Regulatory Compliance in Crowdfunding

The more that I blog or comment about the foolishness in the Crowdfunding industry the more people seem to want to shoot the messenger. Of late, several prominent people in the industry have taken umbrage at my comments; a few have gotten personal. Obviously, I have hit a nerve.

I have never been a particular fan of regulation.  I do, however, appreciate that regulations keep the food supply safe, make the air and water cleaner and force people to buckle up their children into their cars that saves many young lives every year.

I also appreciate that the US capital markets are heavily regulated which keeps many of the scoundrels out. It also helps keep investor confidence in the market high and facilitates the formation and intermediation of capital upon which the entire economy relies. Many people see Wall Street as a den of thieves and want more regulation.  The Crowdfunding industry wants less.

The Crowdfunding industry seems to universally hate regulation. A loud cheer went up from the industry when a federal appellate court recently shot down an attempt by state securities regulators to review Crowdfunded offerings.  I doubt a single one of the cheering throng ever had a private placement reviewed by a state regulator. If they had, they might think differently.

Back in the 1980’s many states required private offerings to be reviewed. You would file the offering, pay the fee and usually get back a letter with comments. It was pretty clear from the comments that some knowledgeable attorney working for the state had actually read the document. You could just make the suggested corrections or get that attorney on the phone to discuss them. I never found the process to be adversarial.

To the contrary, I always took some comfort knowing that a seasoned professional had reviewed the document and passed on it. If one of the offerings had later been questioned by an unhappy investor, I would have taken comfort in being able to tell a judge that I had reviewed the offering with regulators in half a dozen states.

At this writing, only ten firms have registered with FINRA to become Crowdfunding portals under Title III of the Jobs Act. A portal will be able to offer Crowdfunded securities to non-accredited investors. It is something that a great many people in the Crowdfunding industry wanted. More firms will certainly take the plunge and register with FINRA to become portals as time goes on.

The Crowdfunding industry sees a need to offer these speculative investments to mom and pop investors. Everyone understands that most Crowdfunded startups will fail. Notwithstanding, the industry continues to stress the “opportunity” for mom and pop to invest in the next Amazon or Facebook.

To be fair, most of the people in the Crowdfunding industry are content to offer investments only to accredited investors on platforms that comply with Title II of the Jobs Act. Many appreciate that hundreds of billions of dollars worth of private placements are successfully sold by the mainstream financial industry every year and follow the well trodden path to success.

Let’s be clear about the fact that owning a Crowdfunding platform or portal can be a lucrative business. Issuers in the mainstream Reg. D private placement market often pay a 10% commission, most of which goes to the individual stock broker who makes the sale. Many Crowdfunding platforms charge a similar listing fee for each offering, all of which goes to the house.

There are a number of people in the Crowdfunding industry who are convinced that regulatory burdens are keeping Crowdfunding from reaching its full potential. They want Congress or the SEC to ease the regulatory scheme for Crowdfunded offerings. The primary concern is that compliance costs too much. The obvious retort is that non-compliance is likely to cost more.

The securities laws, both state and federal, deal primarily with the issuance and trading of securities. They are designed to provide transparency and stability to the capital formation process that is central to our entire economy. If you were to boil all of the laws and regulations down to a single word, that word would be “disclosure”.

FINRA has its own rules which govern the day to day operations of its member firms. A Crowdfunding portal will have no need to concern itself with most of FINRA’s rules. The portal is not trading securities, issuing research reports or handling transactions in options.

Three specific FINRA rules will get the most attention; the rule regarding investor suitability; the rule regarding communications with the public; and the rules regarding the offering and sale of private placements.

FINRA’s suitability rule restricts investment recommendations to those within the customer’s risk tolerance. Every customer who purchases a security on a Crowdfunding portal is buying a speculative investment. Every customer agrees that they understand they can lose every dollar they are investing and that they can afford to sustain the loss. Under the Crowdfunding rules the amount of money that a non-accredited investors can invest is limited. Compliance with the suitability rule is cheap and easy.

FINRA likewise has a fairly comprehensive set of guidelines regarding advertising materials and other communications with the public.  In most cases a portal will use a “tombstone” advertisement which is also cheap and easy.

Other marketing materials for each offering of securities will need to provide accurate information and a balanced presentation of what the investment provides and does not provide.  This applies to the videos with which the Crowdfunding industry seems enamored. If a video is used in conjunction with any offering the video must be accurate, balanced and otherwise comply with the advertising rules.  Again, compliance with these rules is cheap and relatively easy.

