Having complied with the securities laws, produced a meticulous PPM, and gone down a thousand rabbit trails with potential investors, the entrepreneur now must close the deal. At last the end is near, but certain hurdles remain — primarily getting an investor to sign on the dotted line and fund the deal. Getting the check is not a legally complicated transaction, but what document comes before the dotted line?
To give a quick primer on the various documents: If you have done a full blown PPM, you will include in the PPM package the appropriate legal documents. While these documents are deal specific, you will typically find in a PPM a subscription agreement whereby the investor ‘subscribes’ or offers to invest in the company and signs the underlying corporate governance documents, e.g. an operating agreement or an investor rights agreement.1 These documents will sometimes be executed via a joinder agreement, which essentially has the investor agreeing to these documents.
Sometimes when you have a PPM outstanding, an investor or group of investors will want to do the entire deal themselves. In such a situation, assuming it’s acceptable to the investor, the investors will have a stock purchase agreement or similar agreement. Sometimes you get to this point before you get to the PPM. If there is a single or small group of investors, they will simply execute a stock purchase agreement as opposed to going the full blown PPM. Sometimes a PPM is necessary to get a single or group of investors to move forward with a stock purchase agreement. As always, there is not a standardized process in this area of investment. A stock purchase agreement will contain the representations and warranties and disclosure of exceptions, if any, to these representations. As a consequence, if you have a stock purchase agreement, it may not be necessary to have a PPM or other disclosure document because of these representations.
From my legal perspective, I want to be sure that these documents accomplish two main goals. First, I want to get an acknowledgement from the investors of the risk involved with the transaction. Even in standardized investments of public company stock, somewhere in your documentation you are signing off on the fact that prior performance is not an indication of future success. Similarly in the private markets, the documents somewhere should have a litany of risks factors that outline the perils of the investment. It is essential in the documents, typically in the subscription agreement, that the investor acknowledges those risk factors.
Additionally, if the securities exemption upon which the company is relying requires that all or a certain number of investors be accredited investors, or alternatively, if the investors must meet certain suitability requirements2, then the documents must ascertain the net worth of the individual investors. Asking someone who is kind enough to invest in your highly risky endeavor how much they are worth requires a little finesse. However, in order to comply, the company must have a reasonable basis upon which to rely as to how much their investor is worth. A written and precise acknowledgment from the investor as to his or her net worth is consequentially essential. Additionally, given the fact that people are prone to exaggerating their net worth, or more precisely, give the illusion that they are wealthier than they actually are, particularly in conversation, written acknowledgement if essential. This requirement is tricky because of the delicate nature of the investor/company relationship. However, if they truly are wealthy and they are the least bit sophisticated in these type of investments, then the wealthy investor will know that these written questionnaires as to his or her net worth are standard and essential, and he or she will happily fill one out. An attorney or other intermediary can perform a valuable role in being the buffer or in-between on one of these investments.
It is within these documents that the die is cast, so to speak, as to the relationship between investor and entrepreneur and founder. It is like the children’s game where you drop a ball at the top of a maze and watch it go down — knowing that gravity will get it to the bottom but unsure which direction it will take. While impossible to know all of the various contingencies, problems with investments can typically be traced back to questions wrongly answered at this stage and typically involve too much or too little of one of the following:
- Control: Too much control by investors can be restrictive, counterproductive, and lead the company in a direction that is unintended; too little leaves the company without guidance, and as a consequence, they drift aimlessly.
- Investment Amount: Investing too little can starve the investment; too much can have a boot strapping company get fat and complacent and unable to react to the market.
- Business Plan Revenue: Well this is not a matter of too much or too little as I have never had a problem with a company having too much revenue. This is simply the company committing to more than they can generate. Sometimes all the investment in the world will not drive revenue if the market is not there.
Thus, as a final takeaway to all of the investments, I think it is important to remember that good business and good business sense is crucial. Typically, you can fix things that are generating revenue and doing so in a profitable manner. If it is a bad business, however, no agreement is going to save the company.
Goodrich Law Firm, LLC
1 The mechanics of operating agreements, shareholder agreements and investor rights agreements will be dealt with in later articles.
2 Because of the interplay between state and federal securities law, you will almost always need to ascertain the wealth of the investor in order to meet either the Reg D accredited investor threshold or the suitability standards in Alabama state securities law. The small exemption (under 10) may be the sole exception to this rule, but even in that context, it is far better dealing with people who can afford to lose their investment if they are truly investors.