A long time ago, when I was a young lawyer fresh out of school, I was walking with a friend along a side street in Manhattan, probably in the West 30s. There were brownstones on both sides of the street. We stopped in front of one that had a small shop on the street level.
In the window were two shelves on which were displayed a series of antique dolls, doll clothes and doll carriages and furniture. Many seemed to be from the early 20th Century if not earlier. The shop was dark and the sign on the door said: Hours by Appt. Only.
“Interesting business” I remarked. My friend responded: “That isn’t a business, it is someone’s dream”.
In some ways, every entrepreneur and small business owner is a dreamer. They try to turn the intangible, an idea, into something tangible, a business. Assigning a value to any business is not an easy task. While the business is still a dream it is virtually impossible.
Of all the things that we teach business school students, corporate valuation is given very little time or attention. When a business needs to be valued because it is being bought or sold the task is relegated to accountants. Accountants plug data about earnings and assets into established formulas and come up with a value.
Accountants can determine the “book value” of a business by subtracting the company’s liabilities from its assets. That rarely tells the whole story. What if there is little or no data? What if the business has no earnings or assets?
Assets are placed on a balance sheet at cost and are then depreciated over time. The true value of the asset is not always represented in the financial reports. Some assets, especially real estate can often appreciate over time to greatly exceed their cost.
We teach that real estate should ultimately be valued at its highest and best use. A developer may see a dilapidated old farm as the site of a shopping mall or residential development. Still, the current owner carries the farm on its books at cost minus depreciation. The value of any parcel of real estate can change dramatically in the time it takes to hold a press conference announcing a new development.
Accountants will often add a line item for the company’s “good will” which is more often than not the accountant’s way of capturing the value of the business as a going concern, including the value of its brand and customer base. This, too, is far from perfect.
I have helped many clients buy or sell a business over the years. If they use a business broker to facilitate the transaction they are likely to hear that a business is “worth” 3 times next year’s projected earnings.
This may not be a proper method of valuing a small business either. It is modeled after the way that many research analysts predict the future price of publicly traded securities. But with privately held companies, the risk is often higher so the price for which it sells, logically should be lower.
Yes, I know that this is the antithesis of the view practiced by venture capital firms who are often dealing with companies that have little more than an idea that they want to bring to market. These companies do not have earnings or assets. The values assigned to portfolio companies by venture capital firms have no basis in reality nor are they entitled to be included in any serious discussion of finance.
Intellectual property like patents, copyrights and trademarks are very hard to value at the time they are first obtained. No author knows that they have a best seller on the day their book is published. Few know that their book will be made into a movie or that anyone will pay to see it. So, what is the “value” of any book on the day before the manuscript goes to the publisher?
As an example I have a friend who is a noted cartoonist. Her characters were originally published in the US for an American audience but have found a huge following in Japan. Was that in her business plan when she sat down to draw those characters for the first time? Hardly.
One of the interesting things about intellectual property such as copyrighted material, is that it can be segmented in myriad ways. A novelist can sell the right to have his book published in the US to one publisher and the rights to publish the book in a dozen other countries, or a dozen other languages to a dozen other publishers. The theatrical rights and film rights to the same novel can also be segmented and sold. In the right circumstances, the rights to produce and sell merchandise that derives from the novel may be the most valuable rights of all.
The value of intellectual property can vary greatly based upon how it is used and how it is sold. Young Bill Gates might have sold the operating system he purchased from a third party to IBM for a nice profit and gone on to do something else. Instead, he licensed the software and received a royalty every time IBM sold a PC with the operating system in it. The result was the Microsoft Corporation which made Gates the world’s richest man. We use a lot of royalty or revenue sharing arrangements in crowdfunding because they are clean and simple.
Back in the 1990s when there was a new and disruptive technology introduced every day, I would ask my students if they could identify the most valuable intellectual property that was in use in the 20th Century. It had been a century of tremendous innovation, much of which had been superseded by even better innovation. Many very valuable patents and other IP had become worthless.
The object of the exercise was for them to identify a simple idea that had been patented, trademarked or copyrighted, that had become very valuable even though no one could have predicted the magnitude of its success on day one. I wanted to demonstrate just how difficult it was to value things that had never been done before. Two pieces of IP stood out.
The first was the copyrighted image that is Mickey Mouse. The media giant that is Disney today started with an animated short film of a mouse whistling. Maybe the most recognizable face on the planet, I do not believe that even Walt Disney would have valued the ownership of the copyright at anything close to its true value.
The second was the patented formula for Coca Cola. I have been in a Jeep in the middle of a jungle where the guide said that there was a village up ahead where we could stop and get a Coke. Pour yourself one and try to imagine how many cans and bottles they have sold. How would you have valued that patent on the day it was filed?
I think that I have made the point that placing a value on any business, especially a start-up, is a waste of time and effort. I will encourage any small business owner to dream big, but you just cannot put a number on it.
If you’d like to discuss this or anything related, then please contact me directly HERE
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 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.
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 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.
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.
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
I think that it is patently absurd for people to accept the fact that 90% of start-ups will fail in their first year or two. That number screams that the market for new business formation is not efficient. Economics teaches that markets hate inefficiency and always strive to do better. But this is one statistic that never seems to change.
I have read quite a few books and a lot of articles written by so-called experts dissecting why start-ups fail and how to make them succeed. Much of it is nonsense.
There are really only three primary reasons why a new business will fail; 1) the owner lacks basic business acumen; 2) the business is under-capitalized and 3) the business misread the market. All can and should be avoided if the entrepreneur knows what he/she is doing. Usually lack of experience and the ability to run the business profitably is what leads to the failure. There are a lot of would-be entrepreneurs who do not know what a successful business looks like or how to run one.
It is hard to find an article that discourages entrepreneurs and entrepreneurship. But some people need to be discouraged because they do not have what it takes. Fortunately, most of those people could learn what they need to know even though most will not.
When I was teaching economics I used the example of a restaurant, specifically a small pizza parlor, as a way of demonstrating how profitable a restaurant or any business can be. Of all start-ups, restaurants often top the list of those that fail most often and more quickly than other businesses. That should not be.
In the example, the restaurant’s owner stops on his way to work to buy the ingredients that he needs, flour, cheese, tomato paste, pepperoni, etc. to make the pizzas. If he opens his shop at 11AM, he can convert all of those ingredients into pizzas and back into cash, at a healthy mark-up, by the time he closes that evening. That type of rapid inventory turn-over is almost impossible to get in any other business.
