Fake Business News

I think I first heard that we were entering the “Information Age” in the 1990s. The internet was just coming on-line. It promised that every book ever written would be available without a trip to the library. It promised that I could view every painting in every museum in the world without ever getting on an airplane.

In just two decades we have become inundated with information that is simply false. I am not talking about political “fake news” or “fake facts” spewed by politicians. No one in their right mind expects politicians to be truthful.

The internet has become a prime source of financial information and anyone can add to the growing library, even if they have no idea what they are talking about.  The world is full of information about finance that is pure fantasy.

For a great many years I got my business news daily from the Wall Street Journal. When I moved to San Francisco in the1980’s I started reading the San Jose Mercury News because it had the best tech reporters around.

I admit that I am somewhat of an information junkie especially as it regards business, the economy and the financial markets.  I currently watch the national news on PBS or CNN. I have been known to watch Bloomberg TV especially the shows focused on European and Asian markets. I read scientific and tech journals and law review articles. I am an old dog trying to learn new tricks. I want to keep up with what is going on in finance, law and technology.

That is one of the reasons that I like LinkedIn.  I have connected with people all over the world and through them I get articles about many things that are going on in the global marketplace that I would not otherwise read.  But not every one of those articles has any value at all.

Some of the articles are written by people who call themselves strategists, influencers, gurus, visionaries, evangelists and futurists.  Many seem to be self-appointed experts without credentials or experience.  Some just regurgitate stupidity because they cannot discern good information from bad information or ask intelligent questions about what they are reading.

Is it unfair to expect that someone who holds themselves out as an expert in finance have an MBA or have worked in finance?  Is it unfair to expect someone commenting on a fairly complex legal issue to have graduated from law school?

This seems to have carried over to the mainstream financial press. There are “experts” contributing columns to Forbes and Fortune who could not find their way out of a paper bag. They lack context, perspective and expertise.  So much is the need for content that quality has gone out the window.  The desire for “views” and “likes” is more important than the quality of thought that goes into the writing.

This has also migrated over to the conference circuit. When I go to a conference, I want to learn something valuable from people who know what they are talking about. I want to hear speakers who have been in the trenches; those who have walked the walk.

Many conferences refuse to pay for the best speakers opting instead for those who will speak for free and pay their own way in exchange for “exposure”.  Some conferences charge speakers to appear. This eliminates many of the best academics and usually people from big companies who do not need the exposure and certainly are not going to pay for it.

There has always been some amount of fake news about some businesses. Tobacco companies said that smoking did not cause cancer; coal and oil companies deny global warming.  You would expect a salesperson or CEO to say that their company’s product is the best or their service the fastest and that is not troubling. But there were always rules.

For any company with investors the dissemination of financial information is regulated. Every press release and often every advertisement is usually vetted by  the company’s lawyers to assure accuracy and compliance.

When a public company published financial information it was presumed that the information was accurate. There would be auditors looking over managements’ shoulders in any event.  There are quarterly phone calls with analysts who ask questions. If management gets a reputation for being too optimistic on a recurring basis, people know about it and begin to discount what they are saying.

If you worked for any large company, when you made a statement in public you always represented that company. You were expected to maintain a professional demeanor, to go out of your way not be controversial or say something that might make the company look bad.  You were always expected not say something that was stupid or inaccurate. That is still true in many cases but it is far from universal and it seems to be less and less true as time goes on.

This becomes a serious problem when a small company is trying to obtain funding from investors.  Investors are entitled to a full and fair disclosure of the actual facts.  Most of the Wall Street firms take care to verify the facts that they are passing on to investors but this has become a significant problem on the fringes of finance like Crowdfunding and investors are getting ripped off every day.

I speak with people every week who want to raise funds for their business. I appreciate that many of the people who contact me have done some research first. But just because you heard something at a Ted Talk or read an article in Inc. does not make it real.

One of the core premises in the Crowdfunding market is that the investors can fend for themselves or that the crowd will be able to separate good investments from bad ones. That is simply not true, has never been true and is unlikely to become true.  The vast majority of investors have no idea what questions to ask and if they do, they have no ability to verify whether the answers they get from the company are true.

This “fake” news often shows up in the company’s sales projections. Projections in an offering are always rosy but the projections need to have some basis in fact. I have asked people who are Crowdfunding their offering how they arrived at their sales projections and many have no idea if their product is priced correctly or what their competition is offering.

I try to be pretty careful about what I write on this blog. I limit my articles to areas which I know fairly well, finance, law, investments and economics. I do a fair amount of research for any article. When I write articles for this blog, all of which are read over by a colleague before I publish them, I always ask myself “would I be willing to say that to a judge?”

I have been taught to be a critical thinker. I think that the best lawyers are. I was taught to question facts and assumptions. As a lawyer I try to understand the underlying transaction and the expectations of the parties whether I am writing the paperwork or litigating over someone else’s.  It carries over to this blog and other articles that I write.

When I started this blog I said that I was constantly amazed by the vast amount of patently foolish investment advice in the marketplace and promised to call out financial foolishness whenever I see it.  I never expected that so much of that false information would present itself or that so many people would accept that information without question.

So far I used the blog to point out the obvious facts that 1) robo-investment advisors, in part because they are looking backwards not forwards, are virtually useless; 2) investing in a cannabis related company has the extra risk of investing in a business that is patently illegal; 3) the Crowdfunding industry needs to act like responsible intermediaries because the offerings are either bad investments or fraudulent and 4) crypto-currency has limited utility as a method of finance in part because it is a very expensive way to raise money.

You should certainly be aware that there are a great many articles out there that see the world very differently on each of these subjects. The more time I spend reading what is out there, the more I know that I have my work cut out for me.  The simple truth is that markets need accurate information in order to operate efficiently.

 

The Future of Investment Advice

In order to understand the future of investment advice I think it is essential to understand how the industry has developed to where it is today.

When I started in the financial services industry back in the 1970’s retail customers got advice about what to buy and sell from their stockbrokers.  At the larger brokerage firms that usually meant that your broker would call you and tell that they or the firm’s research department had identified a stock that was a “buying opportunity”. This was often accompanied by a recommendation of what you should sell to pay for your new purchase so your broker would make not one, but two commissions from the recommendation.

When the stock market suddenly crashed in 1987 a lot of customers asked their stock broker why the broker had not seen the crash coming. The brokers really had no good answer. The crash took a lot of money out of the market and caused a lot of customers to lose faith in their broker’s ability to select investments for them.

Partially to placate those customers with something new and partially to make more money the industry introduced wrap accounts. A wrap account places the customer’s account into the hands of a professional money manager for an annual fee which is shared with the introducing stockbroker.

Wrap accounts introduced the idea that the individual brokers would be compensated on the customer assets under management (AUM) rather than the commissions that their accounts generated. This let the brokers do what they do best (sell) and let the professional money managers manage the accounts.

It also created a conflict of interest. Managers kept investors fully invested because that is what they had been hired to do. If the managers started to accumulate large cash positions in customers’ accounts, the customers might withdraw the cash. That would be counter-productive to the brokers who were being paid to bring in more and more new assets.

By the mid-1990s the market had recovered nicely and people started asking how long the boom would last.  At the end of 1996 Fed Chairman Alan Greenspan attributed the sharp run up in stock prices to “irrational exuberance”.  Neither the brokers nor the money managers advised the customers to sell when they had large profits and maintain a cash position

Much of the run-up in the 1990s was attributed to new tech companies that not everyone understood. Consequently, the firms hired highly qualified research analysts to parse through the various issues and recommend what they considered to be the best.

At the same time, the brokerage firms were making a lot of money by underwriting new issues of these tech stocks. In many cases the research analysts were working to support the efforts of the firms’ investment bankers. They only wrote reports describing why their firm’s banking client’s offerings were a “buying opportunity”.

That also created conflicts of interest.  When the market finally crashed it was revealed that some analysts had never suggested that the price of any of the stocks they covered would not go higher. Some analysts never recommended a “sell” on any stock they followed even when fundamental analysis told them that they should be selling.

Again, when the market crashed in 2001 a lot of people asked their broker why they did not see the crash coming or take some defensive action to protect their profits.  And again, the brokers did not have a good answer other than “no one can really predict the market” which, of course, is exactly the skill that the stockbrokers and money managers had been espousing to customers all along.

The brokers themselves got more than a little frustrated with the large wire houses and many jumped ship. Sometook their clients and set up shop as independent investment advisors.

The accounts were still housed at a brokerage firm that got paid a commission on each trade but the advisors now kept all of the annual account management fees. This was a better deal for the advisor even if they now needed to pay their own rent and overhead. The idea that no one can really predict the market suited these independent advisors well because they were more interested in acquiring new customers and assets than picking good investments.

That led to a concept that as long as a portfolio was diversified it really did not matter which stocks were in it. By diversifying the stock portion of the portfolio into different asset classes the advisors were trying to avoid what had happened in the tech wreck. The theory was that if you bought stocks in different asset classes, the collapse of one sector, like tech, would not hurt you too badly.

