When a company offers its shares for sale to the public in an Initial Public Offering, it must file a share prospectus with the Securities and Exchange Commission (SEC). But what about when a private company offers its shares for sale to private investors? This is where a Private Placement Memorandum (PPM) can be used.
What is a Private Placement?
Before discussing the memorandum, let us first cover the basics of private placements. In the context of startup investing, a private placement means selling shares to specific investors under a private arrangement that is not available to the general public on the open market. It is important to note that private placements have fewer regulatory requirements compared to shares sold to the general public on a stock exchange such as the New York Stock Exchange. Private placements are common for startups seeking early-stage funding from investors. In these private stock transactions, the company does not need to prepare a prospectus.
What is a PPM?
A Private Placement Memorandum (PPM) is a legal document setting out the deal terms, risk factors, and objectives of an investment made under the private placement offering. A PPM includes items such as an introduction to the company, financial statements, description of business operations, risks, biographies of key management, and additional details describing the company and how it operates. The information provided must be current, accurate, and truthful.
A PPM is mandated only in specific circumstances. However, even if it is not a requirement, it is generally advisable for issuers to provide one.
How Does a PPM Work?
A PPM serves the following primary functions:
- It provides a prospective investor with a description of the offering, helping them in their decision about whether to invest in the company.
- It provides sellers with some protection against the liability that comes with selling stock on the private market.
If a company is planning on offering shares utilizing a PPM, it is important for them to understand the applicable regulations.
When shares are offered for sale via a public offering, the offer must be registered with the SEC and highly detailed information must be provided in a prospectus. The process for registering public offers with the SEC is long, expensive, and complicated. So, Regulation D offerings were created by the SEC to allow companies an exemption from that registration process, provided they follow certain rules, such as dealing with only accredited investors or qualified purchasers (depending on the specific requirements of the offer).
Types of PPMs
Private Placement Memoranda are often used by startups for capital raising purposes, but they may also be used for other purposes, such as:
- Selling common stock in a corporation
- Notes (debt) from a mortgage broker business
- Limited Liability Company promissory notes (debt)
- Bond sales by county financing authorities
- Mutual fund shares that are held by a trust
Offering Materials vs. Private Placement Memoranda
The term “Offering Materials” is a broad term to describe any material that presents an offering to investors and could include items such as an investment pitch deck, a webinar, an email, a presentation, subscription documents, term sheets, a corporate letter, a business plan, or similar material.
Unlike the broad category of Offering Material, the term Private Placement Memoranda is specific and designates a particular document that must contain certain information. A PPM could be one of the documents included within a set of Offering Material.
The 506 Rule and How it Impacts PPMs
The SEC’s Rule 506 of Regulation D allows two types of exemptions that permits companies to sell shares without registering the offering with the SEC, as follows:
- Rule 506(b) allows a “safe harbor” under Section 4(a)(2) of the Securities Act, provided a company satisfies certain requirements, including no solicitation (advertising) to market the stock, and selling only to “accredited investors” and up to 35 non-accredited investors. If the stock is being sold to non-accredited investors there are additional requirements.
- Rule 506(c) allows a company to solicit and advertise the offering to accredited investors, provided they comply with certain requirements, including taking reasonable steps to verify accredited investor status.
When raising capital, if companies comply with the requirements of Rule 506(b) or 506(c), they do not have to register their offering of securities with the SEC. However, a company must file a “Form D” with the SEC upon the first sale of its stock.
The provision of a Private Placement Memorandum is not mandated for all offerings under Rule 506(b) or 506(c), because it depends on the amount of money being raised and the accreditation status of the investors involved in the purchase of stock. However, a PPM is generally considered advisable, so as to increase the level of confidence for the investor and to reduce the liability risk for the seller.
Components of PPMs
A Private Placement Memorandum should include:
- An introduction outlining the basic terms of the offer and some information about the company.
- A summary of the offering terms such as a term sheet.
- Risk factors that could impact the investment, both general and specific.
- Company description and management profiles, including the history of the company, its products and services, biographical information on management, etc.
- Offering details, including the type, class, rights, and restrictions.
- Pertinent details such as the company’s dividend policy, anti-dilution provisions, restrictions on resale or transfer of the stock, etc.
- Details of how the raised capital will be used.
- Conditions and disclaimers, including specific requirements of the State in which the offering is made.
- Information on any current or pending legal proceedings of the company.
- Instructions for how to invest in the offering.
- Exhibits providing supplementary information that could be important for an investor’s decision.
The Difference Between a PPM and a Business Plan
As described above, a Private Placement Memorandum is a formal, full-disclosure legal document providing company details for potential investors, giving them information they need to assess the risks and opportunities of investing in a company. A Private Placement Memorandum is typically conservative in its projections, often considering less-than-favorable operational scenarios in order to present realistic potential outcomes to investors.
On the other hand, a business plan is often used more as a marketing document that may provide less detailed information than a PPM in some areas and may expand on the PPM by providing more information in other areas. A business plan typically has a marketing focus and in addition to operational information, it may also contain anticipated revenues, market potential, financial projections, forward-looking statements, and more. A business plan is typically optimistic in its projections, often presenting favorable operational scenarios.
Following on from the above, it is important to remember that while a Private Placement Memorandum is a legal document, it may also be used as a marketing document. After all, the purpose of a PPM is to encourage investors to invest in a company. So, when drafting a PPM, a company will generally seek to find a balance between legal/compliance (risk mitigation) and marketing (attracting investors).
What Prospective Investors Should Consider in Every PPM
Prospective investors should consider both the general and the specific nature of a PPM when considering an investment in a company. The potential investment may have both risk factors and opportunities that are common to the market sector as a whole but then also risks and opportunities that are specific to the particular company that has prepared the PPM.
As noted above, while a PPM is a legal document, its primary purpose is to attract financial investors. It should therefore be written in relatively plain English to aid understanding of the offering and recognizing that complex legal language may discourage potential investors. An important consideration for investors is that the Private Placement Memorandum should not be a generic, boilerplate document that looks like it has been created from a standard template. It should be specific and relevant to the company, to provide confidence that it has been prepared considering the particular issues relating to the potential investment.
It is important that the Private Placement Memorandum is thorough, complete, and detailed. It should include all the components listed above and diligently present the risks associated with the investment, along with other necessary information. If something pertinent is missing from the PPM, this should be treated as a red flag.
A Private Placement Memorandum is an important legal document that must comply with certain regulatory requirements as part of an offering of company stock for sale to potential investors. The PPM should contain information explaining the potential risks of the investment and other relevant details sufficient to assist a potential investor in his decision about investing in a company.
If you are interested in building your portfolio by adding investments in startups, you can find more information here on how to start angel investing and how to find opportunities for angel investing on the Propel(x) platform.
This article is for informational purposes only. Propel(x) does not provide legal, financial, or tax advice and investors should consult their advisors prior to making any investment.
As with any investment, past performance is no guarantee of future performance, and any investment decision must balance the risk against the potential return. Private investments are highly illiquid and risky and are not suitable for all investors. There is no guarantee that a liquidity event will ever take place.