The ICO Is Dead. Did The Lawyers Get The Telegram?

The ICO Is Dead

Rewind to 2018

I spent a good part of 2018 reading the white papers for hundreds of Initial Coin Offerings (ICOs). More than 1,000 ICOs were offered to investors around the world that year.

I admit that I was intrigued. Many of these offerings were targeting US investors from overseas.  This type of cross-border finance has always existed but it has always been on the margin of the US securities market. ICOs seemed to want to bring it into the mainstream.

Big companies outside the US could always deposit their shares with a bank or custodian and issue American Depository Receipt (ADRs) to US investors. Financial advisors often tell their clients to diversify a portion of their portfolio into overseas investments.

Some people thought that the tokens issued by these ICOs were an entirely new asset class. Others, myself included, saw that they were being sold as investments and if they could be traded or re-sold, they were just another security.

As I published a few articles on the subject of cryptocurrency, I started getting calls from lawyers around the country who wanted to hear my thoughts on whether the tokens were a security or not and where the line might be drawn. There is nothing unusual about that. Lawyers seek advice from each other all the time. The discussions about ICOs naturally revolved around the Howey decision.  

During this period there were a lot of articles on crypto websites that re-printed the basics of the Howey test and argued why this or that cryptocurrency did not pass it.  Some people argued that the Supreme Court’s decision from 1946 should not be applicable to the new technology.

There had been several US Supreme Court cases on the same subject subsequent to Howey and opinions from other appellate courts as well.  The ultimate question: “is this financing the sale of a security?”, has been considered time and again.

I researched the question extensively in the 1970s.  At that time the marginal US tax rate on the highest wage earners was 70%. At the same time the tax code was full of special credits and deductions as incentives for various types of activities.

Smart Lawyers & Tax Breaks

There was an industry populated by some of the smartest and best credentialed tax lawyers and CPAs who created transactions that took advantage of those incentives to help high earners get relief from their income tax liabilities.  The “products” were remarkably innovative.

One of the incentives was accelerated depreciation on various types of tangible assets.  Using leverage, you might buy a piece of machinery for $1,000,000, depreciate it to zero in 3 years, and pay it off in 10 years. If you put $100,000 down, you got the benefit of the depreciation on the entire purchase price early and depending on your income, you might reduce you tax liability to zero for 3 years.

Of course if you were a high earning doctor you were not likely to be operating the machinery which was a requirement to obtain the deductions.  Many of these tax shelter programs were packaged as “turnkey” operations which raised the question: “are you buying the machinery which can be depreciated or a business which cannot?”  The latter might mean that the transaction involved the sale of an “investment contract” and thus the question: “is this a security?”

I researched and wrote opinion letters that concluded that particular transactions were not investment contracts. The answer to this question, then and now, centered on the economic realities of the transaction.

Judgement Day

Last week a US District Court Judge in NY looked at that same question regarding the tokens issued in an ICO from a Russian company called Telegram. Telegram claims to have raised $1.7 billion through its ICO world-wide, with only a fraction of the investors located in the US. There was no dispute that Telegram was promising investors that they could profit from re-selling their tokens at a later date.

The ICO Is Dead

The Judge’s decision was well reasoned, hit all the points, and really surprised none of the lawyers that are interested in cryptocurrency or ICOs. The SEC brief was full of cases that it had successfully relied upon for years.

Some of the lawyers with whom I spoke in 2018 were writing the paperwork for ICO offerings. Several of the best were on the phone with the SEC staff discussing each offering because they appreciated that they had an obligation to keep their client within the regulatory white lines. That is something that Telegram, apparently, never wanted,

I read yesterday that Telegram intends to appeal the Judge’s order which is to be expected, but they are also, apparently, thinking about defying it.  The Judge has ordered them not to distribute their new tokens and they may do so any way.

Let’s be clear. Telegram did not need to take money from US investors in the first place. If they wanted to they could have followed the rules and registered the tokens or sold them under an exemption to accredited investors only. They chose not to.

In all probability they could have settled with the SEC early on by simply returning the money to the US investors, but they chose to fight the SEC instead.  Nothing in the Judge’s opinion was new law. The facts in this case were not in dispute.

I would have advised Telegram initially that they were issuing securities, had they asked. I think most securities lawyers would have agreed. The investors were going to profit from the efforts of others. That was the economic reality of the transaction.

Some lawyers apparently disagreed and gave Telegram the green light to make its offering in the US in the first place.  After reading the Judge’s decision I find that troubling. What case law were they reading? Will their opinion letters to Telegram on this subject become public as that case continues?

During this time there were some lawyers who publicly stated that SEC’s rules regarding the issuance of cryptocurrency were unclear. I tried to throw cold water on them at the time. If you cannot define a security, or know one when you see one, how can you hold yourself out as a securities lawyer?  

As I was writing this story over this weekend I exchanged comments on LinkedIn with a university Professor who is a fan of Telegram and its platform. He told me that Telegram has over 300 million users. He assured me that Telegram does not sell user information. He reminded me that its founder had refused a request from the Russian government for a backdoor into its system.  I asked him why he thought that any of that was true.

I reminded him that Telegram has never disclosed what it did with the $1.7 billion it raised. Telegram has never disclosed any financial information whatsoever. It may have raised more or less, it may sell user data and it may be in bed with the Russian government. Auditors have never seen its books or its operations. Telegram’s self-serving public statements have no more value than did Madoff’s public statements.

The real issue here should be that if Telegram issued securities, then it failed to give US investors any of the information to which they were entitled. That, of course, is fraud.

As I said, this type of cross-border financing intrigues me. Going forward I expect to help more and more companies from around the world successfully reach US investors. Some amount of creativity may be needed to make the “economic realities” of these transactions attractive to US investors. But there is a difference between creativity and fantasy. Good lawyers know the difference. If your client wants to test the boundaries of the system, they should do it with their own money, not funds taken from investors who were never given all the facts.

If you’d like to discuss this or anything related, then please contact me directly HERE

Or you can book a time to talk with me HERE

Robinhood- Robbing the Not So Rich

Robinhood

There is nothing like a stock market crash to shine a light on the bad actors in the market. Many of the people who will be exposed will be out and out scam artists. Some of those scams will have been sold thorough mainstream brokerage firms that refuse to spend what it take to actually investigate what they sell.

Many more investors will lose money because the mainstream stockbrokerage firms will continue to offer investors conflicted or unsupported advice.  Investors are being told to “stay the course” and stay invested as the market is sliding to an inevitable bottom, perhaps a year away. 

Investors who lose money will file arbitration claims against their brokers to recover those losses, just as they did after the crash in 2001 and 2009. This time around they will be joined by many customers of online firms who lost money because those firms failed to operate properly. This is something that has not happened very much in almost 20 years.

Wall Street

I started on Wall Street in 1975 as the NYSE, Federal Reserve and the brokerage firms were changing over to large mainframe computers from the legacy hand written orders and record keeping.  There was a lot of skepticism at the time as to whether the computers could carry the load.  The SEC mandated that duplicate paper records be kept for several years just in case of an outage. 

The market crash in 1987 was the first significant correction where the market was wholly computerized.  Before you draw similarities between 1987 and what occurred in the markets last week, remember that the internet was still not widely accessible. The vast amount of information that is available today was not available in 1987.

The Black Monday crash was certainly exacerbated if not caused by computerized, program trading.  Program traders were using computers to analyze the data they had faster than others and then use that data to get in and out of the market before other traders caught up. As a result of Black Monday, the NYSE instituted circuit breakers which, until last week, had only been triggered once or twice since 1987.

When the market crashes, customers want to know what is going on and they want to know immediately.  This fact should not surprise anyone! Nor should it surprise anyone that securities industry regulators have always taken notice when the customers could not access their brokers or accounts.

The year 1975 was also the year that Wall Street did away with “fixed” commissions and unbundled its two primary customer services of advice and execution.  This was the birth of the discount stock brokerage firm and the DIY investor.  By 1987, Schwab and the other discount firms had millions of customers.

Stockbroker?

If you still had a stock broker on Black Monday you had someone to talk to. I know many brokers who were returning calls well into the evening on that day. If you used a discount firm, you had to go to their office to access your account and find out what was going on. Many people did just that.

There was a story that went around a day or two after the crash in 1987. When people at one of the discount brokerage houses could not get through on the telephone to place an order, they showed up, en masse at their local office. The story went that there was such a crowd of panicked customers trying to get into one office, that one of the employees was lying on the floor in the break-room in a fetal position. 

When it was all over the SEC recommended that discount firms beef up their call centers to handle the overload as trading volume was steadily increasing.  Today, most of the large discount firms have local offices supported by call centers.  Complaints that “no one picked up” are rare.  

Trading

About 10 years later, as the internet made trading from home possible, a lot of people took up the challenge and became “day traders”.  Discount firms were opening more accounts than they could handle as the computers they had maxed out.  The problem was noticeable.

Robinhood

I went to a conference to hear a representative of the SEC speak to this issue of customer capacity.  He told the crowd that “you can only fit so many people in RFK Stadium”.  His message was clear, if you don’t have the capacity to service the customers, don’t take them on.  No one in the audience was surprised.  Since 2000, complaints about lack of computer capacity have been rare as well. 

Which brings us to Robinhood Financial, a brokerage firm that claims 10 million distinct customers. Many of its customers are younger, first time investors. 

Robinhood

Robinhood’s site crashed multiple times last week, as the market see-sawed and volume grew. Individual customers were locked out of their accounts during several periods of exceptional volatility.   If you cannot access your account you are not going to be able to lock in gains or avoid losses. You are likely to lose money that you did not intend to lose. 

Apparently no one told the owners of Robinhood that this is not supposed to happen.  They were not part of the brokerage industry in 1987 or in the late 1990s as the industry heeded the regulators’ advice and bolstered their systems and capacity. 

In point of fact it appears the owners of Robinhood have no real experience operating a brokerage firm. They are techies by training and experience and apparently not very good ones.

Robinhood’s website boasts the following: “We are a team of engineers and designers, and we hold the products we craft to the highest standard. We believe that exceptionally engineered systems — not marble office buildings on Wall St — are the cornerstones of establishing trust.”  If you want an example of false advertising, there it is.

