Private placement memorandums (PPMs) are vital and provide transparency for potential investors and protection for sponsors. However, understanding how PPMs are structured, what’s included, and how detailed to go is important to a successful offering. Central to that are the “5 W’s”. These are five basic questions that must be answered in detail within the PPM, and include:
- Who?
- What?
- When?
- Where?
- Why?
In this post, we’ll explore what should be documented under each W to ensure the PPM offers full transparency, disclosure of the goal, the overarching plan, and how everything comes together to make investors a profit.
Who?
Who is involved with the offering? If someone has a material of 10 percent or greater ownership, it must be disclosed. Or if they’re in management, and they have management rights or controls, they must be disclosed.
Company: The “who” starts with the issuer itself. Sponsors must describe when it was formed. Is it a brand-new company, which might be preferred because there’s less to disclose, or is it a company that’s been in operation, and is there a history that needs to be disclosed?
Management: Who is in charge? Who’s leading the team? Who makes up the management team? For management with an LLC, it’s the person that may be managed, seeing if there’s a management entity involved. Or if it’s a limited partnership, there’s often an LLC or a corporation that serves as a general partner. There’s a person at some point behind the scenes managing what’s happening with the company. You must disclose who that is. With all these key principles, sponsors should include bios and past performances, including any skeletons that might be lurking in their closets.
To be more specific, bios do not need to be super detailed. However, they must include at least the past five years of business experience, including places of employment, job titles, and responsibilities. For experience and performance, think of things like raising capital and investor outcomes. Highlight deliverables, communication successes, and other relevant items. It’s also important to disclose when things did not go to plan because, without those details, investors don’t enjoy transparency and cannot make informed decisions.
In terms of skeletons lurking in closets, be prepared to disclose elements that affect investor trust, sponsor credibility, and more, including the following:
- Regulatory issues
- Bankruptcies
- Any felonies or misdemeanors
Failure to disclose these types of information can be a securities violation in and of itself.
Investors: Who can invest? Is it limited to accredited investors only? What are the suitability requirements? What must be qualified for suitability, meaning investors’ qualifications, before they can contribute funds?
What?
What is being offered? It could be a promissory note. It could be debt. It could be an equity interest. There could be preferred stock, common stock, different classes, or just a profit interest. There are many ways to make an offering to describe what sponsors give to the investors. What that is must be fully disclosed and described within the PPM.
Type of Securities Described in a PPM
When discussing what type of securities may be described in the private placement, it’s important to understand preferred equity and common equity.
Preferred Equity vs. Common Equity
With preferred equity, there is an accrual rate paid to the investors when the company has the money. Depending on how it’s structured, sometimes it adds up until the company pays. Sometimes it is paid if the company can afford it.
However, it’s more akin to a debt, but it’s a debt that you cannot default on. That’s a necessary clarification. With preferred equity, it is a percentage return to the investors. It sits in front of the common equity, but it’s only possible to default if the company has sufficient financial standing to make those payments on time.
Common equity is just good old-fashioned ownership of a company. Investors get a percentage of the profits, have voting rights, and are concerned about profitability, even more so than the preferred equity investor.
Why is it that preferred equity is paid, the debt is paid, and common equity gets the upside of how a profitable company is operated?
Common equity gets all the upside after all expenses and all preferred returns have been paid out. With preferred equity, it’s a fixed return.
Two other options are offering debt and offering promissory notes through a private placement. With these, there is generally a maturity date, an interest rate, and a debt sponsors must pay. If the sponsor defaults, it can force them into bankruptcy.
Which one of these types of investments makes the most sense for a business? It’s a deal-by-deal consideration. It comes down to what kind of business activity is being funded. Let’s consider a simple example.
Many sponsors love convertible notes. What’s a convertible note? In this situation, the sponsor borrows money as a debt. The investors are lenders and have a preferred position if there’s ever a bankruptcy or liquidation. However, if things go well with the company, debt investors can convert into common equity and enjoy the upside. For a startup company, it’s a fantastic way to get up and running with a limited number of investors to help reach early goals.
When?
When does everything happen? Often, the when is in the future. A sponsor might have a business plan that explains what they’re going to do, step after step, but the reality is, they’re all forward-looking statements, meaning they are still determining what will happen in the future. So, sponsors must be very careful about describing when everything happens. Sponsors must preface it with their intention, but state that it’s all an expectation, a hypothesis, and only a fact once it occurs.
The offering starts on the date on the offering memorandum. The PPM generally states when the offering ends. It is possible to do an offering that lasts years. However, if you do long-term funding through a private placement, sponsors are still required to update and supplement the offering once per year with current information, including financial statements.
When can you start spending the money that’s being raised? Sponsors can only spend the money once they can effectuate the business plan. Suppose the deal involves real estate. If you can’t close on the real estate, you shouldn’t be spending the investors’ money because then investors have a loss if it doesn’t close. Be ready for that lawsuit.
From a business perspective, there’s a minimum amount of money to raise to launch the company. Until the deal hits that amount, whether it’s equity or debt, it comes together based on the company’s structure and investment. Sponsors must wait to hit that minimum threshold to start moving forward with their business to spend any investment money.
When will construction rehab or project development be done? You must spend the money to accomplish these things within the business plan. However, when it comes to construction or rehab, as an example, sponsors must have the property in hand first. If the business doesn’t own the property, there’s nothing to construct, and there’s nothing to rehab with product development.
When can investors expect their dividends or distributions? It varies from situation to situation.