The most expensive rules with which a portal or platform will need to comply deals with the sale of private placements. The rules mandate a “reasonable” investigation of private placement offerings. FINRA issued specific guidelines for the offering and sale of private placements in 2010.

Those guidelines (FINRA Notice to Members 10-22) provide: “While BDs are not expected to have the same knowledge as an issuer or its management, firms are required to exercise a “high degree of care” in investigating and “independently” verifying an issuer’s representations and claims. Indeed, when an issuer seeks to finance a new speculative venture, BDs “must be particularly careful in verifying the issuer’s obviously self-serving statements.” The Notice goes on to make suggestions for how due diligence investigations are to be conducted in various circumstances and for various types of offerings.  It highlights the need to identify “red flags” and to resolve them.

The Notice also references several securities anti-fraud statutes, judicial opinions and enforcement actions. There is really nothing new here. I got my training in due diligence in the 1970s and attended my first conference on due diligence in the early 1980s. Not that much has changed.

The small segment of the FINRA brokerage firms that sell private placements to retail investors has a history of conducting due diligence very poorly.  In most cases, it is because they do not want to spend what it costs to do it right even though they may receive a 1% fee, from the sponsor, to do their own and independent due diligence.

Approximately 90 small FINRA firms sold interests in various real estate offerings made by a company called DBSI. DBSI was operated as a classic Ponzi scheme with previous investors being paid from new investment not operations or profits. When the court appointed receiver sued those firms for a return of the commissions that they had illegally obtained, 50 of the firms went out of business.

The Commonwealth of Massachusetts sued Securities America, one of the larger FINRA firms selling private placements over another Ponzi scheme called Medical Capital. Securities America apparently had a due diligence report that raised a number of questions and red flags about Medical Capital and chose to ignore the report. Securities America apparently sold $967 million worth of securities in this Ponzi scheme to retail customers. Medical Capital sold $2.2 billion worth overall. Adequate due diligence would have stopped Medical Capital in its tracks.

Over the years, I have met a number of due diligence professionals who are serious about their job and who do it well. The best bring some judgment and a healthy amount of skepticism to their work. They understand what a “red flag” looks like.

I have also personally cross-examined due diligence officers and industry experts who worked at FINRA firms and outside companies many times.  If they are on the witness stand, it is because I have alleged in the complaint that the loss suffered by the investor could have been avoided. I would argue that if the firm had adequately investigated the offering, they would not have sold it.

Within the first 10 questions I usually ask about their training in due diligence.  Most of the people who do not conduct due diligence investigations correctly were never trained to do so. That fact seems to be true in the Crowdfunding industry as well.

It is also true that due diligence investigations for many offerings are not cheap. That is the primary reason that Crowdfunders do not like to be reminded that they are required to do it. If a company approaches a platform on Monday and the due diligence report is ready on Wednesday, the odds are that the investigation was inadequate.

I wrote a blog article last fall when the SEC brought its first enforcement action against a Crowdfunded company, Ascenergy. The article was reprinted in several Crowdfunding publications. I do not believe that the Crowdfunding industry wants to offer the public fraudulent offerings. I think that most people in the industry unfortunately do not know how to spot one.

I also wrote a blog article about Elio Motors.  I chronicled a number of red flags that I saw when the shares were being offered. Those included the fact that the firm had no patentable product and was raising less money than it needed to deliver one by a factor of 20.  Elio had apparently been taking orders and promising delivery before it made its offering and continues to take orders and deposits even though it has no way to deliver the product.  Notwithstanding, many people in the Crowdfunding industry herald Elio Motors as a success because it was one of the first to raise funds under the new Reg. A+.

The very first call I received about the article was from a class action attorney who saw what I saw.  I suspect that the attorney had someone buy some shares in Elio so that he will be first in line to file a class action when Elio goes under. You can bet that the officers, directors, lawyers and Crowdfunding platforms that participated in the offering will all get sued when the time comes.

Some people in the industry seem to think that if they do not register with FINRA these rules do not apply to them.  Actually, the rules are what is known as a “codification of reasonable conduct” which was a phrase the SEC used to use for rules that were proposed but not finalized. If you sell private offerings on your platform that turn out to be fraudulent, you can explain to the judge why you ignored these simple rules that would have avoided the fraud and protected the investors.

