September 2021- Crowdfunding at the Crossroads?

September 2021

The crowdfunding industry is about to announce that more than $1 billion has been raised from investors on the Regulation CF (Reg. CF) funding portals. It is a milestone worth noting for everyone involved in the crowdfunding industry.  

Right now there are approximately 63 Reg. CF funding portals in various stages of the licensing process. Of those, only 27 are operating with 5 or 6 dominating the Reg. CF market. The great bulk of that billion dollars was raised on only a handful of funding portals. 

Also this week the SEC has brought its first case against a Reg. CF funding portal, TruCrowd, headquartered in Chicago.  Among other things, TruCrowd is accused of allowing a company to list its offering on the TruCrowd portal after TruCrowd became aware of some significant “red flags” about one of the people who was associated with the company.

TruCrowd had been alerted to the fact that this person had a criminal past, promised to look into it further, and then did not. TruCrowd apparently allowed the offering to continue, simply ignoring the warning. TruCrowd and its owner have now been accused of participating in the fraudulent offering.

News about TruCrowd’s difficulties with the SEC began to circulate on Monday 9/20.  That same afternoon I got an e-mail from TruCrowd informing me that Shark Tank celebrity Kevin Harrington has endorsed a company raising money on TruCrowd’s funding portal.   

A week earlier Harrington and his partner Mr. Wonderful (Kevin O’Leary) were sued by a group of 20 entrepreneurs claiming that they were defrauded by the pair who had promised to help them get funding but failed to deliver. Mr. Wonderful, of course, shills for StartEngine, one of the largest funding portals. 

The crowdfunding industry is remarkably resourceful. Lacking in funds, many of the participants trade in favors and goodwill. There is a lot of investors’ money splashing around and it is always interesting to see where some of it pops up. 

Last week I published an article about a crowdfunding “rating service” named KingsCrowd that is raising funds from investors using a funding portal named Republic. KingsCrowd, which is little more than a shell, claims a $45 million pre-money valuation.

KingsCrowd’s business is to “rate” companies who are themselves using crowdfunding to raise capital.  All of KingsCrowd’s “value” is tied up in the proprietary algorithm that produces these ratings. 

Yet when asked about KingsCrowd’s own $45 million valuation at a company sponsored Q&A last week, the CEO likened it to values assigned by VCs to other high flying companies. Apparently, he was not asked why he did not seem to trust his own algorithm to rate or value his own company.

The KingsCrowd rating system considers, among other things, an issuer’s management team. Save for the CEO, KingsCrowd has no employees, directors or management team. Is the CEO failing to disclose that his own rating system gave his company a bad score?

The CEO was asked why he was selling his own stock at the same time he was soliciting other people to invest in his company. He apparently disclosed that he needs the funds for personal expenses, including his upcoming wedding. No one asked him why the transaction was structured to put more than $1 million into Republic’s pocket for the company’s Reg, D offering, funds that the company did not need to spend.  

KingsCrowd has been reviewing offerings on Republic’s portal since at least 2020.  Republic has had plenty of time to determine exactly what the algorithm can and cannot do. If Republic has a 3 inch file full of documents that verify that KingsCrowd’s algorithm “works”, then I am certain I will hear about it.

The “notice” of the bad actor’s past, came to TruCrowd from a securities lawyer who was not formally affiliated with the portal. I applaud that effort. It serves no one in the crowdfunding industry, if we let investors invest in scam after scam. Unfortunately, TruCrowd did not listen.

I connected with Republic’s CEO and sent a copy my article suggesting that KingsCrowd’s valuation was way too high.  I am going to punctuate that by offering my opinion, in the words of an old friend, that only “an idiot on acid” could come up with that $45 valuation for KingsCrowd or try to defend it.

The very last thing the crowdfunding industry needs is a corrupt rating system. KingsCrowd’s “independence” from Republic, after this game of “you take a million and I take a million” that KingsCrowd and Republic are playing, is certainly suspect.  If the ratings are not “independent” they have no value at all.

KingsCrowd claims “Wall Street has Morningstar, S&P, and Bloomberg; the equity crowdfunding market has KingsCrowd”. Having followed those services over the years, I think it safe to say that none would place a value of $45 million on KingsCrowd today.

I suspect that the active and retired compliance professionals who follow the blog are all shaking their heads thinking that it is time for Republic to put a halt to both the public and private offerings that KingsCrowd is selling. When a transaction runs up against a regulation, a good compliance officer helps to re-structure the transaction until it complies.

It is certainly time for someone to sit down with KingsCrowd’s CEO and tell him that he needs to be picking out a CFO and Board of Directors at the same time he is selecting his Best Man and ushers. I might suggest taking his algorithm and data over to EY, or similar consulting firm, and see if they will take a look and issue an independent report on what the algorithm does and with what accuracy.

