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

Or you can book a time to talk with me HERE

Remembering the “customer’s man”

customer's man

The 1970’s

Several weeks back I had lunch with a colleague who, like me, had started in the brokerage business in the 1970s. At one point he referred to himself as a “customer’s man”. It was a term used to describe a registered representative that I had not heard in years. It evoked a way of doing business that has largely been lost.

At that time, commissions and costs were fixed across the industry. Today, we see these costs as an impediment to our ability to maximize investment returns. We have lost sight of the value that a good customer’s man brought to the process.

A good customer’s man got to know you.

The brokerage firms encouraged every customer’s man to get to know every one of his customers and to get to know them well. You would meet in person to share lunch, drinks, dinner or to play squash, tennis or golf. Over time and many conversations you would get to know quite a bit about each others’ lives and families. Your customer’s man would become one of your trusted advisers.

A good customer’s man was a good stock picker.

Customers’ men were always on the look-out for the next stock that was about to make a move. They were selling their ability to pick stocks and to buy them for you at the right price.

Your customer’s man would always tell you which stocks he was following and why he was following them. He would call to tell you when the price had dipped and to recommend that you give him an order to buy a few hundred shares for you. You would not hesitate.

A good customer’s man made money for you.

Customer’s men were judged by how much the stocks that they recommended went up. It was a simple metric that everyone understood. Very few built their book of customers by advertising or seminars. The best built their books by word of mouth. They asked existing customers for referrals. Customers who made money following their broker’s recommendations gave the best referrals.

From the 1970s forward if the firms wanted more customers, it meant having more brokers with bigger and bigger books of customer accounts. The big action was moving established producers around from firm to firm. Front-end bonuses for really big producers became really big. Just about every broker wanted to be a bigger producer.

That attitude was good for the firms and they encouraged it. Brokers became almost exclusively focused on bringing in more customers. No longer were they judged for the stocks that they picked or how much money their customers made. Producers were now judged on how many “assets under management” they have.

The actual management and investing of the customers’ funds was increasingly handled elsewhere. Enticing new customers meant selling the investing and management skills of others.

The 1987 Crash

This was logical as so many of the customers’ men had not seen the 1987 crash coming. If they had, logic suggested that they would have pulled their customers out before it happened.

customer's man

It was time to let the experts manage your investments. Customers were sold many different kinds of managed funds, annuities and other “packaged” financial products. All of these products were expensive from the customers’ standpoint. The firms had built in significant underwriting costs and management fees.

Many of these fund managers drank from the Kool-aid that said that price/earnings ratios of 50 or more were sustainable and likely to go higher. Individual brokers who questioned the wisdom of the high paid fund managers and research analysts were brought into line or shown the door.

When the tech market inevitably crashed, many in the industry argued that “no one had seen it coming.” They said the same when the market crashed again in 2008. It was a phrase that was repeated so often that people started to believe it.

It re-enforced the idea that the average financial adviser can do no better than average. Everyone just started buying the index, certain that no human being who actually works in the markets every day could actually have awareness of what was going on or to help customers profit from it.

The index was much cheaper than a human adviser in any event. Lower costs were more efficient and would increase returns, provided, of course, the market goes up.

A good customer’s man always put the interests of his customers first. It was an era when almost every business adhered to the idea that “the customer was always right.” When is the last time that you heard that phrase or saw it posted in a business or an office?

Today, the industry staunchly opposes any regulation that would require individual brokers to put their customers’ interests first. That should tell you everything that you need to know about the financial services industry today.

The individual registered representative, the back-bone and the public face of the brokerage industry will likely not survive another generation. Their jobs are already foolishly being replaced by computer driven robo-advisers.

The industry will survive and prosper without the customer’s men. It is already oblivious to what it has lost.

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

Fidelity’s Folly: Bitcoins for All?

Fidelity

Fidelity Investments

People keep asking me what I think about Fidelity Investment’s announcement that it will act as a custodian for bitcoins and other cryptocurrencies. As anyone who follows me knows, I don’t think very much of it at all. 

Fidelity has made it clear that it is “all in” on cryptocurrency. Its website notes that: Fidelity Investments “operates a brokerage firm, manages a large family of mutual funds, provides fund distribution and investment advice, retirement services, Index funds, wealth management, cryptocurrency, securities execution and clearance, and life insurance.” 

