**MEMORANDUM** **To:** Board of Directors, Northgate Metrics **From:** Counsel **Re:** Series B corrective action, ARR/retention misstatements, anchor investor, founder secondary, and board duties **Privileged & Confidential — Attorney Work Product** --- ## Executive Summary Do **not** sign on schedule using the current deck. The CEO’s proposal — close at the old metrics and “fix the deck for the Series C” — would convert an already serious disclosure problem into a fresh, knowing securities fraud. The old ARR and retention figures are misstatements of present fact, not protected projections. The CFO email establishes at least recklessness and likely knowledge. The anchor investor has a rescission claim that cannot be cured by after-the-fact correction. The remaining $32M can still be saved by a full, specific correction **before** they sign. The founder secondary should be suspended, and the board must not approve the deal on the current terms. --- ## 1. The ARR and Retention Figures Are Misstatements of Present Fact, Not Protected Projections ### A. “ARR: $14.2M” is a present, historical statement and is materially false The statement “ARR: $14.2M” is not a projection. It is a factual representation of current annual recurring revenue. But the composition does not support it: - **$2.6M** is one-time implementation-services fees — by definition not recurring. - **$1.1M** is a signed contract that is not yet live and is terminable on 60 days’ notice before go-live — not current recurring revenue. At best, it is contingent backlog, not ARR. - The company’s own standard recurring subscription revenue is approximately **$10.5M**. So the ARR figure is overstated by approximately **$3.7M**, or about **26%**. Even if the company wanted to use a nonstandard definition of ARR, it had to disclose that definition and reconcile the number to a standard recurring-revenue basis. It did not. The statement is an untrue statement of a material fact, or at a minimum an omission of material facts necessary to make the statement not misleading. ### B. “Net revenue retention: 138%” is also a present, historical misstatement Net revenue retention is a measurement of revenue retained and expanded from a starting customer cohort, including churn and contraction. The 138% figure was calculated by excluding the **two largest accounts lost during the year**. Including them, retention is **111%**. That is a 27-percentage-point overstatement. The 138% figure is not a projection; it is a historical metric computed on a cherry-picked cohort. The company omitted the cohort definition and the excluded churned accounts. That is misleading. If the company wants to show a supplemental measure such as “retention among continuing customers,” it may do so only if clearly labeled, fully reconciled, and presented alongside the full-cohort number. The deck did none of that. ### C. The final-slide disclaimer does not help The deck’s final slide says projections “involve risks and uncertainties.” That is boilerplate. It does not: - identify the ARR or retention figures as projections; - define the components of ARR; - disclose the excluded lost accounts; - disclose the non-renewal; or - provide meaningful, specific cautionary language tied to the actual risks. The safe harbor for forward-looking statements does not apply to misstatements of present or historical fact. The disclaimer does not convert a false current metric into a protected projection. --- ## 2. Materiality A reasonable Series B investor would plainly consider these facts important. - **ARR gap:** $14.2M vs. $10.5M — a 26% overstatement. ARR is the central pricing metric for the company. At the implied valuation multiple of roughly 15.5x ARR ($220M ÷ $14.2M), the overstatement is worth roughly **$57M of apparent value**. - **Retention gap:** 138% vs. 111% — a 27-point difference. Retention is a core indicator of product quality, customer success, and future growth. A 138% figure is exceptional; 111% is still positive but materially less compelling. - **Non-renewal notice:** The second-largest customer, representing about **9% of subscription revenue**, has given notice effective in four months. That is approximately **$0.945M** of annualized subscription revenue at risk. A reasonable investor would want to know this before investing, even after all other metrics are corrected. - **Total mix:** No other information in the deck makes these facts unimportant. The CEO’s statement that “the business is real” is not a disclosure and does not cure the false metrics. Materiality is not a close call. --- ## 3. Scienter and Who Is Exposed ### A. The CFO email is strong evidence of knowledge or at least recklessness The CFO wrote: > “Everyone counts pipeline-adjacent. Keep the number. We can true it up after the round.” That email: - acknowledges the figure was not computed on the standard definition; - directs that the number be retained; and - expressly defers correction until after the financing is complete. That is not an honest mistake. It is conscious disregard, and likely actual knowledge that the number was misleading. “True it up after the round” is effectively an admission that the company was selling investors on a number the CFO knew would later have to be corrected. ### B. Who is exposed - **The company.** It made the statements in the deck and used them with every prospective investor. It is exposed to rescission, damages, and related costs. Corporate scienter can be established through the CFO’s and CEO’s knowledge. - **The CFO.** He likely has primary liability because he created, approved, or controlled the numbers. His email defeats any argument that he acted negligently rather than recklessly or knowingly. - **The CEO.