I had no idea that the SEC was about to sanction TruCrowd when I wrote the article about KingsCrowd last week.  Against the backdrop of the TruCrowd complaint, I expect that Republic will halt both offerings unless they do not think that I am waiving a red flag.

To me, this boils down to a question of whether or not Republic will take some amount of ownership for the ridiculous, unnecessary, and misleading valuations featured on its own portal. It would be a signal to other portal operators to do the same.

FINRA has previously expelled two other funding portals, each time questioning the valuations attributed to the companies seeking investors’ funds. The argument can certainly be made that a grossly exaggerated valuation is itself a red flag that the company making the offering lacks substance. 

The ball is in Republic’s court. Like I said, this may be one of crowdfundings’ crossroads moments, or not.

If you’d like to discuss this or anything related, then please book a time to talk with me HERE

Start-ups, are you buying investors online?

Start-ups, are you buying investors

I have been writing a lot about crowdfunding lately and speaking with other people in the crowdfunding industry.  From our conversations, it is obvious that most do not share my perspective on the entire business.  I see crowdfunding as continuing an evolution of the capital markets already in progress when I started on Wall Street in 1975.

In 1975 the stockbroker was king. People did not buy investments, I was told early on, stockbrokers sell investments.  Good stockbrokers, especially those on their way up, aggressively sold stocks. The sales pitch was often about one particular stock, frequently supported by a report prepared by research analysts.  Analysts were “ranked” every year and firms paid the “1st, 2nd and 3rd All-American teams”, handsomely.

While there were certainly stockbrokers who met their clients for lunch or at the club for golf who came back to the office with orders in hand, much of the “selling” was done over the telephone.  Young brokers were encouraged to stay into the evening and engage in a ritual known as cold calling.

During my training, I spent an evening with a single page from the NYC phone directory, script in hand, dialing for dollars. Most people had those old, heavy rotary phones.  I swear, I could hear the receiver sucking in air as it was being slammed down onto its cradle.

What cold calling teaches us is that some percentage of the calls you make will respond favorably, and buy what you are selling.  If you want to make more sales, you need to make more calls.

I mention this only as a backdrop.  This “sell-side” focus has shifted, significantly. Today, a great many retail stockbrokerage customers, make their own decisions about what to buy and what to sell in their stock or retirement accounts.  These customers are enticed by lower costs. They respond to advertising, and they will rely upon information delivered to them online.  Without these investors, crowdfunding could not exist. 

If I were teaching Law and Economics today, I would look back to 1975 and say that is where it all started.  Changes in the law, a new one enacted and an old one discarded, were the catalysts for enormous changes in the way the capital markets operate. The market responded to those changes by bringing in millions of new people who were affirmatively looking to invest and who brought trillions of new dollars with them.   

ERISA, enacted in 1974 created the tax-deferred Individual retirement account (IRA).  It was intended to incentivize millions of small savers to put their money into a bank or the stock market and to leave it there for the long term. 

In response to this new market of small investors who might start small and add a few thousand dollars every year, John Bogle opened the Vanguard Mutual Funds. Mutual funds provided a simple way for small investors to participate in the market.

Mutual funds had been around for a long time by then.  They were commissioned products sold by many stockbrokers.  And while an IRA account was the perfect vessel for mutual funds, what I would stress to my students would be the shift in the way mutual funds were advertised and sold directly to investors.

Vanguard and the other mutual funds actively advertised for investors seeking to make direct purchases.  Instead of dealing with a stockbroker who would call whenever they had, something that they wanted you to buy or sell, with a mutual fund, an investor could just put their money into a fund and the fund will do it all for you.  Somebody called it “passive investing”. Instead of touting the skill of their analysts to pick winners, these mutual funds sold convenience.

In 1975, both the State of New York and the City of New York were functionally bankrupt. The stock market had tanked and lending had ground to a halt.  The economy was in the midst of abnormal inflation.  People responded to the idea that they take some risk to grow their retirement funds in the stock market rather than save it in a bank so they could keep up with inflation.

Also in 1975, the New York Stock Exchange repealed its long-standing rule that had fixed the commissions that NYSE Members charged for each trade.  Mainframe computers were being installed up and down Wall Street. The costs of everything from executing trades to sending out confirmations and monthly statements were going down.

When commissions were fixed, the customer was charged a commission that reflected both the costs of execution and the “other” services that the brokerage firm provided, most notably, research that would tell the customers what to buy and when to sell. As commission costs became a source of competition, Charles Schwab and others were already talking about “unbundling” the cost of executing a trade from the research component that had always come with it. 

Schwab and its “discount” competitors demonstrated that a great many investors were happy to sit at home and make decisions on what to buy and what to sell, based only on what they read themselves. And while Schwab and other discount brokers now offer research reports, very few customers of discount firms are exposed to the type of research available to institutions. 

