Month: January 2016

Equity Crowdfunding – What the Crowd Expects

Investors, Issuers

As the crowdfunding industry moves from rewards programs to equity offerings companies that are seeking funding will need to step up their game. Investors will not receive your product at a discount. They will have very different expectations.

When you make a debt or equity offering for your company on a crowdfunding portal you are asking investors to help you to fulfill your dreams with their money. That is perfectly fine and in many ways is a process that is at the very core of the capital markets.

What do investors expect in return? If you have not asked that question and if you are not prepared to answer it, raising debt or equity capital in the crowdfunding market may be more difficult than you think.

Investors invest their money to make money. It may sound obvious until you realize that for crowdfunding investors it is very unlikely that it will happen. Most crowdfunding investors will lose their money.

Even if you are successful and profitable for many years crowdfunding investors will not be able to cash out of their investment in your company until you sell the company. That is one reason that many investors will select investments that pay dividends (preferred shares) or interest (debt offerings).

Your investors will be prepared to lose the money that they are giving to you. They know that all crowdfunded investments are speculative. They know that the best deals are likely to be scooped up by angel investors or venture capitalists. They know that despite your best intentions and best efforts most new businesses fail.

For smaller companies that want to use a crowdfunding portal for financing I cannot over emphasize the importance of being able to demonstrate to investors that your company can succeed. At the very least, you should be able to show investors that you have put the pieces into place to give your company a fighting chance.

Equity crowdfunding can be expensive and cutting corners can lead to problems and a campaign that does not get you the funds that you need. You are going to need an experienced securities attorney to prepare your disclosure documents and to guide you through the regulations. You are going to pay a portal for the privilege of listing your offering and you are going to need to fund the marketing effort to reach out to potential investors. If you are going to spend this money to reach investors, your offering needs to be strong.

Remarkably, many of the experts in the crowdfunding arena have never raised any significant amount of money from investors. Many cannot, themselves, tell a good deal from a bad deal. They certainly cannot gauge whether your offering will be well received by investors.

I have reviewed business plans and pitch decks from dozens of companies that want to raise funds through crowdfunding. From an investor’s point of view, many of these offerings are weak. Many people do not seem to appreciate that having a great idea or product is not the same as having a great business.

Equity crowdfunding will necessarily tap into a pool of investors who have had experience in the mainstream financial markets. If you expect them to invest in your business, you should be prepared to demonstrate at least the following:

1) That you understand your business, not just your product. Investors appreciate that you want to tell them that your product will sell millions of units, cure disease or become a ubiquitous part of everyday life. What they really want to know is about your business. Show them not only that people will want to buy your product but that you can produce it profitably, deliver it efficiently and sustain both.

2) That you will follow the rules. The most common abuse in the private securities market is that the marketing materials accompanying the offering are not complete or balanced. The sales pitch frequently exaggerates the positives to the exclusion of the negatives. If the video that accompanies your offering shows people saying things about your business that are very different from the disclosures in your official prospectus, you have a problem.

3) That you can tell investors what you really intend to do with their money. Vague statements in your prospectus that allocate funds for “research and development” or for “general corporate purposes” do not encourage investment. Specific details help investors to better gauge your business.

4) That you will spend investors’ money wisely. Hewlett and Packard, Jobs and Wozniak started out in garages. Why do you need an expensive  loft with a cappuccino machine and foosball? Make money first, buy toys later.

5) That you will allocate some money for reserves. The last thing that either you or your investors want is for you to run out of money just before you get to the finish line. You should plan for problems, delays and contingencies because they will happen.

6) That you have a full management team. Investors know that 4 techies and a CFO do not make a company. It starts with people with experience in the industry in which you will be operating. Investors like to see a marketing director with real experience selling similar products and a lawyer to help with contracts, problems and problem avoidance. If you are not yet ready for a full time marketing director or general counsel, at least have someone with marketing or legal experience on your board of directors.

7) That you have good, experienced and active advisers and directors. Frequently companies seeking investment dress up their board of directors with people with good resumes. Investors want to see a board with the experience to give you the advice that you will need. The same is true for your corporate attorney and accountants. However, if these people are not available to actually help you, then they do not belong on your board.

