The Top Ten Traps for Investors

Posted on May 17, 2007

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The Alabama Securities Commission recently released its top ten traps for investors.  Included on the list were the usual suspects – internet schemes, investment seminars, and oil and gas schemes.  Also included was a warning about Private Securities Offerings:

Private Securities Offerings. Con artists are turning increasingly to private securities offerings under Rule 506 Regulation D of the Securities Act of 1933 to attract investors without having to go through the full registration process. Although sometimes legitimate, these offerings are often associated with fraud. Remember: Especially with lightly regulated investment offerings, it pays to consult a trusted financial adviser.

Exemptions from public registrations and limits on regulatory oversight are crucial for start up companies.  These regulations and the accompanying state "blue sky" regulations are fundamental to providing capital to early stage ventures.   

When a person invests in their cousin Joe’s business, they are able to do so because the investment is a private investment and not subject to securities scrutiny. These regulations allow friends and family members to invest and the companies that they establish to exist.  Without these regulations, the regulatory burden would cripple the capital markets for small businesses.  If every investment regardless of size or amount of the investment was subject to filing and disclosure requirements, many of these type investments would not take place, and these investments are extremely critical for early stage companies.

Fundamental to this system is a level of trust between the company and the equity purchaser. Along with this trust, however, the investor must have the understanding that the venture involves a high level of risk.  From the investor’s perspective, an understanding that all the capital may be lost is crucial.  Hopefully (and we try to do this for our clients whether it is a ppm, llc operating agreement or simple investment disclosure), a disclosure exists that essentially states all capital is at risk.  Companies take this disclosure seriously.  Investors need to know that they can lose everything.  Yes, your cousin Joe may have a great business plan and be perfectly capable, but something may still go wrong early on that ultimately dooms the business.

From the company side, fair and reasonable disclosures and realistic expectations are crucial.  Investors need to be compensated for the risk they assume.  Companies should not take money from investors who cannot afford to lose the entire investment.

Although not surprising, abuse of this law is extremely disturbing.  As is often the case, a government reaction could cripple the capital markets – a few bad apples spoil the bunch.  Everyone needs to do their part to increase awareness and better understand the risks and rewards of investing in private companies.

Mike Goodrich, Goodrich Law Firm,LLC

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