Raining on Crowdfundings’ Parade

If you follow my blog, you know that I am very much in favor of the crowdfunding market place developing and succeeding. However, I need to throw a bucket of cold water over the exuberance that the industry exhibits. I want to inject some much needed reality and perspective into the discussion.  I want to ask some of the hard questions that people do not seem willing to ask. I want to de-bunk some of the major claims that form the foundation of the crowdfunding industry and to set the record straight.

There has been an enormous amount of hype around equity crowdfunding. In mid-May, the last of the JOBS Act sections will take full effect allowing a registration process for equity offering up to $50 million. This section allows mom and pop investors to invest in start-ups and smaller companies, albeit for only a limited amount of money.

Up until now equity crowdfunding (buying shares of stock in small companies and start-ups on crowdfunding websites) has been limited primarily to wealthier, accredited investors.  The equity investments that are being offered on crowdfunding platforms are among the most risky investments available.  Should small investors actually be encouraged to take these risks with their hard-earned money?

The crowdfunding industry expects that these small investors will fund a multitude of new companies and that this new source of capital will greatly boost the industry’s income. It is the income that the industry will earn, not the profits that investors will make that drives the hype.

It is not difficult for a crowdfunding platform to generate a seven-figure annual income for its owners.  Crowdfunding platforms can actually net more profit per dollar raised than a traditional investment bank because they perform a fraction of the work and provide few of the valuable services that a company needs to make a successful offering.

The crowdfunding industry is remarkably cavalier about investors’ money. Nothing about equity crowdfunding respects investors or cares whether investors get a fair shake, let alone a legitimate opportunity to make a profit for the substantial risk that they are taking.  The crowdfunding industry is focused on itself and upon companies that want to raise money. The investors are an afterthought.

What, exactly, does a crowdfunding platform do to help a company seeking funds to succeed? Before the offering not much; after the offering, even less.

Every investor in every market has the same goal; they invest their money to make money. In crowdfunding that has not happened and there is nothing on the horizon that suggests that it will happen.  This is not just about the lack of liquidity for crowdfunded offerings; it is about the fact that most crowdfunded businesses fail.

So let me start with the simple declarative sentence that should counterbalance much of the hype: if you invest in shares of a start-up on a crowdfunding website, it is very, very doubtful that you will ever see your money again.

According to the SEC, the common refrain is that 9 out of 10 start-ups fail, but an equally interesting statistic from one post-mortem analysis is that 70 percent of failed start-ups die within 20 months after their last financing and have raised an average of $11 million.  In other words, not only are these investments highly risky, they also fail quickly.

That statistic is for the larger start-ups funded by institutions and professional venture capital funds.  Smaller start-ups funded on crowdfunding sites cannot expect to do better and most likely will do worse. These are companies that frequently cannot attract venture capital, which is why they come to ordinary investors on crowdfunding websites in the first place.

Unless something is done about this enormous failure rate, equity crowdfunding is not a sustainable model. While this is just my opinion, it is supported by basic math and economics.

If Wall Street brings an IPO to market raising $50 million, the company issuing its shares gets the money that it can use to create new products and new jobs.  Almost immediately, the investors can sell the stock for more or less and re-invest the same money into another IPO.

The same $50 million might fund a handful of smaller businesses on crowdfunding platforms but the great bulk of those funds cannot be recycled into new businesses because the investment are illiquid and most initial businesses will fail.  It is not even fair to say that the crowdfunded offerings create new jobs when the companies and the jobs are usually gone within 2 years.

Assuming that equity crowdfunding grows to where it can raise $500 billion in a given year, the bulk of that money will be lost so another $500 billion in new money will need to enter the market the next year for new companies to get funded.  For how many years is that likely to occur?

This model is unsustainable if for no other reason than investors will not keep going into their pockets again and again if they only lose.  Long term, equity crowdfunding can only be successful if the businesses that it is funding succeed. Right now very few people in the crowdfunding industry are focused on that fact.