Some people in the Crowdfunding industry despise regulation because they believe that the inherent unfairness of the capital markets that keeps otherwise worthy entrepreneurs from becoming billionaires.  I could glibly remind you that life isn’t fair but the truth is there is no data to support this particular unfairness.

There have always been ways for entrepreneurs and small businesses to get funded.  Before Crowdfunding, entrepreneurs worked two jobs or hustled family and friends for startup cash. The SBA has pumped billions of dollars directly to this market for decades. We managed to get the light bulb, radio and the personal computer into the marketplace before Crowdfunding.  There is far more venture capital money around today than ever before.

There are certainly many professionals in this industry who are doing it right. But there are also many who write blogs, give interviews and put on conferences that do not.  This is the group that keeps chanting, “Regulation is killing Crowdfunding”.  Respectfully, foolish amateurs are killing Crowdfunding with a desire to change the rules rather than play by them. There is much too much hype and much too little substance in this industry.

The fulcrum in the Crowdfunding industry is the desire to fund new businesses. There is an amazing lack of concern for the investors, without whom the industry will wither and die.

As a matter of full disclosure, I am currently counseling people actively involved in the Crowdfunding business. I have been advising a group of realistic executives who want to remove the risk from investors in this market. It is not that difficult. They have spoken to a number of existing platforms about this but have gotten no takers. There does not seem to be a serious interest in protecting the investors at any level of the Crowdfunding industry.

I am also counseling established real estate and business brokers who want to add Crowdfunding to their arsenal of capital raising tools. These are two groups that appreciate the value of raising money efficiently and who are beginning to understand how they can leverage Crowdfunding to make money. To no one’s surprise, most are professionals who have been around the block once or twice. They understand that regulations need to be complied with rather than complained about.

I do not go out of my way to seek out negative aspects of the Crowdfunding industry about which to blog or comment. Many of my negative articles were the result of articles by other bloggers. One lawyer in particular who blogs regularly about Crowdfunding made favorable comments about both Elio Motors and Med-X which in my opinion are scams.

The same blogger spoke highly about two vendors to the Crowdfunding industry who offer a lot for very little but who did not impress me as people who could deliver anything of value when I interviewed them. I would be happy to send my clients to a good vendor if the vendor can supply what the clients need. In both of these particular cases, the vendors were too inexpensive to be able to provide what was actually required. Crowdfunders hate to spend their own money to obtain investors’ money.

I fully intend to continue to call out foolishness in the marketplace whenever and wherever I see it.  I think that is especially fair if I see someone who does not want to play by the rules and who wants your money anyway.




Funding Startups – The Perfect Pitch

Funding a new business is one of most perplexing and frustrating challenges that entrepreneurs face.  Like many other things in life funding your business is a process that requires focus.

One of the paradoxes of the information age is that there is so much bad information readily available. If you approach financing your business using the ideas that you read in an entrepreneur’s book or from a guru whose presentation you sat through at a conference, you are not likely to connect with most investors.

I have been involved in various aspects of corporate finance for a long time.  I think I have a pretty good idea of what investors want and expect. My approach is decidedly old school. I approach finance in the way it has been traditionally taught in well respected business schools. I advise companies seeking investors to do what I have seen work time and again.

I especially shun the advice that suggests that you need to set forth the problem that you are solving or that what you are doing is “disruptive” or will change the world for the better.  (Yes, I actually saw that advice in an article in an otherwise well reputed financial publication).  This may describe some businesses, but only a very few. Businesses that are not disruptive also deserve to get funded.

Funding is a business relationship between you, your company and your investors. It certainly helps if you can understand the transaction from the investors’ point of view. Investors will give you money if they believe that you can make money and they will receive an adequate profit for the risk that they are taking. You do not have to be disruptive; just profitable.

Here are 3 things that investors know about any business that approaches them for funding:

1) Most start ups fail. I know that you have heard this before but people who invest in startups need to be convinced that you will beat the odds and have a very good chance of succeeding. Most professional investors get pitched by a lot of companies. You need to convince them that you are the cream of the crop, period.

2) Not every person is cut out to be an entrepreneur. Just because you have a great idea or product does not mean that you understand what it takes to run a successful business.  Most businesses have a lot of moving parts. There are essential tasks, like finance, sales and marketing that cannot be left for you to figure out after you have been funded.

3) Never forget the golden rule of finance: the person who has the gold makes the rules. I am always amazed when an entrepreneur tells me that they will only sell 10 or 20% of their business for the million dollars they need. It is a valuation that they got from listening to the “smart and savvy” crowd. If you need a million dollars to succeed and are not willing to forget your ideas about what your business is worth and hold out for the deal that you want, you are likely to end up owning 100% of nothing.  Investors do not grow on trees.

