Selling Private Placements

Why aren’t people buying crowdfunding? That question has people flocking to conferences and spending a lot on so-called experts looking for the reason that most equity crowdfunding campaigns fail to raise the money that they want.  Let me save you some money and a week on the road by stating the obvious: people are not buying crowdfunding offerings because no one is selling them.

I recently had a conversation with an entrepreneur who was funding his business on a crowdfunding website. I had viewed his offering and asked for more information. He sent me an e-mail and we scheduled a phone call.

He was professional throughout the conversation.  He was knowledgeable about his product, his customers and his competition. His sales projections were realistic and he seemed to have a good team in place.

What he lacked was any real sales skill. He had certainly spoken with dozens of potential investors before he got to me. It was obvious that he did not know how to close the sale.

Compare that with a professional stockbroker. Stockbrokers sell private placements and they are highly incentivized to do so. Private placements pay brokers higher commissions than almost any other financial product.

One of the first things that I learned when I started working on Wall Street was that people do not buy investments, rather people are sold investments. That is the lesson that the crowdfunding industry does seem ready to learn.

People are often surprised to learn that far more money is raised through private placements than public offerings every year. The JOBS Act which enabled crowdfunding to compete with mainstream stockbrokers actually made it easier for the brokers to sell the same private placements in direct competition with the crowdfunding platforms.

When the SEC adopted Regulation D in 1982 to provide a safe harbor for these private, non-registered offerings it defined a class of accredited investors, wealthy individuals with $1,000,000 in net worth or $200,000 in annual income. At the time this was a relatively small group of people. Due mainly to inflation this group has grown substantially since 1982. Many accredited investors who might consider investing in a start-up already have a stockbroker.

By the end of the 1980s there were a number of brokerage firms that specialized in selling private placements and many companies that packaged these investments for them. Most of these private placements were for various types of real estate or oil and gas investments. That is still true today.

A lot of these investors were baby boomers because they had money to invest and many were retirees or near retirement age. These people were specifically looking for investments that would provide steady income to help offset their retirement expenses.  Many private placements were sold based upon projections of monthly or quarterly income.

Selling an investment that throws off a substantial monthly check should not be that difficult, but it is. Virtually every security offered through a private placement has a substantial risk that the investor will suffer a complete loss of their investment.

In part because the universe of individuals who might want to take that risk is limited, the brokerage industry charges a hefty commission to sell these investments. Even the largest firms that package real estate or oil and gas investments as private placements frequently pay a 10% commission to the brokerage firms that sell them.

When you add legal, due diligence and marketing costs, the up-front expenses for a private placement can often add up to 15% or more. Those syndication costs are taken out of the offering proceeds. Some private placements also burden investors with pre-arranged exit costs if the property is sold.  I have seen real estate syndications where the property needed to appreciate by 30% for the investors to break even.

Reg. D offerings were not supposed to be “public” offerings and brokers were constrained to sell them only to people with whom they had a prior business relationship. Advertising a private placement or what is called “general solicitation” was always prohibited.

Given the high commissions that rule was often overlooked. It was not uncommon for a broker to hold a seminar where a sponsor would present the details of an offering that had just closed.  At the end of the presentation, the participants would be invited to sign up if they wanted to be notified when the next offering became available.

Attendance at a seminar was probably not the SEC’s idea of a prior business relationship but these went on for years.  The sponsors paid for the seminars and compliance directors at the brokerage firms looked the other way.

The JOBS Act eliminated the rule against general solicitation. That opened the door for general advertising of private placements. The only condition was that they could only be sold to accredited investors. Advertising of these offerings to accredited investors has exploded.

The JOBS Act was supposed to offer investors the opportunity to invest on-line through websites that did not charge commissions. Eliminating that commission cost should have created better economics and better deals and given the crowdfunders a leg up. Sadly, that has not been true.

Rather than up their game, the crowdfunding industry seems content to list offerings for companies with half-baked ideas, inexperienced management and unpatented products and processes. Add to that a fair amount of out and out fraud because the offerings are un-vetted and it is easy to see why the mainstream brokerage industry has little to fear from the crowdfunders.

What I see in the future is the mainstream stockbrokerage industry establishing crowdfunding sites where potential investors can browse offerings after being solicited by advertisements. Once there, the websites will make the potential investors presence known for licensed registered representatives to follow up and close the sale.

This is not what many of the crowdfunders had in mind when they lobbied for the JOBS Act.  Some believed that the crowd was capable of making intelligent decisions about investing in start-ups and that many people would want to put their money into these small companies.  Neither assertion was ever true.

I am probably alone in suggesting that crowdfunding will make a better adjunct to a traditional brokerage firm than a replacement for it. I suspect that it will not be long before others begin to see what I see and the “contact for more information” button on a crowdfunding site will go to a licensed stockbroker who will close the sale and be paid a commission.

There is a difference between marketing or solicitation and selling. Selling is what the crowdfunding industry needs in order to ultimately be a successful tool for corporate finance.

 

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