Fidelity would certainly wish to expand each of those profit centers. With bitcoins and cryptocurrency there is the potential for enormous growth if Fidelity can turn them into just another “investment”. It can’t, even though it is trying very hard. 

Just last week, Fidelity’ Director of Research published a report that suggested that bitcoin is a “potentially useful” asset for “uncorrelated return-seeking investors”. The report said that “in a world where benchmark interest rates globally are near, at, or below zero, the opportunity cost of not allocating to bitcoin is higher.” 

Please do not be impressed with that gooblygook. There is no real data about bitcoins for the Director of Research to research. You cannot analyze bitcoins in any traditional way. They are merely a few lines of computer code. This report is reminiscent of the type of justification that analysts gave in the dotcom era for supporting stocks, with no income, trading above $100 per share. 

The report further suggests that bitcoin’s current market capitalization “is a drop in the bucket compared with markets bitcoin could disrupt.” That certainly sounds like a “buy” recommendation to me.

The primary markets that bitcoins might disrupt are banks. In truth, bitcoins, when used as payment in commercial transactions, disrupt nothing. Banks and banking are not going away.   

If you consider how many payroll and Social Security payments are already deposited directly to recipients’ accounts and how many of those recipients pay their electric power or insurance company “on-line” it is fairly easy to see that converting the deposit to bitcoins before you make the payments is an extra step not likely to find favor.  

The one thing that will cause the current price of bitcoins to appreciate is a lot more investors willing to buy them and hold on. That is the strategy being pushed by Fidelity with the blessings of “pseudo” market professionals. 

Last month, Fidelity stated that it had polled a number of the “professional” fund managers and investment advisors who are currently its customers.  Apparently enough advisors would consider bitcoins for their advisory clients to warrant Fidelity acting as a bitcoin custodian. 

Some number of advisors who already use a Fidelity platform will certainly purchase some amount of crypto currency for their clients’ accounts.  That “professionals” are buying bitcoins is likely to be used by Fidelity as a reason to advertise them to average, small investors as “what the Pros” are buying. 

In 2 years, Fidelity may have many billions of dollars’ worth of bitcoins held in accounts on its platform. That will not make it the right thing to do.

Law and Economics, which I taught back in the 1990s, studies how our interwoven markets interact with the laws that regulate them. Judges interpret those regulations, often influenced by what they perceive the regulators intended to accomplish.

The regulations that govern our financial markets (equity, debt, currencies and insurance) have evolved over the centuries with the markets that they regulate. The introduction of something as novel as crypto currencies into the financial markets should be expected to suffer some adverse legal consequences. 

As a matter of law, every Registered Investment Advisor (RIA) and anyone investing other people’s money is held to a fiduciary’s standard of care.  Fiduciaries are usually required by law to: 1) act in the best interests of their clients, 2) preserve and protect the assets entrusted to them and, 3) when investing to act as a “prudent” investor would act.

A fiduciary’s duty to its client or beneficiary is a much higher standard of care than in any ordinary commercial transaction. To satisfy that standard often means taking “extra” care to mitigate obvious risks.

Fiduciaries become fiduciaries when people trust them to hold their property or to act on their behalf.  People most often trust fiduciaries because they have specific expertise in the matter at hand. Both fund managers and RIAs fit that description. Both are held to a fiduciary’s standard of care and their conduct is most often judged against that of other experts in their field. Most investment professionals will never purchase any crypto currency for their clients.

Fidelity, the fund managers and RIAs who do purchase bitcoins and store them at Fidelity obviously believe that the price of bitcoins (currently in the range of $10,000 a piece) will appreciate and perhaps double or more.  It is certainly possible this could happen.  Two years from now the price of a bitcoin might have risen to $20,000 each and possibly higher. Many of the bitcoins held at Fidelity will have been purchased at close to that amount.   

Let’s assume that for some reason or another, in a 90-day period, the price drops back to $10,000 each.  That could result in several billion dollars in actualized losses as some will “hold” all the way down in hope of a rebound.  Does Fidelity shoulder any liability for these actualized losses?

