Role of Disclosure
The Role of Disclosure in a Securities Offering
Both federal and state laws require companies conducting a securities offering to tell each potential investor all material information about the company, its principals, and the investment opportunity (including the risks of the investment) that a reasonable person would want to know in order to make an informed investment decision.
The offer and sale of many goods and services in the United States is governed by the market principle of "caveat emptor," which means "buyer beware.” This principle does not apply to the purchase or sale of securities. Unlike the purchase of a tangible asset such as a used car, which the buyer can test drive and have inspected by a mechanic, a security is an intangible asset whose value depends upon the performance of the company that issued it and the market's assessment of the company's prospects.
Investors generally do not directly examine all of the company's plants, equipment, contracts, books or records nor do they conduct interviews with the company's management and key personnel. In order for investors to be informed on issues that relate to the value of the security and the risks of the investment, securities laws require the company to tell each prospective purchaser all material information about the company.
For registered public offerings of securities and to claim certain exemptions from registration, disclosure documents must be filed with those government agencies responsible for regulation of securities offerings. Whether a filing with the state Securities Division is required is described in the Division's informational brochure entitled "Offering Options" and on our website.
When disclosure documents are filed with these agencies, they usually possess legal authority to review the disclosure document. The agency may comment on disclosure issues and, based upon the company's response, request the company to add or modify text to more fully explain certain factual circumstances of the offering or risks of the investment.
The Securities Act of Washington
Persons who omit to state material facts or make untrue statements of material facts in connection with the offer, sale or purchase of a security in the State of Washington are violating state law. In other words, companies cannot lie about material facts which may affect the success or failure of the company nor can they fail to tell the whole truth about those facts.
Criminal and Civil Liabilities
The Securities Act provides for criminal and civil penalties for failing to disclose material facts or making untrue statements of material facts. A person who wilfully violates RCW 21.20.010 of the Securities Act may face criminal prosecution resulting in a fine of $5,000 or imprisonment for not more than ten years, or both. Each act constitutes a separate offense.
The Securities Act also imposes civil liability on companies and their principals who offer or sell securities in violation of RCW 2120.010. This means that an investor who purchased a security from a company which failed to disclose a material fact or made an untrue statement of material fact in connection with the sale of that security will be able to sue the company for the return in cash of the full price paid plus interest at 8% from the date of purchase.
The Securities Division is authorized to institute administrative and injunctive proceedings against any person who violates RCW 2120.010. Upon determination by the Division that a person has violated this section, the Division may bar the company and any of its principals or their affiliates from selling securities in the State of Washington. In addition, costs of the investigation may be assessed against the violators.
PREPARATION OF A DISCLOSURE DOCUMENT
In an offering of securities being made to the general public, written disclosure is provided in a document prepared by the issuer called a “prospectus.” In an offering being made only to a limited number of persons pursuant to an exemption from registration, written materials provided by the issuer are known as “private placement memoranda” or “offering circulars.” These disclosure documents not only inform the prospective purchaser about the investment opportunity but also aid in resolving possible future disputes between the company and dissatisfied investors.
Preparation of a disclosure document is perhaps the most important aspect of conducting a proper securities offering. It demands a substantial commitment of time and concentration in that each component must be thoroughly analyzed and presented in a manner that may be easily understood by an ordinary individual. The benefits from this exercise, however, are well worth the effort.
First, the disclosure document probably will be the main way the company tells its story to persons it hopes will invest in the company. Therefore, the company will want to provide a complete description of its business, any operations (including financial results) to date and the business background of its management.
The company should also disclose any special aspects of the company’s development such as whether it has been granted any patents, produced a prototype suitable for mass manufacture or executed contracts for which it reasonably can anticipate immediate revenues. The company should be careful not to exaggerate any claims. It only should make statements which are backed by factual data. Projections of future financial performance are strongly discouraged and rarely allowed, particularly in registered public offerings.
Second, developing a disclosure document helps the company's management focus on describing all the important elements of the company and its business. The company should not attempt to engage in too many ventures at one time. A person is more likely to invest in a company which is perceived as having a clear idea of its business as reflected in the disclosure document. Remember, the company always can issue additional securities to help finance the next stage of business development.
Third, the disclosure document serves as protection for both the company and its officers and directors from possible future lawsuits from dissatisfied investors claiming misrepresentations or inadequate disclosure. Use of a good disclosure document may avoid long and costly legal arguments over who said what about any particular issue. Addressing all material facts and risks of an investment in the disclosure document that is given to investors at the time of the initial investment goes a long way toward minimizing future lawsuits and the cost to the company of defending them. Remember, if the investor wins such a lawsuit, the company AND the persons responsible may be liable for the return of the investors' money with interest.