This did not help investors when the market crashed in 2008. This crash was caused by a bubble in real estate and foolish lending in the financial sector. Most companies are affected by what occurs with banks and real estate as both effect business and consumer spending. Diversification only mitigates certain risks. This crash involved a systemic risk, not an asset sector risk, a fact that many brokers never understood.

It should not surprise anyone that investors again asked their advisors why they did not get them out of the market before it crashed.  Again the response was “no one can predict the market”.

Since 2008 the advisor industry has seen the rise of robo-advisors.  These are popular with millennial investors who do not trust the Wall Street professionals after 2008.  Robo-advisors select portfolios based upon algorithms. This makes as much sense as throwing darts at a list of stocks and bonds even if you are a champion dart thrower.

Robo-advisors are not even attempting to predict the market and they are not programmed to ever sell the portfolio if the market starts to crash, which we all know, it will. They are just selling diversification at a lower price. They achieve “diversification” by buying mutual funds or ETFs. These contain so many stocks that mathematically, there is no actual diversification.

Robo-advisors advertise that people pay too much for investment advice. I would argue that most customers pay too little.  My current advisor spends countless hours poring over financial statements and research reports to pick individual stocks.  He gets the same 1% of AUM as advisors who put all of their clients into pre-selected diversified portfolios of various funds and ETFs without really knowing a lot about them or how they might be expected to perform. With investment advice, like everything else in life, the rule should be that you get what you pay for.

What I think may be an intelligent alternative going forward is for people to just put their investment advisor on a fixed monthly or yearly retainer.  It would cost more for a larger portfolio than a smaller one because all portfolios need to be constantly monitored and larger portfolios require more time. Advisors would keep their customers and get referrals by keeping their customers happy.

And what makes customers happy?  They want to have more money in their accounts at the end of the year than they had at the beginning of the year. That is true even if the market crashes because there is nothing more foolish than staying in the market when the market is going down.

The customers will never truly be happy and get the results they truly want until advisors thoroughly analyze and review the stocks they recommend and purchase and hold only those that they believe are likely to appreciate. They will never get there if advisors refuse to take profits and move to cash when the market indicates that they should. They will never get there if advisors diversify to mitigate some risks, but not all.

People actually do predict the future performance of individual stocks and the market in general. I doubt that you would be surprised if I told you that the ones who do it well get paid a lot of money by investment banks, mutual funds and large institutions.

The advisor industry needs to understand that parroting the phrase “no one can predict the market” every time the market corrects is the fastest way to be demonstrate that you do not know what you are doing. Providing beneficial investment advice takes time and effort. Advisors are entitled to be paid for their efforts. But first they have to actually do the work and that work is accurately predicting the future price of individual securities and the market in general.

 

 

Any Good Business Can Get Funded

I am always amazed when I get negative feedback to the premise that any good business can get funded. This is especially true when people tell me that businesses owned by women or minorities cannot get funded or that businesses locate outside of New York, Silicon Valley or some other money center have limited access to capital.

Frankly I think that a failure to get funding demonstrates ineptitude on the part of the entrepreneur. Inexperience is a greater impediment to attracting capital investment than gender, race or location.

When I was younger a business had two choices for funding, banks or Wall Street.  Wall Street would not take a company public until it was profitable. Companies often used an IPO to pay down debt and improve cash flow to pay dividends to the shareholders. If you wanted to get funded on Wall Street, it helped if you went to Princeton or Yale or your father did. It was very much a “who you know” network.

Banks provided the bulk of the capital that was available for small business. They still do. They do not care who you are as much as they want to know that you will pay them back.

When I graduated law school in the 1970s women could not get credit cards and minorities could not get even a loan application at any bank. So you cannot tell me that it is more difficult for women and minorities to get funded today.

The US Small Business Administration (SBA) has programs which will guarantee bank loans for about 20,000 small businesses every year.  I speak with entrepreneurs seeking capital all the time. I always ask if they have tried the SBA.  Most of the people I speak with never heard of the SBA or never considered it.  If you are looking for funding for your business, that is mistake number one.

Even if you do not qualify for a bank loan the cost of capital should be your primary concern. Shopping for a loan will give you an idea of how much money costs and how loan payments would impact your cash flow.  If, for example, you intend to borrow $1 million at 6% for 10 years, then the loan will cost you $600,000 and you will need to take $1.6 million out of cash flow to pay it back.

Many people think that venture capitalists will fund their business. That is simply not true. There are actually very few VC funds and they fund very few businesses every year. Some VCs specialize, i.e. they only fund biotech companies. That is great if you are a biotech company and know where to find those VCs with the expertise to evaluate your company. Randomly chasing after VC funds is a waste of time.

The serious money in venture capital is controlled by people who do a lot of analysis and extensive due diligence. Consequently, they like to invest in somewhat larger slices of $10 million or more. If they get 10% of your equity for that amount you are going to have to sell a lot of your product to bring the real value of your company up to the point where they will make a sizeable profit.  Consequently, not many companies will qualify.

The start-up world and especially Silicon Valley are full of stories about start-ups that become unicorns that exceed a $1 billion valuation but they are few and far between. If you are going to swing for the fences, fine. But for most companies this is not an option.

What makes the statement “any good business can get funded” true is the JOBS Act or what most people call equity crowdfunding.  It affords any company the opportunity to sell debt or equity securities directly to investors.

The JOBS Act opened the door for smaller companies to reach investors.  For most companies Reg. D is best because it is the least expensive and it has the largest developed market. Over $1.7 trillion is raised by businesses using Reg. D every year. If you want to raise money for your business, logic would tell you to go where the money is.

The best thing about equity crowdfunding is that the business owner controls the process. You hire an attorney to prepare the legal paperwork for you, prepare the marketing materials, list it on one of many crowdfunding websites and use your marketing program to attract investors.  You do not have to wait for the loan committee at a bank or for a broker/dealer to put you on their calendar. You can usually start raising money in 4-6 weeks from when you start the process.

Despite what you may have heard about crowdfunding campaigns that are not successful, it is really not that difficult if you hire people who know what they are doing.  Business owners call me about crowdfunding all the time. I always ask them the same four questions.

Questions 1 and 2. How much money do you want to raise and what do you intend to do with that money?  If your answer to the second question is that you intend to “disrupt” this industry or that industry, you better be able to demonstrate that you know a lot about that industry and especially about your competitors.

What investors really want to know is that you have a good business plan and that you are raising enough money to execute it.  It is always better to stick with what you know and hire people who know what you do not.  You should be able to show that you are not just building a better mousetrap but that you are building a good, profitable business.

Question 3. What is in it for the investor?  Investors are often disrespected in the crowdfunding universe. This is partially because the crowdfunding platforms compete for issuers and partly because many crowdfunding platforms are operated by people who do not understand what investors want.  In truth all investors want the same thing; they want to end up with more money than they originally invested.

People who are willing to invest in a start-up understand that most start-ups will fail.  It is important to distinguish yourself and convince investors that your company has a better chance to succeed because you have mitigated some of the risk.

Over the years, I have used a variety of financing tools including preferred shares and revenue sharing models to help start-ups manage their cash flow and still make the investment attractive to investors.  No two companies are the same. If you are thinking that you can just download a template for your offering without some real advice about how to structure it, you are not likely to be successful.

Question 4. What is your fundraising budget?  This is what really separates successful fundraising programs from unsuccessful ones.  You should always be prepared to spend a little more than you think you may need.

What is an adequate budget?  Enough to prepare the legal paperwork, marketing materials and to drive enough potential investors to your offering to get it funded. For a Reg. D offering, few companies spend as much a $50,000 unless they are raising $10 million or more.

One of the common mistakes people make is selecting the wrong crowdfunding platform.  Several advertise that they have had 10,000 investors or more but most crowdfunding investors are not loyal to a particular platform. Only a very few platforms are right for any particular offering. You need to make a decision about which platform to use based upon a number of factors including the size of your offering, the industry that you are in and how your offering is structured.

Under the JOBS Act you can make a Reg. D offering on your own website if you wish.  Given the fact that you will be paying for the marketing costs, it may make sense to be on your own platform where there will be no competition from other offerings.

I speak with about a dozen companies every month and I only take on one or two because I do not want to work full time. If I take you on I will walk you through the process and usually get you funded. That goes for companies owned by women and minorities and those located in Toledo or Tallahassee.

Using the JOBS Act any good business can get funded. If you are going to run a business, then you have to get things done and not make excuses. That goes for financing your business as well.

If you cannot fund your business with equity crowdfunding then it is on you not the market. It is actually a lot easier, faster and more certain than chasing venture capital.

Behind the Crowdfunding Curtain- StartEngine Goes Public

StartEngine, one of the first and most active crowdfunding platforms has filed the paperwork to offer stock under Regulation A. They are raising $5 million, offering 1,000,000 shares to the public at $5 per share.

