Background

Unless the founders have very deep pockets, it is fairly unusual for a privately held company to develop its products or technology, hire the employees needed to execute its business plan, and grow the company, using only available cash flow from operations.  In order to achieve these goals, most companies require outside capital – either in the form of debt or equity.

Since banks are reluctant to make loans to companies without some operating history and a predictable revenue stream, development-stage companies often look to friends and family for their initial need for outside capital, and look later to so-called accredited investors.

Investing in early stage companies is obviously risky, largely because the investment is illiquid.  There is no market for the company’s equity if the investor wants or needs to liquidate its investment.  However, this is balanced by the fact that the investors have substantial “upside” if the company is successful.

Raising outside investments is always a challenge.  However, it is all too common for companies that are successful in raising capital from outside investors to underestimate the importance of nurturing and strengthening those relationships.

Some Practical Suggestions

The key to building and maintaining strong investor relationships is communication.  Management of privately held companies would be well advised to look to the requirements imposed upon public companies.  The Securities Exchange Act requires companies whose stock is publicly traded to provide their stockholders with information on a quarterly and annual basis, as well as prompt notice of certain events that may have a material effect on the company’s business or financial condition.  This is accomplished by requiring public companies to file, respectively, Forms 10Q, 10K, and 8K with the SEC, which in turn makes those filings available to the public, including stockholders.

Form 10-Q must be filed for the first three quarters of the public company’s fiscal year.  It includes unaudited financial statements and an overview of the company’s business and financial condition, including any material payment defaults, legal proceedings, and a management discussion and analysis (MD&A) of the company’s financial condition and results of operations.

Form 10-K is an annual report for the preceding fiscal year including information for the 4^th quarter not covered by the earlier 10-Qs. It covers most of the same topics as those covered by the 10-Qs, though the financial statements must be audited.  It also must include an MD&A, the directors’ and executive officers’ names and other information about them, and any disagreements with the accountants over financial disclosures, among other items.

The purpose of Form 8-K is to make the public aware of material events that occur outside the 10-Q / 10-K reporting cycle.  These typically include changes in senior management, major acquisitions and divestitures, material litigation, and the like.

It is a fact of life that when investors do not receive regular communications from the companies in which they have invested, they often assume the worst.  While private companies need not provide the same level of information required of public companies, they should provide regular reports to their investors that contain the good, the bad, and the ugly. 

Private companies should also keep in mind that, given the challenges of raising capital from outside investors, a satisfied group of early investors is often the best source of further investments if the company needs to do a follow-on offering of its securities.

This memorandum is intended to provide general information of potential interest to clients and others. It does not constitute legal advice. The receipt of this memorandum by any party who is not a current client of the Business Law Group does not create an attorney-client relationship between the recipient and the firm. Under certain circumstances, this memorandum may constitute advertising under the Rules of the Massachusetts Supreme Judicial Court and the bar associations of other states.