I look at a lot of pitch decks. There are a great many people who will tell you how to pitch your company to investors. Some will tell you to keep it short. Some will tell you to load your pitch with charts and graphs.  Some people suggest that you cannot pitch your company without a video.  If your product moves and is best presented in operation in a video, then by all means include one. If your video is essentially talking heads, graphs and the product sitting on a table, then I would tell you to save your money.

I personally believe that nothing beats a well thought out and well written business plan.  Most investors feel the same way. It should not be too much to expect a company that is seeking funding to be able to set forth exactly what they propose to do with that money and how they will use the investors’ money to earn a profit.

You should be able to present financial projections of your company’s operations for 3-5 years.  No projection of the future operations of a startup is totally accurate but you should have a reasonable basis for the projections you make.

It is easy to draft a projection that says something like “the company will sell 1 million units in year one, three million units in year two and 5 million units in year three” but you must be able to support that assumption. I always recommend more detail; enough to fill up a comprehensive spreadsheet.

These projections can make or break an investor’s decision to fund you. They should show how your expenses will ramp up and how you will achieve economies of scale. These are important indications of how well you are in command of your business.

Any investor can take their money to the mainstream stock market and buy shares in an established company that will pay them a dividend and the shares are liquid. They will earn a profit if the shares go up and are protected from catastrophic loss if the shares start to go down because they can sell them at a moment’s notice. The investor that puts money into your company takes a much greater risk and expects a much greater reward. That model, income and liquidity, is what you are competing against.

I always caution entrepreneurs not to promise that their company will cash out investors in an IPO or will sell out to a competitor. No one can predict that either will ever happen. Both events are rare.

Investors do expect some idea of how you will get their money back to them and when. You can structure your offering with preferred shares that pay an annual dividend. You can agree to buy the shares back from investors or give them the option of selling them back to you at a profit at some point in the future.

When you make your pitch you must be confident. Self-confidence comes from the knowledge that you know what you are doing.  The message that you want to deliver is that if they give you the funding you seek, you will make it happen.

I always recommend that you bring your product or prototype with you rather than pictures or a video. Let the investors handle it and if possible, operate it. Show them that the design is pleasing; the craftsmanship is good and the functionality excellent.

One presentation that I sat through stands out in my mind. After the group of investors had looked at the product and listened to the entrepreneur describe exactly why it was better than its two established competitors, she went on to say the following:

“We expect our product to sell for $299 retail. The two competitive products retail for $50 and $100 more than our retail price. We intend to source our product from an established manufacturer in the Far East and land it at Long Beach for $95 per unit. That will drop to $85 per unit when we reach a critical monthly volume. We are projecting sales to reach that level within 12 months. We have set the initial wholesale price at $150 per unit.

Our marketing plan was developed by a marketing pro with 20 years experience working in this industry. Our sales manager has 10 years of experience selling similar products to many of the same customers that we intend to reach. The sales manager intends to hire 3 sales professionals who will be highly incentivized to open new accounts. We would be happy if the salespeople were the highest paid employees in the company because that would mean they are opening good accounts at a higher than projected rate.

Both the marketing manager and sales manager are prepared to give their notice to their current employers and join us full time once we are funded. We have taken care of all our packaging, patents and trademarks. We therefore can hit the ground running.

We are offering investors a preferred stock issue that will pay an annual dividend of 8%. We will agree to redeem your shares, at your option, for 200% of face value after 3 years and 300% of face value after 5 years. As you can see from the projections, we will be able to fund those redemptions internally, even if our sales are 25% less than projected or if we need to cut our margins by 25% to boost sales. We hope, however, that you will stay with us for the long term.

We have 3 founders on our Board of Directors and 3 outside advisors who have helped us get to where we presently are. There is a seat on the board for you, if you want it. I issue monthly reports to the board which you will receive in any event.

You should note that we intend to run pretty lean. With our small workforce, we will use a part-time bookkeeper and an outside payroll service. There is no HR or Customer Service department.  If a customer needs service, they can speak with me. It’s my name on the door.  Problems get resolved while the customer is on the line. Any questions? “

The group that I was a part of did not fund this company but it did get funded a few months later. The entrepreneur was self assured, had covered her bases and had that intangible attitude that stuck out from the crowd. Funding your company is a business transaction. This entrepreneur was all business.