If you follow my blog, you know that I have written about several other Reg. A offerings; Elio Motors, Med-X, Ziyen, etc. which I thought were essentially scams run by people with questionable intentions.  I have my issues with StartEngine, but I never thought the owners were dishonest or trying to scam investors. Nothing of that sort should be inferred here.

The fact is that crowdfunding platforms, like most businesses, are not public. This offering is the first I have come across where a company that is actually active in this marketplace has published audited financial statements and made disclosures about its business and the risks inherent in that business. For someone like me, who is working in crowdfunding with some of StartEngine’s competitors, looking through this information was irresistible.

First and foremost, StartEngine itself is a start-up and is losing money funding other start-ups.The company lost $1 million in 2015, almost $3 million in 2016 and another $1 million during the first 6 months of 2017. The company had initially raised a little over $5 million in venture capital and has essentially burned through it. It now wants another $5 million to continue.

StartEngine’s business is basically a website and has 13 full time employees. It has no cost for goods sold and the bulk of its expenses are for administrative purposes and marketing.

The core premise of equity crowdfunding is that it facilitates the sale of new issue securities without the commissioned salespeople who perform this function at traditional stock brokerage firms. The commission savings are passed on to the companies who list their offerings on the platforms and ultimately to the investors. It is certainly fair to expect that because the offerings do not have a commission expense more of the funds that are raised will go to the company that is funding its business.

The JOBS Act permits three types of offerings to be funded on a website. StartEngine offers all three; Regulation A, Regulation Crowdfunding (CF) and Regulation D offerings.  At the end of August StartEngine announced that it also intends to offer crypto-currency offerings(ICOs) on its platform. With a full menu, StartEngine can offer more flexibility to a company seeking funds and a larger selection of investments for potential investors.

Under Reg. D a company can raise an unlimited amount of money from wealthier, accredited investors, under Reg. A up to $50 million and under Reg. CF up about $1 million. Reg. A and Reg. CF offerings can be sold to any investor albeit in limited amounts.

StartEngine was one of the first movers in the Reg. A market. The offering document notes that they have hosted the Reg.A offerings of ten companies.  StartEngine’s first offering, Elio Motors, eventually raised $16,917,576 from 6,345 investors.

Regulation CF went into effect on May 16, 2016. StartEngine has acted as intermediary for offerings by 58 companies; raising $7,383,960. According to Crowdfund Capital Advisors, of the 26 platforms registered with FINRA, StartEngine was second in terms of the number of Reg. CF offerings. Overall, in two years of operations, the StartEngine platform has raised about $40 million for issuers from over 17,000 investors.

For a little perspective I write the legal paperwork for crowdfunded offerings being made under Reg. D that are listed on various competing platforms.  I am on target to write the paperwork for $50 million worth of offerings during calendar 2017 and probably more next year. I work part time, out of my home on a 5-year old laptop.

My advertising budget is zero dollars. I get all my business through referrals or because someone reads one of my blog articles and thinks that I have some common sense. I take the time to speak with a lot of people who are starting new businesses and are seeking capital. I have referred a few to appropriate crowdfunding platforms, even if someone else writes the paperwork.

With a six figure per year advertising budget StartEngine should easily be able to host and sell $100 million worth of offerings per year or more.  If they did, the company would be profitable.  So what is the problem?

There are three parties to every transaction, the company seeking investment, the investors and the platform that introduces the other two. The intent should be that all three will ultimately make money from each offering. If the investors make money they will be happy, come back again to make additional investments and recommend the platform to friends.

Roughly 1/3 of StartEngine’s entire customer base invested in Elio Motors. I questioned Elio at the time that StartEngine put Elio’s offering on its platform.  It was obvious to me that Elio was not likely to ever put out its vehicle or turn a profit and I wrote just that.  If that was obvious to me, it should have been obvious to StartEngine as well.

StartEngine’s offering document mentions that it may be liable if a company that lists on its platform gets sued for securities fraud.  It states that even if StartEngine is a party to the suit and prevails, being a party to these suits might cause “reputational harm that would negatively impact our business” in addition to the costs of its defense.

Regulators have just begun to catch up with Elio. Elio was recently fined roughly $550,000 by the State of Louisiana for taking deposits for its non-existent vehicle without a proper license to do so. The lack of a proper license should have come up in the pre-offering due diligence investigation conducted by StartEngine.

Even if Elio is never alleged to have committed securities fraud, the company is insolvent and is unlikely to ever produce a vehicle or operate profitably.  Investors will lose the money that they invested.

Reputational damage for a company like StartEngine also comes from listing any piece of crap that comes along. Why should investors be expected to come back to StartEngine a second time, or a third, if the companies that StartEngine lists on its platform are not likely to succeed?

StartEngine defines its mission as: “To help entrepreneurs fuel the American Dream.” Its long term objective for 2025 is to “facilitate funding for the startup and growth of 5,000 companies every year.”

Assuming that each of those companies raises only $500,000 StartEngine is projecting that it can bring in $2.5 billion in new money every year.  Given that most or all of that money will be lost, I think that is a fantasy. StartEngine is likely to become known as a place where investors flush their money down the toilet long before 2025.

Had I been asked to write this mission statement I would have said something like “the company’s objective is to match investors with worthy companies that offer new technology and new products.”  The key word is “worthy”.

There is no way to sugar-coat the fact that 90% of start-ups fail and that many fail very quickly, usually within the first two years.  No one who I have met in crowdfunding denies that fact and most just accept it as a fact of life, even if they really do not want to talk about it.

An intermediary like StartEngine should be able to discern which companies are more likely to be part of the 90% that will fail and which have a chance of being part of the 10% that will succeed. That is what broker/dealers and investment bankers do every day and have done for decades.

The mainstream stockbrokerage industry has no difficulty identifying or funding new technologies. Stock brokers raised money for Apple and Microsoft when very few people owned personal computers. They raised money for Genentech at a time when no investor had ever heard the words “genetically engineered pharmaceuticals” before.

The offering suggests that StartEngine intends to harness the power and wisdom of “the Crowd”. To be blunt, no one has ever suggested that the crowd has any wisdom sufficient to discern which companies are worthy of investment and which are not. If they did, I doubt anyone would invest in StartEngine.

The lawyers who prepared the StartEngine offering included this statement as a risk factor: “none of our officers or our chairman has previous experience in securities markets or regulations or has passed any related examinations or holds any accreditations.” That, in one sentence, is StartEngine’s entire problem.

StartEngine’s customers are the investors, not the companies raising money. StartEngine has no idea how to give investors what investors want, a fighting chance at making money from the investments that they make.

Some of the other crowdfunding platforms understand this. MicroVentures has a reputation for turning away potential issuers that do not meet its standards.  I have worked with WealthForge which crowdfunds offerings to institutional investors. They would not consider offering those institutions any company that lacked the substance to succeed. Both were founded by or employ people with backgrounds in mainstream brokerage or investment banking.

Running a crowdfunding platform and funding companies without someone trained in investment banking is like running an animal shelter without a veterinarian on staff.  You can round up the animals, but you may not really be able to help them.  People who adopt the animals will never know if the animal is sick or healthy and that is something that they want to know.

Investing in start-ups is risky. You can run your platform like  newspaper want ads taking any ad that comes along or you can use some judgment and refuse ads for bottled water that claims to cure cancer because you know that your readers will not be happy. It is incumbent upon any crowdfunding platform to mitigate the risk for the investors that look at the offerings it lists.

I have personally resisted the idea of working for one of the crowdfunding platforms although I have advised a few. If you seriously want to invest in a crowdfunding platform, I could assemble a team and improve upon what StartEngine has to offer, without the baggage of offerings like Elio Motors, for a lot less than $5 million, probably around $500,000 (maybe even less if I do not replace my laptop).  I could operate the platform profitably and offer a return on your investment probably within a year. Interested? You know where to find me.

 

Why the Panic of 1893 is Relevant Today

The difference between studying economics and economic history is simple. In the former you learn how markets work and how to work within markets. In economic history you study all the times that the markets failed to work, including the market crashes, depressions and panics. The latter are far more interesting.

When I was teaching economics I would throw in a discussion of a panic or depression just to keep the students awake.  A good financial panic can get and keep your attention in the same way that motorists will never fail to look at two cars parked along the side of the highway that have been involved in an accident.  The more damage to the cars, the more people just cannot look away.

I frequently discussed the Panic of 1893 because it was at the same time a relatively simple and complex affair.  It was the worst economic disaster in the US up to that time and it came at the end of a period of prosperity and expansion the likes of which the US had not previously seen.

The events that led up to the Panic of 1893 and the measures taken by the government to deal with it are all relevant today.  There was a lot being discussed back then that is still being discussed today.

A lot of people who favor crypto-currencies frequently tell me that our current financial system is flawed and doomed because of the crash in 2008. That our economy survived 1893 and was still around to crash in 2008 is an indication of the market’s resiliency.  The reforms that took  place in the century after 1893 only made the US financial system stronger.