** The CEO now knows the metrics are false and proposes to proceed anyway. If the company signs on schedule, the CEO will have participated in the fraudulent sale. “Fix it for the Series C” is not a defense; it is evidence of an intent to close the round before correcting. - **The directors.** If the board approves the financing while knowing it rests on false materials, that is a breach of the duty of candor and good-faith oversight. Under the supplied rule, this implicates **loyalty, not merely care**. Board approval would expose directors to personal liability and would not be protected by business-judgment deference. - **The founder.** If the founder sells shares before the non-renewal and the false metrics are corrected, she is exposed under the insider-trading/antifraud rule. If the founder is also the CEO, her exposure is even more direct. --- ## 4. The Anchor Investor’s Wired $8 Million The anchor is already **irrevocably committed**: it signed a subscription agreement and wired funds based on the deck. Under the supplied reliance rule, correction of a misstatement **after** an investor becomes irrevocably committed cannot cut off that investor’s reliance. That means: - The anchor can assert rescission or damages based on the original ARR and retention misstatements. - Merely correcting the deck now does not cure the anchor’s claim. - The company cannot keep the $8M simply because it now discloses the truth. ### Company’s options 1. **Offer rescission.** Return the $8M, cancel the shares, and unwind the tranche. If the anchor still wants to invest, it can do so in the corrected round as a new investment. This is the cleanest legal path. 2. **Negotiate a reaffirmation and amendment.** Deliver full corrected disclosure, repricing or other adequate economic protection to the anchor, and obtain written acknowledgment that the anchor is continuing **after** receiving corrected information. A mere “we’ve corrected the deck” letter is not enough. 3. **Do not unilaterally keep the funds.** If the company refuses to offer rescission and the anchor later rescinds, the company will face litigation and possibly a judgment. Proactive remediation is better than defensive litigation. ### Should rescission be offered? Yes. The anchor has a strong rescission claim. Offering rescission does not admit liability, but it gives the anchor a clean choice and prevents the company from compounding the original misstatement. If the anchor chooses to stay, the company should repaper the investment on corrected terms. --- ## 5. The Unsigned $32 Million For the remaining $32M, **correction before signing can cut off reliance** if done properly. That is exactly what the reliance rule permits: once investors receive the truth before they become irrevocably committed, they cannot later say they were induced by the old false statement. But the correction must be real: - Withdraw the old deck and say it should not be relied on. - Deliver a specific reconciliation: - Prior ARR: $14.2M - Less non-recurring implementation fees: $2.6M - Less signed-not-live terminable contract: $1.1M - Corrected ARR: $10.5M - Correct retention: - Prior NRR: 138%, excluding the two largest lost accounts - Corrected NRR: 111%, including all customers in the cohort - Disclose the **non-renewal notice** from the second-largest customer, representing approximately 9% of subscription revenue. - Disclose that the prior disclosure was not a mere formatting issue and that the company has had a metrics-integrity failure. - Include meaningful risk language, not boilerplate. - Require each investor to sign an acknowledgment that it received the corrected disclosure before becoming committed. - If the “term sheet” commitment is itself legally binding, treat those investors the same as the anchor. Review the term sheet before relying on the “unsigned” status. If a signed term sheet contains a binding obligation to invest, then correction before signing the subscription agreement may be too late. The company’s counsel should review that document immediately. --- ## 6. The Founder’s $4 Million Secondary The founder **cannot proceed on the current plan**. The non-renewal notice is material nonpublic information. The founder is selling shares to investors who do not know that the company’s second-largest customer will not renew. Under the supplied insider-trading rule, a person who sells securities while in possession of material nonpublic information about the issuer, to a buyer without that information, violates the antifraud rules. That applies directly to founder secondary sales in a private financing. The secondary may proceed only if: - the company first delivers complete corrected disclosure to each buyer; - the disclosure includes the non-renewal notice; - the sale is repriced to reflect corrected metrics and valuation; - each buyer signs after receiving the corrected information; and - the founder has no other material nonpublic information that has not been disclosed. Even then, the safer course is to **suspend or pull the secondary**. A founder sale in the middle of a disclosed metrics restatement creates an appearance of “getting out while the getting is good.” The reputational and litigation risk is high. If the round reprices, the founder can sell at the corrected price, but only after the buyer has had time to digest the corrected materials. **Recommendation:** pull or indefinitely suspend the founder secondary unless and until the corrected round is fully documented and the investors affirmatively confirm they want to buy founder shares on corrected terms. --- ## 7. The Board’s Position If It Follows the CEO’s Proposal The board is in a different position from the CEO. It owes a duty of candor to shareholders and a duty of good-faith oversight of the company’s disclosures. If it approves a financing **known** to rest on misleading materials, that is a breach of loyalty, not merely a failure of