The Fund Managers and RIAs certainly do. Unlike most litigation, where the burden of proof is on the plaintiff, in many states, fiduciaries are required to demonstrate the reasons that they made the offending investments.  Much of the case will be dependent upon what the advisors can show were their reasons for buying bitcoins in general and also specifically on the day and at the price that they did. They will also have to demonstrate why they held on as the price deteriorated.

Given that there are no fundamental reasons for purchasing bitcoins I suspect that most will try to defend themselves arguing that bitcoins are a hedge against adverse results in the rest of the portfolio. That argument is likely to fail. 

Bitcoins are, after all, a commodity, and putting aside the fact that most RIAs are not trained or licensed to sell commodities, gold would be a more accepted hedge if that is what the RIA wanted to do. If nothing else gold is unlikely to lose 1/2 its value in a short period of time, which bitcoins have already demonstrated they can do. 

Litigation

Fidelity’s role as a platform or clearing firm might save it in Court but these customer claims are more likely to be heard by arbitrators appointed by FINRA, especially if Fidelity is named as a respondent. I have been an arbitrator and argued many cases in front of others. They are more likely to be older and their view of bitcoins will probably be closer to Beanie Babies, than as a new form of currency that trades in a very opaque market. 

Fidelity

Two recent cases brought by the SEC will not help Fidelity’s defense either. The first is SEC v. ICO Box, where the SEC alleged that the platform “facilitated” the sales of more than 30 different crypto currencies. “Facilitated” is a word that will make defense lawyers crazy. 

By the time that these claims get to a hearing I suspect that complaining customers will be able to present a banker’s box or two of “reports” written by Fidelity that suggest that RIAs purchase bitcoins for their customers. That should certainly be viewed as a “facilitation”.

The other case is called SEC v. Lorenzo.  Lorenzo was charged with copy and pasting an e-mail written by someone else and sending it to prospective investors. The SEC alleged that Lorenzo “disseminated” misleading information in order to make the sale. Given the outrageous claims made by many in the bitcoin world, some Fidelity employee is more likely than not to resend a report or article that Fidelity cannot defend.

The mutual fund industry, Fidelity’s core business, is under great stress to lower the fees it charges investors.  For all the BS that you may hear about how Fidelity’s actions in embracing crypto is “cutting edge” or “visionary”, it makes more sense that Fidelity is touting crypto to make up for revenue lost elsewhere.

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

Reg. CF – Will Fools Rush In?

Reg. CF – Will Fools Rush In?

I have written a lot of articles about crowdfunding in general and specifically about crowdfunding to accredited investors under Regulation D.  I have largely ignored the much smaller financings that are accomplished under Regulation Crowdfunding (Reg. CF) that accept investments from all comers. The time has come to fill that void.

REG CF

Reg. CF was the last of the regulations issued by the SEC under the JOBS Act.  It embodied much of what proponents of the Act had wanted….a sanctioned method for community funding for start-ups and small businesses. 

The first Reg. CF offerings began in May 2016. Despite a few success stories, the Reg. CF marketplace has yet to mature.  I do not see that coming at any time soon, despite the out-sized need for small business capital.

Reg. CF created a new class of financial intermediary called “portals” which are essentially websites where companies seeking investors are displayed.  But the portals are more than just websites.

The SEC wanted this market to be regulated, in part to protect investors from fraudulent offerings and in part to provide the companies seeking capital with a way to interact with investors in a regulated environment. The SEC required the portals to register with FINRA, the stock brokerage industry’s regulator, and to adhere to FINRA’s regulations.     

Until recently only about 50 portals had been registered with FINRA, a number that had been fairly static for a while. A small handful of the portals handle the bulk of the transactions.  Some of the earlier portals have quietly gone out of business. The rest quietly grind out only a few offerings at a time. 

Top Ten REG CF Portals Ranked By Capital Raised 2020

Reg. CF required that investors be given specified disclosures about each company.  It set baselines for the presentation of financial information and set limits on how much any small investor could invest every year in these very risky ventures.  A required filing gives the SEC specific information about each offering. 

Reg. CF allows companies to raise no more than $1,070,000 in a single year. For reference, the average loan guaranteed by the SBA is closer to $600,000. The SBA guarantees about 40,000 loans per year and rejects a similar amount. There are many thousands of small companies that do not come up to SBA standards.

A great many companies would have their capital needs satisfied with much less than $1,000,000.  These companies should be looking to Reg. CF portals but are not. The portals have not demonstrated that every listing will get funded which is what any company should want.   

