs an exercise in balance. The balance ought to weight toward compliance (mitigating risk), but you (and your lawyers) can’t ignore the importance of producing a document that encourages investors to invest! There are plenty of ways to do this while still protecting your company and yourself from undue risk.
The rest of this article assumes that your company qualifies for one of several exemptions that allow you to avoid Securities and Exchange Commission (SEC) registration for the securities you will issue. This a topic for another article, although for now you should know that, whenever you issue securities in the U.S. (or outside the U.S. but subject to U.S. laws), you must ALWAYS have an exemption from registration or you must register the securities with the SEC before issuing them. And, the particular exemption may drive certain PPM requirements because certain exemptions require certain types of information disclosure.
PPMs should be drafted in plain English (simple wording) as much as possible. Although it’s true that PPMs focus more on the legal issues surrounding the private securities being offered, that doesn’t mean they should be written in complex legalese. After all, PPMs serve as marketing tools for potential investors who are considering placing their funds—and to a certain extent, faith—in the issuing company.
One important thing to understand is that there is no one-size-fits-all approach when it comes to drafting the right PPM for your specific startup. In fact, the contents of a PPM should vary depending on the deal structure, industry, target audience, and specific exemption that an issuer (the company offering the securities for sale) is relying upon to avoid SEC registration. As mentioned earlier, this last item – the exemption you are using – may create a requirement to include certain information in your PPM.
There are software products and “PPM mills” that kick out standard, off-the-shelf PPMs. Be very careful of these. Hopefully, you will never need to prove the value of a PPM you use to raise capital. If you do, it will be in litigation brought by an aggrieved investor, and one of the key determinations a judge or jury will make is whether your specific PPM sufficiently represented the specific risks of your specific offering. This reality calls for custom legal work – there’s no way around that. That doesn’t mean you need to spend a ton of money and you can do a lot of the work yourself if you’re so inclined (and you can even start with a software-developed PPM form), but please don’t take a PPM that’s produced by software, change the name to your company, and run off to raise money. You would hurt yourself way more than you would help.
I advise my clients to tailor the length and content of the PPM to their specific deal, but never soften the tone. The most important goal of a PPM is to clearly communicate to investors the risks associated with investing in the issuer. Even in a deal involving private securities, it’s crucial to provide (through a PPM or in any way) prospective investors with information about the company, its financials, the terms of the securities being offered, and the related risks.
You don’t need to fear being candid about the risks. Any investor whose check you take needs to know and understand that early-stage investing is risky. If honesty about that turns off an investor, that’s good. I know, I know, you want to get the check, but there are certain checks you don’t want to cash and there are things you shouldn’t do (and some things you must do) when pitching investors.
All that said, there are certain types of information commonly included in PPMs. Let’s take a closer look at this information.
A Checklist for the Main Topics (Information) in a Private Placement Memorandum
Below is a list of common sections for a PPM. These are used like chapters in a book – to separate out parts of the PPM that logically should be grouped together. Use this as a basic PPM checklist for the high-level topic areas in your PPM.
- Notices to Investors
- Executive Summary
- Company Purpose and Overview
- Terms of the Offering and Securities
- Risk Factors
- Use of Proceeds
- Financial Information
- Legal and Tax Matters
If you are raising money for your business, it will likely make sense to provide information for all these sections since they are general topic areas that are relevant to investors purchasing most private securities. Depending on what you are raising capital for, the amount of information in a given section will vary. For example, with restaurant and real estate offerings, which are often done with limited liability companies taxed as partnerships, the tax section will be fairly dense. This is because partnership accounting is complex. On the other hand, for a technology startup that is a corporation (a c-corporation), the tax issues are much simpler and the tax section will be relatively brief.
Knowing these common parts of a PPM is a great start to understanding the overview of a PPM. Now, let’s dive deeper into each section to help you understand the more granular substance of the “typical” private placement memorandum.
Notices to Investors (Requirements for Many PPMs)
A PPM should include notices that are important (sometimes required) for prospective investors. Common investor notices included in most PPMs include:
- No registration; reliance on exemptions from registration (recall that PPMs are only used for private, unregistered securities offerings)
- No public market (for the securities)
- High degree of risk (it’s true – all private capital raising is risky)
- Restrictions on transfer of the securities
- No one is authorized to make representations outside the offering materials (the investor is not relying on statements made “on the side”)
- Descriptions and summaries of documents in the PPM are qualified by the actual documents
- No legal, business, or tax advice (investors need to hire their own counsel or choose to not hire counsel, but they can’t rely on your company’s legal counsel)
- Right of the company (issuer) to modify or withdraw the offering
- Opportunity of the investor to ask questions and receive information
I won’t go into more detail about these notices. You can search the Internet for more text and explanation of them. But, they’re important disclaimers and, in some cases, information you are required to provide under securities laws to be able to rely upon certain exemptions from registration.