During the period 1870-1890 the railroads opened the west and people moved onto the Great Plains.  Farmers, not the industrialists, were the foundation of the US economy and were apparently too busy farming to have children because the food supply actually grew faster than the population.  Wheat was the primary commodity and whether the farmers understood it or not, the price of wheat was very much determined by a global economy.

US farmers borrowed heavily to finance their own farming operations. As production went up, prices came down and the depressed prices made it difficult for them to pay back the banks that had lent them money.  The same was true of cotton farmers in the South. Cotton was a major cash crop both before and after the Civil War. By 1890 the price became depressed as growers in Egypt and India added more and more tonnage to the world markets.

Since the farmers could not sell their wheat or cotton, there was no need to ship it anywhere and railroad revenues also dried up. The Philadelphia and Reading Railroad went bankrupt as did the several other large railroads. All were big employers and unemployment started to climb.  Part of this was due to the fact that as the railroads had been building more and more track and added to capacity that outgrew their market.

A company called National United Cordage which made rope out of hemp also went bankrupt.  The company had sold bonds to finance its operation and used the money to try to corner the market on hemp.  National Cordage was the most actively traded stock on the New York Stock Exchange at the time until rumors that the company had over extended itself caused the lenders to call the bonds and the company collapsed.

As National Cordage and the railroads went under, the stock market became uneasy and crashed.  Somewhere in the neighborhood of 500 banks closed as did thousands of businesses and farms. Unemployment shot up.  By some counts as many as 50% of the able bodied men who had been working in factories in Ohio were out of work.

In 1890 there was a drought in Argentina which killed off the wheat crop. This should have been good for American farmers but was not, for reasons that few people saw coming.  Years later when there was a similar drought and famine in the Ukraine, Herbert Hoover engineered the purchase of wheat from US farmers and shipped it to Russia. That would have helped the farmers in 1893, but no one apparently had the foresight to come up with this solution until 30 years later.

The Argentinean farmers were largely financed by British and European banks. In order to obtain the investment, the banks in Argentina originally hired Baring Brothers, one of the oldest English merchant banks, to assist them.  When I was giving this lecture to my economics students in 1995-1996, Barings had just been put out of business by a single young trader on its derivatives desk in Singapore who had made huge bets with Baring’s money and lost.

Barings was a little smarter in the 1890s because at the same time it was steering its clients into Argentine bonds, it was also buying US treasury bonds which were backed by gold.  European investors, panicked by the losses in South America, began to cash in the US bonds and demand gold as repayment. Almost immediately the US gold reserves fell to 100 million ounces which, by law, they were not supposed to fall below. The government actually borrowed gold from JP Morgan to make up its deficit.

The US was in the midst of a decade long debate about fiat currency.  At the time, fiat meant anything that was not gold or convertible into gold. The primary alternative was silver and many economists disregarded it out of hand simply because it was not gold.  You can only imagine how an economist from in the 1890s would feel about Bitcoins as an alternative currency today.

In 1890 the Congress had passed the Sherman Silver Purchase Act which required the US to purchase silver from mines in Western states. The idea was to deflate that value of US currency so that farmers could re-pay banks with currency that was worth less than it was when they borrowed it.

This encouraged silver mining and an over-supply of silver which helped to reduce the price of silver in the marketplace. It actually got to the point where a $1 Morgan silver coin had only about $.60 worth of silver in it.

The Silver Purchase Act was passed in conjunction with the McKinley Tariff, a very protectionist law that caused taxes on imports to rise dramatically and prices on many common goods to increase.  Certain protected industries such as wool and tin plates did well but overall prices went up for ordinary consumers.

At the time tariffs were the primary source of tax revenue for the US Government because the income tax had not yet been enacted. Tariffs were taxes that impacted small people buying common goods and aided the rich industrialists whose businesses were protected.

One of the interesting things about the Panic of 1893 is that it happened very quickly.  The railroads filed for bankruptcy, the banks closed and the stock market crashed all in a period of about 10 weeks. It led to several years of a deep depression.

Just prior to the 1893 collapse there had been a growing Populist movement that supported an agrarian economy and chastised Eastern elites, banks, railroad interests and gold. The Panic should have helped their cause, but did not. The Populists won 5 states in the Presidential election of 1892 and 9 seats in the House of Representatives in 1894 but had largely faded away by the end of the decade.

Not much in the way of reforms came out of this Panic but it was not the last. The Federal Reserve Act followed the Panic of 1907 when a few hundred more banks failed and securities market regulation and the FDIC originated after the stock market crash in 1929.

What I personally find interesting is that the issues present in 1893, globalization of finance and trade, the over-extension of credit, over supply of commodities and services, droughts, tariffs and protectionism, fiat currency, railroads and transportation, Populism and regional politics and even hemp are still in the headlines and issues surrounding them still on the table.

The overriding lesson is that finance is about trust and value.  It took 100 years after this Panic and several subsequent panics until the phrase “irrational exuberance” entered the economic lexicon but that phrase only explained what we should already have known.  The best lesson of 1893: “Do not build what you cannot use. Do not borrow what you cannot re-pay”.

 

Cannabis and Crypto-Currency-The Blind Leading the Blind

A few weeks back I wrote a blog article where I stated that I was not interested in preparing the legal paperwork for any company that was raising funds for a cannabis related company. In the same article I said that I would also decline the opportunity to prepare the paperwork for an initial coin offering (ICO).  Either would be lucrative for me but in both cases I saw significant problems for the investors.

I might have predicted that people would start sending me the paperwork for ICOs that were looking to fund cannabis businesses seeking my thoughts and comments. Two stick out as examples of how not to raise money for your cannabis business.

In July, the US Securities and Exchange Commission (SEC) issued a report on ICOs. Crypto-currency is all the rage this year with some offerings raising millions of dollars in a matter of minutes and coins when issued quickly appreciating in price. Bitcoins for example have been appreciated significantly this year and some people think that Bitcoins are a legitimate investment, an assertion that is questionable at best.

The SEC correctly concluded that most crypto-currency offerings would fall within the definition of a security and thus its jurisdiction.  There was really no surprise as the SEC initiated about a dozen enforcement actions against crypto-currency issuers before it wrote its report.

Because an ICO is the offering of securities it is required by law to either 1) register with the SEC or 2) be exempt from registration assuming that an exemption is available. In either case, the issuer of the coins is required to give potential investors all the facts that would be material to making an investment decision.

If investors who purchased the coins got a discount on an ounce or two of marijuana the coins might not be securities. These two cannabis ICO offerings are clearly offering securities.  In both of these cases, investors profit if the underlying business profits which is more than enough for these to be securities and the SEC to have jurisdiction.

There are some facts which the SEC and any securities lawyer would consider to be material. This would include who is running the company; how much money is being raised and what will it be used for; the basic structure of the company’s ownership; how investors get paid and how much they might expect; an idea of the size of the market in which the company intends to compete and the names of the companies that are its major competitors.

Nothing really earth shattering,but the SEC has been reviewing offerings and ruling on how these facts are disclosed for decades. Making the disclosures correctly requires a fairly good idea of what the SEC expects and an equally good idea of the operation of the business offering the securities which is why securities lawyers who prepare offerings really have to know what we are doing.

The first cannabis ICO I looked at was for a company called Growers International.  Like all ICOs it uses a “White Paper” (which it prefers to call a “Green Paper”) instead of a traditional prospectus.  I doubt that it was prepared by a securities attorney. (I would suggest that you might add the words “Like, cool” or Yeah, man” between the sentences and it would read like the script of an old Cheech and Chong movie but I do not want to insult Cheech or Chong.)

From the Green Paper: “Q: Why should I trust the team? How do I know this isn’t a Pump & Dump situation?  A: We ask that all investors do their research on the people behind Growers International. Our lead developer has found success in both the cryptocurrency arena as well as in the cannabis industry. If there is any question regarding the legitimacy of the project, we encourage investors to reach out to Ryan (Lead Dev) personally on slack.”

It is always a good idea to research the people who are running any company into which you are making an investment.  In this case the “Green Paper” discloses the management to be: “Lead Developer: Ryan Wright (34, California / Taipei); Blockchain Programmer: Eddie E. (48, New Zealand); Web / API Developer: Michael J. (32, Maidenhead, England); Social Media Director: Devvie @Devnullius (40, Sweden); Community Coordinator: Jeremy Toman @MadHatt (37, Canada) who prefers the name ‘Tyler Dirden’ or ‘MadHatt’;Graphic Designer & Cryptocurrency Consultant: Chris S. @Elypse (26, Detroit); Community Manager: @DayVidd and Bitcointalk Manager & Financial Consultant: Dr. Charles @drcharles (26, USA).”

I suspect that if you contact Mr.Wright as suggested he will vouch for them all if he bothered to ask their last names. Do not bother to ask about Members of the Board of Directors as they have apparently not yet been appointed, so one Director might turn out to be Pablo@Escobar.