A very large percentage of the offerings that list on Reg. CF portals raise very little money.  Still, a great many start-ups and small businesses ask for very little.  Many of the offerings seek less than $100,000. 

Many of those small offerings do not employ a specialized marketing company or even an organized crowdfunding advertising campaign.  Too many of the campaigns rely solely upon the company’s existing social media contacts which are rarely enough to get the company funded. 

Portals

Very, very few of the portals are wildly profitable, if at all, even though the compensation structure is patterned after the wildly profitable mainstream stock brokerage industry.  Most portals charge close to 7% of the funds every company raises. The very best portals raise a total of less than $1 million every week.  This against a backdrop of so many companies in need of capital.

Five new portals were registered this month and the scuttlebutt around the industry is that another dozen portals more or less are in various stages of the registration process. Many anticipate that the SEC will raise the limit to $5 million. That may or may not happen and it will have little import since most of the portals have no idea how to raise even $100,000.

Just in the last few months, I have spoken with several people planning new Reg. CF portals. With one exception, none of these new portal owners knew anything about selling securities which is the business of any portal. None seemed particularly interested or focused on helping the listing companies raise the funds that they seek, even though the portals get paid a percentage of the funds that are raised.

FINRA

FINRA has always been a fairly lax regulator.  Notwithstanding, like many regulators, FINRA can get their teeth into you. They especially like to tangle with smaller firms that would rather settle than fight. 

Reg. CF – Will Fools Rush In?

I expect FINRA to get more involved as it is aware that the investors themselves have little recourse. If an investor invests in a Reg. CF offering that is a total scam no lawyer is going to file a suit against the portal if the loss is only $500.  Even a $1 million Reg. CF offering is likely too small for a class action.

FINRA has its own set of portal rules and an established set of standards and practices.  FINRA views the portals as being in the business of selling securities to public customers and should be expected to act accordingly.

Several people in the crowdfunding industry have suggested to me that crowdfunding platforms and portals have no real liability if an offering they host uses fraudulent or deceptive means to attract investors.  At least with portals, that is categorically not true.

FINRA’s Rules for Portals specifically forbids the portals from engaging in fraudulent conduct with the same language it prohibits the mainstream stock brokers. As the portals do not have trading desks, the only place the portals might engage in fraudulent conduct is regarding the offerings they host.

FINRA expects each of its Members to have some system in place to verify the information that the listing companies provide to the public investors.  FINRA has warned its members to not accept the self-serving statements of the founders of these companies at face value.  In many ways, this is the antithesis of the approach that many portals take, especially with start-ups. 

I have said before: when a portal lists an offering for a pre-revenue company, with negative or minimal book value, and allows the company to claim a “valuation” of tens of millions of dollars it is a fraud.  What some VC might think or say about the company is not regulated in the same way as a firm registered with FINRA.  The lawyers who allow the portals they represent to make a misrepresentation as to the “value” of a company are not doing anyone any favors. 

There are very few lawyers who work with Reg. CF portals. Every one of the lawyers that I have met or spoken with was a very competent professional.  But not all of them could really see Reg. CF offerings from the investor’s point of view which FINRA is likely to adopt as its own.

I recently spoke with an attorney who represents one Reg. CF portal and who is in the process of helping a client set up another.  His new client writes a blog with a lot of followers. The blog features articles about specific start-ups.  His client frequently appears on podcasts that get a significant amount of viewers. The client hopes to leverage his notoriety to help the companies that list their offerings on his new portal.

Rules Are Rules

FINRA expects portal owners to follow its rules regarding communications with the public.  When you are selling securities much of what you can and cannot say is regulated.  There is also a list of things that you must say when talking about an offering where you expect to collect a fee if the offering is successful.

Reg. CF – Will Fools Rush In?

FINRA has already expelled one portal owner for what he said about an offering in an interview away from his portal. There will be others.

I asked the attorney if the portal he was working on had an in-house compliance officer with experience to check all the scripts and the advertising copy for compliance before it is released.  He told me that his client had not even thought about it.

That is the nub of the problem.  Only one of the new portal owners with whom I spoke had a clear idea of how they would find companies to fund or how to make certain that there were always more investors available than securities to sell.  And that is really crucial to the success of this business.

