Please STOP Funding Start-ups with “Impractical” Business plans

Please STOP Funding Start-ups

Too many people in the crowdfunding community seem to think that the crowdfunding industry exists solely to provide access to capital to small entrepreneurs who have previously been denied access by the evil banks and brokers on Wall Street. 

I think that the crowdfunding industry will eventually grow and compete with the mainstream banks to fund the same credit worthy companies. The industry just needs to point itself in that direction, something it has been reluctant to do.

Fundraising for start-ups has become remarkably easy with the JOBS Act and equity crowdfunding.  A good, well-funded and professional crowdfunding campaign should receive the funds it seeks every time.

Still many small companies struggle to raise even $50,000 on a Reg. CF funding portal.  Too many of these small Reg. CF offerings fail to raise all of the funds they seek. Part of the reason is that, statistically, 90% of start-ups will fail.

The total universe of investors who might invest in these start-ups is a very small segment of the total number of investors and represents a limited pool of capital. The challenge for any issuer that is crowdfunding for capital is to reach out to enough of the right investors and deliver the right message about your company to them.

Many of the crowdfunding “experts” seem to view investing in start-ups and small businesses as gambling, not finance. That is because many of the funding portals and “experts” know very little about finance.  Some of the portals seem to list any company that can pay the upfront fees.

A great many of the start-ups that seek funding on the Reg. CF funding portals do not deserve to get funded. The offerings are, for want of a better word, crap. The business model they present is unlikely to succeed. Investors are likely to experience a total loss. These companies need to either get their act together or just give up on the idea of getting strangers to fund their business. 

When I read a business plan, I can usually tell if the company has at least a good chance of success or not. It is more than me making an educated guess because there are usually clear signs. Operators of Reg. CF funding portals are supposed to make the same judgment and refuse to host an offering that presents an “impractical” business plan.

Unfortunately, some of the portals do not seem to understand their responsibilities as FINRA members.  Several of the funding portals have no personnel on staff with any experience in any aspect of selling securities, let alone compliance with the regulations. 

I recently joked that what the crowdfunding industry needed most was an introduction to Benjamin Graham because most people operating funding portals think Ben Graham invented a cracker. It is only funny because it is true. 

Several years ago, FINRA expelled crowdfunding portal UFP (uFundingPortal), in part for listing companies with “impractical” business plans. Despite FINRA’s clear warning to the funding portals not to host these types of offerings, many of the funding portals continue to ignore FINRA. 

So what, exactly, does FINRA mean when it is telling funding portals not to list a company that has an “impractical” business plan? It starts with what the company that is raising money is trying to accomplish and whether or not, following its business plan, management has a reasonable chance of making it happen.   

The presentation of an offering on a funding portal should eliminate much of the hype and exaggeration. Notwithstanding, many entrepreneurs are clearly being encouraged to “dream big and promise big” by funding portal operators. If a company is raising capital from investors by making promises it is unlikely to keep, then its business plan is “impractical”.

I think that everyone would agree that a company that is raising $100,000 and promising that it will be enough money to build a skyscraper in Manhattan or to develop a drug that will cure all cancers has an impractical business plan. The same would be true if the skyscraper was not designed by an architect or the drug was intended to be sold without FDA approval. 

A business plan that suggests that the company will sell one million units of its product using social media would be impractical if the company did not have some way of backing-up that assertion.  FINRA has a consistent policy that requires that there be a reasonable basis for all sales and revenue projections. 

As the regulators move forward I think that they will find that a company that intends to market a product that infringes on another company’s patent has an impractical business plan. But not every case will be as clear cut.

Can the Management Deliver?

Investors know that 4 software developers writing code and a CFO do not equal an operating company. It helps if the company has people with experience in the industry in which the company will be operating. At a bare minimum, every company seeking investors should have managers that have experience in managing people. 

With start-ups, it is a red flag if the CEO does not have experience managing a lot of people. It is one thing to get people to work well together and produce the work that needs to be done. It is another in this day and age to comply with often complex workplace rules.

