Considering Investing in a Small Company’s Stock? Pay Careful Attention to the Deal Docs and Who’s Ahead of You.

I have people come to me to seek advice regarding a potential investment in a new-ish company (maybe a bit beyond startup phase) they’re considering making. Usually, it’s an opportunity presented by a friend of a friend, and a salesperson has contacted them on behalf of the company. It could be a corporation, or maybe it’s an LLC, but regardless of the entity’s form it’s a security or securities that are being sold. Typically, that salesperson has generated and sent over a few documents, including a Private Placement Memorandum, an Investor Rights Agreement and a Stock Purchase Agreement. The documents are riddled with terms such as “Accredited Investor,” “IPO,” “Liquidity Event,” “Liquidation Preference,” “Series A Preferred,” “Series B Preferred,” etc., and the client wants to know what they all mean.

A definition of all those terms is far beyond the scope of this simple blog post, but be wary: Each and every one of those terms is heavily loaded legalese that, when taken together, define your rights as an investor. For instance, pay close attention to the rights of the earlier investors, because they’re going to get paid out before you do, whether the payment comes in the form of dividends or from the pool of funds generated by a sale of the company’s assets. If they eat up all the money before you, then you could be left out in the cold.

In addition to that, there are 1,000 little things you can do as due diligence into the company to determine how serious and/or legitimate its management (and therefore chances of success) is. Don’t accept the salesperson’s word. Hiring an experienced lawyer who’s seen these deals on both sides is a very valuable use of your money on the front end. It’s a classic and perfect case of “an ounce of prevention is worth a pound of cure.”

Greg Borman is an attorney in San Diego, California. He practices corporate law, business transactions, and estate planning. He can be reached at greg@bormanlaw.com and at (858) 232-7100.

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