Financing Your Small Business

Disclosure Requirements

The guiding principle behind all offerings of securities, whether public or private, is full disclosure of all material facts concerning the company and the offering. This is so an investor can make an informed investment decision. It is always advisable to err on the side of inclusion in terms of disclosure.

All disclosures must be in writing and made available to each pur­chaser at a reasonable time prior to the purchase of the securities. Each investor must have the opportunity to ask questions and receive answers concerning the terms and conditions of the offering. The investor may request any additional information that the issuer possesses, or can acquire without unreasonable effort or expense, that is necessary to verify the accuracy of the information provided in the disclosure document. Essentially, every investor must have equal access to information. An issuer should not rely upon ad hoc conversations with individual investors to convey all of the information necessary to provide full disclosure. For these reasons, it is important to draft a clear and concise document con­taining all material information. That document is referred to as a private placement memorandum (PPM).

Private Placement Memorandum

The PPM is intended to be an all-inclusive document providing specific information on the company, its business, its management, the risks involved in the investment, and a description of the securities offered. Much like a business plan, it is imperative that the principals of the com­pany participate in the process of drafting a disclosure document to ensure the accuracy and completeness of the information. In addition, an under­standing of the private offering exemption rules is essential, because if you violate any of the rules you could get into trouble with the SEC or state securities administrator.

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Figure 5.1: THE PRIVATE PLACEMENT MEMORANDUM

The information in the PPM should include the following.

• A summary of the offering, containing a synopsis or snapshot of the information that will be discussed in detail throughout the rest of the doc­ument, including (but not limited to):

♦ the name, address, and telephone number of the company;

♦ the date of the offering document;

♦ a description of the securities being offered;

♦ a description of any minimum dollar amount that has to be invested by an investor;

♦ any minimum dollar amount that must be raised in the offering before the funds are spent by the company;

♦ the total amount of money being raised;

♦ any escrow requirements of the offering; and,

♦ the resale or transfer restrictions of the securities.

• A cover page that contains information about any commissions paid to selling agents or finders (where allowed by law) and disclaimers about the high risk nature of the investment and the fact that the secu­rities have not been recommended or approved by any federal or state securities commission and are being offered under an exemption from registration.

• A table of contents to provide a road map for the document.

• A description of the company, including the name of the company, date, state of incorporation, street address, telephone number, and contact person.

• A description of the factors that the company considers to be the most substantial risks to an investor (risk factors) in this offering. This includes all the facts and circumstances that otherwise make the offering high risk or speculative. The following are possible risk factors that will have to be tailored to the company's unique situation — some will be applicable and others will not:

♦ the limited operating history of the company;

♦ the potential fluctuation of operating results;

♦ the intensity of competition in the market or industry;

♦ the company's business model (if unique);

♦ the dependence on key personnel of the company;

♦ the dependence on third-party vendors for goods and services;

♦ the need to hire and retain skilled personnel;

♦ the timing of positive revenue generation;

♦ the need for additional capital;

♦ applicable government regulations that affect the company;

♦ the need to expand operations;

♦ the need to obtain and maintain intellectual property protection;

♦ any conflicts of interest that exist among the company and officers, directors, or key employees;

♦ the fact that this is a high-risk investment—that the investors may lose their entire investment;

♦ the heavy reliance on the plans and concepts of management;

♦ the arbitrary determination of the offering price of securities—the fact that no independent valuation of the company was conducted;

♦ the resale and transfer restrictions of the securities imposed by the lim­ited offering exemption rules;

♦ the fact that no dividends are anticipated in the near future;

♦ if there are no escrow provisions, the funds raised in the offering may be used immediately by the company;

♦ the lack of an independent review of the information in the offering — the investor must rely upon the company for the accuracy of the infor­mation;

♦ that the securities have not been registered with or approved by any federal or state securities commission;

♦ that any forward-looking statements in the document are based on assumptions made by the company; and,

♦ that the financial projections in the document are based on assump­tions made by the company.

• Description of the business of the company, including:

♦ what the company does and proposes to do, including what products or goods are or will be produced, or services that are or will be ren­dered;

♦ how these products or services are to be produced;

♦ how the company intends to carry out its activities;

♦ the industry and competition of the company;

♦ the company's marketing strategies;

♦ any firmly written orders for products or services;

♦ the number of employees and anticipated employees;

♦ any real property and intellectual property that the company owns or has rights to;

♦ the extent to which the company operations depend on patents, copy­rights, trade secrets, know-how, or other proprietary information, and the steps undertaken to protect this intellectual property;

♦ whether the company's business, products, or properties are subject to government regulation, indicating the nature and extent of regula­tion and its effects on the company;

♦ the names of any subsidiaries and which, if any, are included in the financial statements; and,

♦ the material events in the development of the company, including any mergers or acquisitions during the past five years—or for whatever lesser period the company has been in existence—and any pending or anticipated mergers, acquisitions, spin-offs, or recapitalizations.

• If the company was not profitable during the last fiscal year, list the events or milestones that—in management's opinion — must or should occur in order for the company to become profitable, and the manner in which the company will achieve these milestones. Also, state the probable consequences to the company if delays occur.

