Balancing Act

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.

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This article was originally published in the February 1996 print edition of Entrepreneur with the headline: Balancing Act.

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