The purpose of an executive summary in a PPM is to provide a brief, but thorough, overview of the issuing company’s business, management, and terms of investment. The executive summary should help the prospective investor quickly get up to speed on these elements as they consider whether to invest funds in your business. This section will typically summarize the following information in one to three pages:
- A summary of the business and investment opportunity
- Current capitalization of the issuer
- Material terms of the offering and securities
- Requirements and restrictions of the investors who can participate (often limited to “accredited investors” as defined in Rule 501 of Regulation D of the Securities Act.
- Reference to risk factors
- List of documents the investors will sign to participate
An executive summary is not a requirement for PPMs. It’s a helpful tool for investors and business owners choose to include an executive summary for that reason, not because they must.
Company Purpose and Overview:
This is a fairly straightforward and critical item to include in a PPM. Potential investors are considering placing both their trust and money in your company—and in your company’s leadership. They need to have a clear image of your company’s structure, business and marketing plans, and its mission and value proposition (what unique offering you are making to your target customer).
This is the most marketing-oriented section of the PPM and it’s basically a business plan (although you need to be careful to stick to the facts and avoid overselling or exaggerating – in theory, this is the same with a business plan, although. IMO, there is slightly more leeway in a business plan).
Here’s more detail on how to structure this part of a PPM:
- A description of the business’s main operations. Be clear about what is currently being done and what is planned for the future (i.e., what you haven’t yet accomplished)
- Detail about your target customers – who are they and what makes the tick?
- Describe the industry in which you operate – how companies compete, fragmented vs. concentrated (include relative size of the issuer), and how regulated the industry is
- For planned operations, list milestones and challenges to execution (e.g., stages of product development)
- Include a description of the business processes – how the company manufactures, produces, sells, fulfills, or whatever it does to produce and distribute its products and services
- An overview of the company’s marketing plan
- An explanation of your business’ sales cycle (if you sell to schools or the government, it’s a long sales cycle and investors need to appreciate that)
- Identification of supply chain risks and seasonality of revenue, and
The number of employees and the organizational structure of your company, including which employees are critical to success (they all are, although some industries sink and swim on sales people or developers or consultants (in a consultancy) – you get the point)
Terms of the Offering and Securities
Of course, potential investors need to know just what types of securities are being offered for sale. They need to know the price of the offered securities and the material terms of those securities. This means they need to know the details behind voting rights, information rights, liquidation rights, preemptive rights, ownership percentages, mandatory capital calls, convertibility, call and put rights, and whether the securities are collateralized.
A checklist of some other items you should consider including in this section of the PPM are:
- Who may invest (accredited vs. non-accredited investors)?
- Minimum investment amount
- Maximum investment amount (absolute dollars vs. percentage of net worth)
- The appropriate risk tolerance for this type of investment
- Your plan/approach to distributing the securities (the type of solicitation – is it general advertising, which is rarely an option for private placements, but could be an option)
- Are you paying any finder’s fees to people who help identify investors? WARNING: This is a sensitive area with a lot regulation around it
- The documentation investors must sign to invest, and
- Possible future dilution if you issue securities in the future
To me, this is THE most important section of the PPM from a risk management perspective. It is often the source of robust conversation with clients and the point in the process where the need to balance marketing with compliance and risk management is most obvious.
Risk factors should be grouped into general categories and listed in order of priority (most significant risks first in each category). Common categories are:
- Risks related to the company
- Risks related to the industry, and
- Risks related to the offering and the securities you are selling
It’s important to state each risk in a simple, bold type sentence or two. And, it’s important to avoid being repetitive. Considering using cross-references as needed to avoid the pitfall of repetition. Also avoid using generic, boilerplate risk factors. It’s important to be specific and not use risk-mitigating language when detailing risk factors. Seasoned investors know private company investing is risky. They get it and they’ve seen risk factors before. Don’t get soft in this section. If you’re going to do that, you are almost certainly better off with no PPM.