Customers at a pizza parlor are not expecting table cloths and fancy décor so overhead can be kept to a minimum. Since the pizzas come out of the oven one or two at a time, the wait staff can handle more tables than the staff at other restaurants. They may use paper plates and paper cups eliminating the cost of a dishwasher. In most cases, advertising can be done cheaply with signage, flyers and coupons.
Couple that with the fact that the other product the restaurant sells, fountain soft drinks, has a huge mark-up and you can see why a small pizza restaurant can make a lot of money. If he owner is really smart, he will add a soft serve ice cream dispenser as well because it also has a very high mark-up and will substantially increase the total amount of sales and profit per customer.
The further away the restaurant gets from this simple model, the greater the chance that it will fail. Nothing about this discussion has a lot to do with the pizza or how good it is. It is all about the numbers, especially money in and out; how to maximize the former and minimize the latter.
The problem with most people who start a restaurant is that they plan the menu around what they want to serve or what they think they need to serve to attract customers, not on how much money they will make. Likewise, most start-ups focus on their product. But they also need to keep their eyes on the numbers. That is where start-ups succeed or fail.
The real lesson here for any business and especially start-ups is that what you are doing is a business. To make it work you need to be focused on the bottom line. If you cannot operate the business at a profit, it cannot succeed. So why do 90% of start-ups fail: because their expenses are greater than their income.
When someone asks me what I consider to be essential for any new business, I always include an adequate bookkeeping system so the business owner can easily keep track of cash flow, inventory turn-over, etc. It is very difficult to find that suggestion on the list of start-up essentials in any of the hundreds of articles on the subject in Inc. or Entrepreneur Magazine.
The best advice for any start-up would be to “work smart and spend your time and your money wisely”. That is especially true if you are looking for investors. Investors are expecting you to make money and they are expecting that you have what it takes to run a business and that you know what you are doing.
There are still thousands of articles about how to pitch VCs for funding. Over all VCs fund very few companies each year and many thousands of entrepreneurs are trying to get their attention because that is what the articles tell them to do. Pitching to VCs may be the single biggest waste of time and money that any start-up does, especially so if you have to get on an airplane to make your pitch.
On the other hand, boot strapping can be very hard and the lack of cash can hold you back, delay your progress and cause you to fail just when you were beginning to succeed. It is a lot easier to focus on your business when there is money in the bank to pay the bills.
Being able to raise seed capital so that you can focus and move forward is also an indication of other people’s evaluation of you and what you are attempting to do. Feedback from potential investors on your seed round is important. Comments and suggestions, especially negative ones, will help you move forward.
Fund raising for start-ups has become remarkably easy with the JOBS Act and equity crowdfunding. There is a lot of money available. It works for most start-ups because they can control the process and make it work. I started walking companies through the process 3 years ago. Feel free to contact me if you are considering raising capital through crowdfunding or are raising capital and never considered crowdfunding.
A start-up is not a start-up until it starts-up. Every business begins when it makes its first sale. It is a lot more difficult to raise funds for a pre-revenue company versus one which has a product already being sold. Pre-revenue you need a great business plan and a team to carry out your plan. A good idea for a new business is important but execution is everything.
Given that financing a pre-revenue company is difficult, no one should plan on doing it twice; once to build your prototype product and again to launch it. So an article that suggests that should raise money to create a MVP (minimum viable prototype) and then again to take it to market is not really not helpful. If you are going to raise seed capital to get your company off the ground, you should raise enough to get your product into the market, sustain your company until it is profitable, cover the costs of raising more money to help it grow and usually a small reserve in case things do not go exactly to plan.
There seems to be another stream of start-up gospel that suggests if you want to succeed you need to disrupt the market or solve a problem that nags the market. It is vitally important that you understand your market but you do not have to disrupt anything.
Nothing about the pizza parlor solves any specific problems that cannot already be solved in the marketplace. There is no new technology; no bells and whistles; no Blockchain. While in a competitive market like New York City everyone knows a good slice from a not so good slice, I have waited on line at pizza parlors in small college towns around the US for some really mediocre pizza.
I look at a lot of pitch decks and I speak with a lot of entrepreneurs. Sometimes I can tell that the person just does not have what it takes to operate a successful business. When that happens, I usually ask a lot of questions. How will the business operate post-launch? What are the sales goals month to month and where will the sales come from? Where is your break-even point?
From day-one, the focus needs to be not on just starting up but staying open. The reason that 90% of start-ups fail is a lack of execution by the founders. If every entrepreneur focused on running the business well, that number would plummet.
If you are thinking about opening your own business, take a moment to have a slice a pizza and consider why that pizza parlor is successful. Do that for fifty businesses. Look at what they are doing right and what you would do better. Quantify how much more money the business would make if they did things your way.
Once you can analyze what makes other businesses successful, you will on the road to making your own business successful as well. Sadly, the vast majority of people who are considering their own start-up would fail at this exercise. That, more than anything is why the 90% failure rate for start-ups is with us year after year.
If you’d like to discuss this or anything related, then please contact me directly HERE
Most people who consider crowdfunding to raise capital for their business are first-timers. A great many have never even been investors themselves nor considered investing in any of the companies whose offerings are currently on any of the crowdfunding platforms.
Economic downturns always present opportunities for people with the capital to exploit them. I get more calls from CEOs and CFOs interested in crowd finance every week. Many have become interested because the banks they would normally turn to are not lending.
A crowdfunding campaign, if executed correctly can be an excellent source of capital for most businesses. Like any other corporate task, it requires preparation, an adequate budget, and professional execution. Not surprisingly, everyone wants to know what a successful campaign to raise capital from investors will cost.
The “Real Cost”
Most companies will rely heavily on their CFO or outside financial advisor to execute this financing. The CFO needs to consider how the financing will affect the company’s balance sheet, cash flow, and capital structure. The company will need to decide if it should offer investors debt, equity, or another form of financing instrument.
The question of “what do we offer the investors” necessarily comes up early in the planning stages of every offering. The right terms can save a company a lot of money and make subsequent financing easier. The wrong terms can result in an expensive or failed campaign now or may erupt into a costly mess, years later.
For many CFOs the desire to offer investors as little as possible is at odds with the reality that if you do not offer investors enough, they will put their money elsewhere. This is where the “real cost” of any financing is determined.