Adding 20 new portals to a market where most of the portals are not profitable is likely to result in a race to the bottom rather than the top.  Adding more portals whose operators lack essential experience and trained compliance officers is not going to get more small businesses funded correctly.

Ideally, there would already be 50 portals each supplying $1 million per week or more for start-ups and small businesses.  Another 20 would be welcome, especially now when the need for small business capital is great.

With Reg. CF the SEC offered a truly new and relatively simple method of corporate finance for small business.  FINRA offers a roadmap to compliance and respectability. The road to success will come when the portal owners start acting like they are in the business of selling securities and focus on doing exactly that. Sadly, I do not see that happening any time soon.

If there are any portal owners out there who are ready to give up because they cannot run their portal profitably, I have some clients who would be interested in acquiring your registration to help you to salvage something from your efforts.  Serious inquiries only.

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

Creative Crowdfunding

Creative crowdfunding

A mentor of mine used to refer to the process of preparing a securities offering for public investors as a “craft”. He would explain to me:“Before you can sit down and write the offering based on your clients’ specifications, you need to be able to see the offering through the eyes of the prospective investors.”

Crowdfunding is creative finance.  Crowdfunding comes with endless possibilities for creating a variety of unique financing transactions. Each company sets the terms that they will offer to investors. Investors get to say “no thank you” to those terms if other investments are more appealing.   

Many people who work in crowdfunding don’t know the first thing about finance. This limits their creativity and often dooms a crowdfunding campaign that should have been successful.

Crowdfunding Experts

When speaking with a company seeking an infusion of capital, many crowdfunding “experts” give cookie-cutter advice. Some companies use templates to create their offering instead of lawyers. Those companies will never know that there is usually a better way to approach their financing that will be more attractive to investors and at the same time save them a lot of money.  

Creating an attractive investment for an audience of targeted investors on a crowdfunding platform involves a series of tasks. Much of it involves a lot of time looking at spreadsheets.  If you don’t, at the very least, do the following while preparing your crowdfunding campaign, you are likely wasting your time and money. 

Before I structure an offering I expect to review the company’s current financial position. Only then can we decide whether the financing should be debt or equity, whether it should be on or off balance sheet and whether the offering should be for more or less.

You need to be able to demonstrate how you will use the investors’ money and how that money will generate revenues. Your revenue projections need to be supported by real world data and real world assumptions. “We’re going to capture 50% of a billion dollar market in 2 years” is fantasy, not finance.

Every financing transaction has a risk of default or sub-standard performance. You need to understand the specific risks of your business and how to mitigate those risks. You will need to estimate how much of a reward it will take to compensate your target investors so that they will accept those risks. 

Crowdfunding overwhelmingly operates in the Regulation D market selling private placements to accredited investors.  A great many of the accredited investors who you are likely to pitch for your offering have more likely than not, already been pitched to purchase a private placement.

Since the 1980’s the mainstream stock brokerage industry has sold private placements to millions of individual accredited investors. Various types of real estate offerings are the most popular, followed by energy (oil, gas, and solar), films, entertainment and events and equipment financing. 

For over 40 years the mainstream brokers have been selling investors on the idea that private placements provide passive income. Accredited investors are also used to being pitched that private placements come with higher returns. Most crowdfunding is directed at these same accredited investors. You need to give them the information and the pitch they expect to hear. 

The vast majority of accredited investors are baby boomers. They still control the bulk of the money in the Reg. D market. They have grown up with new tech and new companies and they are not afraid to invest in either. But new tech is always risky. You have to offer a return commensurate with the risk.

Crowdfunding as we know it today began with a rewards based model. A company would sell its product on a platform like Kickstarter and use the proceeds from the sales to manufacture the product. Much of the time, the product never got delivered. 

Revenue Sharing

During 2016-2017 there was a lot of discussion among Crowdfunders about a financing model called “revenue sharing”.  In its basic form, a company would raise money from a pool of investors, manufacture the product and then share the revenue with the investors.

Revenue sharing is actually a mainstream tool of modern finance. Many oil drilling programs pool investors’ money to cover drilling costs with the investors and land owners, sharing in the revenue if and when it strikes oil. 