8) That you have a supply chain in place. It is fine if all you have is a prototype at this point, but if you expect to sell 100,000 units in the first year, please be ready to tell investors that you know where you will get those units and what they will cost.

9) That you know your competition. A formal market research report is preferable but if you plan to market a new toy, you should at least be able to say that you have been going to the New York toy show for a few years to see what other people are offering and that you have spent hours at Toys-R- Us or similar toy stores looking at other products.

10) That you are making realistic projections. Do not tell investors that 100 million consumers might buy your product. Tell them how many units you might reasonably procure and sell. Investors like to know that you know what it will take for your company to break even. Talk about astronomical profits after that.

11) That you have taken steps to protect investors and the company. If your product or design is patent-able, apply for a patent. If you are raising money from the public without Directors & Officers’ insurance you are just plain foolish.

12) That you have some skin in the game. Before crowdfunding the only option for people seeking to fund their small business was the Small Business Administration (SBA). The SBA requires collateral for the loans that they make. Usually the company owners or their family pledge the family home to get the funds. Sweat equity is fine, but if you, your family and friends do not have enough faith in your success to have put their hands into their pockets to get you started, why should investors?

This list is by no means inclusive. If you really want to raise capital from investors, your offering needs to be strong and you need to give investors what they want and expect.

If you would like to know how investors are likely to view your offering my partner and I will be happy to review the offering before you put it out on a portal. We will give you the benefit of our combined 85 years of experience raising money and dealing with investors.

We will charge you a ridiculously small amount for a detailed point by point written report, telling you how to make your offering stronger and how to make it stand out from other companies seeking the same funds from investors. We offer feedback, perspective and some constructive criticism that you will not find elsewhere. Call us when you decide to make an equity offering on a crowdfunding portal. We will save you time, money and disappointment.

FINRA looks at Wall Street’s Corporate Culture – It should look at its own.

Capital Markets, Investors , , , , ,

The Financial Industry Regulatory Authority (FINRA) has announced that as part of its 2016 member firm audits it will look into what it calls the firm’s culture of compliance and supervision. The idea is laudable until you put it into context.

Registered representatives (stockbrokers) are routinely incentivized to open more accounts, bring in more money and make more trades. Many successful stockbrokers gain their clients’ trust by presenting themselves as financial advisers when they are not. They are salespeople not analysts or advisers.

That is the culture of the industry. It is demonstrable without an audit.

As someone who has brought arbitration claims against hundreds of stockbrokers, I can tell you that the miscreants among registered representatives are a small minority. Most stockbrokers do not get out of bed thinking “who can I screw today”. More frequently problems arise from advice they are not qualified to give or even more often from financial products that should not be sold in the first place.

The most conflicted advice that is routinely given by FINRA Broker/Dealer firms is for customers to stay in the market no matter what. If the market crashes, which it periodically does, registered representatives routinely tell customers that they did not see it coming and then “don’t worry, the market always comes back.”

Ask yourself: if your stockbroker did not see the market crash coming, how do they know that the market will come back?

My own adviser (an independent Registered Investment Advisor) has been bearish since last summer. After a long bull market he called the collapse of oil prices a “shot across the bow” for the markets and started selling positions and accumulating cash. He has raised more cash of late because he uses stop losses. He believes that protecting a client’s portfolio is part of his job. If your adviser thinks differently or does not use stop losses, send me an e-mail and I will gladly refer you to mine. (I receive no fee for any referral).

A FINRA audit is often performed by an inexperienced auditor (not a CPA) who is thinking about spending a few years at FINRA and then getting a more lucrative job in the industry. Rarely, if ever, do FINRA auditors ask the hard questions.

Trillions of dollars worth of transactions are placed by FINRA firms every year that are perfectly legitimate and need little scrutiny. FINRA would do better to spend time and energy reviewing those transactions that yield the most problems.

Hundreds of FINRA firms and thousands of registered representatives specialize in selling private placements to non-institutional customers. Private placements pay higher commissions than most other financial products and are therefore always a concern for potential abuse. Private placement losses are a multi-hundred billion dollar problem that affects many seniors and retirees, many of whom should never have been offered these investments in the first place.

