Beware the risks that haunt private placements
More businesses are raising capital through private placements because the venture capital industry has shrunk. Instead of one or two VC funds writing checks for $1 million, in private placements, two dozen investors write checks. New rules that allow advertising, general solicitation and crowdfunding will increase the number of private placements.
It being Halloween week, 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, when I’m not writing for TBJ.
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 10 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 about the challenges of your business and how you plan to deal with each challenge. Also remind investors that your strategy isn’t guaranteed to succeed, and 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?
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 firstname.lastname@example.org.