Many franchisers use a revenue sharing model with their franchisees. The parent gets a percentage of the franchisee’s gross revenue structured as a franchise fee, rent, or a royalty on intellectual property. The parent often provides advertising support or promotions to help build sales.

Accredited investors that have purchased Reg. D offerings are familiar with this “slice of the revenue pie” structure. They understand that they will earn less if their oil well pumps 10 barrels a day than they will if it yields 100 barrels a day.  

As I have already mentioned, there was for a while a lot of discussion about revenue sharing.  Several platforms were going to come on line to specifically offer revenue sharing programs. Revenue sharing is a natural for a crowdfunding audience.  Unfortunately it never really took off in the way that I would have expected.  

The crowdfunding industry is still focused on the “buy equity in the business” model, It has gone out of its way to create derivatives like SAFEs to complicate what should be simple capital raising projects.

The crowdfunding industry needs to accept the fact that businesses with no sales or assets are not “valued” at hundreds of millions of dollars in the real world. Insane valuations actually hurt the crowdfunding industry because they drive away serious investors.  Many of those same companies could use creative revenue sharing models instead of trying to sell equity.    

I recently spoke with a business owner willing to sell 10% of his business for $2 million. He wanted to syndicate a Reg. D offering and raise the money on a crowdfunding platform.  He was having a good year and wanted to expand.

The company sells an automated HR suite to businesses with at least 100 employees.  Its customers pay monthly, per employee. The company wants to use the $2 million to open more accounts, each with a large number of employees.    

The company knows the cost of account acquisition and expects at least $10 million in additional revenue in the first year from its $2 million expenditure. Those new accounts are likely to stay customers for many years. 

Instead of selling 10% of the company, I suggested that he share the income stream with investors, pay them back quickly with a generous return and move on. It makes perfect sense.

The company might give the investors 60% of the revenue from these new accounts until the investors get distributions equal to $3 million and then cut them off. They can pay the investors more or less and carry the payments into the future, if they prefer. The company should easily be able to attract $2 million with the promise of paying back $3 million in only a few months.

In this case I would advise the company to take the investors into a separate limited partnership or LLC. Investors like this structure for a number of reasons, not the least of which is that can get paid on the gross sales. They are not concerned about executive pay or management issues. How the company spends its 40% the first year is not the investors’ concern. 

The company does not have to deal with investors on its books and all that entails. This relationship operates and terminates by contract.  If the company wants to sell 10% of its stock later, it will get more if the sales have been increased by $10 million per year.  

I have seen many advertising campaigns funded this way. I have seen companies with multiple products fund one product or even one cargo of its product this way. Most of the crowdfunding “experts” have never recommended this type of revenue sharing arrangement because this type of offering rarely shows up on crowdfunding platforms.

This $2 million gets you $3 million model does not work for every company, but there are other “fund the transactions, not the company” models that may.  These are only one alternative to the traditional equity method. There are others.

As I said, crowdfunding offers opportunities for creative finance, but you need to understand finance, in all its forms, before you can really get creative. 


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

Is Mom Still In The Market?

Is mom still in the market

Millions of retirees are about to get screwed by taking the advice they are getting from their financial “professionals”.  Older investors and retirees are being told to stay invested in the market regardless of the current risks.  It is foolish advice that a lot of foolish retirees will follow.

A lot of people have done quite well in the stock market “buying and holding” during this long bull market. But the time to hold is likely behind us and the time to fold’em is right now. 

Many of these retirees have the same poorly diversified portfolios of stocks they have held for a long time.  It is improbable that the price many of those stocks will continue to appreciate. If anything, the risk that they will continue to go down is greater than the likelihood that they will continue to go up. If they are not going to go up in price, there is no reason to continue to hold them.

Concerned Mother

Last week, I got a call from a friend whose mother was concerned that her account had taken a 6 figure loss in value for the first quarter of this year. His mother is divorced and already retired. Her account is with a large, national brokerage firm. She is concerned that her account balance dropped so much and so fast.

Her broker is telling her not to panic which is always good advice. Investment decisions should be based upon mathematics. It is not very hard today to do the math and realize that holding on to the portfolio you had last year does not add up. 

