Risk Factors

For maximum caveat–emptor value, the "risk factors" section should be referenced on the first page and reproduced in full in a position in the memo prior to the sections in which the attractiveness of the opportunity is trumpeted. Several recitations are standard, indeed would be conspicuous by their absence, namely:

1. The company is in its "development"–that is, most highly vulnerable–stage; its products haven't been proven or marketed.

2. Its success is highly dependent on a few key individuals, none of whom have run a company of any size before.

3. There are fearsome competitors on the horizon.

4. The company will need more than one round of financing to survive.

5. The securities are illiquid.

6. Substantial "dilution" is involved.

7. A few major customers form the backbone of the order bank.

8. The technology is not entirely (or at all) protected by patents or copyrights.

These should be fleshed out with risks specific to the issue: environmental problems, the possibility of technical obsolescence, difficulties in procuring drug licenses from the FDA, and so forth. If in the placement memo, the risk factors risk losing their effectiveness if squirrelled away in the last few pages. Some lawyers use is effective if the parties writing checks see them.

The importance of the risk factors cannot be emphasized too strongly. A federal statute (actually one law in 1995 and a second in 1998 to close a loophole) immunize the sponsors from suit if their "forward–looking statements" are accompanied by "meaningful" cautions. Moreover, significant recent cases have upheld (albeit not yet at the Supreme Court level) the stet effect of language which "bespeaks caution" in a disclosure document, bulletproof in this case meaning a document on which may be founded a successful motion for disposing of a complaint on the pleadings and prior to trial. Courts have, of late, been niggardly in allowing claims to proceed based on "forward–looking" statements which turn out to be inaccurate–claims of "fraud by hindsight" as Judge Friendly has put it–provided there is prominent disclosure of the risks. The decisions have involved both public and private offerings. The defense, however, is not absolute, particularly in light of the Supreme Court's dictum in Virginia Bank shares that "not every mixture with the true will neutralize the deceptions." Drafting good risk factors takes time, effort and creativity, since they cannot generally be taken from a standard form or borrowed from disclosures made by another registrant. The effort of crafting well–tailored risk factors is rewarded, however, not only by better risk factors disclosure but also by improved insight into the business of the registrant. Such insight can favorably impact the quality of the disclosure in the prospectus or report as a whole.

Some practitioners take the view that covering risks once in the risk–factors section satisfies the registrant's disclosure obligation fully. A more conservative view is that risk factors are primarily excerpts from the disclosure document and that each risk, or at least each of the most significant ones, should also be discussed elsewhere in the document.

Deals Terms

On occasion, the founder will argue with counsel that a given risk factor is stated too negatively. In this author's view, that argument is generally a waste of time. The risk–factors section influences few sophisticated investors. They form their independent judgment on the issues; its utility is more prophylactic than educational.

Following the risk–factors section, the private placement memorandum should set out the terms (previously summarized) of the deal; that is, the special features of the securities being offered (preferences, voting rights, conversion privilege, dividends, and so forth), the pricing terms (payable all at one time or in installments), and what the placement agent is being paid. Many private placement memoranda do not include in either the summary or the early discussion an up–front disclosure of the expenses of the transaction, particularly the legal fees. That information usually can be extruded from the pro forma financials, but nondisclosure is not recommended–even though embarrassingly high placement and legal fees may mean to the experienced reader that the offer is sticky and has been "out on the street" for a while.

Use of Proceeds

At or about this point, an SEC regulation requires a public prospectus circulated in a public offering to discuss the use to which proceeds of the offering are to be put. However, unless the issuer plans to pay down debt or use any such proceeds for the benefit of an insider (in which case the discussion should be quite specific), the initial draft of this language is usually cryptic and stylized–"working capital" or "general corporate purposes"–partly out of a desire to avoid leaking sensitive information. To be sure, once negotiations begin, the "use of proceeds" is often a heavily negotiated item. The investors often want a concrete menu, in part to meet the problem discussed earlier, when the start–up has too much money. However, their policing mechanism is not necessarily a sharpened description in the private placement memorandum. The more usual provision is a promise in the Stock Purchase Agreement, tied either to a specific schedule or to the effect that expenditures over, say, $25,000 are subject to an advance approval process.


Some of the most widely read segments of the memo are the discussion of management, the curricula vitae of the directors and senior officers, together with an exposition of their compensation. In the startup world nothing is tranquil. Thus, in describing the management team even the disclosure of names may, on occasion, be dicey. Some people will agree to join the officer corps of a startup if and only if the financing is successful. It is permissible, because there is no other solution to denote these individuals as Doctor X and Mister Y. Disclosure of compensation dollars can also be sensitive, but the requirements of the SEC for public offerings are sufficiently specific to indicate the Commission means business. Prudent issuers should fully set forth for all senior employees the terms of the employment agreement, any understandings concerning bonuses, the "parachutes" (i.e., the penalty paid if the employee is dismissed) and the stock arrangements. The investors are likely to zero in on the agreements between the firm and its key managers; the memo should disclose how the managers have had their wagons hitched to the company with non–compete clauses and "golden handcuffs."

There is a relatively high potential for embarrassment in this section for those charged with due diligence. For some perverse reason, résumés often contain easily checkable lies (X claims a doctorate in chemical engineering from Purdue when he didn't complete the course). Moreover, federal and state laws contain so–called "bad boy" provisions, meaning that disclosures are required and exemptions from registration are not available if anyone connected with the issue (or the issuer) has in the recent past been convicted of crimes or subjected to administrative proceedings which are relevant to the sale of securities. An overlooked felony conviction for mail fraud (particularly if a computer search on the Nexis system would have disclosed it) can be more embarrassing than a phony degree. The importance of the management section is based on the standard mantra amongst Venture Capitalist's, "Bet the jockey and not the horse."


Introduction to Venture Capital and Private Equity Finance