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Why Investors Need to Perform Their Own Diligence (Even for Offerings that Go Through a Broker-Dealer)

Post on: February 7, 2018 | Ricky Segers | 0

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A key component of WealthForge Securities’ business is the diligence we perform on all of the Regulation D offerings that we review. Our number one obligation as a broker-dealer is to investors, and thus we endeavor to ensure our investors are protected from fraud and misleading pitches that may entice them into investing in a poorly communicated private security offering. We do this by conducting reasonable investigations of representations made by issuers in their offering documents and examining the perceived ‘red flags’ regarding the offering, the issuer, the affiliated entities, and covered persons. All WealthForge offerings must meet our firm’s strict standards regarding customer facing offering document components and supplementary documentation.

Despite the processes that we complete before making offerings available for subscription, potential subscribers of WealthForge administered offerings (and offerings from other broker-dealers) need to be aware that they must conduct their own diligence as any sophisticated investor would do before committing his or her financial resources to an offering. Not all offerings are suitable for all investors. Private securities are illiquid and highly risky, and investments are often long-term commitments with no assurance of a positive outcome for the investor. 

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

What is FINRA Notice to Members 10-22?

FINRA Notice to Members 10-22 establishes the broker dealer's guidelines for offering diligence of Regulation D offerings. The full notice can be accessed here. In summary, the notice outlines anti-fraud provisions that must be considered, details what components of a private securities offering must be assessed and to what extent, and establishes a succinct framework for a firm's offering review and consideration. WealthForge conducts its diligence investigation in accordance with firm guidelines established based on the guidance from Notice to Members 10-22. This investigation includes in-depth background checks of covered persons, thorough cross-referencing of provided documents for consistency and clarity, an in-depth analysis of the business prospects, and other features nuanced by the particular offering, its underlying business, and the experience of its management team. Of course, our investigation is specific to each offering, but not to each specific investor's circumstances or desires. Because of this, we have compiled a list of key questions that may be helpful to investors when performing their own diligence on an offering. 

Who is issuing the securities?

A key component of offering diligence is determining who is issuing the securities. An investor in a Regulation D offering may not be able to convert their investment back to cash for an indeterminate period of time. Bearing that in mind, there should be great care taken to get comfortable with who is using the offering proceeds, seeking to provide an investment return. This goes beyond simply knowing the name of the sponsor or manager of a private offering. Many deals have complex organizational structures that are comprised of 10 or more business entities that are affiliated with a parent company or sponsor. One component of WealthForge’s diligence is verifying that all of the entities in a deal are legally registered and do not have any undisclosed ‘red flags’ that could influence an investor’s decision. Investors should supplement this diligence by determining if the offering makes sense to them and matches their investment objectives. Additionally, if an offering structure seems confusing or unusual, we encourage our investors to always ask questions of the issuer. Offering documents should always provide contact information so that potential investors can get in touch.

Why is the issuer raising money?

It seems like a simple question, but it is a must-ask for every deal. A best practice for investors is to review the entire offering package when making a determination of whether to purchase securities. The answer to why the issuer is raising money can typically be found in the use of proceeds section of an issuer’s PPM or offering package. Private offerings vary with respect to their illustrations of the intended uses of proceeds for offerings, as some companies spell out every minor detail of their business plan, while some others provide a broad overview and state that investor funds will be used for ‘working capital’ less fees and expenses. For companies that are heavily indebted and unprofitable, an investor should take great care in assessing the feasibility of the issuer’s business plan. On the contrary, a company which has had sustained profitability and carries minimal debt may be a sound investment despite solely listing ‘working capital’ in their uses of proceeds. 

What tax implications will an investment have?

A well-written set of offering documents contains a clause similar to the following: “Potential subscribers are advised to consult a CPA or licensed tax attorney regarding the tax implications of an investment in the securities contemplated by this offering document.” Offering documents will often contain synopses of tax implications of investments, but these are strictly illustrative and often are not as comprehensive as personal professional tax advice. We always recommend investors seek the assistance of licensed professionals to mitigate the risk of surprise taxes affecting their ROI.

When can investors expect to receive distributions?

Once an investor has determined that an offering has a viable business plan, the next step is to assess whether the payout structure will be a good fit for their investment objectives. To do this, investors should know whether their investment goal is income, growth, growth and income, capital preservation, or something else. If their investment objectives do not match up with the offering’s stated objectives, their money would likely be better invested elsewhere. Refer to the operating agreement or shareholder’s agreement for details on the features of the securities. The governing documents dictate the manner in which profits and beneficial ownership will be allocated, so our broker-dealer review includes cross-referencing them with the offering documents for consistency. Investors should review the governing documents as well, as these documents include the most detail regarding distributions. We encourage potential subscribers to ask questions of issuers whenever considering investment opportunities.

What supporting documents should be reviewed?

When we are performing due diligence on an offering, we check to determine that none of the issuer’s factual claims are baseless. We ensure every representation that is made in the offering documents checks out with the documents provided and our independent investigation. This does not mean that investors should blindly accept facts from a PPM. If an issuer cites the source of a claim in an offering document, that establishes a basis for the claim. Our broker-dealer review includes assessing the legitimacy of sources provided for claims in offering documents, but investors should supplement this assessment by evaluating the limitations of the sources. Additionally, issuers will commonly provide us with appraisals, third-party reports, and other documents which we keep on our internal books and records to establish basis for claims made in offering documents. Issuers often offer to furnish supplementary documents to potential subscribers upon request. Investors should be wary of issuers that withhold supporting documents that could assist potential subscribers in making educated investment decisions.

Investors should request to see the financial statements and tax returns of issuers as well. If an issuer provides audited financials, this bolsters their credibility as an accounting firm is willing to put a license on the line to make a representation regarding a firm’s financials. That being said, an issuer that provides unaudited financials is not necessarily less credible or sophisticated. Companies forego engaging auditors for any number of reasons. In the instance that unaudited financials are available, subscribers should compare the financials provided by the issuer to the tax return for each of the prior three years, if available. Running the numbers to determine that everything checks out gives a much clearer, reliable picture of the company’s financial position. 

In total, the diligence services provided by broker-dealers give investors a head start on assessing the merits of private securities offering. But, broker-dealer diligence is just the starting point. Before subscribing in an offering, investors should always perform a thorough investigation to ensure the investment is suitable.


[WHITEPAPER] Essential Elements of a PPM

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



Private securities offerings may have a long holding period, be illiquid, and contain a high degree of risk. Investors must be able to afford the loss of all of their principal. Illustrative proforma results may significantly differ from actual outcomes. Past performance does not indicate future results. Potential investors should consult with a knowledgeable tax advisor prior making an investment. 

Disclaimer: Altigo provides this information for educational purposes only. It should not be construed or relied upon as legal or tax advice.

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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