The vast majority of the key players and “experts” in the crowdfunding arena have little or no experience in the mainstream financial markets.  Most have no history of dealing with investors even though investors supply the capital upon which the entire crowdfunding market depends.

One of the common excuses that the crowdfunding industry makes is that the current problems are the result of “growing pains” because the industry is still in its infancy. Many people in the crowdfunding industry believe that crowdfunding began with the JOBS Act (2012) and is governed solely by it. Actually, equity crowdfunding has been around for more than 20 years, more than enough time to get its act together.

The first direct to the public stock offering (DPO) done via the internet is generally credited to the Spring Street Brewing Company which successfully raised about $1.5 million in 1995. It was ground breaking at the time, because no underwriter (Wall Street firm and those pesky salespeople) was involved in selling the stock.  No video accompanied the offering as I do not believe that the internet supported video in those days.

The offering was done under the watchful eye of a forward thinking SEC.  Many of the crowdfunding “experts” that you might hire today are not aware of this offering or the serious discussions about DPOs that were engaged in by many regulators and market professionals at the time.  Tell an expert that offerings can be done without a video and they will look at you as if you said the Chicago Cubs just won the World Series.

By 2000, the SEC had already brought a hand full of enforcement actions against other firms that had sold stock via the internet because investors were being defrauded. Wall Street was not interested in DPOs then or now. Scam artists jumped right in. Those scams are the likely reason that the anti-fraud provisions of the federal securities laws are specifically incorporated into every JOBS Act offering.

When an “expert” tells you that the paperwork for a JOBS Act offering is less cumbersome than a regular public offering; they should also tell you that companies still need to disclose all of the material facts to potential investors, no matter what the forms suggest or how cumbersome the disclosures might be.  They should also tell you that the video that accompanies the offering must be in compliance as well.

Every equity offering made on a crowdfunding platform should have the disclosure THIS IS A SPECULATIVE INVESTMENT. INVESTORS CAN EXPECT TO LOSE ALL OF THE MONEY THAT THEY INVEST, in bold, on the first page.  It is the same type of disclosure that is routinely made to accredited investors in the REG. D, private placement market.

The SEC has already brought its first enforcement action against a company funded under the JOBS Act, Ascenergy.  The SEC went out of its way to spell out that the company’s website was a part of the offering. That certainly would apply to any video that accompanied any equity offering.  Most of the people selling videos to the crowdfunding industry are unaware of the Ascenergy case and do not appreciate that the videos they create to support a crowdfunded equity offering need to comply with the law.  That applies to social media campaigns and “tweets” as well.

Many people seem to believe that investors (the crowd) are expected to investigate the offerings themselves. It was never realistic to believe that investors could evaluate a new issue. That is what many people wanted but it is not what the JOBS Act and the SEC regulations delivered.

The JOBS Act places a great deal of the fraud avoidance responsibilities on the crowdfunding platforms. The Ascenergy case called out 4 crowdfunding platforms by name. You would certainly think that these firms have a target on their backs not to repeat their deficient performance.

There is a remarkable absence of trained compliance personnel at the crowdfunding platforms. I spoke with 2 lawyers at one of the larger Crowdfunding platforms a few weeks ago. They were certainly bright attorneys. They had previously worked at law firms and at regulators and had no specific training in investment banking.  There is a big difference between understanding federal securities law and evaluating specific transactions, marketing materials and accompanying social media campaigns for compliance.

I have a particular issue with securities attorneys who are spreading the crowdfunding hype.  Some actually recommend specific platforms and specific offerings. Putting your law firms’ reputation behind a securities offering was always considered a problem.  If you do not believe me, you might want to check with your professional liability carrier.

There are several securities attorneys who are selling technology-based services to the crowdfunding industry.  I started out as a young lawyer with a secretary who took my dictation in shorthand, so nobody has to sell me on the idea that technology can help reduce the costs of practicing law.