Robinhood Financial, like all brokerage firms is a member of FINRA.  It says so right in the fine print on the bottom of its website.  With membership in FINRA should come an understanding that all customers will have access and the ability to place trades in their account whenever the market is open. 

Also in the fine print is this disclaimer:  “Investors should be aware that system response, execution price, speed, liquidity, market data, and account access times are affected by many factors, including market volatility, size and type of order, market conditions, system performance, and other factors.”

Being a member of FINRA and disclosing that your system can be “affected” by a variety of extraneous factors should be mutually exclusive.  System failures are not acceptable in the brokerage industry any more than a software glitch would be acceptable in the operating system of a heart/lung machine. 

Robinhood has previously demonstrated that its management does not understand the stockbrokerage business that it operates in. At the end of 2018, Robinhood announced that it would launch “checking and savings account” that would be covered by SIPC insurance, except that it wasn’t.  The account was supposed to pay out substantially more than any bank savings account except it was never disclosed where that extra income would come from.

No professional brokerage industry compliance officer would have allowed that product to get close to launching. Apparently, no professional compliance officer works at Robinhood Financial.

More recently, FINRA fined Robinhood for directing its customers’ orders only to firms that paid Robinhood for the order flow. FINRA allows for the payments, but it requires the firm to direct the orders to those firms that give customers the best execution price.

FINRA noted that Robinhood’s systems were not set up to follow this basic industry wide rule. FINRA fined Robinhood $1.25 million. All of this begs the question, what other basic industry rules don’t they follow.

Robinhood’s claim to fame is that it does not charge any commission to its customers.   Robinhood executes through a clearing firm and there is no indication that that firm is not charging Robinhood for each trade. It is also clear that the clearing firm did not break down last week. All the problems noted were with Robinhood’s system.

Robinhood has taken in over $900 million from VC investors.  That VC funding allows Robinhood to claim a “valuation” of over $7 billion.  I suspect that some of that money is going to pay for clearing those trades.

Seriously, can a stockbrokerage firm be worth over $7 billion if all it has is software and that software does not work up to industry standards? Can it ever be profitable if it charges it customers nothing? Any profit it might have derived from financing margin loans likely vanished last week as most of those loans were certainly called as the market crashed.

Maybe next time Robinhood’s system will be down for a week or longer.  In a fast moving market the losses could be in the billions. Some regulator needs to look behind the curtain here before 10 million angry customers start calling their Congressperson screaming. At that point it can get really ugly. 

Fintech has become a buzz word for technology that makes the customer experience in finance better and cheaper. VCs pumped $900 million into Robinhood and came out with product that is clearly defective. Technology can improve a lot of things, but applying it to a regulated industry you know nothing about is a recipe for failure and a colossal waste of money.  

If you’d like to discuss this or anything related, then please contact me directly HERE

Or you can book a time to talk with me HERE

Investing for a Global Pandemic

Investing for a Global Pandemic

I have a better than average understanding of investing and the capital markets, but I never give investment advice nor do I tout individual stocks.   I do listen to what others think and I pay attention to who is investing in what. I read a lot of articles and research reports every day and I frequently speak with professional investors and advisors.  

Correction or Crash

Last week’s market correction was the 7th or 8th I have been through since I began on Wall Street in the 1970s. No two were exactly alike. I learned a few things each time. 

No one can accurately predict where the DJIA will be in 30 days or 60. That has always been true; but the underlying cause of this correction, the portent of a global pandemic, adds some unique variables. 

I know this article will likely just get lost in the blizzard of financial content that a 3,500 point drop in the Dow will generate. Still, the opportunity to take a stab at “Investing for a Global Pandemic” was just too good for me to pass up. 

I already know the advice that customers of the large wire houses will get. They will be told not to panic, but rather that it is always best to hold for the long term. They will be told that the market always comes back so there is no need for them to liquidate anything.   

That advice is nothing more than an uneducated coin flip. Professionals who are paid to help people invest should be able to do much better than that.

Even worse, that advice is conflicted. Financial firms know to the dollar the cost of acquiring new customers. They do not want existing customers to cash out and potentially move away.  Advising the customers to “stay the course”, strongly implies “stay with us”.

Shares owned by customers can also be used to collateralize the aggregate borrowing that the large firms must do to finance the margin debt held by their customers. The margin rate “spread” goes right to the firms’ bottom line.

“Always hold for the long term”

The “always hold for the long term” strategy is also designed to cover up the fact that much of what passes for financial advice is just wrong. Many customers have portfolios using “asset allocation” which was supposed to contain “non-correlated” assets to hedge against catastrophic losses and yet their balances are down substantially.    

Many customers will be looking at their account balances and wondering what happened. This is especially true as this is tax time, when many people will have their year-end 2019 statements in hand as they prepare their tax returns.

The “big lie” of course will be that no one could have predicted this correction would happen. The brokers will claim that they saw nothing that might make them want to suggest to their customers that they might consider actually realizing the profits they have accumulated during this long bull run.

The underlying economic conditions are still good. Interest rates are still low and employment is still high.  Still, a lot of people have predicted a correction because the primary market indicator, the overall price/equity ratio has been way out of its normal range for some time. Even after last week the P/E for the S&P 500 it is still high.  It should eventually be expected to revert to its normal range even if everything had remained “normal”. With the reality of reduced profits next quarter and next year because of the pandemic I can find nothing to support the idea that the market will be higher next year.

There are always external events that can traumatize the market. One good blizzard or hurricane can cause billions in lost sales across wide regions of the US. The US frequently gets more than one blizzard and hurricane each year. 

There is always political discord or a war somewhere. Unions have gone on strike and closed industries and ports for months. There is always a fair amount of news about events that can and do disrupt markets.  Still, the markets survive.  A global pandemic, however, conjures up the image of the potential for a truly mass disruption.

Governments

The world spent several weeks watching people trapped on cruise ships being quarantined while the virus spread. Cruise ship passengers tend to be middle class and their plight was clearly noticed by the middle class investors many of whom no longer saw the wisdom of holding cruise line shares in their portfolios.

I certainly noticed how poor the reaction was of the various government agencies involved. The Japanese, by leaving infected passengers on board the cruise ship and in proximity to uninfected passengers did not contain the virus very well. The Chinese were filmed adding thousands of hospital beds when the story everyone wanted to hear was that they had effectively contained the virus, not that they were expecting thousands more to get sick.  

The governments of several hot spots of the infection around the world have been accused of under-reporting the number of infections and deaths. The corker was the US government which flew several infected passengers to an air force base in Solano County in California only to have people off the base become infected very quickly.

Is it improper of me to expect that modern governments in the 21st Century should respond differently to a pandemic than the characters in Monty Python who wheeled a wagon around a plague-ridden medieval town singing “Bring out your dead”? 

Good, Bad or Really Bad?

From the standpoint of the stock market the question may not be how bad this crisis gets, but how long it lasts. The next 10 weeks are likely to tell the tale. If not contained by then, with the number of new cases significantly down from their peak, the DJIA may truly reflect an apocalypse. 

The virus might be contained and crisis might be downsized by May. The market might have resumed its climb with new highs by then.  Japan Airlines might be adding extra flights for the overbooked Olympics in August.  But right now, that is not the way people are likely to bet. If they do not think that will happen, there is no reason for them to stay in the stock market.

If the Olympics are postponed or cancelled, it will mean that containment is not in the offing. The number of people infected by then will be significant and the fear widespread.

The crisis will hit the US hard when people stop going to restaurants, sporting events, super markets and malls. Recessions start when waiters get laid off and cannot pay their rent. Given that so much of what is manufactured and sold in the US relies upon parts made elsewhere, a slowdown, at the very least, seems inevitable.

Stock Picker

If I had to pick out stocks to invest in right now I would think that a good recession would be positive for companies that sell alcohol or cannabis. If Americans can’t work, it is a safe bet that some will be on their couches with a joint, a six pack or both.  

Investing for a Global Pandemic

For serious investors the drop in the DJIA and the market in general has lowered the price and increased the yield of a lot of stocks of good companies that pay a steady dividend. Buy some this week and if the market continues to crash you buy more and average down.

I am not really expecting a pandemic that will kill millions of people, but it would not be the first time. And, given that we live in an interconnected global marketplace, a much smaller event could still have devastating economic consequences. 

The fact that there is so much discussion about this spreading virus and that its impact could be huge, is scary in and of itself. That alone is not good news for anyone still holding stocks which is roughly ½ of the households in the US.

The real story should be the very pedestrian and ineffective steps taken in the US that might contain it. When action is needed right now the worst thing that the government can do is fail to act even if the actions it does take are the wrong ones. This government, our government, has been remarkably slow to act.

If you’d like to discuss this or anything related, then please contact me directly HERE

Or you can book a time to talk with me HERE

I Would Gladly Pay You Tuesday

I would gladly pay you

I have been self employed for a long time.  In some regards, I am a founding member of the gig economy. I have worked on thousands of different projects and cases where I was brought in to lend my talents and experience to a team of other professionals. Along the way I have been fortunate to have worked with many people from whom I learned a great deal.

I never advertised other than publishing an article or two. My business grew as my reputation grew. A majority of my new clients were referred to me, often by other lawyers who I had never met. Referrals are still the source of most of my business.       

Equity Crowdfunding

I am currently helping companies raise money using equity crowdfunding. Writing the paperwork for a securities offering is relatively easy for me. I try to put in the time and take care to give every client the advice that they need. 

I keep busy because equity crowdfunding has become less expensive.  More and more companies appreciate the fact that they can raise capital on better terms than are available at any bank.

Equity crowdfunding is inexpensive, but it not free. If you intend do it correctly you need a good lawyer to advise you and to prepare your offering paperwork. You also need a good marketing company to differentiate your offering from the many others that are out there and to get a lot of prospective investors to see it.  

Free or Pay Later?

I have been getting more and more calls from people who want to hire me, but not pay me. Some of the people who call me are just trying to figure out what an offering will cost them to raise the funds that they need. I am happy to quote a fixed fee for most crowdfunded offerings which seems to be well received. 

