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Part 1 of 3: Will Your Private Placement Memorandum (PPM) Risk Factors Protect You?

 

Part 1 of 3 Risk Factors.jpgWhat are PPM Risk Factors and why do I need them?

Every properly drafted private placement memorandum or PPM has a risk factors section.  And, although one primary purpose of a PPM is to present your startup company to private investors and crowdfunding portals, an equally important purpose to the PPM is to protect you and your company from legal exposure.  The risk factors section of a PPM essentially is the part of the PPM that tells investors why and how they could lose part or all of their investment.  However, it is critical to note that the Securities and Exchange Commission (SEC) has been clear that boilerplate or PPM template-based risk factors may not be enough to protect a company from the so-called anti-fraud provisions of the securities laws.  So, it is extremely important that your PPM includes custom, industry-specific risk factors in order for you to be protected from investor lawsuits and compliance violations.  If you don’t get this right, you are simply diving head first into shark infested waters.

More about risk factors.

Risk factors are cautionary statements about risks a company may face that could have a material adverse impact on its business, financial condition, and results of operations, and which, in turn, could lead to losses by investors.  Moreover, risk factor disclosure improves the overall quality of a disclosure document by highlighting for investors the challenges posed by a company’s business.  We may even think of risk factor disclosure as an insurance policy for a company because it can also help mitigate litigation and liability risk.

In connection with Regulation D exempt offerings, risk factors are typically included in a separately captioned heading of a PPM, and provide investors with management’s views on the risks the company faces and, if those risks materialize, the effect they may have on the company’s business and the value of company securities held by investors.

Naturally, the people who have the best insight on what the company needs to worry about are senior management.  The concerns that keep them up at night are likely those that should be highlighted in the risk factors section.  This is the reason why management should always work closely with legal counsel throughout the process of identifying risks and reviewing advanced drafts of disclosure documents to ensure the most important risks are identified, specifically described, and tailored as much as possible to the company’s business operations.

Ultimately, it is of critical importance that risk factors be specific to the company because the “safe harbor” protections under Regulation D do not extend to protect companies from the “anti-fraud” provisions of the federal securities laws, which generally require that offering documents include no material misstatements or omissions of material facts.  In the event that risk factors are not well drafted, and industry- and company-specific, their use could undermine the effectiveness of a PPM in protecting the company and its principals from legal exposure and civil liability.

General risk factor guidelines.

Businessman hand holding a pen pointing to RISK word on the paper

 

 

 

 

The risk factors section of a PPM should concisely summarize the major risks in investing in the company.  Risk factors should be specific, focused, and disclose enough information to place the risk in context and enable an investor to assess the magnitude of the risk.

The following are some disclosure guidelines to keep in mind:

  • Risk factors should be limited to those that are specific to the company, and avoid generic or boilerplate risks that could apply to any company or any securities offering.
  • Risk factors should be organized logically. A common and useful approach is to group them into company risks, industry risks, and investment or securities risks (more on this below).
  • Risk factors should be presented in the order of their importance within a particular category. It does not help the purpose of risk factors to identify a significant risk but bury it in the risk factors section between risks that are less significant.
  • Risk factors should specifically address actual emerging risks. It is not sufficient that a risk factor highlight a risk in the abstract if the risk has already begun to materialize.  For example, if a company’s business depends on its intellectual property, it is not sufficient to have a general risk factor on the risk of intellectual property infringement if there is actual ongoing litigation that may compromise, or that is challenging, the rights of the company to the intellectual property.  If the company’s intellectual property is a key asset, failing to disclose that there is litigation involving a key patent may be construed by a court as misleading (and could certainly invite litigation).
  • Risk factors should generally avoid discussion of the company’s plan for addressing such risks. Accordingly, even if the company has taken or is taking measures to address the risks, countervailing considerations that mitigate the risk should generally not be included in the risk factors section.

It is critical to have company-specific risk factors.

These are risks that affect the company specifically: for example, the risk that the company may be unable to successfully market its newest product or implement its medium-term strategy.  Company risk factors vary considerably among companies and industries and can include:

  • Inadequate insurance coverage.
  • Dependence on current management.
  • Lack of operating history.
  • Success of a growth strategy.
  • Risks related to acquisitions.
  • Current material litigation.
  • Challenges posed by competition.

It is critical to have industry-specific risk factors.

Industry risk factors describe risks that companies face by virtue of the specific industry in which they operate. These encompass risks that affect all companies in a similar industry, but may affect specific companies differently depending on a number of factors.  For example, a company operating in the coal industry faces the risk of fluctuating coal prices, but may be impacted differently if its business also encompasses other power and/or energy sources. Industry-related risk factors include:

  • General economic conditions.
  • Environmental risks and associated costs.
  • Legal and regulatory requirements and compliance with applicable laws.
  • Seasonality of the business and inability to predict cash flow.
  • Labor costs and shortages.
  • Uncertain supply, and price fluctuation, of raw materials.
  • Risk of increasing energy costs.

-----> Go to Part 2 of 3 here.

About the Author: Erik P. Weingold

erik

Erik P. Weingold is an entrepreneur and corporate securities lawyer with over 20 years experience under his belt.  He has been practicing law since 1995, and since 1998 has been drafting PPMs that have been used to raise millions upon millions of dollars for startup companies and small businesses throughout the U.S.  Erik is the founder and General Counsel to PPM LAWYERS, as well as Of Counsel to Convergent Litigation Associates, LLC (www.cla-law.com), a national law firm focused on the representation of clients through complex securities and commercial litigation.

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