Investor Pitfalls: Should I Invest in a Privately Held Company?

Summary: Do not invest in companies that do not follow simple rules designed to protect investors.

Recently a friend confided in me that she and her husband had given approximately $30,000 to a man who had a great business idea. He was enthusiastic, well-spoken, and he understood the business model. He assured them that he had operated a similar business in another area that had been successful, and he wanted to do the same thing in Maine. My friends were already involved in a similar business, so combining forces into a related business endeavor made sense. And a friend had vouched for this man. Unfortunately, the man spent their $30,000, asked for more, and when my friends asked for an accounting of their funds, he fled the area. This situation could have been avoided.

The U.S. Securities Exchange Commission (“SEC”) and the various state regulatory authorities permit companies to raise money from private individuals, but each of these regulators has established certain criteria with which companies must comply. On the most basic level, each company seeking to raise capital from investors must file a Form D with the SEC and each state where a prospective investor lives, generally within 15 days of soliciting funds from an investor. Some states, such as New York, require Form D and additional company information to be filed before a company solicits investor funds.

Here are some additional questions for investors to ask prior to providing any individual with investment funds in a privately held company:

  1. Have you filed Form D with the SEC?
  2. Which exemptions from state and federal registration do you plan to rely on?
  3. What states have you filed with or do you plan to file with?
  4. What types of financial statements do you intend to provide to investors?
  5. Do you intend to provide a private placement memorandum?
  6. How many accredited investors do you anticipate?
  7. How many non-accredited investors do you anticipate?
  8. How are you affiliated with the company? (To ask of the person requesting investment funds.)

A prospective investor should take all investment materials and the answers to these questions to a qualified business attorney for a quick review. Even if the company does not yet have materials to provide to a prospective investor, the answers to these questions will reveal the preparation and character of the company and the individuals representing it. However, as a general rule, if a company or an individual is soliciting investor funds, investors should receive a large packet of documents, including: (1) a copy of Form D (preferably the version filed with the SEC); (2) a private placement memorandum (a lengthy disclosure document); (3) financial statements (preferably several years’ worth of financials reviewed by an outside accounting firm); (4) an investor questionnaire (regarding accredited investor status); and (5) a subscription agreement (describing the terms under which the investor makes the investment).

If my friends had asked even a few of these questions, they likely would have retained their $30,000 or at least invested it more wisely. The legal system provides that fraudulent conduct by a company or non-compliance with regulatory requirements should result in rescission of the investment. This means that a company would be required to refund an investor’s funds, possibly with interest. However, unless the company is still in existence and has available assets or company owners can be located, the investor generally will have no satisfactory recourse. Often the investment has been spent and the individuals involved either do not have available assets or cannot be located.

This information is provided as general advice. For additional information and expertise when investing or seeking investors, consult one of Rudman Winchell’s qualified business attorneys.

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