By UpCounsel Corporate Attorney Audrey Kravets

In the first part of this article, I touched on the fundamentals behind drafting a PPM. The second part of this article is a detailed discussion of one of the parts of the PPM that is the most difficult to draft, the most complicated to understand and potentially the most material to the investor: the Risk Factors.

Company Risks and Offering Risks

This is my favorite part of a PPM to draft and to read, and it is the part of the PPM that my clients usually hate the most at the start but are the happiest with at the end. As an investor, you need to be able to understand the company and offering risks. Ideally, the company took a little time and energy and tried to make the risk factors jargon-free (or at least limited jargon). However, it is not the company’s job to make you understand their business. They need to lay out the risks in a simple, concise manner. But if you want to invest in the latest and greatest social gaming application but you do not already know that Google has the Play Store or Apple has the App Store, the company is not obligated to tell you that. Companies should educate potential investors but avoid condescending to them.When it comes time to start drafting the Risk Factors, companies will typically look at this one of two ways: Can a lawyer just give me a list of risks that most people put in here? Yes, I can. But I am not going to. But I will pivot you over to the second way to look at the Risk Factors, which is from the perspective of your specific company. I think companies often think that the Risk Factors will be never ending or take forever. If we work together, they typically do not take that long. If your lawyer has experience in the industry, then a conversation with them should actually be enjoyable and easy. They can help you take that list that they were reluctant to give you at first and together try to figure out what fits with you and what doesn’t.

So what happens with the company that just asks for generic risk factors? That is actually not a wrong place to start. There are specific risks inherent in a business in any industry depending on the maturity of the company, and there are certain risks within a sector that will almost universally apply to all companies from bootstrapped startups all the way to titans of the industry. For example, yes, it is relevant if you distribute your app through a single distribution channel and that channel is Apple. If Apple decides to remove you from the app store, then what? The PPM gives you a platform to tell the investors what makes your company risky, and even more importantly, what your plan is to mitigate that risk!

Early Stage Companies

Let’s start with risks for smaller companies. For example, how about dealing with the reality of a (sometimes very) limited operating history and limited financial history? Past performance is no guarantee of future returns. So if your company has a limited operating history, then you need to be upfront about that. You need to help the reader understand what that means for your company. Maybe it means that you will not be able to know how much marketing will cost once your product is ready to go. Maybe you will have to pivot almost immediately from your primary product, or you will run into issues early on with disputes over intellectual property, or you do not know how to measure your sales cycle accurately, or maybe you do not fundamentally understand how to manage your cash flow.

It can be tempting to take a run of interest from Kickstarter or Facebook and try to extrapolate from that meteoric growth going forward, but a savvy investor will see through that and ask, “what’s next?” When it comes to limited financial history, that is likely also going to mean that you are potentially a black hole for money. You probably are not yet profitable.. You may also have already racked up some debt. Be very clear and open about the debt and what the plan is to service the debt. If your mom lent you $10,000, then you need to treat that at “arm’s length” as much as possible. Be serious about it. Don’t treat her like she is your mother, treat her like she is a financial institution. And then go search for what “arm’s length” means. Or drop me an email and ask.

Consider if you are a one-hit wonder. If you watch Shark Tank at all, you will know that sometimes the sharks say no to an investment solely on the rationale that the investment would only be in a product, not a business. If you are a new company with a primary product, admit that. There are places in the PPM to sugar coat this and talk about how you are going to expand into complementary products immediately, but the Risk Factors section should be direct. Tell your potential investors that not only is there a possibility that your product will fail, but your ability to expand your creative juices into new products that make money might be limited.

Which brings me to another point: Human capital. If you get hit by a bus tomorrow, then what? Are you, the founder, a risk factor? Are you the most significant risk factor? What about your strategic partners or advisors? Are they all under contract? Do they have non-competes? These are all factors that need to be considered. Is your product dependent on your ability to respond to the changes around you? Will your audience demand features that are too expensive or too impossible to bring to market? If you make a mistake, will everyone delete your app? How fickle is your audience? Are you trying to earn revenue in a foreign country? Has anyone looked at how other countries operate? Has anyone thought about the fact that the world is not, “so goes America, so goes the world.” Other countries have other rules; be aware of that.