The other cannabis related ICO I reviewed is prepared more professionally but still, in my opinion, misses the mark by a good country mile. The company is called Paragon Coin, Inc. It is in the process of raising $100 million through the ICO. Just to be clear Paragon supports the cannabis industry, it does not appear that it intends to grow or distribute cannabis itself.

Paragon intends to bring block chain to the cannabis industry.  It intends to use a distributed ledger to bring order to this fragmented industry. According to the White Paper the company intends to “offer payment for industry related services and supplies through ParagonCoin; establish niche co-working spaces via ParagonSpace; organize and unite global legalization efforts through ParagonOnline; bring standardization of licensing, lab testing, transactions, supply chain and ID verification through apps built in ParagonAccelerator.”

All that is fair enough and the names and pictures of the operating personnel are included. Their education and work histories going back 10 years which I would have expected to see are not present.

The White Paper clearly notes that cannabis is not legal at the federal level and asserts that it will only operate in states where it is legal. This is the prime oxymoron of the cannabis industry.  Illegal at the federal level is illegal everywhere. Marijuana is a Schedule I drug and possession or sale is a felony in all 50 states. That is a fact about which that the cannabis industry does not want to think and largely ignores.

The Paragon White Paper describes one of the Risks of investing in its coin offering as follows:

CERTAIN ACTIVITIES INVOLVING MARIJUANA REMAIN ILLEGAL UNDER US FEDERAL

LAWS. SUCH ACTIVITIES INCLUDE BUT ARE NOT LIMITED TO: (A) DISTRIBUTION OF MARIJUANA TO MINORS, (B) TRANSPORTING MARIJUANA FROM STATES WHERE IT IS LEGAL TO OTHER STATES, (C) DRUGGED DRIVING AND OTHER ADVERSE PUBLIC HEALTH CONSEQUENCES, (D) GROWING MARIJUANA ON PUBLIC LANDS, (E) MARIJUANA POSSESSION OR USE ON FEDERAL PROPERTY, AND

(F) OTHER CRIMINAL ACTIVITY OR VIOLENCE ASSOCIATED WITH THE SALE OF MARIJUANA. TO THE EXTENT THE COMPANY AND/OR PARAGON COIN, INC. MAY NOT PREVENT CERTAIN OF ITS USERS FROM USING PRG TOKENS IN VIOLATION OF US FEDERAL LAW, IT MAY SUBJECT THE COMPANY AND/OR PARAGON COIN, INC. TO CIVIL AND/OR CRIMINAL LIABILITY AND THE UTILITY, LIQUIDITY, AND/OR TRADING PRICE OF PRG TOKENS WILL BE ADVERSELY AFFECTED OR PRG TOKENS MAY CEASE TO BE TRADED.

This derives verbatim from the Cole Memorandum which was written in 2013 as a direction from the US Department of Justice to Federal prosecutors as to how they should allocate their resources when they decide who to prosecute and for what. It never made cannabis legal anywhere.

More importantly, the Cole Memo it is not an Act of Congress or Federal regulation and not binding on the current administration in any way. Any suggestion that it will continue to be followed under the current administration is wishful thinking given the Attorney General has repeatedly stated that it will not.

Medical marijuana has been legal in California for more than a decade. That did not stop the federal government from raiding and closing down a large medical dispensary in Oakland, CA in 2012. Parenthetically, Paragon’s initial co-working space is slated to open in Oakland, California.

Perhaps the most troubling aspect of this offering is that it intends to fund the use of block chain, a relatively unsecure distributed ledger to link the many growers and suppliers in the cannabis industry. If successful it may well deal a serious blow to the cannabis industry it is trying to support.

One of the leading ICO platforms, Coinbase, has been engaged in a two year battle with the Internal Revenue Service which wants a list of all the people who use its platform to trade Bitcoins. The IRS alleges that people are trading the coins profitably and not reporting the gains and paying the taxes. The US government has also alleged that drug cartels and other bad actors use crypto-currency to launder money.

If you are in the cannabis industry you have certainly heard stories of how the DEA would obtain the customer lists of hardware stores that sold supplies for hydroponic growing. Everyone who was a customer did not use these supplies to grow cannabis but the government used those lists to identify and prosecute people who did.

If you have a “decentralized” list of a large group of people who are on the list only because they are affirmatively in the cannabis business as Paragon wants to create, how long do you think it will take for the US Government to obtain it? Think that will be difficult because Paragon never touches any marijuana or sells it?

The CEO of Paragon, Jessica VerSteeg, is also CEO of AuBox which the White Paper describes as “an upscale marijuana delivery service in the SF Bay area”. That is more than enough “probable cause”for the DOJ to get its hands on Paragon’s distributed ledger and the names of every company that uses it. The icing on the cake will be when they tell the judge that the cannabis industry is full of drug cartels and money launders which, of course, it is.

When you write the risk factors for a securities offering, it is important to disclose all of the things that might reasonably occur.  Assuming that this ICO raises the $100 million that it seeks, it is certainly within the realm of possibility that the Attorney General might just seize that money under the federal asset forfeiture provisions. The people behind this offering somehow refuse to accept that there was an election last November and that there is a new sheriff in town.

What I took away from these two offerings was a sense that they were prepared by amateurs who were attempting to do something that was way over their head. In this current administration, raising money for a cannabis company waves a red flag in front of the US government. Compounding that fact by raising money through an ICO just increases the size of that red flag, exponentially.

I personally do not think that there is any hope for Green International but Paragon did not demonstrate that it needed $100 million and could have certainly raised a lesser, more reasonable amount in a more traditional fashion which is what I would have advised them to do if they had asked me.

 

 

Is Technology Changing Finance?

A lot of people seem to believe that technology will fundamentally change or disrupt finance and the financial markets.  Many, if not most, of those people seem to be developing technology, selling it or using it to sell products to investors and financial consumers.  Most of these people seem to have degrees or backgrounds in technology not finance.

Having a background in technology does not give you an understanding of finance or the financial markets.  You cannot fix or disrupt what you do not understand and the lack of understanding behind many of these products is simply ridiculous.

I only write about the law and the financial markets. I spent my career as an attorney working in and around the financial markets. I also taught Economics and Finance so I have a pretty well rounded idea about how the capital markets work and how they are evolving.

So I feel perfectly justified to call out the many techies who think they understand the financial markets even though they have never worked in the markets or studied finance. Nonetheless many seem hell-bent to create products that they think are making these markets better and are quick to label the products that they sell as “disruptive”.

I call these people the “algorithms fix everything” crowd.  It is an interesting thought, except that these mathematicians have no math to back up much of what they say about finance.

At the same time, there is an ongoing narrative that suggests that everyone who works in the financial markets is evil. I find it amazing how many people actually think that all bankers and stock brokers get up in the morning thinking “who can I screw today?”  I have personally brought more than 1000 claims on behalf of aggrieved investors against Wall Street firms and written a book about some of the really bad things that Wall Street firms can do, but even I know that Wall Street firms are not evil.

The capital markets handle millions of transactions every day involving trillions of dollars and the almost all of those transactions settle with both the buyer and seller happy. Banks and stockbrokers fund schools, universities, roads and hospitals and virtually every company since WWII, again without serious problems or complaints from anyone. Banks aggregate and intermediate capital and over all they do it quite well.  So what, exactly, needs disrupting?

Still there is a never ending stream of new products and services which claim to be revolutionary and which promise to disrupt the capital markets. On closer examination many of these innovations are more hype than substance. Say what you will, there is nothing disruptive here.  A few examples for your consideration:

1) Algorithmic stock trading – This is a good place to start because it is pure technology applied to the existing markets. “Quant” traders use computers to evaluate trends and trading patterns in the market of various securities. They attempt to anticipate the price at which the next trade or subsequent trades will occur.  Logic says that computers should be able to take in more information that is pertinent to stock trading, analyze it almost instantaneously and execute transactions in micro seconds.

It sounds right, but the reality is that all stock trading is binary; every buyer requires a seller. No one buys a stock unless they believe that the price will appreciate; sellers generally will only sell shares when they think the price will appreciate no further. Both sides to any trade cannot be correct.

Analyzing the information or executing faster is of no use unless each trade you make is profitable.  No one has yet figured out how to accomplish that, nor are they likely to do so.  What we are talking about is predicting the future which is difficult to do even if only a micro-second or two ahead.   And please do not suggest that artificial intelligence will change this.  If there is one right answer based on the current information, e.g. buy APPL, then who is going to sell it?

2) Robo investment advisors- These are similar but much less sophisticated. Robo-advisors do not actually attempt to anticipate future market performance. They make investment recommendations based solely on the past performance of the markets. Anyone who has ever bought a mutual fund is required by law to be told that past performance is not a basis for future results. But that is all you get with a robo-advisor.

FINRA did a study of a half dozen robo investment platforms and found that they provided widely divergent portfolios for the same types of investors. No robo is any better than any other and none is really worth anything.