Investors in every Regulation D offering are always advised that the securities they are purchasing are “very high risk” or “speculative” to the point that investors should be prepared, both mentally and financially, to lose their entire investment. When the risk is high, investors expect to receive a high return as well. Some risks can be mitigated and should be.
The process of deciding the terms investors will be offered usually starts with a series of spreadsheets. How much the company can afford to pay is in the revenue projections. How much the company may need to pay to attract investors requires a good idea of the cost of capital from other sources and a good idea of what other companies are offering in the crowdfunding universe.
I frequently participate in this process. This is because most of the platforms fail to offer this type of advice which most companies sorely need.
I like to ask the questions that investors are likely to ask. I try to help each company see the investment from the investors’ point of view. Wall Street firms sell billions of dollars worth of these private placements every year. They know what needs to be said to get investors to invest.
Regulation D securities will only be sold to US “accredited” investors, mostly those who have a net worth above $1 million (excluding their primary residence). For years the mainstream stock brokerage industry has conditioned these same investors to look at the return that is being promised to them first, and most do.
Investors want to know how you will use their money to make the returns you are promising come true. How you price and present your offering tells serious investors a lot about how serious and professional you are.
What to look for in a lawyer (if you don’t hire me).
Once you have decided on the terms you will offer to investors you will have 3 major out-of-pocket expenditures. The first is a securities lawyer to draft the offering documents. What you say to potential investors in the offering and marketing materials is regulated. A good lawyer will keep you within the regulators’ white lines.
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 to make an informed decision of whether or not to invest.
PPMs have been presented as a bound booklet for decades. The bound booklet PPM is the normal format for disclosure that most practitioners still use. In booklet form, the cost for a PPM is typically $50,000 and upwards.
Crowdfunding websites have begun to change the format and have started 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 is all laid out. Key documents can be viewed with a “click”.
It usually takes less drafting and less time for a lawyer to use the landing page to “lay it all out” which is one of the benefits of crowdfunding. I usually bill in the neighborhood of $20,000-$25,000 for a Regulation D offering done in this manner rather than the traditional booklet form.
Paying for the Platform
Many crowdfunding platforms advertise that tens of thousands of investors have invested in at least one offering that they had hosted. Unless the platform can deliver those investors to you, such claims are irrelevant. You are going to need to execute a marketing campaign sufficient to bring in the capital you seek.
Platforms usually charge a “hosting fee” that covers two or three months for you to use their platform to attract investors to your offering and process them. The processing will include a vendor to verify that your investors are actually “accredited” and an escrow agent to hold the investors’ funds until closing.
Key individuals at each company are required to get a background check to verify that they are not “bad actors” who cannot use the JOBS Act to raise money. Platforms charge for this and the better platforms charge to conduct due diligence on the company as well.
Most platforms charge more the longer your offering is live. A well planned and executed marketing campaign should get you the funding you want faster. Expect to spend $10,000 more or less for the platform hosting and the background checks.
Never Take Marketing Advice from Your Lawyer
Working in financial services where so much of what you must say and cannot say is regulated; I came in contact with a lot of advertising and marketing professionals over the years. In the 1980’s, when stockbrokers went searching for accredited investors they would buy subscription lists from “Yachting” magazines.
A modern-day marketing campaign is skillfully targeted at a pre-selected group of prospective investors. Content is pre-tested and the campaign will target more potential investors than you should need.
The costs of setting up the landing page for an offering can vary greatly. I think that $10,000 is reasonable for setting up the website and preparing the marketing campaign.
Many Regulation D offerings have a minimum investment of $25,000. This equates to a maximum of 40 investors for every $1 million raised. A rule of thumb suggests that for Regulation D offerings, an expenditure $10,000 on the marketing campaign for every $1 million raised seems reasonable.
So for a crowdfunding raise of $3 million, you might spend $20,000 for a lawyer, $10,000 for the platform and related fees, and $40,000 for the marketing campaign for a total of $70,000 more or less. I always tell clients to keep a little in reserve as well, just in case the marketing campaign needs to be extended.
If you borrow $3 million from a bank, the bank will charge 2 or 2.5 points (percent of the loan) as well which is roughly the same. And in truth many of the companies that chose crowdfunding did so because bank financing is not an option for them.
The crowdfunding world has evolved from “put the offering on the platform and see who invests” to a world populated by legal and marketing professionals who get the job done and the money raised. If you want your crowdfunding to be successful, be prepared to pay for them.
If you’d like to discuss this or anything related, then please contact me directly HERE
I have been self employed for a long time. In some regards, I am a founding member of the gig economy. I have worked on thousands of different projects and cases where I was brought in to lend my talents and experience to a team of other professionals. Along the way I have been fortunate to have worked with many people from whom I learned a great deal.
I never advertised other than publishing an article
or two. My business grew as my reputation grew. A majority of my new clients
were referred to me, often by other lawyers who I had never met. Referrals are still
the source of most of my business.
I am currently helping companies raise money using equity crowdfunding. Writing the paperwork for a securities offering is relatively easy for me. I try to put in the time and take care to give every client the advice that they need.
I keep busy because equity crowdfunding has become less expensive. More and more companies appreciate the fact that they can raise capital on better terms than are available at any bank.
Equity crowdfunding is inexpensive but it not free. If you intend do it correctly you need a good lawyer to advise you and to prepare your offering paperwork. You also need a good marketing company to differentiate your offering from the many others that are out there and to get a lot of prospective investors to see it.
Free or Pay Later?
I have been getting more and more calls from people who want to hire me but not pay me. Some of the people who call me are just trying to figure out what an offering will cost them to raise the funds that they need. I am happy to quote a fixed fee for most crowdfunded offerings which seems to be well received.
Some people want me to take shares in their offering
as payment. I tell them, politely, that I like to choose my own investments. I
suggest that if their company is really having a problem raising cash they
should take the shares they are offering to me and sell them to their uncle or
family friend and just pay my fee. The fact that they are raising capital and
are anticipating an influx of cash should make those shares attractive to
“You mean I have to do a seed round to in order to
pay for the financing round?” A lot of
people seem to go through the funds they raised in their seed round to create
an MVP and then run out of cash. Not planning on the costs of a second round
when you raise your seed round is a mistake many start-ups make.
Then there are those companies that want me to wait for my fee until after they raise the money. They see this as some sort of guarantee that I think their raise will be successful.