Investors like checks, and the more they receive, the happier they are. Sponsors build investor expectations while putting together the investment structure, and the timeline of expectations is disclosed to the investors through the PPM. However, some deals involve properties with existing rents. Distributions start month to month. Other deals, especially ground-up construction, can take three or four years for everything to come together. All this information is disclosed to create those investor expectations within the PPM.
When can investors expect a return of capital? An investor’s exit strategy is important to them. How and when are they going to get their money back? Of course, sponsors must consider whether they will sell the company. Are they looking to merge with another firm? Do they think this will eventually go public? Will there be a public market in the future? When do you expect to sell the asset? In the case of a fund, what’s the process of getting the investors their money back if they need it?
Sponsors expecting a fund to operate for 10 years or more should have a mechanism to return the cash to investors that need it. They will start to see investor resistance with a horizon longer than five years to seven years.
Various mechanisms can trigger this action. Sponsors can consider what the net asset value is. So, they have a floating valuation. There can be public market sales, but that generally only happens with something other than a Regulation D offering. Only once you do a public registration or qualification through Regulation A do these secondary markets appear. However, it’s always important to consider how the investors will get their money back.
When will the company cease operations? When will it wind down and what’s the strategy? In real estate, you sell the property, distribute the funds, and then go based on the operating agreement of how to liquidate the remaining balance and wind down the company. With an actual operating company, sponsors must think deeper about the exit strategy, because ultimately, the assets need to be sold or the company is getting sold off somewhere else. However, it’s important to consider how long the investment will last and what’s going to happen to the investors, the company, and the assets of the company.
Where?
Where does the money come from? This is where marketing to friends and family begins under Regulation D, rule 506 B. While sponsors cannot advertise online, they can speak with friends, family members, previous associates – anyone with whom they have an established, demonstrable relationship.
What does “relationship” mean, though? Some sponsors assume that because they’ve had someone’s email address in their contacts for five years, that establishes a preexisting relationship. However, that relationship must bear scrutiny. If there has been little or no communication between the two, then there is no demonstrable relationship there. Moreover, those previous communications must be for purposes other than solicitation.
Where does the money go? A use-of-proceeds statement should fully explain where the money goes after it enters the bucket. Expenses could include any of the following:
- Legal accounting
- Broker-dealer costs
- Sales expenses
- Commission payments
- Costs of raising capital
- Research and development
These costs must be broken down to highlight where every penny goes once it leaves an investor and enters the business or deal. Again, this is about transparency and providing potential investors with the full picture in an easily understandable way.
Of course, expenses change as the deal progresses, so the use statements are also forward-looking. It’s important to make clear that these cash flows are how things are predicted to occur, but that reality may be different once the strategy is in motion. In some cases, dramatic changes in scope, targeted acquisitions, timelines, and other factors that materially affect investor returns require you to go back to investors and explain the changes and provide them with an opportunity to opt out.
Once the company is in operation, the real estate’s been bought. Clients are paying their bills and distributions. That’s the next step. With a corporation, it might be called a dividend. Within an LLC or a limited partnership, it might be called a distribution. It’s all the same thing. It’s just money that’s going back to the investors.
To touch on taxes, the situation depends on the type of entity or investment in question. Often, especially in the technology space, C-corporations are the formation of choice. A C-corporation pays for its taxes, and the investors only get tax forms if a dividend was paid out.
On the flip side, you can have an LLC with partnership taxation. With the partnership, taxation, the profits, and losses are distributed down and paid by the LLC or partnership owners. If there’s depreciation or loss, those also go down to the owners, tax returns through a K1. K1 is a specific form that lets the IRS alert owners about the amount of income or losses that flow through to the investor or the owner’s tax returns.
Why?
Why is the offering being made? That’s that story of what you’re trying to accomplish. What are your goals? If you’re targeting a particular market or an industry, explain that industry. What background information do you know, and why will your company excel? Once it has this capital funding in success and whatever your ultimate goals and plan, maybe what can go wrong from here?
Why is this company raising investor funds? This is where sponsors disclose the operations, where they expect the company to go, and the future business plans. If it’s an operating company, financial information must often be disclosed to investors. If enough capital is raised and it’s a new company, there are no financial statements to provide under Regulation D.
Now, sponsors may need to get under Regulation CF or Regulation A’s audited financials for a brand-new cleaning company. However, they don’t have to do that under Regulation D, if they start with a new company. This ultimately limits the amount of risk for issuers and investors from the unknown things that often happen in the background or the past of a company.
Work with a Knowledgeable Attorney
The devil is in the details when it comes to private placement memorandums, which is why it’s incredibly important to work with a knowledgeable attorney. Any PPM is required to be written in understandable, everyday language accessible to anyone without any sort of special education or experience.
However, the operating agreement is very formal and requires specific language to be legally binding – it’s a contract. The operating agreement must match the details in the PPM, which can be challenging given the difference in how they’re written. Without an experienced attorney, it’s possible to end up in a situation where the documents do not match. For instance, one document may refer to a sharing ratio and the other says the manager decides when and what to distribute to members and investors.
Conclusion
Structuring a PPM correctly and ensuring it matches the operating agreement are critical steps in getting a deal off the ground. However, a single misstep could mean major repercussions, including fines and fees from regulators, a loss of trust from investors, and more. Contact Crowdfunding Lawyers today to schedule your consultation and learn how we can help you create an accurate, easy-to-understand private placement memorandum and legally binding operating agreement.