3) Crypto currency- It was a discussion about Bitcoins that was the initial impetus for this article. Aficionados of crypto currency actually think that they are developing an alternative currency for an alternative financial system. People seem to want to just print their own money and on one level I can understand that.  But that level is more of a fantasy than reality.

The reality is that I can buy food or virtually anything else in most places in the world with US currency. Why do we need Bitcoins? What exactly, is their utility?   When I ask that question I get any number of weak responses. More often than not, I get a tirade about banks and/or governments being evil.

What proponents of crypto currencies never want to face is the fact that the crypto currency market has been full of people laundering money from illegal activities.  The banks that crypto currency fans love to hate are required by law to know their customers and have systems in place to prevent money laundering.  It costs money to follow the law and have those systems. It is money that the crypto currency platforms do not want to spend. If there is a common thread in the crypto currency world, it is that people want to skirt or simply ignore the regulations that keep the markets safe and functioning.

4)  Crowdfunding Platforms- Crowdfunding clearly works and works well as evidenced by the significant amount of money that it has raised for real estate and real estate development projects.  At the same time the crowdfunding industry is populated by a great many people who fall into the “I do not care what the rules say, I am in this to make a buck” crowd.  I have written several articles about how some of the crowdfunding platforms do not take the time to properly verify the facts that they give to potential investors.  Due diligence can be expensive and some of the platforms just refuse to spend what it takes to do it correctly.

Crowdfunding replaces the role that stockbrokers typically fulfill in the process of raising capital with a website and do it yourself approach.  With a stockbroker, the company that was seeking capital got that money the vast majority of the time because the brokers were incentivized to sell the shares. With crowdfunding it is very much hit or miss whether the company will get funded. Many of the better crowdfunding platforms charge close to what a brokerage firm would charge and the investors get none of the protections or insurance that they would get with a stockbroker.

5) FinTech and FinApps – I can go to my bank’s website and send a payment to my electric utility company. I can do the same at the utility company’s website. I admit that it is convenient, but it is hardly disruptive.   Remittance companies like PayPal merely move money from my bank to a vendor’s bank.  And PayPal posted a $3 billion profit in the last fiscal quarter.  So they may charge less of a fee per transaction than a bank, but is not essentially different, and again while PayPal holds my money, I get no insurance against hacking or theft.

Apps that allow me to apply for a mortgage on my phone are really doing no more than eliminating a bank employee who would enter the same information from a written application into the bank’s computer. Again, it is convenient but not necessary.  And the money for the mortgage comes from either a bank or stock brokerage firm so there is nothing disruptive here, either.

Is there nothing truly new and disruptive in finance? Of course there is. They deservedly gave the 2006 Nobel Prize in Economics to Muhammad Yunus for developing a system of micro-finance that continues to create millions of entrepreneurs and lift millions more out of poverty. I doubt that one line of computer code was needed.

Micro-finance has the ability to put globalization on steroids.  Who will be disrupted?  Quite of few people with big school pedigrees and enormous student debt who write code to disrupt finance but who never understood finance in the first place.to

The Start-up Funding Wars-Another Dispatch from the Front Lines

I speak with start-ups and business owners who are trying to raise capital for their businesses several times a week.  Some are my age or close to it; others are very much younger.  Most know their own business well, but few understand the ins and outs of raising capital which is why they call me in the first place.

If I take on the task of helping a start-up raise funds I can usually get them the funds they need.  That is not an idle boast. I will not even attempt to help a company solicit investors if I do not think that the company is a good investment.

That is unfortunately the case with the vast majority of the companies with which I speak.  I will review any pitch deck and offer comments and suggestions for free.  I will spend an hour of my time on the phone with any entrepreneur, no charge. Most simply do not measure up.

What I want to hear is that you have a business.  I want you to tell me that you have a product; that you know what it will cost to source your product and that you have actual customers who have bought or at least used the product and have reacted favorably to it.  If you are not yet at that stage, at the very least I want to know that you are close.

The difference between raising funds for a product that has been developed and raising funds to develop a product is huge. The number of investors who will take a chance on the latter is much smaller. It can still be done but it might take a little more time and money to reach them.

The two things that I do not want to hear is that your product will “disrupt” the market or that your company is destined to have a billion dollar plus valuation.  Neither is likely to come true.  I would rather hear that you have a good marketing and sales plan in place and have hired good, experienced people to execute it.

Please do not ask me to sign a non-disclosure agreement (NDA) before we speak.  In the first place, I am an attorney at law, so everything that you say to me is confidential if you want it to be.  In the second place, if your product or process is so novel, valuable and proprietary then get it patented.

Please do not send me a pitch deck that has no resemblance to a business plan. If your pitch is all flash and no substance it is not going to work. Investors want to see what you are going to do with their money and how and when your company will become profitable.

Please do not tell me that you have read all the books about funding a start-up and have attended several conferences featuring the best start-up “gurus”.  If you had read all the books that actually count, you would probably have an MBA in Finance.

Sometimes I can help a small company up its game by suggesting that it add some additional directors, patent its product, refine its business plan or change the terms or structure of its offering.  But more often than not, I find myself turning away business.

What I really want to hear most in that first phone call with any entrepreneur is that he/she can close the sale. If you are going to deal with investors, you are going to have to do more than tell them about the great company that you are building. You are going to have to ask them for a check. To get it, you need to tell investors how they are likely to profit from the investment in your company and why you can make it happen.

I am not a philanthropist. I charge for my services albeit less than I used to charge when I was paying rent for an office in a financial district high rise.  I will not work for stock in your business and you cannot pay me later after we raise money for you.

It takes money to raise money.  If you raised seed capital from friends and family to develop your product and did not raise enough to take you to the next level of fundraising at the same time, let me say this judiciously, you blew it.

I generally tell people to budget between $35-$50,000 if you need to raise between $5-$15,000,000.  So far none of my clients have gone over budget and most have spent less, but running out of money would be aggravating to all concerned.

A lot of people ask me to introduce them to VCs. I know a few VCs on both coasts and a few in between.  Most are serious investors meaning that they want to invest in companies that will succeed and produce a good return on their investment.  This is true of all investors, not just VCs.

For most start-ups seeking venture capital is a waste of time.  VCs actually fund very few businesses every year and each has its own funding requirements. The process is time consuming (even companies that get funded can be at it a year or more) and often political (like a lot of things in life it is often who you know that is important).

For most start-ups and small companies, equity crowdfunding would be the preferred way to raise funds.  It can be quick (90-120 days) and inexpensive ($35-$50,000).  I work with several equity crowdfunding platforms and several different marketing companies.  If you start with the idea that you are just going to slap an offering together as inexpensively as possible, put it up on a crowdfunding platform that has dozens of competing offerings and send out an e-mail or two to prospective investors, you are more likely than not going to fail.

I know a lot of people in the crowdfunding industry and I think that I know the best of the best.  I can usually direct a client to an appropriate crowdfunding platform and a marketing firm that will get the job done. I use different firms for different offerings of companies in different industries and at different stages of their corporate development.

Funding is always a team effort. That is why I like to pick the team.  I try to use the best people for each job.  Some charge more than others but like everything else in life, you get what you pay for.

To save time here are three types of offerings that I do not do.

1) Anything to do with cannabis. It is not that I am a wimp on the subject of marijuana. I was in college in the 1960s.  It is just that I can read the handwriting on the wall. Cannabis is illegal in all 50 states, no matter what the state legislature may have enacted.  The current US Attorney General, Jeff Sessions, seems to be getting ready to start enforcing federal law and closing down the retail stores and medical dispensaries.  He recently loosened the rules on asset forfeiture, meaning that nice warehouse where some company is growing cannabis might be seized and sold without a trial.  If I was an investor who helped to fund the purchase of that building I would sue the principals for using my money to participate in an illegal enterprise.

2) Any Reg. A+ offering. Reg. A+ requires the registration of shares with the SEC so that they can be sold to smaller investors. There is more than enough money in the Reg. D private placement market to fund your business. A Reg. A+ offering will likely cost you $150,000 or more to raise the same amount of money. That does not scream “look how smart I am” to any investor.

3) Any ICO. Recently I have been asked by more than one company to do an Initial Coin Offering (ICO).  These are offerings denominated in crypto-currencies. Several have raised significant amounts of money.  The SEC has declared that depending on how these offerings are structured they may be securities. Most of the lawyers with whom I spoke would err on the side of caution if they were asked to prepare an ICO. I got quotes in the range of $150,000- $250,000 just for legal fees. Again why spend that much more than you need to spend to fund your business.  And if you need a gimmick like an ICO to fund raise funds, what does that say about your business?

By refusing to fund businesses selling cannabis, any Reg. A+ or any ICO, I am leaving a lot of money on the table because these offerings, especially the latter two, pay well.  I have the expertise but I also have a reputation. I will not advise a client to use Reg. A+ or an ICO when a Reg. D offering will work just as well and cost them much less.