With crowdfunding, because there is no stockbroker,
it is not unusual for prospective investors to ask to speak with the
entrepreneur on the phone. Not every entrepreneur is a great salesperson. “What
if your campaign yields a lot of potential investors and you can’t close them?”
I ask. “Is that a risk I should take?”
There are also those who seek a discount on the fee and promise me a “fat” monthly retainer thereafter. I question why they would not want to see the quality of my work on the offering documents before they hired me for the long term.
I speak with a lot of securities lawyers and
marketing companies working in crowdfunding and many have experienced something
similar. For some reason it seems to be on the upswing. There seem to
be a lot of people who think they can get by without paying for these services
up front. If you want to hire people who actually know what they are doing
that is not likely to happen.
We are in the midst of a raging bull market. A lot of people have jobs and there seems to be a lot of disposable income floating around. Just try to get tickets for Hamilton or check out the long lines at any airport or Apple store.
There is certainly more money around that is available for investment in start-ups which is another reason crowdfunding is becoming easier and easier. Yet for some reason a lot of start-ups do not seem to have two nickels to rub together and no one that believes in them enough to loan them money to raise the capital they need to take them to the next level.
I have a colleague who edits these blog articles.
When he read this one he asked: what set you off this time? Funny he should ask,
A few weeks ago I got a call from a patent lawyer who wanted to introduce me to a client of his who had multiple patents. The client wanted to set up a series of companies for the different patents, raise some money for each and hire people in each company to bring the products to market. The lawyer thought that since I was looking at multiple raises for multiple companies and multiple fees he should get a referral fee from me.
I spent an hour and a half on the phone with the prospective client. He had done some research on crowdfunding before the call. He asked a series of intelligent questions.
In the aggregate he anticipated that he would need
to raise about $20 million spread over 6 different offerings. He was confident that his products were going
to “disrupt” at least two very large industries full of Fortune 500
companies. He could not resist telling me how his “brilliant innovations”
would net him billions.
When I declined to work without a retainer, he
started yelling at me and calling me names. He told me that I was ignorant
because I could not see how successful his products would be.
“Let me get this straight”, I asked him, “if only one of the six companies you want to start takes off, you are confident that you will make millions, yet you do not want to invest what little it takes to raise the money to get them started?” He hung up on me.
Assholes a Plenty
You really have to be on this side of the conversation to understand that, just like some lawyers, some entrepreneurs can also be assholes. I do not have to share your dreams to provide competent work and good counsel. I should not have to take the risk that I will do the paperwork well and you will turn off investors with your inexperience or arrogance.
I should not even have to be writing this article but I do know that once published I will get a thank you from lawyers and marketing companies that also work with start-ups. I suspect that other freelancers and not just those who work for start-ups experience something similar.
I do not want to discourage any entrepreneur.
If all you want to do is pick my brain then please just be upfront and say so. I am happy to read your pitch decks, take your calls and help to get you ready to raise capital for your company. I don’t charge for that.
But before you get on that road, you have to put gas in the car. It’s just a fact of life.
If you’d like to discuss this or anything related, then please contact me directly HERE
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.
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
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
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
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.
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
Investment Crowdfunding Today
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.
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 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.
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
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.
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.
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.
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
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.
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
rules and the basic mathematics of investing and the capital markets apply to
crowdfunded offerings. Investment crowdfunding is corporate finance.
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.
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.
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
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.
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.
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
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.
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.
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.
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.
was exclusively targeted at these wealthier, accredited investors. From the
beginning, the crowdfunders were competing with the established stockbrokerage
industry for these same investors.
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.
Act removed this restriction for both stockbrokers and issuers. Crowdfunding
enables these issuers to advertise specific offerings to the same targeted,
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.
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.
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.
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.
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.
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
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
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.
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
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.
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.
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.
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
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
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.
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
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.
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.
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.
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.
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.
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.
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.
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
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
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.
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.
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
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.
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.
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
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 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
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.
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.
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
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.
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.
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.
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.
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
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
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
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.
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.
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
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
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.
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.
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
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.
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
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
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
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
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
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.
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
I speak with start-ups and small businesses every week. Many
know only what they heard at a conference or read in a book. Few have a
financial professional working with them to advise them what investors want and
expect. As a result, many companies offer investors too little or in some
cases, too much.
The key takeaway should be that crowdfunding replaces the
traditional Wall Street stockbroker with a marketing company. There are more
marketing “experts” out there than you can imagine but I have run into only a
handful that seem to have one successful campaign after another.
The costs of good campaigns have come down, but they are not
free. If you are determined to fund your business and do not have the funds for
a professional campaign, be prepared to max out your credit cards or ask your
friends and family to do so.
I worked on Wall Street when it went from handwritten paper order tickets to computers and watched those computers speed up trading to the point no one imagined possible at the time. I honestly believe that as crowdfunding continues to grow and mature it is likely to have a similar long-term impact on small business capital formation in ways unimagined today.
If you’d like to discuss this or anything related, then please contact me directly HERE
I have been a huge fan of the potential of investment crowdfunding since the SEC’s first experiments in the late 1990’s allowing issuers to use the internet to sell their securities directly to investors. There was a lot of discussion among issuers, regulators and the traditional Wall Street firms at the time. However, very few investors were included in those discussions. There was a clear consensus that investors were entitled to the same “full disclosure” that the purchasers of any new issue would receive.
The JOBS Act in 2012 codified the use of the internet as a way of offering new issues of securities to the public. Nothing in the Act, or the subsequent regulations suggested that investors who purchased securities on a crowdfunding platform would not be entitled to the same disclosures. The SEC’s very first enforcement action against an offering done on a crowdfunding platform, SEC. v. Ascenergy, confirmed this.
The SEC has been doling out sanctions against people associated with the Woodbridge Group of Companies, a high end real estate developer and apparent Ponzi scheme. Woodbridge claimed to have a wealth management company in its group that raised money for mortgages and bridge loans. The wealth management company hired dozens of highly commissioned salespeople. Many of the salespeople claimed to operate “financial” firms that looked like legitimate financial firms. The salespeople were telling investors on their websites that these investments were “safe” and “secure”.