Some people want me to take shares in their offering as payment. I tell them, politely, that I like to choose my own investments. I suggest that if their company is really having a problem raising cash they should take the shares they are offering to me and sell them to their uncle or family friend and just pay my fee. The fact that they are raising capital and are anticipating an influx of cash should make those shares attractive to someone. 

“You mean I have to do a seed round to in order to pay for the financing round?”  A lot of people seem to go through the funds they raised in their seed round to create an MVP and then run out of cash. Not planning on the costs of a second round when you raise your seed round is a mistake many start-ups make.

I would gladly pay you

Then there are those companies that want me to wait for my fee until after they raise the money. They see this as some sort of guarantee that I think their raise will be successful.

With crowdfunding, because there is no stockbroker, it is not unusual for prospective investors to ask to speak with the entrepreneur on the phone. Not every entrepreneur is a great salesperson. “What if your campaign yields a lot of potential investors and you can’t close them?” I ask. “Is that a risk I should take?”  

There are also those who seek a discount on the fee and promise me a “fat” monthly retainer thereafter. I question why they would not want to see the quality of my work on the offering documents before they hired me for the long term.

I speak with a lot of securities lawyers and marketing companies working in crowdfunding and many have experienced something similar. For some reason it seems to be on the upswing.  There seems to be a lot of people who think they can get by without paying for these services up front. If you want to hire people who actually know what they are doing, that is not likely to happen.  

Bull Market

We are in the midst of a raging bull market. A lot of people have jobs and there seems to be a lot of disposable income floating around. Just try to get tickets for Hamilton or check out the long lines at any airport or Apple store. 

There is certainly more money around that is available for investment in start-ups which is another reason crowdfunding is becoming easier and easier. Yet for some reason a lot of start-ups do not seem to have two nickels to rub together and no one that believes in them enough to loan them money to raise the capital they need to take them to the next level.  

I have a colleague who edits these blog articles. When he read this one he asked: what set you off this time?  Funny he should ask.,

A few weeks ago I got a call from a patent lawyer who wanted to introduce me to a client of his who had multiple patents. The client wanted to set up a series of companies for the different patents, raise some money for each and hire people in each company to bring the products to market. The lawyer thought that since I was looking at multiple raises for multiple companies and multiple fees he should get a referral fee from me.

I would gladly pay you

I spent an hour and a half on the phone with the prospective client. He had done some research on crowdfunding before the call.  He asked a series of intelligent questions.

In the aggregate he anticipated that he would need to raise about $20 million spread over 6 different offerings.  He was confident that his products were going to “disrupt” at least two very large industries full of Fortune 500 companies. He could not resist telling me how his “brilliant innovations” would net him billions.  

When I declined to work without a retainer, he started yelling at me and calling me names. He told me that I was ignorant because I could not see how successful his products would be.

“Let me get this straight”, I asked him, “if only one of the six companies you want to start takes off, you are confident that you will make millions, yet you do not want to invest what little it takes to raise the money to get them started?” He hung up on me.

Assholes a Plenty

You really have to be on this side of the conversation to understand, that, just like some lawyers, some entrepreneurs can also be assholes. I do not have to share your dreams to provide competent work and good counsel. I should not have to take the risk that I will do the paperwork well and you will turn off investors with your inexperience or arrogance.

I should not even have to be writing this article, but I do know that once published I will get a thank you from lawyers and marketing companies that also work with start-ups. I suspect that other freelancers and not just those who work for start-ups experience something similar.

I do not want to discourage any entrepreneur.

If all you want to do is pick my brain then please just be upfront and say so. I am happy to read your pitch decks, take your calls and help to get you ready to raise capital for your company. I don’t charge for that.

I would gladly pay you

But before you get on that road, you have to put gas in the car. It’s just a fact of life.

If you’d like to discuss this or anything related, then please contact me directly HERE

Or you can book a time to talk with me HERE

Observations on the state of investment crowdfunding-January 2020

Investment Crowdfunding

Introduction

The SEC began experimenting with companies selling their shares directly to the public utilizing the internet with the successful funding of the Spring Street Brewery in New York City in 1996. Several other companies followed suit.

I was teaching finance at the time. Netscape had gone public a year earlier. There was a lot of discussion about using this new World Wide Web to sell offerings directly to investors.  Some people thought this new process of distributing stock would “disrupt” financings forever.  One “expert” suggested that JP Morgan and the other investment banks would be priced out of the marketplace within a few years.

What was true then, is still true today. If investors will buy the shares, this new direct-to-investor method of selling those shares will succeed.  All these years later, we can safely say that investment crowdfunding, as it has come to be called, works.   

One of the first things I learned when I began working on Wall Street was the saying: people do not buy investments, rather people sell investments.  The stockbrokerage industry is still largely a commissioned based system. When a new issue of stock comes to market, stockbrokers, then and now, will pick up the telephone and “sell” shares to their customers. That is the “meat and potatoes” of the traditional underwriting process.

Investment crowdfunding eliminates those stockbrokers and the commissions they are paid. At the same time, crowdfunding eliminates the one-on-one conversation between the investor and the salesperson. It uses the internet to reach out and draw investors in.

Success or failure of these self-underwritten offerings rests almost solely upon the marketing campaign that puts each offering in front of potential investors. What a company offers to investors and to how many potential investors that offer is made are the “meat and potatoes” of investment crowdfunding.

There is ample evidence that investment crowdfunding has quietly become a legitimate tool of corporate finance for small and medium-sized businesses and projects. Like any other tool, it works best when you know when to use it and how to use it correctly.

Investment Crowdfunding Today

Investment crowdfunding has demonstrated that it can attract investors and their money. Several of the crowdfunding platforms have each raised more than one-half billion dollars from investors for the offerings they have listed. Sponsors of several individual real estate funds have raised a hundred million dollars or more on their own websites. The number of investors who have made an investment on a crowdfunding platform and the total amount they invest continues to increase year over year and still has a long way to go. 

With the JOBS Act in 2012, Congress told the SEC to regulate and legitimatize direct to investor financing. The SEC responded with three regulations, one new and two modifications of existing regulations, Regulation D, Regulation A+ and Regulation CF. 

Each regulation covers financings of different amounts (Regulation CF up to $1,070,000; Regulation A+ up to $50 million and Regulation D is unlimited) and each has its own requirements for the process of underwriting the securities. There is a small, and very good group of lawyers actively assisting companies who are crowdfunding for capital to stay within the regulatory white lines.

Thousands of companies have raised capital under these regulations. That does not imply that every offering has been successful, far from it. But it does suggest that there is capital available for companies that navigate the crowdfunding process correctly.

The cost of capital, when funding a company through crowdfunding, is competitive with commercial and investment banks. Unlike any type of institutional funding, companies that fund using crowdfunding get to set the terms of their offering to investors. That flexibility is especially important to the small businesses that the JOBS Act was intended to serve.

The technology of maintaining a crowdfunding platform or conducting an individual offering has continued to evolve and costs continue to come down. More and more companies are raising funds by adding a landing page to their existing website.

The website can provide all the documents the investor needs in order to consider the investment. Investors can make the payment for their investment with the touch of a button. The “back end” vendors, such as an escrow agent that holds the funds until the offering is complete, plug right in. 

The setup costs vary with the content. The “INVEST” button is usually leased by the month for a three to four-month campaign. The overall costs set up a DIY campaign seem to be in the range of $10,000-$20,000. I have seen companies spend more and less. 

Investor acquisition costs have been slashed with new data mining techniques and automated solicitation. Highly targeted database development, e-mailing and social media advertising have become much more efficient. Crowdfunding campaigns can now reach out to far more potential investors, for far less money, than even one year ago.

As the costs come down and the numbers of investors who have made a purchase on a crowdfunding platform continue to rise, investment crowdfunding will continue to move into the mainstream as it has in Europe and Israel.  More and more companies will fund themselves as the process continues to become quicker, easier and less expensive.

Good Investments Get Funded

The basic rules and the basic mathematics of investing and the capital markets apply to crowdfunded offerings. Investment crowdfunding is corporate finance.

A business always wants to reduce its cost of acquiring capital. Crowdfunding has demonstrated that its costs can be substantially less than obtaining the same dollar amount through either a bank or traditional stockbroker. 

Investors always expect a return on their investment (ROI) and will often gravitate to investments that provide a greater ROI.  Successful crowdfunding campaigns strike a balance between what the issuers are willing to offer and what the investors are willing to buy.

The general rule is that the greater the risk, the greater the reward investors need to be offered. Virtually every offering that is currently being made on any crowdfunding platform is very risky. Companies that do not offer investors a return commensurate with that risk are likely to have a more difficult time obtaining funds.

It remains up to each company to demonstrate how they intend to mitigate the risks that their business presents. For any capital raise to be successful, it is important that the company demonstrates how the return they are promising will be generated and when the investors may expect to receive it.

Banks remain the largest source of capital for small business. Any business owner that wants to get a bank loan will need to walk in with properly prepared financial statements, a business plan detailing how the proceeds of the loan will be used and a detailed cash flow projection sufficient to convince the bank that there will be enough cash to make the loan payments when they are due. Investors who might be expected to provide those same funds are entitled to that and more. Offerings that are too light on the details are harder to fund as well.  

Some crowdfunding platforms will list similar offerings promising widely disparate returns. If a platform offers participation in any of three office buildings, one promising to pay investors a 10% return, one 12% and one 14%, it is likely that the higher-paying offering will sell out first. Good projects may go un-funded because of competitive offerings on the platform upon which they chose to list. This is another reason that many companies are starting to do their fundraising utilizing their own website.

Good Marketing Works  

Whether the investment is offered under Regulation D, Regulation A+ or Regulation CF, everything that the company says to prospective investors is regulated. That includes what the company says elsewhere on its website, in press releases, advertisements and interviews. Projections of sales and profits need to be realistic. All claims need to be supported by real facts.

Compliance with the disclosure requirements and marketing regulations protects the company issuing the securities from regulators and investor litigation if something goes awry. Making outrageous statements, promises or projections to investors is more likely to get a company into trouble than to get it funded.  

The mainstream stockbrokerage industry has shaped what investors know about investing. The money that is being invested in ventures on crowdfunding platforms is largely coming from wealthier investors under Regulation D. Many of these investors have prior investing experience, often in similar investments.