Most of the above risk factors focus on the company’s risks; these are business risks related to the company itself. But there are risks within the specific offering as well. I discuss further below a disclaimer that is necessary for dilution that depends on the factors of the offering. Additional relevant disclaimers related to the offering itself include:

  • The offering price is not necessarily determinative of the actual value of the common (or preferred) stock;
  • The results may not be as predicted;
  • Within the parameters of the use proceeds, management may invest the money how it sees fit, even if you don’t agree with those decisions;
  • If the ownership is concentrated among founders or family members, this may mean that other minority shareholders will have more practical influence on company matters than you will;
  • Depending on the number of shareholders already on the cap table, it is possible that there are already too many cooks in the kitchen for the company to run efficiently;
  • Finally, you may never get your money back (and you may never be able to sell your stock to anyone else).

Do your research! There are sample PPMs available all over the internet. You should see what other companies of a similar size and industry are up to because that is likely where comparisons will be drawn. PPMs are for use in private offerings, not public ones, but they are very similar to prospectuses, which are used in public offerings. So you can also learn a lot by searching through EDGAR filings on the SEC’s website for prospectuses. PPMs typically do not go into the same level of detail as does a prospectus, and keep in mind that prospectuses have very specific regulatory functions and requirements. But in terms of getting a better understanding of how the risks (and potential rewards) of these types of investments are communicated, these documents can be an interesting area for research. I caution you against using another company’s PPM as your own, of course.

I also caution you against just picking up the phone or shooting off an email to colleagues of yours and asking about offering details. Such communication, if done without thinking, might inadvertently come across as a solicitation from one side or even both sides depending on what your colleague is working on as well. So be smart about your research and do not create new problems when you are trying hard to solve existing ones!

Established Companies

I want to pivot now to address the concerns of more established companies who are doing project-based financing. Are you creating a special purpose vehicle for the investment? If so, even if you have a solid track record, you need to tell potential investors that your track record is not the same as the SPV. The Risk Factors section is a great place to disclose this, whereas you will perhaps blur the line a bit more in other areas of the PPM. If you are doing a particularly large-scale project, you might be combining equity with leverage. If so, make sure you tell the investor that. Loan servicing can be costly, and you need to make sure they understand that the project is not being financed entirely by other investors. Yes, they should know this already from other sections of the PPM. Yes, you should still mention it here anyway. Them’s the breaks.

You also need to explain the risks in owning the assets underlying the project (e.g., real estate), or the risks in not owning them, depending on the structure. Although the investor may be accredited and even sophisticated in the area of private placements, that does not mean he or she is sophisticated when it comes to real estate.

Even the most well-crafted Risk Factors may go over the head of the first-time private placement investor. Consider also being very straightforward about the arbitrariness of the offering price. There is no public market, so there is lots of room for movement in either direction. So be open and honest and spend some time making it clear that you have concluded the price for various reasons. Project-based financing is undiversified by nature. Whether you have a single product that you are trying to take to the market or an individual commercial property you are trying to develop, you are sinking all of the investor’s money into a single project, which comes with some risks.

As mentioned already above, you need to also consider the role of the key personnel and the fallibility of human nature. Yes, sometimes you will find yourself saying, duh! But don’t be presumptuous of people. Very intelligent, accomplished people may be loath to admit when they do not know something. So just do them a favor and put it all there, in black and white, easy to read and easy to refer back to in case there is a dispute.

Is That the Entire PPM?

Not quite. But that is the part of the PPM that you will be the most involved in. Your lawyer will get to deal with the mind-numbing but vital sections that cover, for example, disclaimers for securities law exemptions (state and federal) as well as limitations of liability. Yes, you have to read them after the lawyer has drafted them. Yes, you also need to understand them. Yes, it will be easy, because you already took the time to find a lawyer that you actually enjoy talking to, and he or she is going to help you stomach the complicated parts so that you can do what you do best.

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About the author

Audrey Kravets

Audrey Kravets

Ms. Kravets is a partner at Kravets and Kravets, a boutique international commercial and business law firm serving clients in the United States and Europe.

At the moment, all of our clients are interested in what GDPR means to them (from both sides of the Atlantic).

My clients easily find themselves addicted to our firm's friendly manner, broad competencies, efficient responsiveness and business-oriented solutions. We are available seven days a week, and our attorneys respond to client emails with pragmatic solutions during all hours of the day. Our firm is fluent in English and German.

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