All information which is material to enable a reasonable person to make an informed investment decision must be disclosed. A good rule of thumb is that anything which you would want to know about a company before making an investment in a similar enterprise would be deemed to be material and should be disclosed to potential investors.
Exactly what information is material is dependent upon the facts surrounding each company and investment opportunity. There are, however, certain key areas of disclosure which apply to most enterprises:
Risks of the Investment. It is important for the company to tell prospective investors the principal factors which make the offering speculative. Investors should be given notice of these risks and those relating to the company's financial condition, its business operations, its reliance on management and the terms of the offering. Each risk factor should be stated in a concise paragraph and relate to a specific problem faced by the issuer or arising on account of the offering. Exhibit A to this document identifies those risks which normally are described in securities offerings.
The Company. Information concerning the company which should be disclosed includes: the address of the principal office of the company and any significant subsidiaries; the general nature of the company's business; its form of organization; when it started operations; where it was organized; the location of its principal plants or offices; whether it was a successor to a former business and the circumstances under which the succession occurred; and other information necessary to describe the material aspects of the company.
Management. Management is an important component of any company. Each executive officer and director of the company should be identified and the position held in the company's management structure should be described. Previous business experience of the management staff is also relevant. Therefore, disclosure of each executive officer and director's previous occupation during at least the past five years should be given, including a description of the job held, type of business in which the person was employed and whether that business is still in operation. In describing management's background, charitable or community activities or degrees or training certificates usually are not relevant unless they directly apply to the business of the company.
Other material items concerning management that should be disclosed include (1) all forms of remuneration (including stock options and warrants) to which management is entitled; (2) the type and amount of securities of the company currently held by management which also should be expressed as a total percentage of ownership of the company and (3) transactions between the company and management. Transactions with management are those agreements or arrangements between the company and management from which management receives a benefit. An example would be where the president owns the building where the company is renting office space and benefits from the company's monthly rental payment.
Use of Proceeds. Other information which should be provided to investors includes a detailed account of how the proceeds from the sale of the securities will be used by the company. The intended use of proceeds should be listed in order of priority. If the offering is subject to a minimum offering amount, the use of proceeds should show how the funds will be used if the minimum offering amount is achieved, in addition to the use of proceeds assuming the maximum offering amount is raised. Further, if any of the proceeds will be used to pay management (e.g., repayment of a loan extended to the company), these arrangements must be disclosed. If more than 15% of the proceeds is to be designated for working capital or other general corporate uses, the offering document should disclose why the business of the company requires that level of uncommitted funds.
Terms of the Offering. A description of the exact terms of the offering (how many shares must be purchased, at what price and by what date) and the type of security being offered (common stock, preferred stock, debt, etc.) should be disclosed. The offering document should also disclose whether it is a minimum offering of securities - meaning that the entire offering will not go forward unless a minimum amount of securities are sold by a certain date. In a minimum offering, the company usually will place subscriptions in an escrow account at a bank until the minimum is reached. If this is the case, the company should describe the escrow provisions and the fact that, should the minimum not be reached, the monies paid into the escrow account will be returned directly to the subscribers.
Net Tangible Book Value of the Company. If the company is offering common stock or securities convertible into common stock, it is important to state what the net tangible book value (NTBV) of the company is on a per share basis before and after the offering. The NTBV of the company on a per share basis equals the total assets (exclusive of copyrights, patents, goodwill, research and development costs and similar intangible items) minus total liabilities and divided by the number of shares outstanding.
If the per share NTBV is substantially less than the price per share the public is being asked to pay, the company should explain the reasons for this difference. The difference between the net tangible book value after the offering and offering price is the amount of “dilution” to be incurred by investors in the offering. It is also material to state the cash price or other consideration paid and approximate dates of purchase by the officers, directors, promoters and affiliated persons of the company for the currently outstanding securities of the company which are the same or convertible into the securities being offered to the public.
Financial Information. Financial information about the company is also material. The capitalization of the company should be discussed. The offering document should also discuss the company's assets, liabilities and cash flow and whether it has had any earnings. In addition, reasonably current financial statements of the company prepared in accordance with generally accepted accounting principles should be provided.
Litigation. Material legal proceedings pending against the company should be disclosed. Also, the company should disclose whether it or any of its principals have been involved in any court or administrative proceeding where they have been found to have violated the provisions of state or federal securities laws or the rules of any national securities exchange or self-regulatory organization.
CONTINUING DISCLOSURE OBLIGATIONS
After the company has sold securities, it is obligated to continue to provide certain information to investors.
If a Washington company has sold equity securities, the Washington Business Corporations Act gives shareholders certain rights even though the principals may still retain majority ownership of the company.
Where a company has registered a public offering of securities under the Securities Act to sell securities in the State of Washington, the company must provide annual financial information to Washington investors within 120 days of the close of the company's fiscal year during the offering period.