Investors like to see that a company has a marketing director with real experience selling similar products. If the company is not yet ready for a full-time marketing director then the company should at least have someone with marketing experience as an advisor or on the board of directors. For many companies the cost of new customer acquisition is a key metric and may be a foundation for all financial projections.   

I listen when a company tells me that its product will sell millions of units or become a ubiquitous part of everyday life. A company should be able to demonstrate not only that people will want to buy its product but that it can produce it profitably, deliver it efficiently and sustain both.

I always ask about a company’s supply chain.  It is fine if all the company has is a prototype at this point, but if it expects to sell 100,000 units in the first year, it should be ready to explain where the company will get those units, what they will cost and how those units will be distributed.

For a pre-revenue or unprofitable start-up, I always ask the company when, in terms of revenue, will the company breakeven. A company that claims it will see double or triple-digit growth needs to be able to support those claims and demonstrate how and why they will come true.

“If we build it, they will come” is not the best approach for realistic sales and sales growth. Even a start-up should be able to make realistic assumptions based upon proposals give by outside marketing firms.

All of the above is encompassed by FINRA’s rules governing how a Reg. CF funding portal is supposed to operate. The regulations include provisions that are firmly rooted in the idea of investor protection and textbook finance.

New rules allow the funding portals to raise up to $5 million for every company. There has been a significant uptick in funding portal applications.

Small investors are being hyped with the idea that crowdfunding portals are offering opportunities for them to invest in the next Facebook or Amazon that will turn their modest investments into huge profits. The last thing the industry needs is more small companies with dubious products and inexperienced managers competing for investors’ dollars.    

The regulators will never accept the idea that investors in the crowd can be left to fend for themselves or that proper disclosures do not need to be made. Equity crowdfunding is not a caveat emptor marketplace. 

A funding portal is a regulated financial intermediary. It is a very small industry with a single regulator, FINRA. Widespread disregard of those regulations is not good for the industry’s long term health.

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Investors: Be Careful Walking Down CrowdStreet

Investors: Be Careful

2016

Back in early 2016, when the first Regulation A + offerings were being made to investors, I wrote a series of articles questioning the veracity of some of the disclosures that were being made. I called out 6 offerings and within a few months, 5 of the 6 had problems with regulators.

Someone suggested to me that I had a talent for spotting scams. It isn’t a talent, it’s a skill, one which I learned when I was a young attorney still working on Wall Street. I was taught how to conduct a due diligence investigation of any company, even when the technology the company was developing was out of my area of expertise.

It is the skill that originally brought me to California in 1980s. I was hired by a law firm to prepare due diligence reports for a venture capital firm that was funding Silicon Valley start-ups.

In the early days of crowdfunding, there was some discussion that the “crowd” of investors could collaborate together and ask the questions on a public platform that investors should ask. That was never true and never really developed. If you want to conduct due diligence on any offering it is always best to hire someone who knows what they are doing.

One of the very early crowdfunding platforms was a company called CrowdStreet which raised $800,000 in seed capital and opened for business in Portland, OR in 2013. It was a Title II platform offering real estate investments to accredited investors. CrowdStreet was one of the few platforms I looked at when I first became interested in crowdfunding. 

Over time, CrowdStreet seemed to quietly grow and succeed. Syndicating real estate is not rocket science and there is no shortage of accredited investors with money to invest.

In 2018, CrowdStreet “partnered” (their word) with a real estate firm in New York City called MG Capital. MG Capital claimed to be “the largest owner-manager of debt-free luxury residential properties in Manhattan”. At that time, MG Capital was offering investors the opportunity to invest in two real estate funds, MG Capital Management Residential Funds III and IV. The principal of MG Capital was a gentleman named Eric Malley.

$500M to $58M?

The private placement memos for these funds touted the success of MG’s two prior funds (Fund I and Fund II) as would have been appropriate. It claimed that MG had raised over $1 billion for the two earlier funds. Based upon their successful raises for Funds I and II, MG projected a successful raise for Fund III of over $500 million. According to the SEC, they actually raised about $58 million, based upon the strength of their prior success with Funds I and II.

