Securities laws in the United States are based around the idea of disclosure and protection of the naïve investor from unscrupulous practices by issuers of securities — the sophisticated guys duping the little guy. However, for many early-stage companies, the sophisticated guys at the table are the investors. Not only do they hold all the cards on the terms of the deal, they know exactly what type of recourse they have if things do not work out the way they would like.
Take the rules surrounding securities fraud. To succeed in a securities fraud claim the investor must show that the issuer made a misstatement of a material fact, or omitted information necessary to make a previously made statement not misleading.
In the world of early-stage companies and unregistered securities offerings that rely on the exemptions under Rule 506, which do not have any disclosure obligations, an omission may be easier to commit than an entrepreneur may first realize. You state you have a prototype — is that prototype fully functional with all of the features to be delivered in the final product? You project 100% year-over-year growth for the next three years — but you omit the assumptions relied upon for those projections. The list goes on.
In the end, it is not important whether or not the investor would actually be successful in any of these claims. The cost, in both time and resources to battle a securities fraud complaint would itself be detrimental to the performance of the company. Investors may also not have any qualms with the litigation proceeding to the point that it spells the end of the company. If they are not happy with the direction the company has taken, forcing a liquidation allows for some return of the invested capital. While every situation is different, some entrepreneurs may find it best to go ahead and settle by giving back funds or giving up more control of the company.
So what is the way to defend or head off any of these claims? Due diligence — which everyone reading our blog should know by now. Due diligence allows the issuer to know exactly where any weaknesses are in its presentation to investors and how to fix issues before they turn into problems.