FINRA has explicit rules about how firms should perform due diligence on private offerings. Failure to conduct a due diligence investigation on private offerings has been a leading cause of investor losses and the reason that a significant number of FINRA firms went out of business when the market corrected in 2008.

Private placements are sold with shiny marketing brochures that are supposed to be reviewed by compliance departments but frequently are not. Do FINRA auditors routinely review the marketing materials for private placements at the firms that they audit to see if they are appropriately reviewed and not misleading? They do not.

FINRA would do well to examine its own culture.

It has never been my practice to file complaints with FINRA’s enforcement branch, in part because they are consistently ineffectual. Some time back, I did file a complaint on behalf of an 80 year old client who had been sold a particularly ugly private placement for a building in the mid-West.

The sponsor, who was also the master tenant responsible to make payments to the investors claimed to be a college graduate who had previously owned a seat on one of commodity exchanges. He also claimed to have been a successful real estate developer.

In fact, the sponsor had never graduated from college, never owned a seat on any commodity exchange and his only prior development had filed for bankruptcy protection leaving many sub-contractors unpaid. I submit that no competent due diligence officer who actually investigated this offering would have approved it. That did not stop dozens of FINRA firms from selling this and other private placements offered by the same sponsor.

The investors ultimately lost the building to foreclosure because the roof leaked badly and needed expensive repairs. The due diligence officer at the FINRA firms that sold this private placement had never seen an inspection report on the building and it is doubtful that a building inspection was performed before it was syndicated to investors. The sales brochure that every investor received described this as a great building and a great investment.

The FINRA enforcement officer that looked into the complaint had never performed a due diligence investigation himself nor was he trained in any way as to what a reasonable due diligence investigation might entail. I know this because I spoke with him more than once. He pronounced the due diligence investigation on this offering to have been fine and on his recommendation FINRA took no action against the member firm.

I took the claim to arbitration and the panel rescinded the transaction giving the customer all of his money back with interest. It certainly helped that the registered representative who had sold the offering to the customer testified that he would not have made the sale if he had known that the firms’ due diligence had been so minimal. If the arbitrators and the registered representative could see that the due diligence was inadequate, why could FINRA’s own enforcement staff not see the obvious?

In another case involving a complex, highly leveraged derivative I asked the branch office manager who had approved the trade to explain the investment to the arbitration panel. After he had embarrassed himself with a clearly incorrect explanation the claim settled. I doubt that many FINRA auditors could have adequately understood this particular financial product well enough to ask questions about it.

Regulatory compliance in the financial services industry is not rocket science. Every supervisor should be able to spot a bad trade if it hits their desk. Compliance does take time and can be expensive.

If the firm has one compliance officer for thousands of salespeople or one due diligence officer reviewing dozens of offerings every month FINRA does not need to delve into the corporate culture. It is a safe bet that adequate compliance is not happening.

I know that more than a few regulators and compliance professionals read my blog. I would appreciate your thoughts and comments.

Elio Motors- A Crowdfunding Clunker?

Capital Markets, Investors, Issuers , , , ,

A colleague asked me to look into the securities offering of Elio Motors in Phoenix, Arizona. The company is one of the first to register shares to be sold under the new Regulation A.

Reg. A allows smaller companies to raise up to $50 million without the use of an underwriter. Elio is selling its shares directly to investors through a Crowdfunding platform called StartEngine.

Elio is attempting to raise $25 million making it one of the largest direct to investor financings to date. Many people in and around the Crowdfunding industry are anticipating the offering’s success.

Elio claims to be a designer, developer and manufacturer of highly efficient, low cost automobiles. The company intends to offer a 3 wheeled, gas powered vehicle that will get 84 MPG and cost roughly $6800.

It certainly sounds good and from the pictures that accompany the offering the vehicles look pretty good as well. The company says that it hopes to be delivering its vehicles to consumers by the end of this year.

Unfortunately, that seems highly unlikely. The company currently has only a few drive-able early prototypes of its vehicles. It does not have a full production prototype, a final design, a built-out manufacturing facility or manufacturing processes. Even with this financing, the company will still need another quarter of a billion dollars to get its manufacturing facility into production.

I reviewed the prospectus and made a note of a number of “red flags” – items that seemed a little off base to me. A number of things caught my eye.