The cost of preparing a securities offering or running a crowdfunding platform is important, but should never be the driving issue. Qualified and experienced securities lawyers are still essential to the process of selling equity. Offering securities to public investors incorrectly can be very, very expensive to all concerned.

A few of the crowdfunding platforms carefully vet each offering before they list them.  These platforms reject more offerings than they accept which has to cost them a lot of money.  It is against these platforms that the rest of the industry will be ultimately judged by investors, regulators and class action juries.

Small businesses were funded before crowdfunding. Many entrepreneurs saved up or worked two jobs to get their nest egg to open the business of their dreams.  Others tapped family and friends for seed capital. The Small Business Administration has funded millions of businesses and continues to do so.  Angel investor funds are often made up of groups of smaller investors and are more prolific than ever before.

A good business could often find capital if the entrepreneur tried hard enough and surrounded himself with the right advisors. Better mousetraps get funded and will continue to get funded with or without crowdfunding.  There is nothing “essential” about this new industry.

I spend a lot of my time reviewing pitch books and speaking with founders of companies who are seeking investors. A great many start-ups are not worthy of funding. A great business idea is not the same as a great business.  A great many people with good ideas do not understand what it takes to run a successful business.

Most small equity crowdfunding campaigns fail to raise the minimum amount of capital that they seek.  This inefficiency also suggests that equity crowdfunding is not a sustainable model. In part it is because the owners read a book or two or listen to crowdfunding experts who have no actual expertise. It is also because many entrepreneurs do not want to spend what it takes to do it right.

Traditional underwriters raise the amount of money that they set out to raise virtually every time.  That is the Holy Grail of equity crowdfunding which the industry does not come close to achieving. It is usually because the company raising the money is not willing to spend what it takes to sell their offering to investors.  They fantasize that if they just put the offering onto a platform and send out a few e-mails or tweets, investors will come running with checks.

While no one can guarantee success of a crowdfunded offering that is raising equity for a start-up or small business, there is one group that I have watched that clearly understands how to bring a significant amount of investors’ to each offering that they present.  I suspect that they charge a little more because they obviously do a better job.

I have already had this discussion with several people who are preeminent in the crowdfunding industry and whose best response has been, sadly, that the crowdfunding industry will eventually work things out.  In the meantime, the industry is working things out using money from many thousands of small investors.  The industry is tooting its own horn over its success in being able to separate those investors from their money knowing that the vast majority of those investors will get nothing in return.

The simple truth is that if you have a few hundred extra dollars in your pocket and would like to help a small business succeed, you can go to a local restaurant, order a meal and a bottle of wine and know that the owner will be very happy to have your patronage.  The odds are that the owner stands on his/her feet for many hours a day for 6 and maybe even 7 days a week.

If you are not hungry and have a few extra dollars you know that there is a food bank not far from you no matter where in the US you are that will appreciate your money as much any crowdfunding entrepreneur, probably more so.  I would argue that a food bank donation gives an excellent return on your money in the form of inner satisfaction.

I expect some blow-back from this article, especially that last paragraph.  If anyone would like to debate me on this subject, publicly, I would be happy to appear at any conference. I would expect the topic of the discussion to be “what is the financial benefit of crowdfunding for the crowdfunding investors?”  I know that it is a buzz kill but that is the point.

I have been criticized, repeatedly, because of my negativity toward crowdfunding.  I am not negative about crowdfunding. I just get angry and frustrated by the experts who think they know what they are doing but don’t.  If you do not want me to call out your foolish behavior, stop acting like fools.

Several dozen crowdfunding portals have lined-up to become FINRA members and offer equity offerings to ordinary investors. I am not particularly looking for a job, but I would be happy to sit down with any crowdfunding platform that is actually interested in only offering good investments to investors. I would think that it is the least that they should want to do.

In the next few years a lot of people will be lured into crowdfunding by the hype and will lose their money. It does not usually happen with offerings made by Wall Street firms. It does not need to happen on crowdfunding platforms either.

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