care. The consequences would include: - Personal exposure for directors who vote to proceed. - No exculpation. Any exculpation provision in the charter does not protect bad-faith or knowing violations of law. - No indemnification for fraud. Under the supplied rule, indemnification and D&O insurance do not cover liability finally adjudicated to arise from fraud. - Potential D&O insurer denial. The insurer will likely reserve rights and disclaim coverage based on the fraud exclusion. A director who does nothing more than follow the CEO’s recommendation after learning the facts would be acting knowingly or recklessly. The board should instead: - refuse to approve the current terms; - require correction; - require anchor remediation; - require suspension of the founder secondary; and - consider whether the CFO should remain in office during the investigation. --- ## 8. The Repricing Conversation The company should go to investors before the scheduled signing, not after. The message should be: > “We discovered that our previously reported ARR and retention figures were incorrectly calculated. The corrected ARR is $10.5M. The corrected net revenue retention is 111%. We also received a non-renewal notice from our second-largest customer. We are withdrawing the old deck and reworking the round on corrected terms.” Do not say “it’s just a definitional change.” It is not. ### Likely valuation impact - The old pre-money valuation was $220M on $14.2M ARR, an implied multiple of roughly **15.5x ARR**. - If the same multiple is applied to corrected ARR of $10.5M, the implied pre-money valuation is roughly **$163M**. - Investors may demand a further discount because: - the quality of the ARR is lower than represented; - the retention metric was inflated; - the company has a customer concentration issue; and - the non-renewal notice reduces confidence in forward revenue. - A reasonable planning range for negotiation may be something like **$140M–$165M pre-money**, but the exact number will depend on investor reaction and the company’s leverage. ### Delay, reprice, or restructure? - **Do not sign on schedule.** Delay is necessary if only to complete the correction. - **Reprice is likely necessary.** The old $220M valuation cannot be defended after the correction. A lower valuation is painful, but it is far better than a rescission suit and a destroyed reputation. - **Restructure may also be needed.** If investors lose confidence, the company may need to: - reduce the round size; - issue convertible notes or a bridge; - offer additional investor protections; or - postpone the equity round until metrics are more credible. The best protection for the company is not preserving the old valuation. It is restoring credibility, cutting off further investor claims, and avoiding a knowingly false closing. --- ## 9. Concrete 48-Hour Plan for Counsel ### First 4 Hours: Stabilize 1. Issue a litigation hold. Preserve all documents relating to ARR, retention, the CFO email, the old deck, and the non-renewal. 2. Stop all further distribution of the current deck. 3. Identify every person who received the current deck, especially the anchor and term-sheet investors. 4. Call an emergency board meeting or executive session, with independent directors. 5. Retain outside securities counsel and, if needed, a financial advisor. ### Board Meeting / Director Resolutions 6. Do **not** approve signing on current terms. 7. Approve the corrective disclosure in principle. 8. Authorize the board’s independent directors (or a special committee) to oversee the correction, the anchor remediation, and any related-party founder-secondary decision. 9. Direct management not to communicate with investors about metrics without counsel’s approval. ### First 24 Hours: Corrective Disclosure and Anchor Remediation 10. Draft the corrective disclosure: - Withdraw the old deck. - Provide the ARR reconciliation: $14.2M → $10.5M. - Provide the retention correction: 138% → 111%. - Disclose the signed-not-live contract and the implementation fees. - Disclose the second-largest customer’s non-renewal notice. - Do not falsely describe the issue as inadvertent if the CFO email contradicts that. 11. Deliver the corrective disclosure to the anchor. 12. Offer the anchor the choice of: - rescission of the $8M tranche; or - reaffirmation on amended terms after full disclosure and repricing. 13. Do not use the anchor’s $8M in any new closing unless and until the anchor elects to continue. ### Founder Secondary 14. Suspend the founder secondary immediately. 15. Do not allow founder shares to be sold in the current signing. 16. Any later sale must occur only after full corrected disclosure, repricing, buyer acknowledgment, and no other MNPI exists. ### Next 24 Hours: Remaining Investors 17. Deliver the corrected disclosure and amended term sheets to the remaining investors. 18. Require each investor to acknowledge in writing that it received the corrected disclosure before signing. 19. Renegotiate valuation, price, and any other terms as necessary. 20. If investors will not agree on corrected terms, delay the signing and consider a bridge or other restructuring. ### Final Board Resolutions 21. Record in board minutes that the board: - rejected the CEO’s “sign now, fix later” proposal; - withdrew the prior metric deck; - approved corrected disclosures; - authorized anchor remediation; - suspended the founder secondary; - approved any repricing; and - directed an investigation into the preparation of the metrics. --- ## Bottom Line The company can survive this. It cannot survive by signing a fraudulent round and hoping to fix the narrative later. Correct now, offer rescission to the anchor, reprice the round, and pull the founder secondary. That is the only path that protects the company, the board, and the existing shareholders.