Month: May 2017

Crowdfunding Myths and Realities

Capital Markets, Investors, Issuers , , , ,

I speak with people about crowdfunding every week. I learn a lot from others. But there is a lot of bad information about crowdfunding in the marketplace. Most of it comes from the mouths or keyboards of people who claim to be crowdfunding experts but lack a clear perspective of what equity crowdfunding is and how it should operate.  To make up for their deficiencies, these experts often pontificate about crowdfunding and disparage the capital market of which crowdfunding is a tiny, though useful backwater.

I have heard or read every one of the following statements about crowdfunding uttered by people who claim to be crowdfunding “experts.”  I have included my explanation of empirical reality after each one.  If you attend a crowdfunding conference and hear any one of these statements, ask for your money back.

1) “Wall Street is evil”

Reality:  I have probably seen more bad actors in the mainstream financial markets than most people.  I worked on close to 2000 arbitration claims brought by unhappy and defrauded investors against mainstream financial firms.  I wrote a book about the many things that Wall Street does wrong, so yes there are indeed bad actors in the mainstream financial markets.

But those markets also fund local governments, schools, roads and hospitals. The mainstream markets funded Apple and Microsoft, companies that developed life saving drugs, allowed a lot of people to buy homes and financed almost all of the innovative technologies that we take for granted.  Trillions of dollars worth of transactions take place every week in the mainstream capital markets. The overwhelming majority of those transactions settle without complaint or any reason for concern.

2) “Wall Street freezes out new businesses that deserve to get funding”

Reality: The key word here is “deserve.” Entrepreneurship has always been a core American value. A lot of entrepreneurs are passionate about their businesses.  But passion only gets you so far.  A lot of entrepreneurs fail because they do not have a good business plan, a good team or a good sense of what their market really wants.

Billions of dollars flow to new businesses every year.  There is actually more money available for small business in the US today than ever before and it is a lot easier to reach. The Small Business Administration (SBA) continues to make loans and groups like AngelList have made venture capital available where it was previously very hard to find.

3) “Crowdfunding democratizes the marketplace; it lets the little guy invest in great companies that were only available to wealthy investors”.

Reality: Most of the companies on crowdfunding websites have been or would be passed over by VCs and professional Angel investors. That money is cheaper to obtain and often comes with management and other assistance.  For many companies crowdfunding for capital is a last resort, not a first choice.  There are some good companies on crowdfunding websites, but the bulk would never be considered to be “great” by any standard and all come with a very high likelihood that investors will lose their money.

4) “People are being kept out of start-up investing and cannot profit from investing in the next Facebook”

Reality:  Show me the company listed on any crowdfunding platform that has the potential of becoming the next Facebook.  Facebook did not crowdfund for money and no crowdfunded company has approximated Facebook’s success.  It may happen or it may never happen.  Facebook, and Apple and others, all had IPOs which were open to all investors.  If there is a Facebook lurking on a crowdfunding website, it is currently hidden among a lot of offerings that I believe are absolute crap.

5) “Millions of people would invest in crowdfunding if they understood it and they eventually will”

Reality:  This argument is usually used to convince people that the crowdfunding market will explode when people get the hang of it.  More than one crowdfunding “expert” has suggested that these regulations would open the crowdfunding market to as many as 220 million people in the US.  This, of course, ignores the fact that roughly 50% of US households live at or below the poverty line or are living paycheck to paycheck.

Yes, there is still a lot of disposable income in the US. The lines at Disneyland always seem to be long and the hotels in Las Vegas are perpetually full.  Both Disneyland and Las Vegas are selling instant gratification. Equity crowdfunding sites are not. The most successful crowdfunding sites are offering real estate to accredited investors seeking steady, passive income.  That is likely to continue.

6) “The crowd can discern good companies from bad ones”

Reality:  This is simply not true. Investors in the mainstream markets often depend on research analysts to parse through the financial and other information that companies present.  I have worked with investors for 40 years.  Most could not pass  the second mid-term exam that I used to give my freshman economics class. Most of the crowdfunding “experts” could not pass it either.

Even if the crowd spots a bad offering, there is no mechanism built in that would allow them to say so.  No portal has a place has a “comments” section next to any offering, nor would they be expected to have one.

7) “Due diligence is not necessary”

Reality:  I saw this statement in the very first article I ever read about crowdfunding. It was written by an attorney who claimed to be a crowdfunding “expert” and who wrote article after article on the subject although his resume indicated that he had never actually represented an issuer of securities or a broker/dealer.

Due diligence is how the platform or portal prevents the issuer from committing securities fraud.  There are good people who provide due diligence for the crowdfunding industry but there are many platforms and portals who do not even try to verify the claims that the issuers are making to investors. Due diligence protects the investors and it protects the platform or portal.

8) “There is very little fraud in crowdfunding”

Reality:  There have been only a handful of regulatory enforcement actions in the crowdfunding arena but more are clearly on the way.  Regulators use these actions to send a message about expected and aberrant behavior that the crowdfunding industry continues to ignore.