For answers to specific questions, you are urged to contact the Securities Division. A call to the Division will put you in touch with a small business specialist who will attempt to answer your questions. Additional information is also available in the Small Business Assistance section of the Division’s website.
Your attorney and accountant may also provide assistance. They know you and your business and can help you identify those issues which may need to be discussed in a disclosure document.
The Securities and Exchange Commission (SEC) may also provide assistance. The SEC maintains an Office of Small Business Policy within its Division of Corporation Finance at 450 Fifth St., N.W., Washington, D.C. 20001 (202) 942-2950. The SEC also maintains a website at http://www.sec.gov.
WORD OF CAUTION
This document is meant only to introduce the small business person with the concept of disclosure and the legal requirements relating to giving disclosure in connection with an offering of securities. It SHOULD NOT be relied upon to make a securities offering. There are many other important items with which a person making a securities offering must comply. This document addresses only one of these items. If you want to know more, please contact the Securities Division.
Set forth below are examples of risk factors normally associated with offerings of start-up or developmental stage businesses which make the securities offered by these companies speculative in nature. An example of the type of wording normally used to describe the risks of the investment is illustrated by the SAMPLE WORDING appearing under Item 1 of each category. Inclusion of any of the examples of risk factors or additions to them should be determined by whether the risk factor relates to a specific problem faced by the issuer or arising on account of the offering. Mere general negative statements without explanation should be avoided. Risk factors should be cross-referenced to detailed discussions found elsewhere in the disclosure document.
A. Risks Relating to the Financial Condition of the Company.
1. The Company has a history of losses with no expectation for immediate profits.
SAMPLE WORDING: The Company has never operated profitably since its inception. As of the date of its most recent financial statements, the Company has an accumulated deficit of $ . For the last three fiscal years, the Company has incurred losses of $___ for 2000, $___ for 2001, and $___ for the first three months of 2002. The Company expects that these losses will continue for the next several years and there is no certainty the Company will ever become profitable. (See Financial Statements).
2. The Company has generated limited operating revenues.
3. The Company is minimally capitalized.
4. A substantial portion of the Company’s assets are comprised of intangible items.
5. The Company is dependent on the offering for funds to continue operations.
6. The Company faces adverse consequences if the maximum amount of proceeds are not raised.
7. The Company has significant indebtedness - [some] which will be paid from the proceeds of the offering and benefit current management of the company.
B. Risks Relating to the Business of the Company.
1. The Company is a start-up company in the development stage.
SAMPLE WORDING: The company is in a start-up period (developmental stage) and has not engaged in any significant operations to date. There is no certainty that the company will be successful in overcoming the substantial risks as set forth below in order to advance beyond the start-up period (developmental stage). (See p.___ of the disclosure document).
2. It is uncertain whether a market exists or will develop for the Company’s product or service.
3. The Company’s product and business are unproven.
4. The Company faces competition from existing entities in similar business which have greater resources.
5. The Company has limited or no manufacturing capability.
6. The Company’s products or services are subject to governmental regulation (e.g. licensing, environmental, etc.).
7. The Company faces risks relating to technological obsolescence.
8. The Company needs additional financing.
9. The Company uses trademarks and patents, for which royalties are paid, that are not owned by the company.
10. The Company is dependent upon key personnel.
11. The Company is dependent on the efforts of management.
C. Risks Relating to Management of the Company.
1. Principals of the Company have prior records in similar or other prior business ventures which resulted in losses to investors.
SAMPLE WORDING: Principals of this Company have operated businesses of this type prior to organizing this Company which resulted in losses to investors. Principals [also] operated other businesses in the past which were not similar to this Company which resulted in losses to investors (See p.___ of the disclosure document).
2. Substantial voting control of the Company will be retained by management.
3. Promoters of the Company have disciplinary or criminal histories.
4. The Company pays substantial direct and indirect compensation to management.
5. A substantial amount of the proceeds will be used for the benefit of management.
6. There are material conflicts of interest and transactions between management and the Company.
D. Risks Relating to the Securities being Offered and the Terms of the Offering.
1. The Company has issued substantial amounts of cheap stock and options to promoters.
SAMPLE WORDING: The promoters own ___ shares of common stock for which they paid an average price of $___ as compared with the public offering price of $___ per share. In addition, the promoters own ___ options or warrants which are exercisable to purchase additional shares of common stock at an average price of $___ during the next ____ years. (See p.___ of the disclosure document).
2. Investors will experience immediate substantial dilution of their investment.
3. Investors face the risk of loss of their entire investment.
4. The Company’s securities are not publicly traded and there can be no assurance that a market will develop.
5. There are a significant amount of shares owned by promoters that are available for immediate resale.