• Description of the offering price factors and indicate:

♦ what the net, after-tax earnings were for last year;

♦ the offering price of securities as a multiple of earnings if the company had profits;

♦ what the net tangible book value of the company (the total assets minus total liabilities) is (if the net tangible book value is substantially less than the offering price, explain the reasons for the variation);

♦ the details of all other securities offerings in the last twelve months;

♦ what percentage of the outstanding shares of the company investors will own after this offering; and,

♦ what the post-offering value of the company will be.

• Description of what the funds raised in this offering will be used for, including such categories as:

♦ legal and professional consultants;

♦ intellectual property protection;

♦ research and development;

♦ marketing and advertising;

♦ repayment of debt;

♦ acquisition of assets;

♦ salaries and benefits;

♦ insurance;

♦ lease or purchase expenses;

♦ travel and entertainment;

♦ inventory;

♦ working capital (office expenses, telephone, etc.); and,

♦ expenses of the offering.

• Indicate whether the company anticipates having cash flow or liquidity problems in the next twelve months, or is subject to any unsatisfied judg­ments, liens, or settlement obligations.

• State whether the proceeds of the offering will satisfy the company's cash flow requirements for the next twelve months or whether it will be necessary to raise additional funds.

• Describe the capitalization of the company from the most recent bal­ance sheet date, with any adjustments since then, and also as adjusted for the sale of securities now being sold.

• Describe the securities, indicating:

♦ the attributes of the securities being offered, including the type (com­mon, preferred, promissory notes, etc.), voting rights, dividend rights, liquidation preference, conversion rights, redemption rights, etc.;

♦ any other outstanding securities; and,

♦ whether there is any debt or other class of securities that have the right to be paid before the securities now being sold.

• Describe who will be selling the securities. Typically, securities offered through private placements are offered by the officers, directors, and key employees of the company. The company may, however, employ a licensed selling agent or finder (where allowed by law).

• Describe any compensation to selling agents or finders, if the selling agents or finders will be held harmless for any mistakes they might make, and if there is any kind of business or personal relationship between the selling agent or finder and the company.

• Describe the resale or transfer restrictions to which the securities are subject.

• Identify any escrow agent that will be used to hold the securities if there is a minimum amount to be raised in the offering. The escrow agent holds the money until the minimum amount is raised. If the minimum amount is not raised, the escrow agent returns all monies to the investors, with or without interest, as provided in the PPM.

• Explain the resale restrictions of any presently outstanding securities and when those restrictions will expire.

• If the company has paid dividends, made distributions, or redeemed any of its securities in the past five years, describe when and how much.

• Describe the officers and key personnel of the company, indicating:

♦ the employment, education, business or personal bankruptcy, and lit­igation history of all officers for the past five years, and

♦ any details of any key man life or other insurance policies on the offi­cers and key personnel. Key man insurance is used for business pur­poses, usually to reimburse a company for the loss it sustains when an important member of the company dies.

• Describe the directors of the company, indicating:

♦ the number of directors and any special election or voting trust arrangements for the election of directors;

♦ the employment, education, business or personal bankruptcy, and lit­igation history of all directors for the past five years; and,

♦ any details of any key man life or other insurance policies on the directors.

• Provide information on the principal owners of the company (those who directly or indirectly own 10% or more of the presently outstanding com­mon or preferred stock) and how much they paid for their stock.

• Describe the management relationships, transactions, and remunera­tion, and:

♦ describe any conflicts of interest that the officers, directors, and key personnel have;

♦ describe if any of the officers, directors, key personnel, or principal stockholders are related by blood or marriage;

♦ provide details if the company has made loans to or is doing business with any of its officers, directors, key personnel, or principal stock­holders, or if they have guaranteed or co-signed any of the company's debt or other obligations;

♦ list all salaries and compensation to the officers, directors, and key personnel for the past and upcoming year, and describe any employ­ment agreements the company may have;

♦ list any outstanding stock purchase agreements, stock options, or war­rants; and,

♦ if the business is highly dependent upon the services of certain key personnel, describe noncompete or nondisclosure agreements the company has with them.

• Describe any past, pending, or threatened litigation or administrative actions that have had or may have a material effect upon the company's business, financial condition, or operations, including any litigation or action involving the officers, directors, or key personnel.

• If it is anticipated that any significant tax benefits will be available to investors, discuss them as they relate to the offering.

• Describe any other material factors that could affect the company or its

Business, or that are necessary to make any other information in this

Document not misleading or incomplete.

• For companies that have a significant operating history, include a man­agement discussion and analysis of certain relevant factors, such as:

♦ if the company's financial statements show losses from operations, the causes and what steps the company has taken or will take to address these causes;

♦ any trends in the company's historical operating results;

♦ if the company is selling products and had significant sales last year (state the existing gross margin as a percentage of sales and the antic­ipated gross margin for the next year of operations);

♦ any foreign sales, domestic government sales, and anticipated changes; and,

♦ any strategic alliances, corporate partnerships, or special marketing arrangements.

• Appendices to the PPM should include:

♦ subscription documents;

♦ financial statements of the company (balance sheet and income statement);

♦ financial projections (if used);

♦ operating agreement (in the case of an LLC); and,

♦ any other documents and agreements material to the offering.