Good businesses get funded. While 90% of start-ups fail,  the key is to convince investors that you are among the 10% that will not.  If you are unsure, you are welcome to try to convince me first.

 

Ziyen Inc- Another Reg. A+ Question Mark

I have written several articles about specific Reg. A+ offerings. These offerings are targeted at small investors who are ill-equipped to judge their value as an investment, let alone, the accuracy of the disclosures.

I recently got a call from a colleague who works at a reputable brokerage firm.  He suggested that I look at the Reg. A+ offering of a company called Ziyen Inc.  He thought that it might be the grist for a blog article. He was not wrong.

Ziyen Inc. was incorporated in April 2016 to provide a suite of “cutting edge digital business intelligence, marketing and software services.”  By business intelligence it means information about available government procurement contracts, initially in Iraq and eventually globally.

The offering circular states: “Ziyen currently operates the B2B Procurement Portals “Rebuilding Iraq.net” and “Cable Contracts.net”.  “Rebuilding Iraq is our first B2B Procurement Portal, and the flagship service for the company. We are currently the number one international source for information on tenders, contracts, news and marketing services in Iraq.”

As far as I can tell, Rebuilding Iraq.net lists tenders for contracts that might be found elsewhere and does not charge for the information. It claims that 200,000 people visit the site every month.  When I checked Cable Contracts.net, which does charge for usage on a monthly subscription basis, I did not find any tenders listed. According to the financial statements in the offering circular the company has no revenue and roughly $7000 in the bank.

The company is selling up to 64,000,000 shares at $.25 per share. It is self-underwriting, meaning that there is no brokerage firm involved or even an established crowdfunding platform.  The offering circular mentions two crowdfunding platforms by name and the subscription agreement mentions a third, but I could not find this offering on any of them.

It appears that shares are being sold directly from the company website. The website actually uses shopping carts into which you can put a bundle of shares and check out using a credit card. And before you say that the shares are only $.25 a piece, the bundles go up to $25,000 so this is a serious offering of securities.

The subscription agreement also mentions an escrow agent where investors can deposit their funds, except that no escrow agent is being used.  According to the offering circular, “Subscription amounts received by the Company will be deposited in the Company’s general bank account, and upon acceptance of the subscription by the Company, the funds will be available for the Company’s use.”

No competent securities attorney would permit these types of inconsistencies. In truth, it appears that no competent securities attorney was involved in the preparation of this offering.  None is disclosed and no funds are allocated to pay an attorney to prepare the offering or deal with the Securities and Exchange Commission’s Division of Corporate Finance which reviewed it.

It appears the offering was prepared by the company’s principal, Alastair Caithness, a Scottish-American businessman.  You can tell he wrote the offering circular because he refers to himself in the first person – “I was Head of Sales in a company in the UK” although he never discloses the name of that company.

The offering circular also obliquely refers to other employees and a Board of Directors, none of whom are named. The Company does business in Iraq and for all you know the Company might have people on its Board of Directors whom the US government might not look upon favorably.

I did find six other Board members on the Company’s website, but their backgrounds were short on the type of detail I would have expected to see in an offering circular. The disclosures give incomplete employment histories and several fail to disclose where they were educated.  Nothing negative was disclosed about any of them and I am not suggesting that there was anything negative to disclose. I am only questioning whether Mr. Caithness would have known what disclosures the rules required.

For a little perspective, back in the late 1970s when I was writing registration statements I took some flak from the Division of Corporate Finance because one of the executives at an issuer had claimed to have a Bachelor’s degree and did not. It seems he got his draft notice right before his senior year final exams and decided that graduating was not that important. When he took the job at the company years later his resume said that he had graduated and no one had ever checked. The Division of Corporate Finance told me at the time that was a misstatement of a material fact.

I must have missed the memo where they subsequently decided that not disclosing the names of the members of the Board of Directors in an offering circular was not an omission of a material fact.  Nowhere in the offering circular does it suggest that investors should review every page of the company’s website or every subsequent press release.

The offering circular is dated mid-October of 2016. In mid-April 2017, the Company announced separately that it had established a “new investment division in the company to focus on financing unfunded construction projects in Iraq”.  It claimed to have “the capabilities to provide the finance for long-term projects.”  Financing for long-term projects?  According to the offering circular the company has $7000 in cash in the bank.

In June 2017, the Company announced that Ziyen Energy, a division of Ziyen Inc., had just secured over $36 million dollars of oil reserves in Indiana in the United States.  The deal includes 7 existing oil producing wells worth over $6 million dollars of proven reserves along with a support water injection well and a water producing well for injection purposes with a further potential for 20 new oil producers on undeveloped reserves on the site worth over $30 million.

That would certainly be big news, except the offering circular does not mention Ziyen Energy nor any intention to be in the oil production business, much less in the oil production business in the US. If you were to download and review the offering circular today you would have no idea you were investing in an oil company. Even if you tracked down the press release, it does not disclose how much the company paid for these reserves, whether they were financed, how much the wells are producing or if contracts are in place to sell the production.

As I was researching this article I was prepared to give Mr. Caithness the benefit of the doubt. I thought he was just a businessman trying to raise some money for his own company on the cheap, i.e. without hiring a competent securities attorney.

Then I found this offering on a crowdfunding platform that specializes in Reg. A+ offerings called Wall Street Capital Investment. It is owned by Mr. Caithness who holds himself as an expert and offers to help raise money for others.

Ziyen Inc. is actually the second offering on that platform. The first is a company called Novea Inc. which shares the same address in Cheyenne, Wyoming as Ziyen. (Mr. Caithness is actually in California and presumably operates Ziyen from there. I have no reason to believe that Novea is actually in Cheyenne either.) The offering circulars for the two are remarkably similar and no attorney was apparently paid to prepare the Novea offering either.

Novea Inc. also has neither revenue nor cash in the bank and is in the business of offering warranties that “disrupt” the warranty industry.  One of its largest shareholders is Mr. Carlos Arreola who is Mr. Caithness’ partner in Wall Street Capital Investment. As an aside, the advertising for both companies feature the same actor and the marketing plan and press releases are also very similar.

I also suspect that this is about more than just saving some money on legal fees. Had Mr. Caithness come to me I would have suggested that he raise his funds through a Reg. D offering to accredited investors. He would have spent about the same as he anticipated (the offering budgets $20,000 for crowdfunding and related expenses) whereas the average cost of a Reg. A+ offering is in the neighborhood of $150,000 and much of that is for the lawyers.

Personally I think this offering might have been difficult to sell to accredited investors given that its business plan is weak. But if its Rebuilding Iraq.net website gets 200,000 views per month there would be a steady stream of non-accredited potential investors who are pre-disposed to the idea that Iraq needs rebuilding and might put a few shares in their shopping cart, even though they would actually be investing in a US domestic oil producer.

And that is really the point. Since there is neither a competent securities attorney nor broker/ dealer involved with this offering it is up to the individual investors to investigate this offering and make their own decision. No one has vetted this offering and no one can say whether every material fact is disclosed or accurate. The crowdfunding industry needs to stop deluding itself into thinking that small investors can actually perform due diligence.

Given the internal inconsistencies and inaccuracies, the failure to disclose the names of the Board of Directors and the fact that this was a DIY Reg. A+ offering I would have expected a little more scrutiny by the SEC’s Division of Corporate Finance before it was approved. But that no longer matters.

I know that about two dozen senior staffers at the SEC receive this blog through Linked-in, as do people at FINRA and the offices of state securities administrators in more than a dozen states. I know that people in a few Congressional offices that have oversight on the SEC and crowdfunding receive it as well. This one is a no-brainer.

From the company’s own press releases it is obvious that the information being disseminated to prospective investors in the offering circular does not reflect the current state of the company’s affairs. If a cease, desist and disclose order is not appropriate here, I cannot imagine that it will ever be appropriate anywhere.

I am older than most of my readers. I was around and litigated matters involving Stratton Oakmont and before them Blinder, Robinson and First Jersey Securities, so I think I have a pretty good idea of what a micro-cap fraud looks like. I was not certain that I was looking at one here until I got to the press release about the potential for 20 new producing oil wells. There have been quite a few micro-cap frauds involving oil stocks over the years. Mr. Caithness and his partner are registering a lot of their own stock. My gut tells me that there will be an enforcement action here sooner or later.

I am not a whistle blower. I know a lot of lawyers and others who are trying to navigate the Reg. A+ waters specifically because they believe that more companies need access to capital and that smaller offerings should be open to smaller investors. Their hard work will go for naught if the investors are drawn into scam after scam.

I am not the world’s biggest fan of government regulators. But if you want the fire department to show up and put out a fire, you need to scream FIRE at the top of your lungs. That is really all that I am trying to do.  I am optimistic that some securities regulator will hear me. There have already been far too many examples of fraudulent Reg. A+ offerings that the crowdfunding industry does not want to talk about.  Here is an opportunity for the SEC to re-enforce the need for compliance with the rules. Investors should be able to look at an offering circular and at the very least get accurate disclosures of all of the facts.