Her portfolio today is worth less than it was 3 years ago and as I said, down over $100,000 in this last quarter alone.  Her broker told her to “stay the course” because “these corrections happen and the market always comes back”.  

is mom still in the market

As I have said before this current correction is my 7th or 8th and no two were exactly alike.  In the last two, 2001 and 2009 there were clear indications that the market averages were too high and likely unsustainable many months before the bottom. There was plenty of time to sell out and save some money but many brokers then, as now, told their customers to just hang on. 

The mainstream stock brokerage industry chose to ignore the same indicators that they used when they predicted that stock prices would go up. It is ignoring the indicators that this current market is still far from its bottom.

I wrote an article just two months ago when the pandemic was still tangential to everyday life.   I did not think that the government’s tepid response in January would be so consequential by April.  

I noted the various conflicts of interest behind the brokerage industry’s desire for investors to stay invested.  Recessions hit Wall Street hard.  Profits and bonuses disappear. A lot of people typically get laid-off.  The idea that people might sell their stocks and put the funds in a CD to sit things out gives Wall Street indigestion.  

Just Do The Math

Investing is governed by mathematics. Large institutions control most of the money that is invested in the stock market. Most use the same method of Fundamental Securities Analysis first described,in 1934, by Ben Graham in his book of the same name. That book is still used in virtually every major business school.  A large investor like CalPERS or an insurance company will have hundreds of analysts on staff.   

At its basic level, the analysts are using one primary metric; earnings both current and projected into the future.  A projection of higher earnings for next year would be an indication that the share price will be higher next year as well. Analysts are always looking at a company’s business to see if its revenues and profits are likely to increase 6 months or a year down the road.

What do these analysts see today?

Right now, it is pretty clear that a great many companies will continue to struggle at least until the end of this year. When these companies report their earnings for 2020 next spring, they will show that earnings, if any, will be down from earnings last year.  Lower earnings should indicate lower stock prices.

Every indication is that the stock market is likely to be lower next year. The risk that people who stay in the market for the next year will lose money is high. So why would any financial professional recommend that their clients should stay invested especially clients who are already retired? How much can retirees afford to lose in a bear market?

Regulators Agree

A lot of people who got the same advice to stay invested no matter what eventually watched their account values decline to the point that they finally realized that their broker was full of shit. They sold their portfolios and realized the losses that they had were a result of risks that they never wanted to take.

I handled many customer claims against their stockbrokers recovering losses from the last two corrections. The stockbrokers always make weak defenses when confronted with losses that their customers never expected and which they could ill afford.

These claims are handled as arbitrations run by FINRA, the brokerage industry regulator. They are fast and cheap. Like most court cases, FINRA arbitration claims usually settle before the hearing. Retirees who lose money in the market can often recover some or most of what they lost.

 When every stock brokerage account is opened, there is a question on the new account form that asks for the customer’s “risk tolerance”.   A typical form might ask investors to identify the account as  “conservative”, “moderate”, “aggressive” and “speculative”.  They represent an ascending willingness to lose money. But a willingness to lose is not the same as a desire to lose.

For retirement accounts, especially as the retiree gets older, there is a consensus that the account should become more conservative.  Once people stop working and are using their retirement funds to pay bills, preserving those accounts becomes the paramount concern.

Diversify

A diverse portfolio of stocks and bonds was always considered to be a “moderate” risk account. And then something unusual happened.  The overall market itself has become riskier and many of those diversified accounts took on the risks of an “aggressive” account. 

There is no justification for a stockbroker to tell a customer looking for a moderate risk account to stay invested when the risks of the portfolio they are holding have gone up past the customer’s level of comfort.  Many retirees have already lost more than they can afford to lose.

A stockbroker is required to have a reasonable basis for every buy, sell, or hold recommendation that they make. When arbitrations over losses in 2001 and 2009, went to a hearing, there was nothing that the brokers could point to in their files that showed they had a reasonable basis to tell people to stay invested.

If your brokerage statement shows losses that you did not want, send your broker an e-mail asking for his/her specific advice as to what you should do now.  Ask them for the research reports that support their recommendations.

If they tell you, “the market has always come back” remind them that past performance is no indication of future results. If they tell you that no one saw the pandemic coming, remind them that price to earnings ratios were way above their normal ranges for months before the virus.

If your losses are too high and you get insipid answers from your broker, just send me an e-mail. I will be happy to refer you to an attorney who will help you recover your losses.


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 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

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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

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.

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