SEC Complaint: ICOBox and Nikolay Evdokimov
In all, Woodbridge raised more than $1 billion from
several thousand individual investors. The SEC noted that one of the
salespeople they sanctioned was a self-described “media influencer” who made
frequent guest appearances on radio, television and podcasts nationwide touting
the safety, security and earning potential of Woodbridge securities to
unsuspecting investors. He also touted Woodbridge’s securities on the internet
through his own website.
The JOBS Act clearly anticipates that securities offerings will be posted on
SEC Complaint: ICOBox and Nikolay Evdokimov
The JOBS Act clearly anticipates that securities
offerings will be posted on platforms and websites and investors will be
solicited by e-mails. What those postings and e-mails say is regulated. There
are things that you can and cannot say to potential investors. There are also
things that you must say.
Regulators understand the difference between “posting” and “touting”. Unfortunately, not everyone in the crowdfunding industry understands this. Regulators are beginning to take action against the crowdfunding platforms that do not follow the rules.
This month the securities regulator in Kentucky
entered a Cease and Desist Order against a company called Kelcas Corporation
which was making false claims about oil wells it was drilling. The Kentucky
Order calls out a specific string of e-mails with a representative of the
company selling the investment to a potential investor.
The Order repeatedly notes that the company was using LinkedIn to identify and connect with potential investors. It refers to a post on LinkedIn, specifically seeking investors for an “oil well investment opportunity”. Posts like these are common on LinkedIn and other social media platforms. No one is suggesting that LinkedIn has any liability for allowing this post or others like it, at least not yet.
A day or two after the action in Kentucky against Kelcas, the SEC brought an enforcement action against a crowdfunding platform called ICOBox. According to the SEC’s complaint, ICOBox raised funds in 2017 to develop a platform for initial coin offerings by selling, in an unregistered offering, roughly $14.6 million of “ICOS” tokens to over 2,000 investors.
The complaint further alleges that
ICOBox failed to register as a broker but acted as one by “facilitating” initial coin
offerings that raised more than $650 million for about 35 companies that
listed their offerings on its platform.
The investors who put up their funds to invest with
Woodbridge, Kelcas and ICOBox and the 35 companies listed on ICOBox were sold
unregistered securities issued under the same SEC rules. In each case the
internet was the primary vehicle by which investors were solicited and the
primary vehicle used to provide the fraudulent information to the investors.
What separates LinkedIn from ICOBox or any other
website or crowdfunding platform that connects private placements with
potential investors? In reality, and as a matter of law, not very much.
It comes down to the SEC’s use of the word
“facilitate”. It does not mean that the
facilitator actually sells the securities. Both federal and state statutes
govern not just the sale of securities but
specifically how they are offered and to whom they are offered.
In the case of ICOBox the allegations are that the
platform was actively involved in marketing of the offerings that they
listed. ICOBox promised to pitch the
offerings to their media contacts, develop content for promotional materials
and promote the listed companies at conferences. The SEC included this in the complaint
because the SEC thinks these acts constitute “facilitation”.
ICOBox is not the only crowdfunding platform that
has helped to promote the offerings it lists. I get e-mails all the time from
platforms inviting me to look at specific listings. A lot of those e-mails and a lot of the
offerings they promote make outrageous claims and promises.
The SEC also complained that ICOBox claimed it was “ ensuring the soundness of the business model” of the listed companies. Other crowdfunding platforms claim to “vet” or “investigate” the companies they list. Many of those platforms have no idea what they are talking about. These platforms are lending their reputation to each offering. That also facilitates the offerings.
Where does that leave LinkedIn? LinkedIn does not
claim to investigate any offerings posted on their site. It does however sell paid advertising. Does LinkedIn have a duty to refuse to carry
ads for securities offerings that it thinks are fraudulent? What if LinkedIn ads generated the most sales
leads for an offering or if the ads were specifically targeted at people
LinkedIn identified as “real estate investors”?
LinkedIn joined the ban on ICO ads by the major
social media platforms in 2018, not because ICO ads caused cancer, but because
they were largely fraudulent. Would
LinkedIn refuse to accept an ad from a small real estate syndicator if they had
a reasonable belief that the sponsor did not own the property they were selling?
What would a jury tell the “little old lady”
investor who handed a few hundred thousand dollars to a scam like Woodbridge if
the investor was introduced to the company on LinkedIn and testified that the
company was brought to her attention by a LinkedIn “influencer” whom she
I read the ICOBox case as a clear warning from the SEC to the crowdfunding platforms to get their act together. If the platform stays within the regulatory white lines, then regulators should leave it alone.
Unfortunately, it is apparent that many crowdfunding platforms have no idea what the rules require. They are setting themselves up to be defendants in enforcement actions by regulators or civil actions by disgruntled investors. Platforms that do not have a securities lawyer on staff or on retainer will be easy targets.
If you would like to discuss any of this article further with me then please contact me directly here
Someone in the crowdfunding industry should put that sentence on a coffee mug and send me one.
I have been writing about and working in investment crowdfunding for more than 3 years. I find it interesting to watch this fledgling industry mature. It is certainly attracting more and more new money every year and is past the point where it can be ignored by any company in search of investors.
I have looked at a great many
offerings on a great many crowdfunding platforms. I read a lot to keep abreast of new offerings
and industry developments. I take the time for conversations with platform
owners and their lawyers and several of the better investment crowdfunding
I also speak with a lot of companies who are considering investment crowdfunding to raise capital. Any company that would raise capital in this new DIY crowdfunding marketplace wants to know if it spends the money to list its offering on a crowdfunding platform will enough investors show up and invest? From the company’s perspective, little else really matters.
The JOBS Act was intended to be a
different approach for corporate finance using the internet instead of a
stockbroker to reach potential investors. The internet allows companies to
reach a lot of prospective investors, very cheaply. Success or failure in
investment crowdfunding is more about what you have to say to those potential
investors than anything else.
Selling securities issued by your
company to investors is not the same as selling your product or service to
potential customers. Investors will have different expectations and will respond
to different things.
People who sell securities for a
living will tell you that any new issue of a stock or bond needs two things:
good numbers and a good story. Investors want a return on their
So the best stories are always about how much money the investors will make and what the company will do to provide that return.
There are two distinct branches of investment crowdfunding. First, there are the private placements sold under Reg. D to institutions and other larger, accredited investors. This marketplace is healthy and growing rapidly. Professional money-raisers have caught on that they can use investment crowdfunding, tosubstantially reduce the cost of capital and use that saving to enhance investor returns.