These investors are accustomed to dealing with stockbrokers. The offerings that the stockbrokerage firms present to these same investors are professionally packaged and presented by sales professionals.

Early crowdfunding was exclusively targeted at these wealthier, accredited investors. From the beginning, the crowdfunders were competing with the established stockbrokerage industry for these same investors. 

Before the JOBS Act stockbrokers could only offer private placements to investors with whom they had a prior business relationship. Sponsors of real estate and energy programs would host seminars about their products and invite prospective purchasers. There were already list brokers who supplied e-mail addresses of known accredited investors to invite to those seminars.   

The JOBS Act removed this restriction for both stockbrokers and issuers. Crowdfunding enables these issuers to advertise specific offerings to the same targeted, accredited investors. 

The first crowdfunders used those same e-mail lists to reach those same investors and tried to get them to invest without the seminar or the stockbroker. Overall, they were successful. They demonstrated that investors would make investments based upon what they read and saw on the website alone.   

Marketing for crowdfunding today, like all cold e-mailing, is still very much a numbers game.  If a company sends out one million e-mails and raises only one half the capital it seeks then logically it will continue to send out e-mails until the offering is completed.

Today, virtually any company can run a successful crowdfunding campaign to raise capital. The determining factor is often whether they are willing to spend what it takes to reach out to enough investors to complete the offering.

Regulation D investors are different from Regulation A+ investors and in turn Regulation CF investors are again different. The best marketing firms target the right investors and send them the right message.

Regardless of whether the campaign is for an offering under Regulation D, Regulation A+ or Regulation CF, e-mails lists can be targeted with greater accuracy than ever before.  Marketing materials can be tested for click-through conversion rates and campaigns can be effectively laid out to get the desired funds.

The costs of a good, successful marketing campaign have dropped on a cost per investor basis. I always counsel clients to budget high for marketing and be happy when they spend less than they had anticipated spending. The alternative, running out of money mid-campaign, guarantees failure.

Regulation D Offerings Will Continue to Dominate

Since the 1930s, any security that is sold to investors in the US is supposed to be registered with the SEC. The SEC has specific forms for different types of registrations. 

Regulation D offerings are “exempt” from registration with the SEC because they are not considered to be offerings that are being made to the “general public”. The vast bulk of Regulation D offerings are intended for “private placement” to larger institutional investors. Consequently, the SEC does not provide a specific form or format for the disclosure documents. The SEC does require that investors get “all of the material facts” that investors need in order for them to make a decision whether to invest their money or not. Consequently, no two offerings are exactly alike.

There has been a growing retail market for smaller private placements since the 1970s. This market is serviced by mainstream stockbrokerage firms. Private placements are among the highest commissioned products that a stockbroker can sell. It is not unusual for a company engaged in a private placement to pay a sales commission of 6%-10% to the individual stockbrokers who make these sales and an additional 3%-5% to the brokerage firms that employ these brokers for marketing assistance. 

Regulation D private placements can only be sold to individuals who are defined as “accredited investors”. That includes individuals whose earned income exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years and reasonably expects the same for the current year. It also includes individuals with a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence). There are about 12-15 million households in the US that are accredited investors.

These households are the prime targets for mainstream stockbrokerage firms who have better advertising and more credibility than any crowdfunding platform. Stockbrokers have the benefit of face-to-face personal contact with their customers and offer advice regarding other investments like stocks and bonds. If an accredited investor has been a customer of a stockbrokerage firm for most of the last 10 years, it is likely that they have made money.

The real task for the crowdfunding industry has been to pry these accredited investors away from their established stockbroker or financial advisor relationships. It is absolutely clear that they can do so.

Many private placements are structured to provide investors with passive income. These have been especially popular in the last decade of very low-interest rates.  Real estate offerings are popular because they are easy for investors to understand. They can be structured to provide passive income at several multiples of what savings accounts currently pay.

Regulation D offerings in the $1-10 million range for all types of companies (not just real estate) have become the main products of the crowdfunding industry. As the costs of a successful campaign continue to come down more and more companies are likely to come to this market for funding.

Crowdfunding Costs of Regulation D Offerings Should Continue to Come Down

With any crowdfunding campaign, the issuer has two main costs: the costs of preparing the legal disclosure documents and the costs for the creation and execution of the marketing campaign that brings in the investors. Most lawyers (myself included) insist on being paid before the offering begins.

The standard disclosure document for a Regulation D offering is called a private placement memorandum (PPM). The overriding requirement is for full, fair and accurate disclosure of the information that an investor would need in order to make an informed decision on whether or not to make the investment.  There is no specific form of disclosure document.

PPMs have been presented as a bound booklet for decades. Much of the specific legal language evolved in the 1980s and 1990s when the securities regulators in various states would actively review every offering. Several states would require specific language before approving the offering for sale to investors in their state or pose additional restrictions on who could invest or how much any individual retail investor in their state might purchase. The bound booklet PPM is the normal format for disclosure that most practitioners still use. 

Crowdfunding websites have begun to change the format and to use landing pages to spread out the information about offerings rather than present it as a standard booklet. This format makes the offerings more readable and investor friendly while still making all of the necessary disclosures.

The landing page will provide investors with the terms of the offering, a description of the business and its principals and a table showing how the company will use the money it is seeking. Most include links to current financial statements and revenue projections. The same information about the business, its competitors and the particular risks of the investment that would appear in a bound booklet are all laid out.

Copies of key documents relative to the offering are provided and viewed with a “click”. For the purchase of an office building, the webpage might offer copies of the purchase agreement, title report, appraisal, physical inspection, rent roll, etc. Other types of businesses might offer copies of patents, key employment and business agreements, etc.

The most important tool on any crowdfunding page is the “chat” button. It is not unusual for an investor considering an investment to want to ask some questions or speak to someone at the company. The person who the company puts on the phone with prospective investors must be very knowledgeable about the company, its prospects, competition, etc. They should also understand the regulatory guidelines so that they do not say more than they legally can say.

Most importantly, the person that is chatting with prospective investors should be skilled at closing the sale. If all else has been done correctly, there comes a point where issuers need to ask a prospective investor for a check.  

If an offering is going to be made through a mainstream stockbrokerage firm the costs of having a PPM for a private placement prepared by a mid-sized law firm can run $50,000 and up. Costs can run up with the complexity of the offering, the number of documents that need to be prepared and the client’s ability to respond to questions in a timely manner.

Preparing the paperwork for a Regulation D offering formatted for a crowdfunding platform should require less of an attorney’s time, especially if the issuer and the marketing company preparing the landing page understand what is required. The legal costs for preparing the disclosure documents for a simple Regulation D real estate offering on a crowdfunding platform start in the neighborhood of $15,000.  Offerings with multiple properties and complex or tiered offerings, operating businesses, and start-ups can cost a little more.  

The marketing costs of setting up the website for an offering can vary greatly. Real estate offerings, for example, are fairly simple and straight forward. A photo of the building and a floor plan are typically the only graphic enhancements. The crowdfunding campaign for a start-up or new product might include a video of the founder or a product demonstration. Still, a cost of $10,000- $20,000 is reasonable to set up the website and the marketing campaign.

Many Regulation D offerings have a minimum investment of $25,000. That equates to a maximum of 40 investors for every $1 million raised. A rule of thumb suggests that for Regulation D offerings, an expenditure of $10,000 on the marketing campaign for every $1 million dollars raised seems reasonable.

Real Estate Offerings Will Continue to Dominate

Syndicated real estate offerings are mainstream investments. Many real estate funds and real estate investment trusts (REITs) trade on the NYSE.  Mainstream stockbrokers and advisors have recommended real estate private placements as alternative investments to accredited investors for years. Investors are offered equity participation in existing properties or new construction and fund real estate debt through mortgage funds.

Investors are familiar with real estate. Using limited partnerships and LLCs, it is easy to structure a real estate offering to pass the income and tax benefits through to the investors.

Every time any commercial property changes hands there is an opportunity to crowdfund the purchase price.  Real estate brokers and property managers of all sizes are using crowdfunding to build portfolios of properties that generate substantially higher initial real estate commissions as well as ongoing commissions and management fees.

If no two properties are exactly alike, the same can be said for any two real estate syndications. The success of any real estate venture is more likely than not to rest with local market conditions.

Most real estate syndication offerings are sold based upon the promise of current yield or projected distributions.  Review the marketing materials fora thousand real estate projects sold by mainstream stockbrokerage firms and you will find the current or projected income is always highlighted. That is where crowdfunding the same offering will always have a competitive edge. 

If a sponsor wants to raise a $10 million down payment to purchase a $40 million office building using a mainstream stockbrokerage firm, the sponsor will need to raise as much as $11.5 million to cover the costs of the sales commissions and fees that the stockbrokers receive. That dilutes the return the investors will receive on their investment.

Crowdfunding that same offering and eliminating the sales commission will increase the payout to investors by 10% or more. From the investors’ point of view, the payout (ROI) is the thing that they usually consider first. Crowdfunding any offering should give investors a better ROI.

That focus on ROI has also caused many of the syndications to migrate away from crowdfunding platforms where multiple offerings from different sponsors are lined up side by side. A sponsor is often better off making the offering from its own website where it does not compete with offerings that might offer investors a higher payout and where they can control the marketing campaign and costs.

Crowdfunding platforms, unless they are licensed as a broker/dealer, cannot take a fee based upon the success of the offering. Two years ago, most of the platforms were happy with a straight listing fee based upon how long the issuer wanted to keep its offering active on the platform.

More and more the Regulation D platforms are obtaining a broker/dealer license and are charging based upon the amount that the issuer is raising. The difference can be substantial.

A flat listing fee to place an offering on a platform for 3 months might cost $10,000,usually paid by the issuer upfront.  A success fee to place an offering on the same platform once it has a broker/dealer license might be 3% of more of the funds actually raised.  A raise of only $2 million would cost the company (ultimately the investors) $60,000. That is another reason that many companies are crowdfunding from their own websites.        

As the crowdfunding industry has evolved, the crowdfunding platforms compete with established stockbrokerage firms and the DIY offerings made on a sponsor’s own website compete with the crowdfunding platforms. In the end, the issuers, investors and the crowdfunding industry itself all benefit as costs come down.

