The use of financial models and projections in fundraising by pre-revenue companies and those in the early and optimistic stages of their business cycle is almost universal. Often, companies disclose assumptions underlying the models and projections. Many include warnings and disclaimers in fine print further advising readers of the uncertainties behind the business and risk in relying too heavily on the models or projections. In these circumstances, the fundraisers feel secure in the disclosures accompanying the models or projections provided to investors.
But what will those models and projections look like two and three years later if the business hits choppy waters, expected business partners change direction, or regulators become less accommodating? Will investors cry foul and draw the attention of the Securities and Exchange Commission (“SEC”), Department of Justice, or other regulators? Recent actions demonstrate heightened enforcement risk to both issuers and their executives in the use of models and projections in fundraising by early- and middle-business-cycle companies. In this article, we offer suggestions on how to mitigate or reduce the risk.
Recent Actions Highlight Danger in the Use of Projections by Early-Stage Issuers
The explosion of initial public offerings by special purpose acquisition companies (“SPACs”) and their privately held target companies via de-SPAC combinations in 2020 and 2021 led the SEC and certain of its officials to raise concerns about the use of projections in fundraising and business combinations. In March 2022, the SEC published proposed rules intended to enhance investor protections, including additional disclosures accompanying projections shared with potential suitors. While the SEC has yet to adopt the proposed rules, recent enforcement activity reflects heightened staff scrutiny of projections and accompanying disclosures used in fundraising that issuers, their executives, and advisors should consider before sharing projections and related disclosures, whether or not connected to business combinations or de-SPAC IPOs.
A client of the authors’ firm, a former executive of a technology company (“TechCo”) that went public via a business combination and de-SPAC transaction, was recently issued a Wells letter notifying him of the SEC staff’s recommendation that the Commission authorize an enforcement action against him. The staff alleges TechCo, and our client, presented misleading financial projections to investors in connection with the business combination and related private investment in public equity (“PIPE”) offering in presentations and filings with the Commission. Specifically, the staff alleges TechCo presented specific revenue projections for the two ensuing calendar years from a particular service unit of the business. Within five months of the first presentation of the projections, however, the targeted business failed to materialize and was later abandoned. Nonetheless, the staff alleges TechCo continued to include the revenue projections for several more months in filings with the Commission.
Ultimately, the staff alleges the projections shared with investors omitted disclosure of assumptions and facts that, in the staff’s view, call into question the reasonableness of the projections. This may sound like a routine SEC enforcement action based on omissions of material facts. Not so fast. A closer look at disclosures and access provided by TechCo to investors reflects a transparency that would ordinarily seem to ward off allegations of any intent to defraud. For example, TechCo’s disclosures with the projections included:
- Warning that the projections were based on TechCo management’s “discussions with such counterparties and the latest available information.”
- Explanation that the partnerships underlying the projections depended on negotiations over definitive agreements “which have not been completed as of the date of this presentation.”
- Confirming once again that descriptions of the business partnerships behind the projections remained “subject to change.”
- Arranging for a due diligence call between investors and the potential partner behind the revenue projections at issue.
These disclosures reflect that, at a minimum, investors were told the projections were based on “potential” partnerships, and not signed agreements and committed sales. Moreover, evidence showed that discussions between TechCo and some potential partners continued contemporaneously with most of the filings that included the projections. Nonetheless, the staff alleges that when the partnership negotiations failed to advance as quickly as hoped or expected, continued reference to the projections in filings with the Commission became unreasonable and fraudulent under the federal securities laws.
We often see similar analysis of financial projections and related disclosures in enforcement actions and shareholder disputes where the business fails to develop as expected or as quickly as believed at the time of the share sales. Investors become disillusioned, and recollections of what was disclosed and understood often sour with the passage of time. The recent uptick in enforcement actions regarding technology and early-stage companies, including those that went public via de-SPAC transactions, suggests the clampdown on the use of projections in these circumstances has arrived.
What can an issuer and its executives do to mitigate these risks? Projections are deeply important to investors, and it is unrealistic to propose that companies stop using them, but several strategies could mitigate risk.
Strategies to Mitigate the Risk in Sharing Projections
These strategies to mitigate risk will not close the door to regulatory scrutiny. They can, however, potentially bolster defenses to accusations of deception or misconduct.
1. Title the relevant analysis a “model” and not a “projection.”
If an economic forecast is used in fundraising, title it as a “model” of the business opportunity and not a “projection” of future revenue and income. A “model” describes an analytical tool. A “projection” connotes a prediction or forecast more typical of public companies. Use the “model” description in all communications as well.
2. Do not date the business years in the model.
Date the business progression in the model as Year 1, Year 2, Year 3, etc. Dating the model with specific years (2024, 2025, etc.) can feed into a later characterization of the model as a prediction and provide target dates that can be used against you.
3. Define and disclose when Year 1 in the model begins.
This is particularly important for pre-revenue and early business cycle companies. Does Year 1 begin with the public launch of a new product, adoption of the product by certain partners, regulatory approval of a new product, or clearance of some other hurdle or obstacle to the launch of the business? Defining the start of Year 1 can help guard against unexpected delays in developing the business.
4. Disclose assumptions behind the model.
Disclosing assumptions built into the model can guard against future efforts to allege management concealed factors that years later may appear unreasonable in light of subsequent micro- or macroeconomic events. This should go beyond disclosure of just the Excel spreadsheet or other raw data behind the model. If possible, define terms and provide narrative explanations of the reasoning and bases behind the model. This can help to guard against claims of confusion about the meaning of the data and calculations in the raw model spreadsheet.
5. Document all meetings and presentations relating to the model.
This seems obvious, but we have seen numerous failures by management to memorialize oral representations to potential investors that accompany the presentation of projections and models. Noting questions raised by potential investors can also aid later efforts to reconstruct what was important to investors at the time. This can take the form of a formal transcript or notes from the meeting or presentation.
6. Consider a risk review before sharing the model with investors.
If resources permit, it may be beneficial to have experienced SEC enforcement counsel review the business model and related financial due diligence before disclosure to investors. In addition to identifying potential areas of weakness or exposure, a review may provide a potential advice-of-counsel defense to the company and executives, so long as all related facts are disclosed to reviewing counsel.
While these strategies seem simple, we continue to see enforcement actions aimed at the use of financial projections where some or none of the above strategies were implemented. The SEC’s announced intent to more closely police the use of projections in fundraising, as well as the aggressive positions taken by the staff in the case of TechCo and our client, counsel for greater caution.