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7 Commons Pitfalls When Structuring a Private Offering

Post on: November 29, 2017 | Ricky Segers | 0

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There is no overstating the importance of a first impression, especially when asking people for money. For issuers raising capital, the first impression you will make on investors will often be your offering documents, whether that be a private placement memorandum (PPM), pitch deck, circular, or other summary of your offering. This is especially true for offerings marketed online, such as those that utilize a Regulation A or Regulation D 506c exemption. However, in order to attract investors, you not only need an enticing offering summary, but a well-structured offering to back it up.

Here are a few common pitfalls sure to send up a red flag with would-be investors:

 

1. Irrational operating pro-forma and/or financial models

Most, if not all issuers are optimistic about their businesses when they are raising private capital.  Projecting a pre-revenue company's growth to $1 billion in revenue in three years will rarely attract interest, let alone interest from sophisticated investors. It’s important to be rationally optimistic about forecasts and ground the numbers in operating metrics that make sense. For example, if year one to year two revenue growth is projected to be 75% and little to no investment in sales and marketing is budgeted, how will you achieve the success? Not paying attention to the size of the market relative to the revenue opportunity is also a common mistake to avoid.


DOWNLOAD WHITEPAPER | Essential Elements of a PPM: Getting Started With Your Offering Summary


2. Ambiguous, declarative, and/or hyperbolic statements

Using phrases like “the first” or “the only” or claiming that an objective “will” achieve an outcome is problematic. In the same manner, issuers should avoid any and all statements that may be construed as a guarantee. 

When outlining the investment opportunity to investors, it’s important to be concise and clear. Cut to the chase and back up your claims with credible citations from reputable sources. Impress potential investors with your thorough research grounded in relevant, recent information from reputable sources. In addition, less is more. Concise language in offering documents will help avoid tedious feedback and revisions which cause delays in an issuers' attainment of broker-dealer acceptance.

 

3. Poorly structured fees and return profile

Too often we have witnessed an offering have little investor interest despite having promising business plans due to poorly designed investor return profiles or excessive management fees.  Issuers whose management abstain from collecting any profits until after investors' return of capital often attract investor interest due to their willingness to assume additional risk.

An offering’s inexplicable differences from industry average return profiles, holding periods, preferred returns, and fee structures are an uphill battle to explain to investors. Some investors may not be willing to spend a large amount of time trying to figure out what his or her potential return looks like net of fees. For example, a summary use of proceeds with multiple line items for miscellaneous consulting and advisory fees tends to distract investors. Similarly, offerings with a significant use of proceeds designed to recap founder investment capital originally structured as a loan may send a mixed message to a prospective investor.

 

4. Ineffective use of leverage (applicable to real estate offerings)

Real estate issuers using greater than 70% leverage to acquire a portfolio or property may deter potential subscribers due to perceived additional risk.  An example where the use of higher amounts of leverage may be more appropriate is in a stabilized, low vacancy, cash flowing asset.  A good hypothetical example would be the acquisition of a commercial or residential development with creditworthy master tenants and stable, long-term leases in place. On the contrary, speculative real estate offerings such as a buy-and-hold raw land acquisition may be better suited for an equity dominant capital stack.

 

5. Unsubstantiated valuation claims

Equity offerings of operating companies can be made or broken by pre-money valuations. Offering a company’s equity at too low of a valuation may lead to significant future dilution of stockholder's equity and may lower the maximum amount the company can raise.  Offering equity in an overvalued company is less attractive to potential subscribers and may make it difficult to raise any capital at all.  Having ample support for the rationale behind a company valuation is integral to a successful equity raise.

 

6. Inflexible commission structure

The SEC and FINRA prohibit placement fees and broker compensation that are deemed excessive and/or contrary to an investor’s best interest. We observe that commissions offered to those selling Regulation D exempt securities can vary substantially by industry and offering details.  Issuers offering a commission should consider a flexible commission structure. Using language like “up to X%” instead of a stated, static percentage, can allow an issuer the flexibility to syndicate the deal to other brokers with syndicated commission structure.

 

7. Misalignment of basic investment terms

Offerings with a minimum offering amount that do not raise adequate funds before the offering termination date fail. Having a reasonable offering period (or better yet, a right to extend the offering period at the issuer's discretion communicated in the PPM), may mitigate the risk of running out of time before reaching the minimum contingency. An issuer allowing ample time from the outset of the offering will likely avoid the time-consuming task of notifying committed subscribers that the offering will be extended. This notification can trigger a right of rescission whereby an investor retains the right to reverse his or her decision to subscribe if affirmative consent cannot be reached. 

Bridge financing with expected terms clearly communicated in the PPM is one remedy to create flexibility in the offering structure allowing for alternative sources of financing should the equity portion from new investors be insufficient or be slow in forming.

 

If you are able to avoid these frequent missteps when structuring your private offering, crafting an attractive PPM to attract investors will be much easier.

 

[WHITEPAPER] Essential Elements of a PPM

A poorly constructed offering document can lead to
investor harm and even legal trouble for issuers. 

DOWNLOAD NOW

Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.

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About author

Ricky Segers

Ricky is a business development associate responsible for engaging new potential clients. He graduated from Old Dominion University in 2016 with degrees in Economics and Supply Chain Management before completing graduate coursework in Human Resource Management at the University of Richmond. He holds his FINRA Series 7 License. As a collegiate athlete, he proudly kicked career long field goals of 50 and 51 yards against in-state rivals, UVA and William and Mary, respectively.

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