The Next Thing in Regulation D Crowdfunding is Globalization

Foreign companies have always looked to the US capital markets when they have been able to do so. Interest rates and costs of capital are frequently lower in the US compared to an issuer’s home country. Before crowdfunding, the opportunity for foreign companies to obtain funding in the US was limited to the largest companies.  Foreign companies seeking to introduce their products to the US market or to set up operations here will often consider funding those operations through a US subsidiary. 

Mainstream stockbrokerage firms often recommend that 5% or more of an individual’s portfolio be diversified and held in the shares of “foreign” companies, often through a mutual fund.  US investors also appreciate that they can get a greater value if the money they invest is spent in a country where overhead, labor and operating costs are likely to be substantially less than the equivalent line items in the US. 

At the same time investing across borders can be subject to additional risks including the risk of currency fluctuations and changes to the local economy ofthe country where the company operates. That can mean additional rewards for investors who should expect to be rewarded for taking those risks.

Utilizing data-mining and other modern marketing techniquesfacilitatesfinding US investors interested in investing inother countries. More and more foreign issuers are looking to crowdfunding for US investors and more are likely to follow.

Regulation A+ Continues to Fail

Regulation A+ was the SEC’s modification of an underutilized form of a registration statement. To date very few Regulation A+ offerings have been filed and sold. It remains a very expensive and inefficient way for any company to raise capital.

The handful of Regulation A+ offerings that have sold shares to investors find those shares trading for less today than their original offering price despite a raging bull market. Virtually every investor who has made an investment in a company selling its shares under Regulation A+ has lost money. 

Crowdfunding using Regulation A+ may never get past its abysmal beginnings. Several of the earliest and heavily promoted Regulation A+ offerings were out and out scams.  The crowdfunding platforms that hosted these offerings demonstrated a total lack of respect for the investors and their money and left a bad taste in the mouths of investors who were willing to give crowdfunding a try.  

Regulation A+ requires a form of a registration statement to be filed with the SEC which will be reviewed and approved. There are specific disclosure requirements.  The approval process can take 4 months or it might stretch into 8 or 10 months. The SEC will make comments and depending on the answers and the SEC staff’s concerns the approval process can drag on.

Each round of comments adds time to the process and increases time spent and of course, the lawyer’s bills.  It would not be unusual for a law firm to ask for a $75,000 retainer for a Regulation A+ offering against a total bill for legal services that can be 2 or 3 times that amount and more.

Regulation A+ provides for offerings of no more than $50 million and has slightly easier requirements for companies raising less than $20 million. A company raising even $10,000,000 under Regulation  A+ with a $500 minimum investment may need to secure investments from as many as 20,000 investors.

There are no restrictions as to who may invest or how much, so the pool of potential investors is very large. The marketing costs of reaching out to a large pool of potential investors can be prohibitive.  Marketing costs for a Regulation A+ offering can reach $200,000 and more.

Regulation A+ promises that after the initial offering its shareholders can freely sell or trade their shares. The shares can even list on the NASDAQ.  The continuing problem is that at least up to this point in time no one wants to buy these shares once the offering is completed.

If the company wants to support a post-offering secondary market for its shares it will have to secure market makers from the stockbrokerage community and absorb the costs of continuing press releases and lawyers to review them. These costs can be substantial.

There is still plenty of time for the Regulation A+ market to gets its act together.  In the broader market, however, the trend is away from public offerings, IPOs, in favor of more private offerings under Regulation D. The trend is driven by the fact that Regulation D is far quicker and less expensive. That trend is being reflected in the crowdfunding market that serves both.

Regulation Crowdfunding(CF) Will Continue to Mature

Regulation Crowdfunding (CF) was the last of the regulations that the SEC adopted under the JOBS Act and the one most specifically targeted at helping small businesses raise capital. These are small offerings being made by small companies. They are designed to spread the risk of small business capitalization among a lot of investors.

Regulation CF created a new type of financial intermediary called a “funding portal. Portal operations are regulated as they are required to become members of FINRA. All transactions using Regulation CF are required to be executed on one of the portals. There is no “DIY from your own website” using Regulation CF.   

There are still fewer than 50 registered portals and a small handful of the portals host the bulk of the transactions. A company can use Regulation CF to raise up to $1,070,000 from investors every year.  Many of the Regulation CF offerings seek less than $100,000. A Regulation CF offering in the $200-$300,000 range would seem to be the most efficient.  No individual investor can invest more than $2200 in Regulation CF offerings in a 12-month period.

Where Regulation D platforms compete with the mainstream stockbrokers for the same types of financings that the stockbrokers had always sold, the Regulation CF portals compete with banks to provide funding to the same types of companies that banks normally fund. 

Banks currently provide most of the capital for small businesses in the US. Banks have commercial loan officers in virtually every branch office aggressively seeking to write small business loans. There are always tens of thousands of small businesses around the country seeking some type of capital infusion.

Crowdfunding portals will eventually satisfy more and more of that demand. They will be attractive because the company seeking the funding writes the terms of the financing, not the bank.

Regulation CF portals, because they are licensed by the SEC, can charge a fee based upon the amount actually raised rather than a listing fee charged by the Regulation D platform. A portal may charge 6% or more of the amount actually raised and some take a warrant or carried interest in the company as well.

Only companies incorporated in the US, with their primary place of business in the United States or Canada can use Regulation CF. The SEC requires that specific information about the business and its finances be prepared, filed with the SEC and provided to investors.  For offerings in excess of $500,000, the financial statements must be audited. The total cost for the preparation of the offering material and financial statements should be in the $10,000-$20,000 range.

Unlike Regulation A+ there is no pre-offering review by the SEC. The paperwork, Form C, can be filed with the SEC on the same day that the offering goes live.

If a company is seeking to raise $300,000 using Regulation CF and sets a $500 minimum investment, then a maximum of 600 investors is needed. Early on people were suggesting many companies could crowdfund their business just by using their own social media contacts. Most companies start with a list of family and friends, customers and suppliers.  

Still, a professional fundraising campaign should have a better chance of success.  The advances in data mining and automated e-mail technology have certainly reduced the cost of these Regulation CF campaigns as well.  

For many mid-range Regulation CF fundraising campaigns, a total budget of $30,000- $35,000, with a reserve for more advertising just in case, would cover all legal, accounting and offering costs. Those costs are recouped from the offering proceeds. The owners of smaller cash strapped companies are beginning to realize that they can obtain the cash infusion they need and cover the costs of obtaining those funds by taking a short term loan on their credit cards.

Startups Are Different

Many of the Regulation CF offerings are very small start-ups seeking initial seed capital to get their business off the ground. Obtaining funds for a start-up will always be more difficult than obtaining funds for an established business.

Many of the companies structure their offerings as if they were “pitching” to a venture capitalist rather than their high school history teacher or fellow high school classmates. Good marketing would tell a simple story, but tell it to a great many people.

Regulation CF is designed to help small businesses get started, become established and grow. Not every small business will grow to have the annual sales of Apple or Amazon.  Many companies that will never reach anything close to that can still be good investments.

An ongoing problem that turns off more seasoned investors is the extreme valuations that some companies claim for themselves on the portals. Just because a company is selling 10% of its equity for $1 million does not make give the company a “valuation” of $10 million. 

Operating businesses are bought and sold all over the US every day. The rule of thumb for most businesses in most industries would support a valuation of three times next year’s projected earnings.  Companies with no earnings can still raise money if they can raise enough to become profitable. Valuations, especially ridiculously high valuations are unnecessary and will likely fall out of favor as time goes on.  

Several of the Regulation CF portals encourage issuers to put a valuation on their company when they make an offering. More times than not, it is a rookie mistake. 

You Can Still Fool Some of the People

If I learned anything from the crypto-currency ICO craze is that some investors will invest their money into anything that sounds good even if it is nonsensical. Billions of dollars were invested through ICOs into projects that never had a hope of success. Way too many of the ICOs were outright scams where investors’ money was simply stolen. It was a triumph of hype over reason.

Scamming the investors is not a way to continue to develop crowdfunding as a sustainable method of finance. It does demonstrate that with aggressive marketing virtually any company can successfully crowdfund for capital. 

The ICO craze also demonstrated that these investors were willing to look beyond borders acknowledging their belief that good companies can grow wherever there are good people to grow them. I believe that will become one of the more significant, if unintended consequences of the ICO craze and will benefit crowdfunding in general.

Takeaways

Investment crowdfunding in the US has matured to the point where companies from all over the world can look to this market to obtain capital. As costs continue to come down more and more companies will take advantage of this market to reach out to investors.

Right now, many of the platform and portal operators are themselves an impediment to further growth.  Focused more on hosting any company that comes along, the operators do too little to provide these companies with much needed know-how. These are financing transactions. Someone with a good understanding of finance needs to be involved if the ultimate goal is for 100% of the offerings listed are to be funded. .

I speak with start-ups and small businesses every week. Many know only what they heard at a conference or read in a book. Few have a financial professional working with them to advise them what investors want and expect. As a result, many companies offer investors too little or in some cases, too much.

The key takeaway should be that crowdfunding replaces the traditional Wall Street stockbroker with a marketing company. There are more marketing “experts” out there than you can imagine but I have run into only a handful that seem to have one successful campaign after another.

The costs of good campaigns have come down, but they are not free. If you are determined to fund your business and do not have the funds for a professional campaign, be prepared to max out your credit cards or ask your friends and family to do so. 

I worked on Wall Street when it went from handwritten paper order tickets to computers and watched those computers speed up trading to the point no one imagined possible at the time. I honestly believe that as crowdfunding continues to grow and mature it is likely to have a similar long-term impact on small business capital formation in ways unimagined today.

If you’d like to discuss this or anything related, then please contact me directly HERE

Or you can book a time to talk with me HERE

Girl Scout Cookies – America’s Unicorn

girl scouts

As January winds down, the Girl Scouts will once again demonstrate their high level of business acumen and begin their annual cookie sales. Business schools and MBA programs love case studies of businesses that are remarkably successful. I am always amazed that these professors do not pay more attention to the Girls Scout’s cookie sales program. 

The Girl Scouts have been selling cookies for more than a century. To say that they have it down pat would be an understatement.