Unfortunately, neither Fund I nor Fund II actually existed. On its website, CrowdStreet makes the following claim: “We evaluate the sponsor’s track record, including a review of their quarterly reporting, to confirm they have successfully executed on past deals and can demonstrate stewardship of investor capital. We specifically look for successes in the asset type they are trying to bring to the Marketplace. We want to work with sponsors that value direct relationships with investors and have the infrastructure to support those investors for the duration of the project.”

Forgive me for asking the obvious question but how do you “evaluate” a track record that does not exist?

SEC

According to the SEC, Malley and MG Capital made numerous other misrepresentations in their marketing materials and offering documents, including claiming that investors’ capital was “100% protected from loss” and secured by a non-existent $250 million balance sheet. MG also  claimed that they had partnerships with hundreds of prospective tenants with pre-signed, multi-year lease agreements.

Just the statement “100% protected from loss” is a red flag for any capable due diligence officer. Any private placement is a speculative investment and investors are always advised that they may lose all or part of their investment.

If a company like MG Capital presented a balance sheet claiming $250 million, a good due diligence officer would have asked for an audit. Crowdstreet’s due diligence files should have had a sampling of those leases sufficient to satisfy that MG’s representations were true.

Also according to the SEC, Malley and MG Capital misappropriated more than $7 million in investor assets while using falsified financial reports to conceal huge losses that ultimately forced the two funds into wind-down. At least one early investor sued MG as early as May 2019.

In truth, I don’t follow CrowdStreet, nor did I have any reason to doubt the honesty of its management. I was prepared to give them the benefit of the doubt and assume that they had just been bamboozled by the bad actors at MG Capital.

What actually got my attention was the fact that CrowdStreet is looking for a new President and Chief Compliance Officer. LinkedIn dropped a notice of that job offering into my feed because their algorithm thought it matched my skill set. After 40 plus years syndicating real estate even I thought it was a good match.

I sent in an application last week, in part because the Golden State Warriors were losing (badly), in part because the job was being offered as “remote” which was interesting to me, and in part because if the problem with MG Capital was a one-off, I could probably help them to compartmentalize their exposure.

It took them one day to tell me that my skill set was not what they desired.

Upon further investigation it appears that lawyers who represent investors are lining up to sue CrowdStreet for offerings it hosted that had nothing to do with MG Capital. And let’s be clear, in order for an investor to sue, the investor needs to show that they lost money. In this bull market for real estate, that is hard to do. If CrowdStreet hosted a number of offers where investors were defrauded, in my experience and opinion, the problem at CrowdStreet is a systemic failure.

In addition to a new slate of managers, CrowdStreet is moving from Portland to Austin, Texas. If I had to guess, I suspect that this is the beginning of its winding down process and an attempt to distance the current management from the stench they created.

Multi-Million Dollar Scandal

CrowdStreet may turn out to be a huge, multi-year, multi-million dollar scandal that will turn investors off to the idea of buying shares in a real estate project from a website. That would be a huge black eye for the crowdfunding industry as a whole. 

Notwithstanding, the crowdfunding industry “experts” will, at best, lament this as an aberration. The idea of teaching every platform or portal operator how to conduct a legitimate due diligence investigation is a non-starter. Believe me, I have offered to teach at least one platform that consistently hosts offerings that are BS for free and got turned down.

As I have said before, the crowdfunding industry needs to re-focus on investor protection or the investors the industry cannot live without will continue to stay away.

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

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Making the New Capitalism Efficient

Making the New Capitalism Efficient

Economic theory teaches us that in a perfect world capital would always be allocated to its best use. The best use is always viewed from the perspective of the person or entity that is deploying the capital. Consequently we normally calculate the best use as the highest rate of return that the capital can reasonably achieve. The object is always to use money to make money.

To further this goal, capital has always been deployed to companies that have had the best chance of success. A due diligence process is employed to separate the best companies from those that the market deems less worthy. While far from perfect, this system has historically worked well enough to create our modern society with few truly innovative ideas left by the wayside, meaning unfunded.

In the last 20 years, some people with capital have been content to deploy it for other, more altruistic reasons. Specifically, they want to make capital available to people who have no access to the mainstream capital markets and others who for a variety of reasons could not get funded.