 

Classifying Crypto-Currency

Is a Bitcoin a currency or a security?

This is a question that may interest only a small number of geeks and lawyers, but there is a lot of money already in the crypto-currency market and a lot more on the sidelines waiting to jump in if this question is answered satisfactorily.

The key concern is regulation especially if crypto-currencies are ruled to be securities. The securities markets are regulated in virtually every country and the penalties for issuing securities without following those regulations can be severe.

The history of crypto-currencies traces back to Bitcoins which were introduced in Japan in 2009. The coder who introduced them wanted Bitcoins to be considered to be a currency and used as such, hence the name “coins”.  Had he called them “Bitcode” many of the questions about what they are might never have been asked. At the same time much the market for Bitcoins might not have developed.

Part of the allure of crypto-currencies is the fact that some people see them as part of an alternative financial universe. These people seem to believe that crypto-currencies are part of a trend to replace traditional banks and banking.

Bitcoins store value and are a medium to exchange value,which are two prime attributes of currencies.  But having attributes of currencies does not make them currencies.  That point seems lost on many of the people who are insistent that Bitcoins and similar crypto-currencies are currencies. They are not.

Historically, most people who hated fiat currency preferred to use precious metals such as gold or silver for trade, although other commodities, most notably salt have been used over the centuries. But the simple fact is that fiat currencies work because they are almost universally accepted.

Proponents of crypto-currencies argue that they are becoming more and more accepted and that acceptance will increase.  But accepting crypto-currencies as an exchange of value will not make them currencies in the strictest sense. Salt, after all is just salt, no matter how it is used.

If we accept the fact that Bitcoins were mislabeled to give them the appearance that they were currency that is “mined” and kept in electronic “wallets” strictly is a marketing ploy we can free our thoughts for the real issue; are crypto-currencies a security?

The US Securities and Exchange Commission (SEC) has issued several Investor Alerts warning people to avoid investments and especially Ponzi Schemes that are funded by or which purchase Bitcoins and other crypto-currencies.  But the SEC has not come out and said the coins themselves are securities and that is significant.

The SEC has statutory jurisdiction over securities and the securities markets but not all investments are securities. Your home, for example, or other real estate can be a good investment, but is not a security. The same is true of gold bars or bullion; works of art or collectables and all commodities that trade on commodity exchanges.  All are investments, just not securities or the SEC’s problem.

I wrote a blog article about Bitcoins a few weeks back that got a lot more views than most of my articles because crypto-currency is a very hot topic. Several people forwarded legal opinions to me that specifically addressed the issue of whether or not crypto-currencies were a security.  Several of those legal opinions were written by excellent lawyers at excellent law firms. I was not really surprised to see that they reached opposite conclusions; some thought the coins were securities; some thought they were not.

Each of the opinions was interpreting one US Supreme Court case, SEC v. Howey, which basically defines a security as the “investment of money in a common enterprise with an expectation of profits predominantly from the efforts of others.” Law school students studying securities law spend a considerable amount of time with this case and later cases that applied it.  Any legal opinion asking the question “is this a security” will certainly review Howey and apply its reasoning to the facts at hand.

Personally, I do not think that the Howey test applies to crypto-currencies at all.

Let me take a step back and re-frame the question. If a crypto-currency is not a security, what is it?  I think that if a crypto-currency is clearly something other than a security, especially if it is something already regulated under different statutes, it should go a long way to settling the question. So what, exactly, are we dealing with?

Any crypto-currency is nothing more or less than multiple lines of computer code; a long string of ones and zeros.  Computer code is recognized by law as intellectual property which can be copyrighted and is covered by a substantial body of law both in the US and internationally. No one classifies computer code as a security.

The shares of Microsoft Corp. are a security, not the operating system that it sells. That distinction is why I believe that the coins themselves are not a security.

The last time that I heard so many securities lawyers asking the question “is this investment a security” was in the late 1970s.   At that time the marginal tax rate on the highest earners in the US was 50%-70%. If you earned over a certain amount you would pay one-half of the overage to the IRS.  Perhaps not surprisingly, there seemed to be a lot of doctors, business owners and entertainers with this problem.

An industry grew up to provide this group with a series of “tax sheltered” investments.  These transactions were intended to take advantage of IRS rules that provided tax credits and accelerated depreciation when certain physical items were purchased in a business context.  To qualify for the favorable tax treatment, the item purchased had to have a business purpose, be placed in service during the calendar year and not be a security.

In many cases leverage was employed. A doctor would put down $20,000 and sign an $80,000 non-recourse note for the item.  If the tax credit was 50% of the purchase price, then the doctor would save $50,000 from his tax bill for his $20,000 investment; more in subsequent years when he depreciated the value of his $100,000 item over time.

One of the more famous of these tax shelters was a company that sold lithographic masters of artwork from famous artists.  If you bought the master that had been created by an artist such as Andy Warhol, you might make 500 prints from the master before it wore out. If you could sell the lithographs for $200 a piece you could pay back your note, recoup your $20,000 down payment and still save $50,000 on your taxes.

If you sold those lithographs over a period of years, the price might fluctuate. A Warhol lithograph would likely at least retain its value and it could be exchanged for other works of art if you dealt with the right gallery or broker. That did not make the lithographs into a currency even though they had these key attributes of a currency.

Most of these investment programs came with an opinion letter written by a securities attorney that attested to the fact that selling a physical “item” did not involve the sale of securities because the sale did not satisfy the Howey test.  I wrote a few of those opinion letters back in the day because the law was pretty clear that a “thing” was not a security. As far as I can remember the SEC never brought a regulatory action against one of these investment programs taking the position that the items were securities.

The IRS did, however, take issue with a number of these tax sheltered investment programs. They disallowed the credits and deductions that the programs offered and ultimately changed its rules to close the loopholes.  The IRS is not bound to legal opinions and frequently judges the tax treatment of any investment long after the investment is made.

A key issue was whether you were buying a thing or a business. The same is true today. A coin offering might be a security if the coin owner receives a portion of the profits of that company when they purchase the coin.

The SEC is not bound by a legal opinion on the question “is this a security “.  As I said I read several opinions regarding crypto-currencies that went both ways, albeit on slightly different facts. What I did find surprising is that none of the opinion letters that I read, mentioned the fact that the IRS categorized crypto-currency tokens as “property”, not a “security” back in 2014.

The IRS’s classification is also not binding on the SEC.  But given the fact that the IRS had made this determination that the sale of a crypto-currency would be treated as property for tax purposes and the US Copyright Office will issue a copyright on computer code (but not on a stock certificate) I think any legal opinion regarding the classification of a crypto-currency under securities law should mention both.

Several of these opinions were rendered in connection with specific Initial Coin Offerings (ICO). Again this term is intended to create the look and feel of an initial public stock offering (IPO).  This is marketing and it is intended to create the impression (falsely) that an ICO is just like the offering of a security. Of course, if the SEC should assert that these ICOs were actually selling securities because they had the look and feel of securities and attempt to sanction the people behind them, these same people would be screaming that they did no such thing.

In most of the offerings that I reviewed, buying a coin in the ICO neither conferred ownership of the project nor did it promise any payments, so it would not be difficult to opine that all you were getting was a digital coin, not a security. If coin purchasers receive anything other than just the digital coin, then the issue gets murky.  Given that there have already been close to 1000 coin offerings, some very different from others, it can get very murky.

Just to be clear, this article is my opinion of a fairly new legal issue. It is not intended to be specific legal advice as regards one coin offering or another.

If someone came to me with a proposed ICO and sought my opinion I would probably counsel them as follows, just to keep them out of potential legal difficulty.

1) If you intend to use the proceeds of your coin offering to fund your new business then call the coins what they are: “Great New Tech Company Start-up Commemorative Digital Medallions”. This is just truth in packaging. Why call them coins or currency when they are not?

2) Account for the sale proceeds on your books as if you were selling any intellectual property.  If you wrote and sold a book about writing computer code and used the proceeds to fund your code writing business, you would not enter the sale proceeds on your books as an investment.

3) Go about your business and stay under the radar. There are certainly regulators who believe that the whole idea of crypto-currency is a scam.  At the same time, it does not seem to be difficult to raise money using these digital coins. There are multiple reports of multi-million dollar raises being accomplished within hours.  I can see no reason why anyone trying to raise money in this market would write numerous articles or give interviews bashing banks or Wall Street firms or proclaiming crypto-currencies as the new form of unregulated capitalism.  The best way to attract regulators is often to publicize how much money you are making in an “unregulated” business.

If you do want a formal legal opinion letter that your ICO is not the offering of securities, I would be happy to review the facts and prepare one for you. I probably charge a little less than the big Wall Street law firms.  I know that you will understand that I will need to be paid in US dollars not whatever coin you are issuing.  I cannot use your coins at the market, gas station or movies and it is probably going to be a long, long time before I can.