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Early stage money: The problem with PPMs

Bill PayneBy Bill Payne

Bill Payne has been actively involved in angel investing since 1980, funding over 50 companies and mentoring over 100 more. He is the recipient of the coveted “Hans Severiens Award form the Angel Capital Association, its highest honor.  

The sale of equity in private companies is regulated by the Securities Act of 1933, which requires that the company either register with the SEC or meet one of several exemptions (Regulation D). A Private Placement Memorandum (PPM) is a special business plan defined to meet an SEC exemption. In most cases, those entrepreneurs choosing to raise capital using PPMs retain specialists (many of whom are lawyers) to write their PPMs – a rather expensive undertaking. I don’t fund new companies that have prepared PPMs for investment. I am an angel investor, that is, an accredited investor who is assumed by the SEC and others to be sufficiently wealthy to afford to lose the investment and supposedly experienced enough to make good choices on fundable companies. Angels, as group of accredited investors funding startup companies, are assumed to meet a Regulation D exemption for purchasing equity in private companies.

Like most angel investors, I have preferences for the terms and conditions of investment and intend to negotiate with entrepreneurs on those terms, such as valuation, company structure, the makeup of the board of directors, liquidation preferences and others. I have yet to read a PPM written for a startup company that meets the parameters we angels generally establish for funding new ventures.

[Email readers, continue here…]  If I don’t like the terms offered in the PPM, why don’t I insist that the terms be changed to accommodate my partialities as an angel investor? Sounds simple, huh? Unfortunately, upon completion of the PPM, the first thing that entrepreneurs tend to do is sell shares to friends, family, friends of friends and other acquaintances. Then, only after convincing these “unsophisticated” investors to sign up and write their checks, the entrepreneur may approach an angel or group of angels.

The entrepreneur may have already raised half or more of the cash required in this round and is eager to top off the round. The PPM does not meet the investing terms and conditions of the angels. The valuation is too high, or the PPM is written to sell common stock when it really should have been a preferred stock deal, or other critical terms are not present in the PPM. Since many unsophisticated investors have already funded part of the round, it becomes too complicated to renegotiate the terms of the deal.

It is only fair that all capital sources in a given round should invest under the same terms and conditions. There should not be one version of terms for the early set of investors (the PPM terms) and a second version of terms for later investors in the same round. In the long term, different term sheets for investors in the same round leads to unhappy investors. We angels could insist that the entrepreneur go back and renegotiate the terms of the PPM with all the earlier investors, but the earlier investors may or may not agree to the changes. From a long history of angel investing, we have learned it is just easier to pass on PPM deals and move on to the next opportunity. We see many startup investment deals every year – too many for most of us to fund.

Regarding PPMs, my recommendations to entrepreneurs are:

  • Don’t prepare PPMs to fund startup rounds of investment. It is expensive and may preclude sophisticated investors from funding your deal.
  • Pursue smart money, that is, sophisticated investors who will negotiate a fair deal with you and help you grow your company.
  • Limit your offering: Only sell shares to accredited investors. In the long run, this usually works best for startup entrepreneurs.
  • Thank you, Mr. Payne. It sounds like PPMs are suitable only for later stages of capital raising once a startup is mature. The PPM is a very costly way of raising money for startups that must preserve cash in their early days.

  • Allen Ruszkowski

    Thank you Thank you thank you!!!!!

  • John Hustom

    This topic hasn’t gotten enough airtime in my opinion so thanks for hitting it hard! Incidentally, next Monday OTAF will close on our 45th portfolio company and over the last 125 months of our operation we have broken our “no PPM rule” twice. The first time we did so by stipulating that the PPM be changed to reflect our standard deal terms. This cost the company an additional $10K of legal fees. In the second case the CEO of the company was an OTAF member and his brother (a local lawyer active in our space) wrote the PPM gratis and it reflected our standard terms.

    Great post…

  • I agree with Bill, and while a PPM may have a place in some part in company financing, the startup company generally needs to find the investors first to determine the general terms available to a qualified company, determine if they can meet those terms, conditions, and diligence procedures and then move forward. Raising capital is a consuming job, and many entrepreneurs go through a time consuming learning cycle that only delays their recognition that generally every deal is negotiated with the investors who best understand the company’s value proposition, valuation, and terms that will attract investors.

  • Bob Fried

    Well written and very clear. Thanks.

  • I agree with all of these recommendations, and I prepare several PPMs every year. They have their place in capital raising, but they are pretty much never the right tool for a startup.

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