Reg. D offerings have been sold through stockbrokerage firms since the 1980s. Most are sold to institutional investors. Some are sold to individual, accredited investors. Minimum investments of $50-$100K or more per retail investor are common.
Many of the retail Reg. D offerings
will fund some type of real estate (construction or purchase), energy (oil, gas
and alternative energy) or entertainment (films, music and
games) project. There are professional sponsors; people who package and
syndicate these projects, often being paid to manage the business on behalf of
the investors after the funding.
The costs of selling a Reg. D
offering through a stockbrokerage firm, including commissions, run 12%-15% of
the funds raised. That would be up to $1.5 million for each $10 million raised..
Most Reg. D offerings sold through brokerage firms just raise an additional
$1.5 million and dilute the investors’ return.
Using investment crowdfunding a company can raise that same $10 million
and not spend more than $100,000 in legal and marketing costs and frequently a
The Reg. D crowdfunding platforms compete with stock brokerage firms for projects to fund and for investors to fund them. The same institutions and accredited investors who have been purchasing Reg. D offerings from their stockbrokerage firm for years are catching on to the fact that they can get good offerings and better yields without the need to pay the very high commission.
The other branch of investment crowdfunding is the Reg. CF or regulation crowdfunding. This allows offerings which can help a company raise up to $1 million from smaller, less experienced investors. Reg. CF allows smaller businesses to sell small amounts of debt or equity to small investors.
The Reg. CF market was the SEC’s gift to Main treet American small businesses. There are always a great many small companies that could benefit from a capital infusion of a lot less than $1 million, the Reg. CF upper limit.
To put down a layer of investor protection the SEC required that these portals that are dealing with small investors become members of FINRA. FINRA dutifully set up a crowdfunding portal registration system and has audit and enforcement mechanisms in place.
As a reward for joining FINRA the SEC allows Reg. CF portals to be compensated by taking a percentage of the amount the company raises which the Reg. D platforms cannot. Several of the portals also take a “carried interest” in every company in case the company is eventually re-financed or sold.
The SEC looks at Reg. CF as a tool
of corporate finance for small business. It provides a mechanism where a great
many small businesses should have access to a pool of capital every year,
potentially a very large pool. It provides for a market structure for these
small offerings and incentivizes the portals help raise that capital. All in
all, not too bad for a a government regulation.
Sadly, the Reg. CF industry is still
foundering. There are still fewer than 40 registered portals operating and
several have closed up shop. So why are
these portals not successful? Because the people who operate them are not listing
better investments than stockbrokerage firms.
When I first looked at investment crowdfunding there were a lot of people proclaiming that it would “democratize” capital raising. They believed that the crowd of investors could discern good investments from bad ones and that the crowd would educate each other as to the pros and cons of each. That was never true.
The Reg. CF portal websites are full
of bad information and consequently, bad investments. “Comments”
about any offering that lists on a portal, if any, are always overwhelmingly
positive. Investors will not do any due
diligence or other investigation of the company because they do not know how.
The Reg. CF portals compete with banks, which are the primary source of funding for small business. Here too, a Reg. CF portal can have a competitive edge. When you borrow from a bank you do so on the bank’s terms. On a Reg. CF platform you can set the terms of your financing. Done correctly, you can get the capital infusion you want for your company without giving up too much equity or pledging your first-born child to the lender.
What the portals should be offering
investors are bank-like products that stress the ROI that investors reasonably
might expect to receive. The portals
should be telling investors how each company mitigated the risks that the
investors might face. Instead too many portals and too many people
in the Reg. CF marketplace are still selling fairy tales and lies.
The big lie, of course, is that by buying equity in any of these companies an investor might hit the proverbial home run. Suggesting that investors can or should think of themselves as VCs is patently absurd for any company that I have seen on a Reg.CF portal. I always tell people who ask that if even one valuation on a Reg. CF portal seems very outlandish, then they likely cannot trust that the portal operator knows what they are doing. I would question anything told to investors by any company that lists on that portal.
If a company wants to raise $1 million on a Reg. CF portal, it might end up with 2000 distinct investors each investing an average of $500. To secure subscriptions from 2000 people, the company might need to put on a marketing campaign that will put its offering in front of hundreds of thousands of investors if not more. Success or failure of your fundraising campaign will depend on what you say to these people.
The cost of the marketing campaign is the major upfront cost of the offering. The good news is thatmarketing seems to be more data-driven and more efficient as time has gone by reducing the cost of the marketing.
Sooner or later these Reg. CF portals will wise up to the idea that
they cannot succeed unless the investors can make money. They, too, could offer
better investments than stockbrokers, but do not seem to have bought int the
Until that happens, I expect more
portals to fail and close up shop and the SEC’s “gift” to small business to
remain largely unwrapped.
I first looked at bitcoins in the Spring of 2017 because a
friend asked me for my thoughts. The
price of a single bitcoin had run up sharply and the ICO craze was proceeding
at full speed. Up until that point I
knew very little about either blockchain or cryptocurrency.
I spoke with people who were actually developing blockchain
projects for the big tech companies. I read a lot of articles which they
thought would help me and a lot of other articles that I found through my own
research. I spoke with traders, regulators, and with a lot of people who
thought that they had cryptocurrency all sorted out. There seemed to be a wide spectrum of thought
about cryptocurrency, how it might be regulated (if at all) and whether it
would augment or supplant the established financial order.
I concluded that the bitcoin market was in a classic bubble,
the price rising only because of hype, and the new money that hype always
attracts. I was not alone in that opinion.
Still some intelligent sounding people were making an argument for
continued price appreciation to ridiculous levels. And that was what a lot of people wanted to
The article ends with an invitation to the securities
lawyers who were writing the disclosure documents for ICOs to contact me for a
professional conversation. I would have
had difficulty preparing those documents.
I confessed my professional curiosity to any and all that might satisfy
A lot of lawyers and other professionals did contact me. Many of the lawyers were doing what lawyers are supposed to do, marshaling the facts and applying the law as they saw it. But it was clear that there was not a unified position as to what the facts regarding any cryptocurrency actually were.
Some lawyers approached ICOs as if they were issuing
securities and some as if they were issuing anything but securities. Before the SEC issued its DAO Report, (July
2017) I was of the mind that a token offering might be structured so as not to
be a security. Once the DAO Report was issued, it was clear to me that the SEC
saw tokens as securities and would look at an ICO as the sale of securities
with all that entailed.
