Hiding Information

My co-founder is handling the diligence process with our acquirer and I am not comfortable with how loose he is being with some of the information he is providing. The buyer cannot independently find most of the information, but the bad information may come out after the deal closes. Should I be worried?

I do not know the nature of the information, but the short answer is yes. Absolutely yes. When you provide false or incomplete information in connection with the sale of a company or a financing, you are committing securities fraud. Securities fraud is a felony under federal law, state law, and under the laws of almost all countries.

While the chance of jail time is (unfortunately) very low, since prosecutors often care little about white collar crime, the chance of devastating civil lawsuits is not. All future business partners will do background checks on you which will turn up this legal information. Even if an aggrieved party does not sue you, the world is small and word gets around fast. You will be permanently damaged in the investment world because any reputable buyer or investor will always call people you did business with in the past to get the “real story” about working with you.

In the context of a merger agreement, you often have certain limits on your personal liability for post-closing problems. For example, it may be capped at a certain escrow amount. These limits give you peace of mind, as your exposure is defined. However, in cases when information is not disclosed, is incomplete, or misleading, the cap will not apply and you and your co-founder may find yourselves with unlimited personal liability and years of headache.

Securities fraud is a necessarily nuanced issue, because many people excel at lying. I will not review all the statutory language here (check out the courses), but directly providing false information obviously counts, as does omitting information that is material. You can even commit fraud by literally telling the truth, but omitting information necessary to make the statement not misleading in context. Any act of deceit can, generally speaking, fall within the definition of securities fraud. While courts and juries are fallible and unreliable on many issues, everyone loves to punish a liar.

One of the more disappointing aspects of being an investor is the frequency that entrepreneurs lie to us. Good investors are not careless people and do check information thoroughly. Nevertheless, it is remarkably easy for founders to fabricate or hide information.

Indeed, it is almost accepted practice to lie. In fact, I have attended venture financing events, including at prominent and allegedly reputable accelerators, where entrepreneurs are affirmatively coached how to mislead investors, as if it is just “part of the game.” It is not. It is a felony. The fact that the speakers were not rushed hurriedly off the stage after encouraging others to game the system just shows how much lying for financial gain has infiltrated our venture ethics.

People lie because, frankly, it works. Despite that reality, take the long view. In your acquisition, you will likely be working with the buyer for years. You may want to start a new company and will want the relationship and your reputation. You certainly do not want to spend all your personal wealth paying lawyers to defend you in lawsuits and be in endless depositions, only to have the inevitable damage award ruin you in a bankruptcy.

Investors and buyers are used to some mess. Just be honest. Will the price adjust with the truth? Probably, but the price of your integrity and future ability to continue as an entrepreneur is worth more.

See also: 4.107: Diligence and Disclosures

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