Some of the biggest lies that you will find on crowdfunding platforms concern the valuation and prospects of the business being funded.  I have seen start-ups with no sales and less than $1 million in development expenses value themselves at $20 million or more based upon sales projections of hundreds of thousands of units of a product that does not yet exist.  FINRA has already raised this issue, but the crowdfunding “experts” do not seem to want to address it.

Within the last few weeks, I saw one offering where an executive conveniently left out that he had twice been sanctioned for stock fraud, as if that fact would not be of concern to potential investors.  I recently reviewed a Reg. A offering that was structured like a classic pump and dump scheme and will probably turn into one.

It is not that there is not fraud or the potential for fraud in this market. The crowdfunding “experts” do not know it when they see it.

9) “Government rules make crowdfunding difficult”

Reality: The government rules make crowdfunding possible.  Several real estate funds have raised $25-$50 million and more using basic crowdfunding techniques and there are crowdfunding websites dedicated to films and entertainment that do not seem to be at a loss for investors. The problem is not the rules. The problem is that a lot of the “experts” do not know how to work with them. Those who do have no problem raising money in this market, but true experts are few and far between and compliance with the rules is sporadic at best.

10) “Investors understand that they will probably lose their money so none of this is important”

Reality:  Every new issue of securities, especially those being offered under Regulation D, will include the disclosure “These securities are a speculative investment.  Investors should be aware that they may lose all of the funds that they are investing.”  This is especially true given that most start-ups will fail.

But it is not a sustainable business model for the crowdfunding industry to blithely accept the fact that all investors will lose money. Several crowdfunding sites (most notably MicroVentures and WealthForge) spend a considerable effort vetting companies and are trying to list only the best companies on their sites.  If I were raising money through crowdfunding, those are the sites on which I would want to list my offering.  If I was considering investing in a crowdfunded offering, that is where I would want to spend my money.

Compare that with the statement recently made by an SEC Commissioner to the effect that there appears to be a “race to the bottom” in terms of listing crappy deals on many crowdfunding sites.  This market will become efficient when every company that lists its offering on a site gets the funding it seeks. It will only happen when the patently bad companies are weeded out. That will only happen when the patently bad platforms and portals are weeded out, either by competition or government action.

11) “Equity crowdfunding is disruptive”

Reality:  Crowdfunding may ultimately change the way in which some firms are financed but not in the way that a lot of people seem to think. The Wall Street firms are already positioning themselves to get into this market because it obviates the need to pay commissions to sales people.  Commissions have been on the way out since the 1970s, a trend that has been spurred on by the internet. Crowdfunding is just one more step on the ladder to lower and lower commissions.

It is much more likely that the Wall Street firms will take over the crowdfunding market than the crowdfunding market will supplant the Wall Street firms.  It is, in fact, already happening. I would not be surprised if Goldman Sachs, (some people’s idea of a financial Satan, see # 1, above) is already positioning itself to enter this market.

12) “Equity crowdfunding is new. The problems are just growing pains”

Reality:  Equity crowdfunding is the business of selling securities. There is nothing new about it.  Selling securities over the internet without using a traditional underwriter has been around for almost 20 years. The JOBS Act opened the door for people who are untrained and not knowledgeable about securities to sell them. These people are having growing pains, not crowdfunding. Many untrained people are making money for themselves at the expense of the issuers and investors.

All it takes to enter the crowdfunding market is to set up a platform which is relatively inexpensive and begin to solicit companies to list on it. Owning a platform or portal can be a lucrative business.  As this industry grows there should be a huge opportunity for skilled finance professionals and securities lawyers.

If you are a considering selling shares in your company by crowdfunding look for a platform that has people with experience in finance or the mainstream capital markets.  If the platform’s advertisements include any of the dozen statements highlighted above, pass them by.

 

The Cold Hard Truth About Funding Start-ups

Capital Markets, Issuers , , , , ,

Contrary to what a lot of people seem to believe, it is not that difficult to fund a start-up. Funding a start-up is a process.  It requires a plan and time, effort and money to execute the plan.  The process varies depending upon where you intend to procure the funds. That decision is most often determined by what sources of funding are or are not available .

More often than not the availability of funds depends upon the attributes of the company being funded.  Who you are, how far along your company is and the realistic chances for success are usually the determining factors.

If you believe the blather that successful start-ups must disrupt an existing market or must solve a problem that the market may not know it has, you are making it harder for yourself, not easier. Lenders want the loan principal returned with interest and investors want their capital returned and a return on their investment. You need to adopt that mindset if you want to attract funds.

A great many small businesses receive funds from the Small Business Administration (SBA) which has been making loans to start-ups and small businesses for decades. Like most lenders the SBA wants collateral for the loan and will review your business plan to satisfy itself that you will have the cash flow to make the payments.

The SBA will assist in the process and provides mentoring for businesses before they apply. There are also private SBA loan brokers in every major city in the US. Not every small business qualifies, but many of the SBA loan brokers will provide guidance and assistance if the company is close to the qualifying line.