The DAO Report led to a robust discussion, on line and off,
with those same lawyers and professionals and more. The discussion became somewhat convoluted as
many non-lawyers often in other countries felt comfortable discussing the finer
points of US securities law. A great many of those commentators had interesting
takes on the Howey decision that no
competent US lawyer would ever present to a judge. Many of those “experts” just ignored the
dozens of other cases cited by the SEC in the DAO Report and many other cases
that should have been germane to the discussion.
There was an interesting undercurrent of lawlessness in the cryptocurrency world. It was impossible to search for articles about cryptocurrency without coming across many quoting regulators around the world who were reporting cases of money laundering and fraud. That has not changed. Fans of cryptocurrency were often happy to ignore these transgressions even though it was obvious that regulators would not.
By now I have read several hundred white papers for ICOs.
Some were written by lawyers; other white papers were written by either monkeys
or idiots. Some of the latter were using templates because the thought of
actually hiring a lawyer to prepare documents for a multi-million dollar financing
did not make sense to them.
These white papers are supposed to tell potential investors
what they needed to know so they could make an informed decision whether or not
to send their money. That was rarely the
case. I recall one white paper where the principals of the firm refused to
disclose their last names.
People were claiming to have advanced degrees they never
completed and to have worked at firms where they were never employed. Quite often, outrageous claims were made
about the size of the market to be served and the profits to be made. If these same founders had been sued by investors
in a prior company for fraud, investors in this new company would never hear
I had my bio and picture hijacked and included in a white
paper. So did many other people. There
was no way for any investors to know if what they were being told was true. Very often, it wasn’t.
These ICOs were being sold by networks of unregulated,
self-validating crypto “experts and advisors”.
They traveled in packs to frequent crypto conferences around the
world. They cross-validated each other
in articles on websites that had popped up and which reached many thousands of
people around the world. Some crypto “experts” developed 6 and 7 figure lists
of social media followers.
An issuer could engage any number of these crypto gurus and
just pay them in the tokens to be issued.
The “advisors” would notify their followers about the token sale and
urge those followers to cough up real fiat money to buy them. Along the way the advisors were selling tokens
that they had gotten for nothing in exchange for their sales efforts.
Several otherwise intelligent people tried to convince me
that this was not just a dressed up pump and dump scheme playing out over and
over again. The results were certainly the same because most people who bought
the tokens in these ICOs were left holding the bag.
A significant number of the ICOs were out and out scams
which, sadly, many people refused to see.
Fifty million dollars raised here; one hundred million there, all going
down the toilet of financial history. It
got so bad that several of the large social media platforms banned ads for
ICOs. Several countries banned the sale of ICOs altogether.
Along the way some really bright lawyers thought that ICO
offerings might be structured as SAFTS. I saw it as an attempt to solve a
valuation problem by promising to set the value down the road. They were touted as making the ICO market
less risky. To me they looked to be a riskier “derivative” and began to write
an article that said so. But I never finished that article.
In short order one of the NYC laws schools published their
research and pulled back the curtain on SAFTS. After that most securities
lawyers stopped talking about them.
SAFTS were a financial flash in the pan and not a very good one at
I also had conversations with a number of groups that wanted
to develop a realistic scheme to regulate ICOs and cryptocurrency trading
across borders. Each failed because most
of the participants had never worked at or had dealt with any market
regulator. I wrote e-mail after e-mail
trying to explain that transparency is only useful if everyone in the market
was honest and that without significant penalties for dishonesty no regulatory
scheme can work. All that fell on deaf
ears and each of those groups disbanded.
I also spoke with several people who wanted to create
trading platforms for cryptocurrency but most of whom had no idea what a
trading platform does or how it operates.
I would ask questions like: What would be the minimum standards for
listing on your trading platform? It was
apparent that they had not even worked out that simple, basic and necessary
issue. When I asked about market-makers and liquidity I got a series of blank
Today, at least in the US, most lawyers have accepted the
fact that any ICO sold here will be the issuance of a security and that US
securities laws will have to be followed.
To sell securities to investors in the US the securities
must be registered with the SEC or specifically exempt from the registration
requirement. Registration is an
expensive and often lengthy process. By mid-to-late 2017 a number of lawyers
were reporting that they were filing registration statements for ICO offerings
with the SEC. Apparently, many never got approved.
Securities offerings in the US do not have to be registered
if they comply with regulations which provide guidelines for un-registered
offerings. Un-registered offerings are generally sold only to institutions and
wealthier investors who have no real interest in owning crypto currency. These unregistered securities are not
intended to be traded.
More than one lawyer has reminded me in the last few months
that unregistered securities can be transferred after 12 months if the company is
putting financial information into the market or if the tokens are listed on a
crypto exchange outside the US. I am not
certain that they have thought that idea through.
Investors in an unregistered offering in the US are usually
required to attest to the fact that they are making a long term investment and
not intending re-sale. That is why most
companies in the US that sell unregistered securities provide those investors
with income from dividends or interest.
So if you are selling unregistered securities with the promise of liquidity
and re-sale, you are likely to confuse everyone, except perhaps the judge who
will ultimately set you straight.
Companies from around the world have always wanted to tap
the US for capital investment. It is
often a difficult process for any company and especially for start-ups and
smaller companies. In the ICO market, it
became apparent that political borders and local regulations were not
considered to be important by the issuers.
Investors who should have seen the shoddy disclosures as a
problem seemed happy to invest, convincing themselves that if the offering
“complied” with the laws of the country of origin, then protections afforded to
them by US law were unnecessary. A lot
of people who were touting blockchain because it was supposed to promote
transparency were willing to invest in crypto offerings that provided
Today, people are spending money to “tokenize” real estate,
fine art and many other tangible items as if there was a market for those
tokens or if it made any sense to create one.
If I can buy 1/10,000,000 of a Picasso, do I get to hang it over my
fireplace for 20 minutes?
If you are selling shares in a building that you call
“tokens” and tell me that you believe that all of the laws pertaining to real
estate syndications would not apply, I would suggest that you really need to
re-think what you are doing. There are
established rules for selling “asset backed” securities in the US. Not surprisingly, most of the articles I read
about “tokenizing” this or that fail to mention those rules and most of the people
with who I am now speaking who are preparing to “tokenize” this or that offerings
do not seem to be considering them.
