From the February 1996 issue of Entrepreneur

Billy the kid's classic line about robbing banks because that's where all the money was needs some updating in the 1990s. Though times are changing, the sad fact is that for entrepreneurs, there's rarely money to be had from a bank.

That's why increasing numbers of entrepreneurs are turning to the private capital market to raise the cash they need. This market consists of venture capitalists, so-called "angels," and wealthy individuals, such as doctors and lawyers, who have some risk capital to spare.

There's a lot to be said for raising money privately. It can be done quickly (sometimes); there's no need for a full-blown Securities and Exchange Commission (SEC) registration statement, a document that can be insanely difficult and expensive to prepare; employees or officers of the firm can generally place or sell the issue themselves; and finally, for many, it is the only hope they have of ever raising any money.

But in the same way that old Billy the Kid never knew when he was going to run into a tenacious teller packing heat under the counter, so, too, are entrepreneurs at risk in their hunt for capital in the private equity markets. That is, you just never know when Dr. Smith is going to turn on you for real or perceived fraudulent action. And just as Billy stared down the barrel of many a six-shooter, so, too, might entrepreneurs find themselves looking at a lawsuit head-on.

Yes, indeed, according to attorney Ben Yankowitz, a partner with Heenan Blaikie, a Beverly Hills law firm that specializes in working with entrepreneurs and emerging companies. "There are definite legal risks to raising capital privately," he says. But, Yankowitz adds, common sense and good counsel can ward off a lot of that risk.


David R. Evanson, a writer and consultant, is a principal of Financial Communication Associates in Ardmore, Pennsylvania.

An Even Hand

According to Yankowitz, many entrepreneurs provoke legal action because they do not present an evenhanded scenario in their primary sales document, the private placement memorandum (PPM).

Take, for example, the Chinese theory of market penetration-which, unfortunately, many entrepreneurs use in their business plans and PPMs. It goes something like this: If there are 1 billion people in China, there must be 2 billion ears. If we're selling earrings at $1 each, with a 50 percent operating margin, then market penetration of just two-tenths of 1 percent will yield an operating profit of $1 million. One percent penetration yields profits of $10 million . . . and so on.

The problem with these kind of futuristic scenarios, Yankowitz cautions, is they don't show the other side. "Sure, places like China represent a great opportunity," he says, "but there are also tariff and nontariff barriers, political risks, currency risks, perhaps well-organized competition, and, in many instances, technical considerations."

What can and does happen, says Yankowitz, is that if the company does not take off and there are a lot of angry investors, the PPM can work against you. "If your document is highly promotional in nature," he says, "it begins to look bad in court."

The key to protecting yourself, Yankowitz says, is to exercise restraint in your description of the upside and use an abundance of caution when describing the risk factors and investment considerations. Typical risk factors that many companies face-and hence talk about in their PPMs-are limited or no operating history, reliance on pending patents that may not be granted, reliance on patent protection, reliance on one or two key employees, competition, need for additional financing, and the absence of liquidity in the investment.

"To give them some ideas and boundaries, I counsel clients to get initial public offering (IPO) prospectuses for similar companies and see what risks they are disclosing," says Yankowitz. If restraint is too subjective a criteria for you, he says, "as an operating guideline, do not write in your PPM or utter a single sentence that you cannot back up and provide a reasonable basis for."

Crystal Balls

The second area of danger often encountered in the private equity market is the financial projections. For IPOs, there are rarely, if ever, financial projections contained in the prospectus, even though the SEC has liberalized rules on projections to encourage companies to do so. The potential exposure scares the dickens out of most companies and their attorneys, so although limited projections are allowed, they are rarely offered.

However, private placements, says Yankowitz, are a whole different ballgame. "Financial projections are rather common in PPMs," he says. One of the likely reasons for this is that no state or federal registration is required for PPMs. The important point is if you project financial performance by putting it out there in black and white and you're wrong, your company is exposed, plain and simple.

"Missing projected performance doesn't guarantee a shareholder lawsuit per se," says Yankowitz, who pegs the risk at "medium." Of course, he adds, "your chances rise depending on how badly the company did."

There are also certain factors related to the deal itself that determine the likelihood of action by private investors. That is, with a plain vanilla equity investment in a growth company, where no dividends are expected or promised, investors might see a bad year as a bad year and leave it at that. But missed financial projections that result in missed principal payments or missed dividend payments is another matter-one with very high legal risks.

"If you have several years of operating experience and a track record of growth in sales and earnings," says Yankowitz, "you can probably get away with not making financial projections." But for start-ups and early stage companies, he says, "they are a necessary evil."

So project if you must, but protect yourself. "First off," counsels Yankowitz, "clearly spell out all the underlying assumptions of the projections in your PPM." These assumptions include things like growth in market penetration rates, sales, earnings, shares outstanding, and expenses related to growth, such as personnel, supplies, equipment and office or manufacturing space. When you write out your assumptions for the investor, says Yankowitz, the projections become less statements of what will happen and more the company's reasons for what they believe may happen-which the investor can agree or disagree with.

The second way to protect yourself, says Yankowitz, is to be reasonable. Again, this can be somewhat subjective and difficult to define, but, says Yankowitz, "one of the best ways to understand so-called reasonableness is to put yourself in the frame of mind of the average investor as you are developing your projections."

Finally, says Yankowitz, your PPM should include language that alerts investors to the uncertainty of your projections. Prefacing the projections, or at the bottom of each page of the projections, he recommends printing something like this: These are projections only and must be read in conjunction with the attached assumptions. There can be no assurance that the company's financial performance will equal or exceed the amounts set forth in these projections.

Rules And Regulations

State and federal securities laws provide entrepreneurs with another set of formidable hurdles in the private equity markets. "Even though there are rarely registrations with state and federal regulators," says Yankowitz, "that doesn't mean there aren't securities laws that apply."

There are several state and federal laws that prohibit solicitation or promotion of a deal. The sum total of these rules seems to be that you cannot do much to promote your deal, except by talking and meeting with people you know or people you are referred to by people you know. Even if you hire a brokerage firm to do your bidding for you, there are several laws restricting who they can contact and how they can do it. The important point is to recognize these laws exist and to be aware of them (or pay for informed legal counsel) before you start selling.

Then there's the SEC's Regulation D, which governs the private placement of securities. According to Yankowitz, under Regulation D, companies can raise money with an unlimited number of accredited investors-those with net worths in excess of $1 million or annual incomes of more than $200,000. But for companies selling to nonaccredited investors-those who do not meet the income or net worth benchmark-there is a limit of no more than 35 investors. "If you bring more than this number of investors into your deal, you run the risk of the feds coming down on you," says Yankowitz.

Don't let the regulators get you down, though. It's their job to make things look tough. The fact of the matter is, private deals get done every day. By some standards, the private capital market is one of the largest in the U.S.-consisting of billions of dollars that get poured into emerging enterprises every year.

"Just be careful out there," says Yankowitz. "It can be dangerous."