You can laugh it off, but in about 8 weeks from start to finish the Girl Scouts will sell and deliver about 200 million units and take in about $1 billion in sales. I know Fortune 500 companies that do not come close.  In fact, I know Senior VPs at Fortune 500 companies that would call the Scout’s attempt to deliver that many units in that short a period of time a logistical nightmare. One told me that even thinking about it would make him reach for the antacids he keeps in his desk drawer. 

What is the secret to the Girls Scouts display of logistics perfection? Their mothers already have way too much on their plates to screw around.  Just get them sold, get them delivered and move on, one Scout’s mother told me as she was chaperoning her second daughter around the neighborhood. That phrase should be on a sign on the wall in the office of every sales manager and operations manager in America.

The entire operation is a model of efficiency. I have ordered quite a few boxes over the years. They always deliver exactly what I ordered exactly when they promised. My Amazon Prime deliveries often go to the house across the street.

The cookies themselves are manufactured in two bakeries. They are of high quality and consistent year to year. Over the years they have eliminated some that did not sell well and introduced others.  

Personally I have a thing for Samoas. Maybe it is the combination of chocolate and coconut; the sweetness and the texture.  I have been known to munch my way through an entire box during the NBA All-Star weekend.  If they ever eliminate Samoas from the menu I think it will represent a decline in Western civilization.

People do not appreciate the value of a box of Girl Scout cookies as a business tool. I have a friend who worked in the back office of the trading department of one of the large banks.  Each year he has 10 cases of Girl Scout cookies delivered and stacked up against the wall in the trading room.  He tells me that the traders, in their thousand dollar suits and $300 shoes literally climb over each other to get a box. He told me that some of the traders who don’t know his name and are not certain what exactly he does, refer to him as the “cookie guy”. He is certain that his yearly largess has raised his status at the bank. 

There are a lot of anecdotal stories about cookie sales. Back in the 1980s, one Scout sold so many boxes that it got her an invitation to visit the White House. While waiting to meet Pres. Reagan she found herself waiting in an ante room with Secretary of State George Schultz.   When Schultz complemented her on her achievement, she reportedly responded by asking Schultz if he wanted to buy some.  Do you need a better example of the phrase “never stop hustling”? 

This particular Scout went on to sell more than 100,000 boxes in her Girl Scout career and while still a teenager gave lectures to adults at sales conventions. Her success was not from going door to door but by setting up a table in the DC metro during rush hour. She told the salesmen at the convention to go where the customers are and not wait for the customers to come to you.  

More recently there was the story of the Scout who set up her table at the entrance to one of San Francisco’s medical marijuana dispensaries. Yes there was some controversy about a pre-teenager and marijuana. As a parent I had to face the questions from my own kids about what I was doing back in the 1960’s. Still the munchies are the munchies.

But from a purely business standpoint I would say that both of these young women understood their market better than a significant number of the sales people I meet almost daily.  I cannot imagine the sales manager at any Fortune 500 company not extending a job offer to either.

girl scouts

My own experience with superior Girl Scout sales women came a few years back when two neighborhood Girl Scouts, sisters aged 11 and 9 rang my door bell one Saturday. They were chaperoned by their mother. Each was in a well pressed uniform intending to make a sharp presentation. I invited them in and the oldest started her pitch by asking me if I was familiar with Girl Scout cookies and did I have a favorite.  

I professed my fondness for Samoas and ordered 3 boxes. She responded by suggesting that I try some of the other popular flavors. She knew what was in each of them and described how they tasted. She suggested that I should buy a box or two of Thin Mints “to take to the office”. I ordered 3 boxes of those as well.   

She thanked me and filled out the order form which is color coded for the ease of these young sales people. It also significantly sped up the ordering process. 

When I thought we were done her younger sister stepped forward and asked if I would buy some cookies from her as well. I would have needed ice water in my veins to turn down this innocent looking youngster who apparently had seen Glengarry, Glen Ross and taken it to heart. 

I told her that I did not want to buy too many because I was watching my weight. She responded by telling me that I could buy a few boxes and that they would ship them to servicemen serving overseas. That’s right, a 9 year old who had already learned to anticipate a customer’s objections and have an excellent response ready. 

I wrote a check and two weeks later, right on schedule, I took possession of a case of Girl Scout cookies. I swear if these two had been 20 years older they might have saved Lehman Brothers. 

I think more people should take notice of just how successful the Girls Scouts are. Two years ago I found myself having lunch with the founder of a Silicon Valley start-up who exhibited more ego than brains. He spent the better part of the meal telling me how his yet to be launched company was certain to achieve unicorn status. It never did.  

The Girl Scouts, on the other hand, will likely sell a billion dollars worth of cookies this year. They have a well known and ubiquitous product. Their brand, if not as valuable as Coca-Cola, is certainly closer to it than Uber or Airbnb.  Imagine the Girl Scouts as a unicorn without the ego.

There is huge push to give young girls more training in STEM subjects and a great many programs teaching them to write code.  I am a strong advocate for both, but learning to write code becomes less important if you can’t sell it.  As long as there are Girl Scouts selling cookies, the art of salesmanship will never die.

If you’d like to discuss this or anything related, then please contact me directly HERE

Or you can book a time to talk with me HERE

The Beginning of the End for Oil

End for Oil

Every so often I read a single piece of news that gives me a glimpse of the future. I saw a news article last week that reinforced my belief that we are coming to the end of the Age of Oil. 

Oil became the most important commodity in world trade, literally overnight, and specifically on October 19, 1973. Since that date, oil and its price at the well-head have become a central concern of the global markets.    

Since 1973 enormous wealth has been transferred from the US and Europe to the primary oil producers around the Persian and Arabian Gulfs. Far more wealth than the conquistadors removed from the Americas in gold and silver. This wealth was extracted because the producers agreed among themselves to restrict the supply of oil thus keeping the price per barrel sky high. 

A war between Egypt, Syria and Israel began on October 6, 1973. The US Congress were preparing to provide over $2 billion in emergency aid to Israel.  In response, OPEC, the cartel that managed global oil production, instituted an embargo on oil shipments to the United States. The motivation behind the embargo was political, but the effects were most definitely economic.

The embargo halted US oil imports from participating OPEC nations. It changed the lives of all Americans immediately and had lasting effects in the US. It also had an enormous effect on the participating producing states. But for the actions of the cartel and the embargo all those skyscrapers dotting the skylines in all those OPEC countries would never have been built.

The total embargo of oil to the US meant that there was not enough gasoline in the US to go around. I remember standing in long lines trying to buy gasoline when it was available. I remember that purchases were restricted to “odd and even” days corresponding with your license plate.  It was terribly disruptive to everyone in the US and to every US business. 

The US economy was booming. By 1970, the US had just put men on the moon. US factories were operating at near capacity. The Vietnam War was sucking up a lot of labor and materials. By 1973 there was a noticeable uptick in inflation at the wholesale level.

End for Oil

The interstate highway system was largely completed to facilitate and reduce the costs of trucking goods.  Gasoline fueled all of the trucks that moved all of the goods. In 1970, demand for oil in the US outpaced supply for the very first time.

At that time the cost of regular gasoline in suburban New Jersey was about $.25 per gallon. With a fill-up you would get change back from a $5 bill and either Green Stamps or a 12 ounce drinking glass suitable for iced tea or lemonade. Everyone I knew had a cabinet full of those glasses.

Cartels like OPEC are made up of producers who are most effective when they manage the supply together.  OPEC began a series of production cuts in order to bump up the world price of oil. These cuts nearly quadrupled the price of oil from about $3.00 a barrel before the embargo to about $12.00 a barrel in January 1974, i.e. in about 90 days.   

Officially, the embargo ended in March 1974. The higher oil prices, on the other hand, kept going up.  In 1979 the revolution in Iran bumped prices even further upwards. 

Before the end of the decade, US President Jimmy Carter appeared on television urging people to turn down their thermostats and wear sweaters to keep warm at home because heating oil had become very expensive. He also encouraged Americans to “whip inflation” as the price of most goods went up as production and shipping costs rose. 

For the next 40 years US politicians would promise to make the US “energy independent” again. 

The increased price was also a boon to the large oil companies who profited from the increased price as well.  There were several notable mergers and the resulting behemoths became among the largest companies in the world. Oil had become a “bell-weather” commodity.

In the 1970s and 1980s there was the thought that US domestic production might again surpass domestic US demand. There was a substantial amount of drilling within the US, much of it incentivized by favorable tax treatment. I recall reviewing financing documents for shallow oil wells in Pennsylvania, deep wells in Texas, gas wells in Louisiana and shale oil in Colorado.

The large oil companies had earned so much that they could afford to engage in much more expensive, offshore oil drilling in the Gulf of Mexico and the North Sea. The pipeline from the North Slope in Alaska did not come on line until 1977, but eventually added 1 million barrels a day of crude oil to the supply.

At the same time, the US government lowered the maximum highway speed limit to 55 miles per hour. The auto industry sold a lot of smaller, more gas efficient vehicles.  With all that drilling, conservation and efficiency the price per barrel of oil should have come down. It never did.

Over the ensuing years, the global price pushed through $30 per barrel to $60 and more.  Only recently has the US actually produced more oil in a month than its residents used and not by very much.

There were people in the oil industry and the government who thought that we might “run out of oil” and who spread that thought as a justification for drilling anywhere and everywhere. That certainly seemed plausible in the 1980s when the memories of the embargo and its shortages were still fresh and the internal combustion engine had no competitors.  

People have been talking about electric powered vehicles since before the 1973 embargo.  In the 1980s and into the 2000s they were still a work-in-progress. No one really had tangible proof that we would replace the internal combustion engine in the 21st Century.

End for Oil

What I read last week told me that electric vehicles have finally arrived.

Last week, Tesla Motors announced that they had delivered over 360,000 vehicles in 2019 and are on a path to deliver more than 400,000 vehicles in 2020.  Other companies also deliver electric vehicles to customers and more companies are poised to get into the market. Some will succeed; others fail.

The technology that makes these vehicles possible has apparently evolved to the point that the vehicles are accepted by the public and are priced within a normal, commercial range.  The technology will continue to evolve to make these electric vehicles even less expensive. On board batteries will be lighter, longer lasting and cheaper. Re-charge time will be shortened to minutes. At some point in the next 10 or 20 years, there will be more electric cars and trucks manufactured each year than gas powered vehicles.