There are so many possible risk factors that listing specific ones in this article doesn’t make much sense. And, there are lots of free resources for finding inspiration for risk factors. For a great source of the types of risk factors and sample language (remember to customize it to your company and your particular offering), search for publicly filed registration statements at sec.gov. You can start here – Search for latest SEC filings (Search for forms S-1).
Use of Proceeds
The use of proceeds section should ideally include at least 4-5 categories and as many as 12, with one being transaction expenses (legal and accounting fees, fees to finder’s and placement agents if you use them). Another category is compensation to related parties (e.g., salaries, bonuses, etc.), especially if that money will be distributed from funds you raise.
The other categories should mirror your pro forma financial statement (your expected financial results going forward). You should add footnotes as appropriate and display these items in tabular form for maximum readability.
Investors (whether in a startup or a later-stage company) are entitled to know the financial position and history of your company. The bare minimum of financial information that should be included in a private placement memorandum includes:
- Company capitalization
- Historical financials
- Pro forma financials (include forward-looking statement language)
- Management discussion of financial results
- Timeline to achieve profitability
- Specific financial risks (cross-reference to the risk factors section), and
- Any commentary needed to explain recently declining metrics and results
Certain registration exemptions require audited financials, which can be a huge deterrent for using the exemption (especially for startups). Talk to your legal counsel about this issue.
Investors will want to see that there is a solid management team at the helm of any company in which they invest. This section should be robust and include all the important background information and relevant experience, accomplishments, and setbacks for those who are in key roles in the business’ command structure. At a minimum this will include:
- Biographies for the management team, including all officers, directors or other important related parties
- Past experience of all members of the management team going back at least 5 and possibly up to 10+ years (longer if there is very relevant information further back)
- Discussion of successes and failures (yes, don’t sweep big failures under the rug)
- Compensation, and
- Conflicts of interest
Don’t underestimate the importance of disclosing all potential conflicts of interest that management team members bring to the table. You are likely safest disclosing something if it could even appear to be a conflict of interest.
Litigation and Tax Matters
Disclosure of all legal and tax matters surrounding the business is important for entrepreneurs and founders to include in a PPM. For litigation, you should list any pending or threatened lawsuits – simple enough.
The tax information section may vary from brief (with a software startup) to very long (for a hedge fund or real estate startup). I will level with you — this section is BORING! But, depending on what you are doing (why you are raising investment capital), it may be extremely important. If the entity you use (the issuer) to raise investment capital is taxed like a partnership or s-corporation, in particular, the tax implications can be significant.
It’s always a good idea to attach important exhibits at the end of the PPM. These items can include:
- Instructions for investing
- Subscription/Purchase agreement
- Governing documents (Certificate of Formation/Incorporation, Bylaws or Operating Agreement for an LLC),
- Material contracts
- Investor questionnaire, and
Let’s Talk About What You Need
Securities law is a difficult and nuanced area of the law. It is important to align yourself with a securities lawyer who knows what they are doing. I aim to be candid with clients, and happy to tell them when the DIY approach can be effective. It’s just rarely a good option when it comes to securities law.
Be smart when raising private investment capital (whether from angel investors, venture capitalists, friends and family, or other sources) and talk to a great lawyer. This doesn’t mean you must spend a lot of money or always create a PPM (or, on the other hand, that just because a PPM is not a requirement for the particular securities exemption you use, you should automatically choose not to use a PPM to raise capital). It means at a bare minimum you talk things through with a seasoned legal professional and figure out the right decision for you, your cofounders and your startup or more seasoned business venture based on the specific circumstances regarding how much capital you are raising, the investors you think are likely to invest and other significant contextual facts.
I am based in Austin, with an office in Houston. I am also licensed in Delaware, the hub of corporate law in this country. No matter where you are, feel free to get in touch with any questions or to talk about what your particular situation calls for in terms of approach and documentation around fundraising.
Author: Brett Cenkus
Brett Cenkus is a business attorney with 18+ years experience based in Austin, Texas. He has worked with a variety of businesses and has clients throughout Texas as well as many technology clients throughout the United States. Brett is a Harvard Law graduate with a sharply seasoned mind and an entrepreneurial heart. As a founder of 6 companies himself, he is especially passionate about helping startups succeed. In 2016 Brett was named the winner in the Individual category for RecognizeGood’s Ethics in Business & Community Award. He offers businesses solutions that are in sync with their culture, goals and values. You can learn more about Brett by visiting the About page on this website.