First, the company is insolvent and will continue to be insolvent even after investors put in $25 million. Investors will pay $12 per share and each share will have a negative book value and no liquidity for a long time to come.

Roughly $10 million is owed and due to an affiliate of a large shareholder within the next 6 months. That loan is already over due and subject to a forbearance agreement. If the agreement is not renewed roughly 1/2 of the proceeds of this offering will revert to the lender.

The company hopes to obtain a $165 million loan under a federal government program intended to help existing auto manufacturers expand their businesses. If unsuccessful in obtaining this loan Elio will need to find that much and more, elsewhere.

The government program was intended to help Ford and GM when they were having financial difficulty back in 2008/2009.The program is specifically designed to have low upfront borrowing costs. Elio is paying a lobbyist $1 million to help them to get funding under the program in addition to the lobbyist presently on staff. Perhaps the company does not believe that it could obtain the loan if the government agency judged the company solely on its merits.

There does not appear to be a single dollar of professional venture capital in this company. The company says this is because the venture capital industry moved away from investing in new vehicle startups. Personally, I believe it was because the venture capital industry spotted Elio as a loser or worse, a scam.

There are no patents. Despite years and millions of dollars worth of designs and modifications Elio does not have anything that it deems to be worth patenting. That always begs the question of whether or not their designs infringe on anyone else’s patents.

Perhaps the most disconcerting issue is that the company currently funds itself by taking vehicle deposits from consumers. The company has taken in more than $20 million in deposits from in excess of 45,000 people promising to deliver vehicles for which it does not yet have a final design and still needs up to a quarter of a billion dollars to produce.

The sales projections seem very rich. In order to get its retail price to $6,800 the company is projecting 250,000 units sold annually, meaning sales would be about $1.7 billion. With competition from other larger automotive manufacturers this number even if attainable would seem difficult to sustain.

No one apparently conducted a real due diligence review. StartEngine is not a FINRA firm and cannot be expected to conduct a due diligence review that is up to FINRA standards. The name of the law firm that prepared the offering is not disclosed. Experience suggests that this prospectus is not the product of one of the large Wall Street law firms.

Interestingly, Elio will pay a FINRA firm, FundAmerica Securities, to conduct due diligence on the investors to make certain that they comply with the SEC’s rules regarding how much they can purchase. FundAmerica Securities will receive up to about $950,000 for this service. (For the record, I would have cheerfully performed this administrative task for about ½ the cost).

No similar fee is being paid to anyone to verify the statements in the prospectus and to make certain that all appropriate disclosures have been made. Due diligence can be expensive and the amount spent, if material, would likely be disclosed.

If fully subscribed, this offering will cost Elio about $2.4 million which is about what it would have cost if the offering had been done in the traditional way by a FINRA firm using salespeople. The offering would have been subjected to real due diligence and if it passed more likely than not would have sold out before the end of last year.

I suspect that the “crowd” will buy up all of the shares that Elio is selling, not because the crowd knows what it is doing, but because most people would not know an investment scam if it bit them on the butt.

As I said, a lot of people in the Crowdfunding industry are waiting for Elio to sell its shares as an indication of how the Crowdfunding industry has progressed. The industry would be better served if got behind companies that offered investors a better chance of success.

A Brief History of Securities Arbitration

Investors, Law , ,

The US Supreme Court enforced the arbitration clauses that were boilerplate in the account agreements of most stock brokerage firms and sent almost all disputes that a customer may have with their stockbroker or brokerage firm to arbitration in 1987. Shearson/American Express Inc. v. McMahon, 482 U. S. 220 (1987).

The McMahon case did not find its way to the Supreme Court by accident. Some people in the securities industry were looking for a case to walk up the appellate ladder to get the issue of mandatory arbitration before the Court as early as the mid-1970s.

At that time, the industry had been hit by several large punitive damage awards assessed by juries in cases involving customer losses. Many people in the industry wanted nothing to do with juries. Many states did not then permit arbitrators to award punitive damages.

Certainly the industry believed that it could home court customers and their lawyers. To some extent the industry was able to weed out arbitrators who had the audacity to make a large award against a member firm.