This new capitalism has taken two innovative forms, micro-lending and crowdfunding. Each has the potential to put capital into the hands of people who otherwise would never have access to it. Both have the potential to be transformative at the lowest tier of the global economic system. Neither is focused on highest rate of return as its primary goal.

In its purest form a micro-loan is very small and will often help a subsistence level individual transform into a capitalist. Micro-loans are frequently used to purchase one sewing machine to create a manufacturer; one shipment of goods at wholesale to create a merchant. Some micro-loans are used by a rural community to purchase one used truck or tractor. The benefits of these loans are obvious.

As originally envisioned, micro-loans were often interest free or loaned at an interest rate low enough to cover only the lender’s overhead and the costs of defaults. Even though no one who gets a micro-loan has a FICO score, statistics show the rate of default worldwide to be very low. As much as 97% of the loans are repaid. As conceived, micro-lending is a model of market efficiency.

Unfortunately, as this industry has developed and matured, there are some places where micro-loan programs are managed by bloated bureaucracies. There are stories of interest rates that would make loan sharks blush, corruption and exploitation in the lending process and misappropriation of funds intended for borrowers.

Crowdfunding

Crowdfunding is a remarkable tool for capital formation. Its successful utilization still eludes too many small businesses who might benefit most from an infusion of capital.

The crowdfunding industry still suffers from “experts’ who have no idea how to raise capital. Fraud remains a problem because no one really vets the companies that seek funding. The process itself can be expensive and is often hit or miss even though it does not need to be.

Investors who buy into the equity of a small company on a crowdfunding platform must understand they may take a total loss. Even if the company is initially successful, there is no liquidity for the equity that investors purchase.

There is, I would think, a way to combine the micro-loans with crowdfunding in a way that would remove much of the inefficiency. I think it would be welcomed in the developing world.

In most developing countries there are universities whose students are themselves often making the transition to the middle class. They should appreciate that strengthening the underclass will provide a greater market for the products and services that they themselves will eventually make and/or sell.

What I would propose is that each university in developing countries create a crowdfunding program to enable students to fund micro-loan programs in their own communities.

Most peer-to peer lending platforms allow companies in need of loans to borrow from multiple individuals, essentially syndicating each loan. I envision the university students creating a single fund from which to make micro-loans to many borrowers.

I would ask the students to fund the program by purchasing shares in the fund with a small yearly tithe for the 4 years that they are students and for a few years after they graduate. Call it a 10 year voluntary commitment to purchase shares.

Additional funds would come from sale of shares to faculty, alumni, local banks, businesses and importantly, each country’s expatriate community. University students in western countries could partner with university students in developing countries. All anyone need do to participate is buy one share.

I have intentionally left out any local government involvement or participation. Direct government participation rarely adds efficiency to anything.

Business students and volunteer faculty at each university would administer the fund. This would remove much of the costs and corruption. It would give these students valuable experience evaluating business proposals and detailed knowledge about the local economy that will not be found in their textbooks.

Borrowers would pay a fixed interest rate. A rate of 6% might be sufficient to cover the risk of defaults and provide some amount of internal growth. Real growth for the fund will come from new students who will join the program each year as they enter college.

At some point each fund would reach a predetermined principal amount and be closed. In the US and elsewhere a closed-end mutual fund can become registered and be listed and traded in the regulated securities markets. This would provide liquidity to these crowdfunded investments where none exists.

Even after it is closed, a fund can continue to collect payments on existing loans and make new loans year after year. There would be no reason or requirement for it to liquidate.

As the fund grows after it is closed the per-share value will continue to appreciate. Providing for growth and a liquid market would mean that shareholders could expect to make a profit from their investment.

The closing of one fund will be followed by the opening of a new fund to replicate the process. Over time, multiple funds will exist in every country that wants them, sponsored and funded by university students and others who will see both the benefits of the program and the potential for their own modest profit.

Replicated university to university and country to country a program like this would have a demonstrable effect within a decade. On a continuing basis it has the ability to transform communities and economies in the developing world from the bottom up.

It is an opportunity to demonstrate that altruism and capitalism are not mutually exclusive.

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

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