The real impetus for the changeover will come from the trucking and package delivery industry. The US Postal Service is already reviewing prototypes for electric powered delivery vans. UPS, Amazon and other companies operating fleets will also make the switch.  It does not make good economic sense for these companies to continue to buy gasoline. Instead they will operate the fleet during the day and plug it in overnight.

It should not be difficult to imagine that a company like Amazon might run an all electric fleet and at the same time own acres of solar arrays putting the equivalent of the electricity that they use back into the grid.  Tesla is positioned to sell the idea that customers might charge their cars for free if they generate solar power from the roof tiles and solar panels that they also sell.

It is not unreasonable to assume that there will be more than 10 or 20 million fully electric cars and trucks on the road by 2030 or 2035. That may be conservative. The last large automotive production lines for internal combustion engines are likely to close long before the end of this century.

What may hasten the demise of the gasoline powered automobile is the cartel itself. As demand declines, the cartel is more likely than not to continue to reduce production to maintain the high price for as long as it can. As the cartel cuts production, smaller members will begin to bail out because they will want to sell more than their allotment.

If you happen to stop over in Riyadh or Dubai take a look at their high rise skylines. Cartels do not last forever. The effects of a successful cartel can have a significant impact on global markets and global politics for many decades after they end.

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The Great VC Con Game

The Great VC Con Game

I speak every week with people looking for funds to start or expand their business. With investment crowdfunding, the process has actually become relatively easy and inexpensive. Most people come to me to use crowdfunding as a first choice to fund their business. They appreciate the opportunity to fund their business on their own terms.

Sadly, some report that they spent upwards of $25,000 and more than a year flying around the country attending conferences and pitching to dozens of venture capitalists. If they had called me sooner, I would have told them to save their money.

Pitch Decks

There are a plethora of books and articles and an industry of vendors hawking “pitch decks that work”. Few actually do. When I see a pitch deck I can often tell which “guru” it is trying to follow. 

Unfortunately, most of these experts know nothing about what motivates investors to write a check. One in particular who seems to post on LinkedIn every few hours actually offers the worst advice that I could imagine. 

Logically, investors in your company should really want your company to succeed.  If you want their money, it would seem natural that you would tell potential investors what you intend to do with their money in order to make more money.  Yes, it really can be that simple.

Compare that to the pitch decks that follow the “find a problem and solve it” template. They often minimize the focus on projected revenues and profits. They often leave out the details of how the company will execute its business plan to get there. From an investor’s point of view, return on their investment (ROI) rules.

VCs actually fund a very small number of businesses (in the low 1000’s) every year. Most of the money available for venture capital investment is concentrated into a handful of large funds. Some of the available capital will flow to “serial entrepreneurs” because venture capital is a fairly closed network of people and money.

I was introduced to my first venture capitalist when I made my first visit to Silicon Valley in the mid-1970s. There were a lot more trees and open space on the way to Sand Hill Road back then.

At that time VCs in Silicon Valley were a very small group of very smart people. Many were MBAs or had MBAs on staff to crunch and re-crunch the numbers. This was no small task in the years before VisiCalc.

These VCs were using their own money and the money of a select group of wealthy investors to help small tech companies get their business up and running.  Their goal was to hand these companies over to the investment bankers specifically for a public offering. 

Investment bankers wanted these companies to be profitable before an IPO.  After the offering, research analysts affiliated with the investment bankers were going to project growth in earnings per share. That assured that the IPO investors were almost always going to make a profit from their investment post-offering.  Everybody would win.

San Francisco

I moved to San Francisco in 1984 to work with a law firm that represented a London based VC fund. The fund was making investments in 1980’s era hardware and software companies, companies with cutting edge ideas and those in more traditional businesses as well.  I sat through a lot of pitches. Very few of those companies got funded even though the pitches were well thought out and supported by real facts and research. 

I remember listening to one of the partners in Sequoia Capital being interviewed on TV discussing what they liked about Apple when it was still at the venture capital stage.  I recall that it was more about Steve Jobs’ focus on the design and packaging as it was the tech.  It was more about gross profit than market share.  

Today it seems like “gross profit” is a curse word in the venture capital community.

Investing has always been rooted in mathematics. Today’s VCs have chosen to ignore the traditional math and have created a new math, to line their own pockets, even as the companies in which they are investing continue to fail.

Dotcom

Beginning in the 1990s and especially as the dotcom era heated up, a lot of people who worked in around Silicon Valley, thought that they should become venture capitalists. Some had been founders of the earlier tech companies. Some claimed to have the connections and insight to bring more than money to these portfolio companies. 

The net result was a de-emphasis on the actual, achievable projections of income and how a company might execute to get there. It was replaced with a mindset that said “this is a great idea; millions of people will come to our website and buy our product”. Translated, that means: “Profits? We don’t need no stinking profits?”  

The investment bankers bought into this because it enabled them to make a great deal of money. They took a lot of companies public without real earnings. They then used convoluted reasoning and research to predict share prices in the hundreds of dollars. 

The analysts looking at the dotcom companies created a metric called “growth per share”. I asked one of the prominent tech analysts if they had ever seen that metric in a peer-reviewed journal. Of course they had not.

In the current market bull market post-2008 the VCs have moved the goal posts even further to feather their own nests. Rather than find more and more good companies to fund, they are increasingly conducting multiple rounds of financing on a smaller and smaller group of companies. Most are destined to failure because they cannot operate profitably.

Venture Capitalists

VCs like other money managers get an annual % of the amount of money invested in their fund. The best way to attract new investors is to demonstrate success. If a VC invests in a company at $1 per share and the company goes public at $10 per share then the VC’s success is easy to calculate. If none of the companies in a VC’s portfolio actually go public, the VC’s success is harder to demonstrate.

To solve the problem, VCs have created a metric called “pre-revenue or pre-earnings valuation”.  You will not find it in peer reviewed journals. It is the closest thing finance has to an oxy-moron.

It works like this. Ten VC funds each invest in a seed round of 10 companies. Then some will invest in a Series A round of some of the companies in the other VC’s portfolios, then others will invest in the Series B round, etc. In the end, these VC funds have cross funded each other’s deals at different levels.  Each level is priced higher than the one before.

In the seed round a VC invested $10 million for 10 million shares of the outstanding shares of each company.  By the Series C, D or E round those shares are being sold to the other VCs and now cost $50 each. 

Does that make the original shares purchased in the seed round worth $500 million?  If the company has now issued 200 million shares, is the company worth $10 billion? Not in the real world and especially not if the company is still not profitable.

However the VC can now claim that its original investment is worth much more and use that “fact” to attract more investors into its fund. The VC will receive a % of the amount invested yearly for a decade or more. 

WeWork and the other unicorns will be the subject of business school case studies for at least the next generation. They are the most recent example of what may be the oldest theorem in finance: you can fool some of the people all of the time.  

Capital for new and smaller ventures is essential to the entire system of finance.  Investment crowdfunding is actually a response to the failures of VCs in the dotcom era. The arrogance displayed by VCs in this current market has probably done more to cement the place for investment crowdfunding than anything else. It is up to the crowdfunding platforms and professionals not to make the same mistakes. 

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Sex in Economics

sex in economics

When I was teaching Economics back in the 1990s, I was fortunate to have students who had gone to high school in dozens of different countries. These students had different experiences and had functioned in markets that were often driven by local custom and culture. Their questions and comments helped me to understand a lot about the expanding global marketplace.

When I wanted to create an example to illustrate the application of a theory that I was trying to explain, I always tried to create one that everyone would understand regardless of their country of origin. Consequently, I often talked about sex. 

I admit up front that this may have contributed to my being ranked as one of the more popular members of the adjunct faculty at the university. It also seemed to keep the students awake, which, when teaching a subject like Economics can be task number one.

Economics

Classical economics teaches that consumers are rational. It teaches that because most consumers have a limited amount of money to spend each month, they will organize their spending accordingly. First, they will allocate their funds to necessities (rent, food, clothing, and transportation) and then to items that are necessary but which can be put off (dentist, auto repairs). Any funds that are left over can be spent on items that the consumer may want to buy, but could literally live without (sporting events, vacations). 

In order to get the most “bang” from the bucks they have, consumers should be good shoppers.  They should compare the prices of like products and purchase the least expensive ones that suit their needs. In theory, it is a rational process throughout.

Most consumers acknowledge they should allocate some of their monthly earnings to savings, but few will. Most also acknowledge that they should spend no more than they earn each month.  In practice, that effectively went out of style with the advent of the credit card.

Today, the market is awash in consumer debt, a factor that the classical economists could not consider.

I tried to focus the students on the underlying question: “How could they induce consumers to make an irrational decision to buy their product?”  These were, after all, business school students. 

For most products the answer is advertising. The modern “in your face” daily onslaught of ads that encourage people to purchase products were also not considered by the classical economists for obvious reasons.  The textbook I used, followed the classical view, which, to my thinking, might not give students the whole picture.  

The purpose of any advertisement is to make consumers purchase the product. Many ads will stress a product’s “value” which speaks to our rational side.  But even those ads will frequently feature attractive people making the pitch.  Using actors who are “attractive” does not change the message. But it is likely to get more eyeballs on the ad. 

Sex Sells

Indeed much about advertising is rooted in sex. There is a constant, undisputed theme in advertising: “sex sells”.

sex in economics

I could not, in my mind, conjure up a source of more irrational behavior than the human sex drive. It is not “just the things we do for love”. Sex and our desire for it motivates a huge portion of the spending that people do, even if they have limited funds that might rationally be spent elsewhere. 

For example, sex is at the root of the global fashion and cosmetics industries. These represent trillions of dollars of annual commerce.  And it is not new. Evidence of consumers’ desire for fashion, cosmetics and adornments goes back into pre-history. 

Why would anyone teach that consumer purchases were rational when so much of it was driven by irrational emotions?  And this does not even touch purchases that are made based on other emotional responses such as fear, greed or envy. I thought that perhaps the rational consumer of the textbook who was focused on the price might be a myth. 

