Why Angel Investors Don’t Require Private Placement Memorandums (PPM) any More
Many years ago almost all companies raising money used a PPM (Private Placement Memorandum) as the document to put the deal together. The PPM typically consists of three or four parts including 1) A summary business plan that describes what the business is and how it is going to execute its plan 2) Risks involved in investing in the deal. 3) A term sheet that describes the terms of the deal and 4) the capitalization table showing existing shareholders, types of shares, percentages owned, etc. The PPM was the selling document and, when signed, constituted the completion of the deal.
PPMs were a part of Regulation D exemption from filing with the SEC. Since many people were selling these securities to non-accredited investors (those who did not meet the SEC benchmark of $1 million in assets excluding the primary residence or $200,000 per year in income, or $300,000 for a married couple) they wanted the additional protection of the PPM to ensure that any representations made by the company to unsophisticated non-accredited investors would be documented in one place – the PPM. This made the transaction more transparent and gave the investor some recourse if the terms of the PPM were not honored, but it also gave the entrepreneur some protection since the selling claims of the deal are limited to those that are in the PPM and not to any verbal representations that may have been made.
When early angels invested in deals, they often did so as individuals or loose groups of friends. There was rarely any due diligence and checks were written after meeting for coffee or beer a few times and maybe sealed over dinner. Since the advent of formal angel investing groups, angels have banded together to pool resources and intelligence, to conduct more due diligence similar to what a VC might do – but with the understanding that there’s a lot less diligence to be done on an angel deal since there are typically few past financials to check through and the client list is short or non-existent.
Disclosure vs. Access
It’s important to note that the difference between having access to all information and having a document that provides full disclosure of a company’s situation are similar, yet different things. Angel groups who do solid due diligence demand full access to company documents including up to 100 points on a due diligence checklist. If items are missing, it’s up to the angel group to follow up and demand access to all documents. Even though due diligence typically includes asking the catchall question “is there anything that we haven’t asked that we should have in order to fully understand the situation of the company?”, there is no written statement to this effect other than a Representations and Warranties statements that the founders may supply which state that the companies representations and warranties are true and complete. This statement may put the founders of the company at risk if they misrepresented the status of the company in any way. In contrast, a PPM provides disclosure vs. access, meaning that the offering document includes an exhaustive listing of risks that are disclosed in the document. In some regards, this protects the entrepreneur as well as the investor since the risks contain the most common reasons for business failure which can shield the entrepreneur from certain claims of liability. It presumably protects the investor as well because all risks have presumably been disclosed. This protection may be of little consolation to the investor in a company which has lost everything and finds itself in bankruptcy.
Angel investors have become more like Venture Capitalists over the years and their deals have also become more sophisticated, meaning that the PPM is usually no longer necessary. Angels are all accredited investors, so the bar for requiring a protective document has been raised. VCs will NEVER require a PPM, and today most angel groups won’t either. Most of the top law firms in our area coach companies NOT to bother with a PPM (even though the attorneys stand to make a lot of money from writing them). Because PPMs are not required when selling securities to accredited investors, the cost of preparing them can be a turn-off for investors who want to see that the use of funds is going to be monitored very closely. PPMs can cost anywhere from $5,000 to $50,000 and up. Angels would usually rather see that spent on getting the product done and out in front of customers.
What takes the place of the PPM?
Instead of a PPM investors typically negotiate a deal with a term sheet similar to what a VC would use, but somewhat abbreviated. A term sheet is typically 3-5 pages at the most and includes the major terms of the deal.
Negotiation is often among many people in a syndicate so having a light weight document that can be easily changed as negotiations proceed makes sense. Because everyone in on the deal will invest at the same terms, this is an important consideration. You don’t want to be locked in by whatever your first investors agreed to – the final deal is often changed as more and bigger investors come in.
When looking to VCs for investment, the VC will be the one to supply the term sheet. Wise entrepreneurs will create their own term sheets to bring to angels, since many angels don’t have the legal background time, or desire to spend legal funds in creating one.
Once the deal is fully negotiated, the term sheet goes back to the attorneys who use it to craft a subscription agreement or stock purchase agreement for the deal that has all the detailed legal requirements. There are usually other documents included in the deal as well including a board resolution to offer new stock, investor’s rights document, etc.
The risks portion of the PPM goes away and is dealt with by having investors conduct their own due diligence and determine the real risks that they consider to be most important.
The business plan is still something investors will want to see –it won’t be a legal document, but rather it may be a collection of plans for marketing, product development, staffing, finance, etc. Investors will consider these documents as part of their due diligence.
The capitalization table is also something that investors will want to see as a part of their due diligence. They can learn a lot by understanding who else is in on the deal and what percentages of stock is owned by whom.
In the end, investors get everything they need without having the founders spend a ton of their scarce capital resources. Deals get done in a relatively efficient and effective manner without a PPM. At the end of the day if a deal goes bad, having a PPM doesn’t help anyone since there’s no reason to sue a company that has already breathed its last gasp. Hopefully smart investors doing good due diligence will limit the amount of times that happens!
To learn more about angel and venture capital investing, check out Venture Capital for Dummies, John Wiley & Sons, 2013. http://www.amazon.com/dp/1118642236
