The Problem with Private Placement Memorandums (PPMs)
The sale of equity in private companies is regulated by the Securities Act of 1933, which requires that the company either register with the SEC or meet one of several exemptions (Reg D). A Private Placement Memorandum (PPM) is a special business plan defined to meet an SEC exemption. In most cases, those entrepreneurs choosing to raise capital using PPMs retain specialists (many of whom are lawyers) to write their PPMs – a rather expensive undertaking. I don’t fund new companies that have prepared PPMs for investment. I am an angel investor, that is, an accredited investor who is assumed by the SEC and others to be sufficiently wealthy to afford to lose the investment and supposedly experienced enough to make good choices on fundable companies. Angels, as group of accredited investors funding startup companies, are assumed to meet a Reg D exemption for purchasing equity in private companies.
Why don’t I encourage entrepreneurs to use PPMs or at least invest in those that do? Like most angel investors, I have preferences for the terms and conditions of investment and intend to negotiate with entrepreneurs on those terms, such as valuation, company structure, the makeup of the board of directors, liquidation preferences and others. I have yet to read a PPM written for a startup company that meets the parameters we angels generally establish for funding new ventures. For some reason, PPMs prepared by those specialists just don’t match the standardized term sheets now being used by angel investors.
I don’t like the terms offered in the PPM, why don’t I insist that the terms be changed to accommodate my partialities as an angel investor? Sounds simple, huh? Unfortunately, upon completion of the PPM, the first thing that entrepreneurs tend to do is sell shares to friends, family, friends of friends and other acquaintances. Then, only after convincing a bunch of these “unsophisticated” investors to sign up and write their checks, the entrepreneur may approach an angel or group of angels. The entrepreneur has already raised half or more of the cash required in this round and is eager to top off the round. The PPM does not meet the investing terms and conditions of the angels. The valuation is too high, or the PPM is written for common stock when it really should have been a preferred stock deal or other critical terms are not present in the PPM. Since many unsophisticated investors have already funded part of the round, it becomes too complicated to renegotiate the terms of the deal. What do I mean by “too complicated?”
I think we would agree that it is only fair that all capital sources in a given round should invest under the same terms and conditions. There should not be one version of terms for the early set of investors (the PPM terms) and a second version of terms for later investors in the same round. In the long term, different term sheets for investors in the same round leads to unhappy investors. We angels could insist that the entrepreneur go back and renegotiate the terms of the PPM with all the earlier investors, but the earlier investors may or may not agree to the changes. From a long history of angel investing, we have learned it is just easier to pass on PPM deals and move on to the next opportunity. We see many startup investment deals every year – too many for most of us to fund.
Regarding PPMs, my recommendations to entrepreneurs are:
- Don’t prepare PPMs to fund startup rounds of investment. It is expensive and may preclude sophisticated investors from funding your deal.
- Pursue smart money, that is, sophisticated investors who will negotiate a fair deal with you and help you grow your company.
- Limit your offering: Only sell shares to accredited investors. In the long run, this usually works best for startup entrepreneurs.
Written by Bill Payne
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