Back in 2017 a lot of regulators told me that the ICO boom
came upon them suddenly and that they did not have the staff or budget to deal
with them. They do now and there is
every indication that the leniency some regulators have exhibited is about to
come to a screaming halt.
I was reminded recently of the story of Jonathan Lebed, a 14
year old kid from New Jersey who was investigated by the SEC for stock
manipulation using the internet back in 2000.
This case was a big deal at the time, garnishing a segment on 60 Minutes and some interesting
discussions in the financial and legal press.
Even though he was underage, with the help of his parents,
Lebed had managed to open an account at one or two of the discount brokerage
firms. He was apparently trading his accounts in low price stocks when the SEC
came knocking on his parents’ door.
It seems that in the course of trading Lebed liked to post positive
comments about what he was buying on various websites, bulletin boards and chat
rooms where people who might be interested in purchasing these stocks would see
them. This was in 2000 when the chat
rooms were not sophisticated and the web reached a fraction of the people it reaches
Lebed would buy a low priced stock and then say something
nice about the company in a message that he posted in a chat room. Using
multiple e-mail addresses he might get that same, positive message posted in
200 chat rooms. Some of the people who
saw his posts would re-post them again.
Lebed knew that his simple postings would create significant
interest in these shares and that the price would move up. He commented that posting the messages with
key words in all capital letters would actually get even better responses.
Bringing a lot of attention to a more obscure, low priced
stock can, indeed, lift the price. The SEC called it an intentional market
manipulation. Lebed said that he was
only doing what the research analysts at the big firms did, publish their
opinions about companies whose share price they wanted to go up.
Lebed did all this out in the open. Several of his
classmates and school teachers followed his leads and invested with him. They
were willing to take a chance of doubling their money if the share price of one
of these companies went from $.30 to $.60.
Many of these investing neophytes did understand the
positive effect that Lebed’s postings and his quasi investor relations campaigns
had on these stocks. They wanted to buy
before he posted and get out as the buyers reacting to his posts pushed up the
Lebed was not the only person or group at that time that was
using the internet to enhance the price of shares of small public
companies. But he demonstrated that in
the year 2000 the power of the internet to sell investments directly to
investors was underrated. In the almost
20 years since, the use of the internet to sell almost anything, including
investments, has become much more powerful and pervasive.
In the regulated financial markets the dissemination of
information is encouraged, but it is also controlled. Regulations require that information be
accurate and complete. Public companies are required to report specific
information about their business, to present that information in a specific
manner and to release that information on a regulated schedule.
For a licensed stock broker or investment advisor every
e-mail, tweet, posting, comment and utterance about any investment is subject
to the scrutiny of his/her employer and by regulators. The SEC depends on the
market professionals and market participants to play by the rules. There are
significant penalties for non-compliance.
But Lebed was not a market professional. He was an outlier.
He was an independent investor, not a licensed participant in the
marketplace. In the end the SEC let
Lebed keep most of the money that he made from his trading as long as he
promised to stop.
At the time, no one really questioned the SEC’s jurisdiction
over Lebed or what he was doing. Lebed was a US citizen, operating out of New
Jersey. His posts were about US companies whose shares traded in the US
markets. Many of his posts were made through a US based internet company (Yahoo
In the ensuing 20 years, social media and on line platforms,
publications and unregulated “experts” have demonstrated that they can easily sell
investments directly on line to millions of investors. Moreover they have demonstrated that they can
disseminate information about public companies and new issues without regard to
the truth of the information. And they
can do so without regard for regulations or national borders.
In the “direct to investors” investment world, social media
“followers” has replaced “assets under management” as a measure of how many
investors’ dollars a person can bring to an investment or new offering. And you can buy people who have a lot of followers.
If I wanted to hype a stock, either a new issue or one that
is already trading, I can make a financial arrangement with any number of
independent “experts” who have a lot of social media “followers”. Some may write articles for financial
publications, some write books and blogs and many can be found going from
conference to conference and podcast to podcast.
Any financial “expert” can purchase the right to give the
keynote speech at a conference and purchase any number of other speaking slots
and sponsorships as well. Anyone can
buy interviews on financial websites, blogs and podcasts or pay for the right
to create and distribute positive content on these sites.
If you look at the numbers you can get an idea of how this
works. I can hire a financial “expert”
to tout any stock that I wish. The “expert” will send his/her followers a
series of e-mails, appear at a series of conferences and write a series of
articles about that company. An expert with 1 million followers might reach 2
million other investors who see re-prints and references to it.
If only 10,000 investors of those followers invest an
average of $1000 a new issuer can raise $10,000,000. That much new money coming
into a thin trading market can often raise the trading price of the shares of a
There is no limit to the number of experts I can hire or the
size of the e-mail lists I purchase for their use to augment their own list of
followers. If I hire multiple experts to
hype the same stock, other experts who have not been paid may mention the
company independently. And before you
say that this type of scheme using paid experts to hype the stock may be
questionable under US law, who said that US law applied?
If you solicit investors in the US for a new issue the offering is subject to US
law. That would require full and fair
disclosure to investors in the US and provide for government penalties for
non-disclosure. But what if you donot
make the necessary disclosures and you only solicit investors in other
The capital markets are regulated country to country. Each country has its own rules which apply to
financial transactions involving its citizens and issuers. Each has rules governing transactions
executed on the exchanges domiciled in their country. The laws of the country
where the issuer is domiciled, the exchange is located and where the investors
reside may all apply to a single transaction.
An overriding question with the direct to investor market is which
country has jurisdiction and over what actions and activities.
If an article about a company’s share price or prospects
from a European website gets republished or re-distributed in the US is the
author subject to US law? What if the author knew the information in the
article was false; do US investors have any recourse? Does it matter if the author got a royalty
for the re-print?
Would the answer be different if the false information
originated with just one shareholder who bought a large block of shares cheap
and now wants to pump up the price? Does
it matter if that person is in a country other than where the shares trade or
the articles originate?
I recall that when the Lebed case was discussed a lot of
people thought that the internet would change and globalize the capital
markets. It clearly has.
I think that there is still a lot of discussion that needs
to be had and a lot of questions that need to be asked and answered. In the meantime, it should be obvious that
the current international regulatory scheme does not overlap as well as it
The current and expanding global reach of social media create
opportunities and but also highlights problems.
The flow of capital and information continue to globalize. At the same
time I am certain that it would is a lot easier today for a 14 year old to manage
a single successful, global stock manipulation.