The wire houses handled many of the claims with in-house lawyers because as they were self insured. Where there was a separate insurance carrier law firms around the country were enlisted in the industry’s defense. Throughout, defense lawyers have constantly assisted each other and have consistently acted to further their clients and the industry’s interests by shaping the rules and the forum.

I think that the industry would have been happy to keep arbitration simple. Events in the late 1980s and early 1990s conspired against it.

Customers do not file arbitration claims against their stockbrokers unless they lose money. Many customers lost money when the market crashed in 1987. Shortly thereafter, junk bonds began to default. Real estate limited partnerships were failing and a lot of those had been sold to seniors and retirees.

One firm, Prudential Securities, spawned thousands of claims which were resolved individually in arbitration or mediation. Claims against Prudential and other firms selling similar products caused a lot of lawyers from around the country to begin to take on customer disputes.

Up until that point, most claims involved the alleged misconduct of individual representatives such as churning or unsuitable recommendations. Now there were claims involving financial products where every customer who purchased them had been defrauded.

Prudential and the other firms put forward a number of aggressive defenses. The customers’ lawyers began to share information with each other. Eventually some of those lawyers formed the Public Investors Arbitration Bar Association, PIABA. There was now a formal industry of  customer representatives which substantially leveled the playing field.

At that time I would have said that these arbitration claims were easier to defend than to prosecute. The industry always had access to the information, people and documents that it needed to defend the claims. Customers were often limited to those documents that the panel ordered to be produced at the discovery hearing. Basic discovery in arbitration was not simplified and made uniform until 1999.

Tens of thousands of customer claims were resolved in arbitration after losses stemming from the 2001 “tech wreck” and the 2008 “credit meltdown”. The vast majority of the claims settled just like they would have if the claims had been filed in any court.

There have been tweaks to the arbitration rules over time but the basic system is the same. Arbitration still promises a resolution of a customer’s claim in less time and for less money than a resolution of the same claim in most courthouses.

Efficiency has always been a hallmark of arbitration. When I started (in the 1970s) most claims were resolved with a single day of live testimony. The customer and the broker would each tell their story to the panel. Few panels needed experts to explain the rules or the transactions to them.

The issues in these claims are rarely complex. The brokerage industry and the claimants’ lawyers share the blame for adding complexity where none was needed.

FINRA arbitration is far from perfect. I have elsewhere documented that in one case only one FINRA arbitration panel out of 35 thought customers who were sold a particular Ponzi scheme should get their money back. FINRA Arbitration – How investors actually fare.

Some commentators have attributed results like this to arbitrators who are biased or anti-consumer. Some have argued that arbitrators who worked for the industry will not make a substantial award against it. Others have argued that, because it is run by the industry, FINRA arbitration in inherently biased. This has resulted in more neutral panels and panel selection.

Personally, I do not believe that arbitrators should have to be educated by the customers’ attorneys to the fact that selling shares in a Ponzi scheme to any customer is beneath the standards of the industry. There is a difference between an arbitrator who is neutral and one who has no experience with investments or investing.

Unlike many lawyers representing customers who want arbitrators who are neutral, I frequently hope to get a retired branch office manager or compliance professional on the panel. I believe that customers frequently get a better result when the arbitrators are well informed and personally experienced in proper industry practices.

Too many people who comment about the perceived inequities of arbitration fail to consider that there are often legitimate defenses to these claims. Brokerage customers are generally a wealthier and more educated sub-set of the general population. They frequently approve the offending transactions, sign forms that acknowledge that they have read all of the disclosures and receive monthly statements which they are expected to read.

Arbitrators will often apportion the blame for the losses sustained by the customer between the parties. They will frequently consider a customer’s failure to mitigate their losses when assessing damages.

Arbitrators will also consider how the customer would have fared if they had not purchased the offending investments. If the general market was down during the time period of the claim, industry lawyers will frequently assert that the customer would have sustained losses even if they had gone to a different broker who had sold them something else.

The best cure for any perceived ills in the arbitration process will always be loss prevention. It starts with better educated investors but includes better compliance at the firms as well.

FINRA would do well to remember that for all its efforts to make the arbitration process more neutral, FINRA also has an important enforcement function. The greater certainty of the customers’ ability to recover inappropriate losses, the greater the deterrent to the offending conduct.