Investing in a private company is very different from investing in a public company.
Although public companies are required to disclose vital information about their company to the investing public through a prospectus, Main Street investors ignore these disclosures.
That’s because most Main Street investors aren’t interested in the minute details about the underlying company of the stock they’re investing in. They’re speculators – relying more on soundbites on cable television or tweets for their investment decisions.
Main Street investors don’t invest like private investors.
Investors in public stocks are speculators – hoping to buy low and sell high. The public disclosure system is more like a “Buyer Beware” disclosure system instead of the private system of disclosure meant to inform and educate the investor on the viability of the business they’re investing in.
With public stocks, if you invest through a Wall Street broker, you often get the disclosures in the smallest print after you make the investment decision. It’s more like “By the way, here’s the link to the company’s prospectus you just invested in if you’re interested” and less like, “Here’s some vital information you should be aware of before investing.”
Do you think any investors checked Hertz Car Rental’s filings this year warning investors that the business might never recover from bankruptcy? Not a chance. Despite that, Hertz has been a hot stock – even with no underlying value.
Here’s why people are alright with ignoring the prospectus when investing in public stocks: If things go south, they can sell their positions in an instant. They might lose money, but they can get out quickly. They can get out in an instant because public markets are liquid. Private markets on the other hand are a different beast.
You hand over money to a promoter of a private investment, there’s no market to turn around and sell your securities the next day. Private investments have long investment windows – typically 5-7 years.
Because of the illiquidity of private markets and the long investment windows, you need to be very careful about who you turn your money over to.
With private investments, the disclosure document – private placement memorandum (“PPM”) – plays a much more vital role than a prospectus does with public investments.
Private offerings may not be required to jump through the same rigorous hoops as public offerings to offer their securities to the investing public, but there are certain strict requirements they must comply with to claim exemption from registering with the SEC.
One of the major requirements a private offering needs to satisfy to claim exemption from registration is to provide adequate disclosure to prospective investors to make an informed decision.
The other major requirement is that the company qualify investors to make sure they have the financial means and sophistication to invest in a long-term, illiquid investment.
Offerings that use advertising or general solicitation such as through mass emails, telemarketing, or seminars are only permitted to take Accredited Investors who meet certain income and net worth requirements. Failure to provide adequate disclosures and/or taking unqualified investors can blow up an offering’s exemption and put the promoters in hot water.
Besides being a requirement to qualify for an exemption, a PPM is also a window into the company soliciting your capital. Many PPMs can tell you all you need to know about investing in a company. It can also raise red flags to prevent you from making a huge financial mistake.
So how vital is it that the company you’re considering investing in provides you with a PPM?
So vital that the SEC has ranked the lack of a PPM #4 on the list of “10 Red Flags That an Unregistered Offering May Be a Scam.” The SEC explains exactly why you should never invest privately without a PPM.
Avoid an investment if the salesperson will not provide you with anything in writing. A legitimate private offering will usually be described in a private placement memorandum, or PPM. Similarly, sloppy offering documents that contain typographical, spelling, or other errors can be a red flag that the investment could be a scam.
Recently, I caught wind of investors investing in a private company in a real estate venture and no one received any documentation.
Without documents or disclosure, there’s no telling what these investors were investing in. A PPM provides vital information about a company that, if done right, can tell you almost everything you need to know to make an informed decision.
Here are the major disclosures you will find in a typical PPM:
- Issuer Name and when and where organized.
- Description of securities being offered and terms of the offering.
- Business description:
-Company and market data
-Development or renovation plan
- Management and management compensation.
- Projected Use of Funds and Financial Statements.
- Risk Factors.
Without these disclosures, you will have no idea about the track record of a company’s promoters, their understanding of the market and risks, and any financial projections.
How do they plan to use the proceeds from their offering?
What is there in writing to hold the company’s feet to the fire if they don’t use the money as they had represented to you?
Oral representations aren’t going to cut it. Without terms of an offering in writing, nothing is going to stop unethical promoters from paying themselves high salaries, hiring family members, buying vehicles for personal use, and the list goes on and on.
When are they planning to pay you back? That would be nice to know.
Without a written document, you’re expected to rely on oral representations. You know what often happens when someone tells you to take their word for it. You’ll never see your money again.
The lack of a PPM can be one of several warning signs about the company you’re considering investing in – all screaming for you to run away.
- A lack of a PPM can be a sign of arrogance. The promoters just don’t see why they need to comply. These are exactly the type of promoters you should avoid. If they don’t care about rules, they’re not gonna give a second thought about using your money for personal reasons.
- A lack of a PPM can also be a sign of bad advice. I’ve come across many real estate offerings where the promoters have tried to convince me that their lawyer (who happens to be the best family lawyer in their town) advised them that they didn’t need a PPM. For one stupid reason or another for erroneously telling their clients they don’t need a PPM, the result will be that they’re gonna get their client in serious hot water down the road that can include fines, penalties, and even jail.
Here’s the bottom line:
If a company takes your money with a promise of a return and you’re not allowed to take part in the management of that company, that’s called a passive investment and that company is selling a security and they cannot sell a security without a PPM.
THE PPM IS ESSENTIAL
DON’T INVEST WITH ANY PRIVATE VENTURE OR REAL ESTATE GROUP WITHOUT ONE!
The lack of a PPM is a sign that you’re either dealing with an incompetent promoter or one that’s gonna scam you out of all your money.
The lack of a PPM or even a shoddy one should be a major red flag and you should always run from these deals.