I caught up with Richard Posner’s Sex and Reason (1992) a few years after it was published. His well researched and well presented book came to the conclusion that the human sex drive was rooted in our biology and that acting upon it was perfectly rationale behavior.  

I still have difficulty in reconciling the perfectly rational price theory with less than rational human behavior.  Over time I have come to believe that the latter might actually be underestimated as the determining factor for our purchase decisions. In this regards, I think that business school students might need a lot more sex, at least in their curriculum. 

I liked to challenge my students. I asked the class why so many consumers would reach for a fragrance that was priced at $350 per bottle. People buy fragrances to attract a partner for sex. Would not a fragrance that cost $60 get the job done? 

Vegas Baby

I would ask: If a sex worker in Las Vegas charges $500 to perform a sex act when a sex worker in Brazil might charge $20 for the same service, what can you infer from this data? Yes it is about overhead and what the market will bear, but it is also an introduction to globalization. Change sex worker to software developer and you will see what I mean.

sex in economics

Cable television and the internet itself were once brand new technologies that were slowly beginning to find acceptance from the general public.  In both cases each got an early shot in the arm from one source, pornography.

On cable, networks like HBO screened soft core porn after midnight. It is what made the cost of cable acceptable to many new viewers and indeed what attracted many new viewers. Data at the time suggested that a lot of people liked to watch in bed. If you need a reference go to Wikipedia and look up Sylvia Kristel. 

I think that everyone knows that there is a lot of porn on the internet, but not everyone appreciates how large a business it represents. MindGeek, parent of Pornhub, does not report its revenues but measuring them in the billions would not seem inappropriate. It may not be as large in gross sales as Amazon, but MindGeek’s cost of goods is minimal. 

Sex is even prevalent in finance. I wrote an article about crowdfunding back in 2015 when it was still new and I was just beginning to look at it with a critical eye.  Investment crowdfunding was and is about getting people to look at your offering.

I wrote at the time: “If eyeballs are what you need to successfully crowdfund a company, it would seem logical then that the easiest company to crowdfund might be one selling a line of lingerie. No crowdfunding consultant worth his/her fee would likely tell the company not to include its product catalog in its presentation to investors if that catalog had pictures of models wearing lingerie.” About one year later a lingerie company in London started a crowdfunding campaign that followed that advice and raised all of the funds that they were seeking.  

Sex, Drugs and Rock n’ Roll

The music industry certainly uses sex to make sales. I grew up at a time when Elvis Presley appeared on television from the waist up because much of the audience had “issues” with the way in which he moved his hips.  Currently, it’s obvious that much of the music and entertainment industries have seen that portion of the audience as far out of the mainstream. A music video without some sexual reference? Hard to find near the top of the charts.  

A few years back, I caught an interview of Mick Jagger that was being conducted by a business reporter. Jagger has flaunted sex and sexuality throughout a very long career. The Rolling Stones were starting a tour and the topic was the economics of touring.

mick jagger

Jagger suggested that the tour itself would probably net the band over $100 million, not counting the record sales. The reporter asked how the band could achieve that kind of financial success from traveling around and playing music. Let’s face it, very few musical groups have had that kind of sustained success.

Jagger responded that he had just paid attention in school. The response made me smile. He is a graduate of the London School of Economics.    

I hope that my students were paying attention too.

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Hey FINRA- Look Over Here

Finra

FINRA, the stockbrokerage industry’s regulator, often does an absolutely atrocious job of policing its members. It was not always so, but in the last few years FINRA has clearly turned a blind eye to some really outrageous conduct that is going on right under its nose.

There are two distinct types of scams that have been prevalent in the stockbrokerage industry for decades. The first involve bad investments that come down to the registered representatives from the corporate level. These scams would never be sold to investors if the firms had conducted an adequate due diligence investigation.

FINRA has a fairly high bar for its member firms when it comes to due diligence on a private placement. It tells its member firms that they may not rely blindly upon the issuer for information concerning a company, nor rely on the information provided by the issuer and its counsel in lieu of conducting its own reasonable investigation.

In the late 1980’s and early 1990’s a company called Towers Financial was selling pools of consumer debt through dozens of FINRA firms. It was ultimately revealed that the company never owned the debt and it was just a Ponzi scheme. About 200,000 investors lost close to $250 million.

The lesson of Towers Financial was that it is virtually impossible to conduct a due diligence investigation on a company claiming to hold large amounts of consumer debt without a full audit of its books.   Most companies of that size would have an audit as a matter of course. Towers was an exception. A lot of people suffered because of it. FINRA (the NASD back then) never suggested (or mandated) that its members should have been concerned about the lack of an audit. 

Fast forward to the mid-2000s. A company called Medical Capital also claimed to have pools of consumer debt which it really did not have. FINRA members helped the company raise over $1 billion from thousands of unsuspecting customers. It too was a Ponzi scheme and it too was unaudited.

FINRA did very little in the way of enforcement and again refused to simply direct its members to require an audit of any pool of consumer paper. An audit is the only way any firm can verify what the issuer is claiming.  Several of the state securities administrators raised the same questions but the brokerage industry refuses to get the point.

Last week I looked at another company for whom about 60 FINRA member firms raised a little over a $1 billion. Was it audited? No. Is it a Ponzi scheme?  No one has said so officially yet, but there are red flags everywhere. I would hope that FINRA would be all over it, but I know that they will not.  FINRA refuses to see these types of scams even when you rub their noses in them. When public customers keep losing a billion here and a billion there the regulator is clearly asleep.

Case on point.

When I was filing claims on behalf of public customers with FINRA for arbitration, it was never my practice to send a copy of the complaint to FINRA’s enforcement division.  I would only do so if I thought the offending conduct on the part of the broker or the firm was particularly obvious, onerous or both. The very last time that I sent a copy of an arbitration claim to FINRA enforcement they bobbled the ball.

The claim was on behalf of an elderly investor who had forked over about $600,000 to purchase interests in a private placement which would own an office building in the mid-West. Within a year the investors discovered that the roof leaked and that they were on the hook to replace it.  The FINRA member firms that sold the offering had not bothered to have the building inspected as part of their due diligence investigation. Most people would never buy a home without an inspection report.

The offering also described the sponsor as a “successful” developer when in fact his only prior development had ended in bankruptcy with many of the sub-contractors unpaid. The sponsor did not even hold a degree from the school listed in the private placement disclosure documents.

I documented all of this in the claim with appropriate exhibits and sent a copy to FINRA’s enforcement department.  The FINRA staffer who responded told me that the due diligence that the firm had conducted was just fine and that he felt no further action against the firm was necessary. 

I composed a response that expressed my feelings that the FINRA staffer was a ****** idiot. My partner at the time correctly decided that he would not allow me to send the letter because, in his words, you can’t fix stupid. 

Another case on point. 

A little more than a year ago I was asked to look at a series of arbitration claims that were being filed at FINRA against a small group of small brokerage firms located in the New York, Long Island and New Jersey metro area.  The attorney who sent them to me wanted my help in preparing the claims for hearing and my testimony as an expert witness (yes, I still do that) regarding the substance of the claims and the supervision of the brokers. What I discovered was conduct that was obviously intentional and truly disgusting on the part of the brokers and the firms.

There are apparently dozens of disparate customers voicing the same complaints against these firms. It was obvious that the brokers were cold-calling older businessmen and retirees in the mid-West. Quite a few listed their occupations as farmers.

The customers were complaining that the brokers had sold them on the idea that they were superior stock pickers who were and who would continue to make substantial returns for their clients.  Yes, I know that most readers of this blog would not fall for that, but apparently hundreds of public customers did.

Once the accounts were opened each customer complained that they had lost money because the brokers had churned their accounts and had made unauthorized trades. Of all of the claims that customers can make against their stockbrokers, these two in particular, excessive and unauthorized trading are the easiest allegations to prove or disprove. 

In the stockbrokerage industry a broker cannot enter a trade in a customer’s account without the customer’s prior approval. In the normal course of business a broker will get permission from the customer to buy or sell a security, hang up the phone and enter the order.  So there should always be a record of the phone call showing the time it began and the time it ended and also a time-stamped record of when the order was entered and when it was executed.

I asked the attorney if the firms had produced records of the phone calls where the brokers and customers had spoken prior to every trade. Not a one.  Obviously the firms and especially the Compliance Directors know that the trades were not authorized.

Churning or excessive trading has been a problem in the brokerage business for at least as long as my tenure in it.   If you are “investing” in a company then you are betting that the share price will move up as the company’s earnings improve. In the normal course it will take until the company’s next quarterly report before you and the market know if you were correct, often longer.

Investors will usually buy a stock and hold it for three or six months or longer. If your portfolio is worth $1 million, then you might turn over (buy and sell) its value two or three times a year. More than that is always suspect.

Traders, on the other hand, buy and sell stocks every day. That is why they gravitate to firms that charge very low commissions per trade. When you see a customer at a full commission firm turning their account over more than once every other month, they are either really foolish or the broker is crooked and taking advantage of them. In the records that I reviewed the customers were paying hundreds of dollars in commissions for each trade.

According to FINRA’s own Brokercheck™ reports there are today ten or so firms in New York, Long Island and New Jersey that have multiple brokers with multiple claims from public customers whose accounts may have been turned over more than 50 times a year, generating millions of dollars in commissions. FINRA tells customers to always look at the Brokercheck™ reports, but apparently its own staff fails to do so.

I see all these scum brokers ripping off unsuspecting customers just by reading the arbitration claims. The Compliance Directors and owners of these small firms certainly see them. The clearing firms are getting paid for every trade so they must see it too. Some of these claims are from 2015 and the brokers are still at their desks churning accounts every day.

Back in the mid-1990s the NY Attorney General published a report on small firms in NYC, Long Island and New Jersey that were churning accounts. The report suggested that several were associated with organized crime. Different firms are involved today, but the ones that allow these brokers to make unauthorized or excessive trades are still stealing money from public customers. They may or may not be “organized” but they are certainly criminals.

What will it take for FINRA to take its head out of the sand and close down these firms and bar these brokers, compliance directors and firm owners from the securities business? FINRA gives a lot of lip service to enforcement. This repugnant conduct calls for action.

(PS- If FINRA enforcement or any state securities administrator would like a list of these miscreant firms and brokers, just let me know). 

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