Venture capital funds (VC) or angel investor groups seem to be the choice for most start-ups. VC’s can provide management and other assistance in addition to funding. The bulk of venture capital money goes into second round financing and many of the funds specialize in tech or bio-tech companies only.

Most venture funds are willing to take a calculated risk on young companies. That calculation includes their ability to recoup their funds with some type of post financing liquidity transaction, like a merger or IPO.  Consequently, a great many companies do not qualify.  In truth, VC’s only fund a very limited number of smaller start-up companies every year.

There are far more companies that are chasing venture capital than there are venture capitalists. Consequently, the VCs usually get to fund the best companies they see.

The world is full of stories of companies that pitched dozens of VCs before they got funded and even more companies who repeatedly pitched VCs and never got funded. There are a great many books and consultants who will tell you how to make your pitch better but the truth may be that your company is just not as attractive as the others competing for the same funds.

I would hope that it would be obvious that it is easier to find funding for a company with a well thought out and well prepared business plan than a for a company whose business plan looks like it was written on a napkin by a couple of drunken frat boys.

Investors will certainly want to know if your product works, whether or not it can be sourced, whether or not people will purchase it and at what price.  You can show them with spreadsheets and marketing studies or you can start selling your product and generate some revenue.  An operating company should always be easier to finance than a company that needs funding to begin operations.

This flies in the face of the idea that all an entrepreneur need do is develop a minimum viable prototype (MVP) and then shop it around to venture capitalists. I have known a lot of VC’s over the years and almost all would tell me that they fund businesses not prototypes.

Investors also legitimately want to know exactly what you intend to do with the funds that they give to you. They also want you to use their money efficiently.

Several years back I met with a young code writer who was working at one of the larger Silicon Valley companies. He and a few of his co-workers had an idea for an APP. They wanted my help to raise $1 million so that they could quit their jobs and spend a year working on it full time.  Once the APP was developed and tested they would have had no money left for marketing and no one with any marketing experience to help them.

I suggested to him that it might easier to raise the money if their plan was to have the code for the APP written in India for a lot less and use the difference to package and promote the finished product. That way he and his cohorts could keep their day jobs and they would have a sufficient monies to hire a real marketing pro to help sell the product once it was developed.

I might as well have suggested that they enlist in the Army. They wanted the entrepreneurial experience paid for by someone else.  A good VC will see through that attitude and as far as I know that particular group never got the funds they were seeking.

Crowdfunding`is the financing tool that is the foundation for my belief that funding any start-up is not that difficult. If you follow this blog you certainly know that I continue to be concerned about the absolute disregard for investors in this market. But executed correctly, a good crowdfunding campaign should obtain the funds it seeks almost every time.

I recently had a beer with a long time friend is a lot more cynical than I am.  His thought was that since you could fool some of the people some of the time, I should just embrace that fact and come around to the thinking that any start-up could get funded if it spent enough money advertising its offering in the right way.

My friend was thinking that a good advertising company could put lipstick on any “pig” of an offering and sell it to investors on a crowdfunding website because most investors in this market really had no idea what they were doing.  While I personally decline to assist bad companies looking for capital, many in the crowdfunding market will simply list any company that shows up on their website.

I have a little experience in advertising and a lot of respect for people who do it well.  Selling securities usually takes a different approach than selling a product but my friend was thinking in more generic terms.  The point here is that selling securities is often referred to as a “numbers” game.

Advertising is about “eyeballs”.  If you want to sell shares in your company to 500 people, then a lot more than 500 people need to see your advertisements for the offering.

When someone comes to me with the desire to crowdfund an offering, I always recommend that a good marketing company is essential.  Several marketing companies that work in the crowdfunding market are careful to follow the rules. Many more are not.

Whether you are selling a loan package to the SBA or equity to a VC, angel or crowdfunding audience the operable word is sell.  Selling is not free. The old saying that it takes money to make money is true here as well. It takes money to raise money.

If you want to fund a new business you should be prepared to spend money for a professionally prepared presentation. I know a company that sent e-mails and their presentation to a list of one thousand VCs and Angels six times before one responded. They then flew cross country, made a presentation and got nothing.

With crowdfunding, I again recommend that you hire someone to prepare a professional presentation, a good lawyer to help you prepare the paperwork and budget enough money to drive potential investors to your offering. If you want to raise funds for your business, it will cost you money to do so.

I speak with a lot of people who essentially bootstrap their business until they are ready to bring it to market and then seek funding. Many are stymied because they are essentially broke at this point and do not have the resources to pay for lawyers, business plans, videos and a marketing campaign.

A lot of people wring their hands and feel sorry for this group. I,however, am not among them.  I believe that any company good enough to seek funding from strangers, should be able to borrow enough from family, friends, neighbors and college roommates to pay for a campaign to raise more funds.  If your Uncle Fred who has known you since childhood is not willing to invest in you, why should you think that my Uncle Fred or anyone else’s would?