How to avoid securities fraud claims as a startup

How to avoid securities fraud claims as a startup

The relationship between an investor and the startup it invests in should be managed carefully. One of the most common missteps is poor communication. Which is closely followed by unrealistic expectations. 

One of the ways to better manage expectations is for the startup to avoid making grandiose claims during the investor courtship and due diligence process. What got me thinking about this was a question that I recently got asked to answer on Quora. The person involved wanted to know where he could meet investors that were interested in a guaranteed return on their investment of 50% every three months. I don't see any problem with that question, do you?

Avoid quoting percentages

The above claim is a securities fraud claim just waiting to happen. The only reason you should ever quote a growth or return rate to an investor is if you have the historical proof to back that claim. And by historical proof, I don't mean a few months of data. I am talking six months worth of data at a minimum. Even then, I recommend being ultra-conservative with any statistics you quote.

So, what should you say? I always recommend either of the following qualifiers to any kind of claim. "If I could get you an X% return would that be enough to interest you?", or "Our projections call for an X% return based on research of other similar business models".

Take funding in tranches

While it may not be convenient for your startup to take funding in tranches, i.e. in chunks & over time, it can be a good way to avoid issues with your investor(s) such as securities fraud claims.

By taking your funding in chunks & over time you create a scenario where there are often milestones attached to the next funding tranche. In this fashion, the full amount is not funded immediate and through a "blank check". Here is an example.

  • The investor agrees to provide you $500k in funding
  • The first tranche of funding immediately, to the tune of $300k
  • Four, to the tune of $50k per tranche, subsequent tranches are available 
  • Tranche 1 is funded when your startup have finished the MVP
  • Tranche 2 is funded when your startup has its first 1000 users

Have the proper documentation

Not ever funding round requires a private placement memorandum (PPM). If you are unsure if you should have a PPM available for investor review then make sure to talk to your attorney. While getting a PPM professionally drafted can be costly, having one can also provide some level of comfort that investors are being given all of the information that they feel is necessary to make an investment decision.

Wrapping up

What about your startup? Have you been involved in any legal disputes with founders? If so, any best practices for protecting yourself and your company?

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