What other types of risk factors do I need?
Private Placement Memorandum or PPM risk factors describe the risks to an investor specific to an investment in a company’s securities. Securities include equity in a company as well as debt in a company. Different types of securities carry different types of risks that affect their value in different ways. Generally, these risk factors focus on the specific security being offered and the structure of the offering being conducted.
When issuing debt securities, one of the main sources of risk factor disclosure is restrictions, or a lack of restrictions, on debt incurrence (because higher leverage could lead to an increasing number of competing claims in bankruptcy and an inability to incur additional debt if necessary may prevent the company from financing its operations or investments). In addition, if the debt is subordinated or unsecured, it is appropriate for the company to highlight this fact to explain to investors the relative ranking of their investment. If the company is highly leveraged and also has outstanding bank loans, for example, it should disclose this, along with total amounts outstanding, its current ability to service debt expenses, its sources of liquidity and the impact of a default under any one agreement. These risks should also include the company’s ability to generate sufficient cash flow to pay down the debt and whether a trading market for the debt exists or may develop.
When issuing convertible debt, additional risks specific to convertible securities are also necessary, such as, for example, risks related to tax treatment, accounting treatment and conversion, such as the inadequacy of the value received on conversion due to certain adjustments to the conversion rate. In addition, disclosure also includes risks related to ownership of the underlying securities (typically equity).
Risk factors relating to equity securities will typically address equity class structure and the company’s dividend or distribution policy, as well as risk factors relating to dilution. In addition, if the company is majority-owned by a small group of insiders who can effectively exercise control of the company, it is important to disclose that fact as well.
What happens if my risk factors are not good enough?
Because risk factors are particular to the risks of a particular company, there may be wide variation in the types of risks a company discloses. However, in the category of company-specific risks, risk factor disclosure relating to the use of financial projections deserves some special attention. Although accurate financial projections are difficult to prepare for any business, they are notoriously difficult to prepare for new businesses because of the lack of a significant operating history. Because financial projections are likely to be inaccurate in some respects and may prove to be materially inaccurate, it is critical that risk factors be specifically tailored to the type of financial projections provided and the assumptions and estimates that underlie them. Two recent cases illustrate the dangers of inadequate risk factor disclosure and why it is so important to have an experienced attorney draft custom industry- and company-specific risk factors.
First, in Greenwald v. Odom case, the Georgia appellate court found that the risk factor disclosure in a company’s private placement memorandum was not specifically tailored to the financial projections. The risk factor disclosure did not address the assumptions underlying the following items: (1) the company’s revenue forecasts; (2) the ability of the company to satisfy its debt obligations through the future sale of one of its divisions; and (3) the company’s accounts payable. For example, the company did not disclose that: (a) revenue forecasts were based on customer contracts in the pipeline rather than in hand; (b) there was no identified buyer for the division and no negotiations had occurred with any party for the sale of the division; and (c) the company had significant accounts payable that were long overdue. Accordingly, the risk factors were not sufficiently cautionary to the investors and did not protect the company against an action for securities fraud.
Second, in SEC v. Tecumseh Holdings Corp., the Federal District Court for the Southern District of New York found that the risk factor disclosure failed to adequately caution how unrealistic Tecumseh’s profit projections were. Instead of stating that the company was losing money, the risk factor disclosure in Tecumseh’s private placement memorandum merely stated that the company “had not yet generated any operating profit” and suggested that the only reason it was not generating operating profit is because it had not “formally commenced its new operations.” The court found that the other cautionary language— describing the investment as involving a “high degree of risk” and “highly speculative”— was too general to alert an investor to the fact that the company’s profit projections were unrealistic.
In short, companies that provide financial projections should ensure that they include robust disclosure regarding the material assumptions and estimates underlying that financial information, as well as risk factors that explain, in specific, accurate and plain language, the risks that may undermine the accuracy of the projections.
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About the Author: Erik P. Weingold
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.