The Private Placement Memorandum is a complex legal disclosure document which relies on The Securities Act of 1933 and Regulation D, adopted in 1982, to permit securities offerings to specific parties which are exempt from registration with the SEC. This rule was enacted to enable startups some leeway in raising funds from parties with whom they have had a preexisting relationship for at least 30 calendar days before an offer to buy such securities is made. Most capital raising activity is conducted under Rule 506b of Regulation D; however, a new option exists which is rapidly gaining attention as a result of the JOBS act of 2012, which ordered the SEC to remove prohibitions on public advertising, which then split Reg D into two: 506b and 506c. The latter rule removes the ban on public advertising which 506b retains. It also preempts state regulation of such offerings aside from basic notice filings and fees for such filings, same as 506b.
The Private Placement Memorandum (PPM) document is not required under either rule, but if not provided to investors all securities related anti-fraud laws and regulations still apply, which include affirmative misrepresentations as well as material omissions. This means that issuer liability and potential rescission of the investment (an order mandating the return of investor funds) may be a greater possibility if complete disclosures are not made by the issuer prior to accepting investor capital, therefore the PPM is highly advisable in most cases.
Generally, both rules require the acceptance only of “accredited investors” who are individuals with a net worth over $1 million or have earned more than $200k for the prior 2 years and expect to make at least that much in the current year; however, 506b permits up to 35 non-accredited but “sophisticated” investors, which is a subjective directive and has no formal definition. In any case, 506b permits self-certification of the appropriate investor status while 506c requires the issuer to affirmatively verify and take reasonable steps in confirming an investor’s accredited status. Nonetheless, fund raising under 506c will be substantially less costly and easier than under 506b.
Generally, most PPMs will begin with a series of boilerplate notices to the effect that the information in the PPM is confidential, is not intended to be sold or advertised to prohibited parties, that the securities are unregistered, that changes may occur in the issuer’s governing documents or investment criteria after the PPM is signed, that the securities may not be sold or transferred without first being registered with the SEC and without compliance with the issuer’s governing documents, that the PPM will describe substantial risks in the investment which the investor must be able to bear, that the investor may meet with the issuer to ask any further questions are review and additional documents, that “forward-looking statements” are merely conjecture and not guarantees of future performance, and probably a number of disclaimers specific to the geographical location of a given investor. All these items should be reviewed carefully and discussed at length with your legal counsel when evaluating the offer. First you will want to ensure that you qualify as an accredited or sophisticated investor, and next that you are able to bear the partial or complete loss of your investment, or otherwise the inability to receive the return of your capital for an indefinite period.
Next you are likely to see a summary of the entire offerings including definitions of the main terms and documents of the offering. Some of the provisions that will be present will describe the offering, the investment strategy, the management fee, how the subscription process will take place, the duration and closing date of the offering, who the managers and administrators will be, required investment amount and procedure for investment, distributions/allocations to be made, if any, and terms thereof, any lockup periods, transfer restrictions, fund dissolution and redemption rights, right to information, tax considerations, risk factors, voting rights, proxy rights, disclaimers, and other similar matters which we will get into in more detail in the future. Make no mistake, this is a long and complex document; such disclosures take extensive amounts of time to draft or review.
The next part of the PPM will generally get into greater details regarding the investment such as where the invested funds will go, whom the eligible investors are (usually a description of what an “accredited investor” is) whether individuals, entities, and/or tax-exempt investment vehicles. Generally the manager of the fund will reserve the right to decline any investment which it deems improper for any given investor. Next there may be some general discussion of the tax treatment of the interests being subscribed for by the investor. Usually, many such offerings will provide a K-1 and Form 1065 to allow filing for investors as partners within the scope of an LLC investment structure, while shareholders of preferred stock in a corporation will file as ordinary income on form 1099-DIV with regard to any dividends paid by management or the board of directors.
Risk disclosures may be the title of the next section where the possible loss of the entire investment will be described. There will be no assurance of any profit or any return of capital. There may not be any right to receive audited financial records or demand information from management. There may be delegation of management responsibilities to outside parties over which the offering fund will have no control, conflicts of interest disclosures, and the possibility of a return on investment may be predicated on the performance and actions of 3rd parties which may not prove beneficial to investors. Further, additional capital to continue operations and pursue business opportunities may be required which may mean additional financing rounds which may not be successful or if successful may dilute the ownership interests of the investment firm, if the interests held are equity interests, of course. The duration of the investment should be discussed and the general uncertainty thereof will likely be stated. Litigation risks are always present and will likely be mentioned as well.
Another section may have an invitation to contact the offering administrators with any questions or requests for information, which is a standard part of any PPM in order to comply with various anti-fraud provisions of federal and state law. It is possible that all fiduciary obligations to investors may be totally disclaimed, and an extensive discussion of this issue may be present in a PPM including potential dire consequences to the investors. Such disclaimers are permitted by some states, including Delaware, and are something to always be very wary of. This basically means that the managers of the fund or company managing the investment funds have the right to act against the interests of their own investors, for their own benefit. Generally this would not be acceptable for an investment which this law firm was conducting diligence on for a client. We always want as much responsibility and as many duties as possible from any investment manager so that the client has someone to go after in case the manager is acting in a grossly incompetent, malicious, or criminal manner. While some fiduciary duties and liabilities may properly be disclaimed, such as liability in ‘regular’ negligence for example, all fiduciary duties should not be permitted to be erased.
The final section will probably be a description of the subscription process, as in all the required documents must be signed, the fees and investment sums remitted to the proper parties and accounts, and the investor must be accepted by the administrator of the fund. There may also be some definitions at the front or back of the PPM, these are extremely important since they may provide some highly significant information regarding the investment strategy, timeline, return of capital, management, investment amounts, interests held, and other salient information. You are urged to review any “definitions” section very carefully with your attorney.
Please don’t hesitate to contact the BELENKY LAW FIRM PLLC for any kind of investment review counsel. This firm has reviewed a large number of such documents and a new investor cannot possibly hope to understand every term and the implications of all provisions on their own without competent and diligent assistance. The risk you run of losing your investment is far more substantial than the cost of having such documents reviewed by experienced and knowledgeable legal counsel.