The stockbrokers’ response to this unbundling can be encapsulated in their advertising slogans of the time: “Thank you, Paine Webber”; “When EF Hutton talks, people listen” and my personal favorite: “Smith Barney makes its money the old-fashioned way, they earn it”.  The mainstream industry doubleddown; they were selling advice and they were proud of it. 

Without good advertising and a lot of it, the full-service stockbrokers, the discount firms like Schwab, and the entire mutual fund industry would not have grown into the behemoths that they are today.  The result of all of that advertising is a market full of millions of investors who are comfortable making their own investment decisions.  This includes a significant number of baby boomers who still represent a very large pool of capital that is available for investment. 

What does this have to do with crowdfunding in 2021?

If I have learned anything from watching the growth and evolution of this market since 1975, the one thing that stands out is that for companies that are selling investments, good advertising works. There is a cost, certainly, of acquiring investors for any given offering, but if you pay that cost, you will get enough investors to pony up the investment that you seek.

The best people in marketing who are working in crowdfunding understand that it is very much a “numbers game” just like “cold calling”, although now much less expensive and efficient. Modern data mining techniques enable each company that is seeking investors to present its offering to an audience that is more and more specifically targeted. 

I call it “buying investors online”. What do you call it?

I have sat in marketing meetings for various players in the financial services industry many times. Depending upon what these companies are selling and to whom, the marketing and sales strategies differ greatly.

The common denominator of these varied strategies is that they are all measured by the same standard, CAC, the cost of acquiring each customer or investor. The object of any marketing campaign is to attract the most customers (and their ‘orders’) from every dollar spent on any advertising directed at those customers. 

In crowdfunding, while statistics are few, it is obvious that the costs associated with acquiring investors varies greatly, offering to offering. Some offerings fail because investors do not find them attractive, most, I think, because they lacked marketing muscle.  

Personally, I find it painful to watch a company that has hired me to prepare the paperwork for their offering fail to acquire the investors they need.  Often, these company’s campaigns fails because they hire the marketing company that was the lowest bidder.  I try to steer my clients to a marketing company that may not be the least expensive, but gets the job done.   

The Regulation D, private placement market has found enormous success using crowdfunding for investors.  Even now, a sponsor can identify potential investors for the purchase of an office building who can afford to invest, who have an interest in real estate, and who live close enough to the property, to drive by if they want to look at it. And the data mining techniques that created these targeted mailing lists are still in their infancy.

Crowdfunding for capital has become a simple process.

Step one: create an investment that will be attractive to investors

Step two: create advertising copy that can be pre-tested and shown to be effective

Step three: put those ads in front of your pre-targeted lists of prospective investors.

Step four: Repeat step three until you raise the money you need.   

I have written elsewhere that I believe that crowdfunding has reached the point where it will now quickly grow to be a major source of capital for start-ups and small businesses.  A major reason will be that companies seeking funding can now approach crowdfunding with a high degree of certainty that they will get funded. With the proper perspective, those companies can appreciate that they are buying investors online. 

 

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

Or, you can book a time to talk with me HERE

 

Crowdfunding Professional Association – An Open Letter

Crowdfunding Professional Association (CfPA)

To: The Board of Directors

I appreciate that I am a person who no one wants to hear from; a New York lawyer with an attitude and a big mouth.  Fortunately, I have made it work by finding clients who appreciate not only my advice, but the reasoning and experience behind it. Still, I know that people would rather suck an egg than listen to a lawyer.

I worked on Wall Street and helped finance companies for 20 years before I understood finance. That understanding came from teaching finance to college students. There is nothing like going back to the textbooks to create a framework for understanding the nuances of any subject.

I have made no secret of my dislike for the CfPA. I see nothing of value being discussed and certainly nothing of value produced by your organization.

I have been invited to make some practical recommendations to the CfPA Board of Directors. I have no illusions that most of the CfPA Board will simply ignore me. I have been saying many of the same things since 2015. 

To soften the discussion, I think it better that you think of me not as a lawyer but rather a college professor, albeit one who does not give credit for wrong answers. These are my thoughts.

What is best for the investors is best for the crowdfunding industry

There is a great pool of capital available for investment into all kinds of projects and businesses. The job of the crowdfunding industry is to connect companies looking for capital with investors who will provide it.

The JOBS Act was intended to provide capital for small businesses to expand and grow. The Regulation D Title II platforms have demonstrated that investors will invest $25,000-$50,000 or more based largely upon information they learn from a website. Crowdfunding, as a method to source investment capital clearly works. 

Crowdfunding operates in a unique niche market. It competes with banks and commercial lenders for companies seeking funds. At the same time, crowdfunding competes for investors with the mainstream stockbrokerage industry. Those are huge markets full of tough competitors.

Title II private placements went online and immediately competed with the traditional stockbrokers who sold similar offerings to investors face-to-face. There are Title II platforms and broker/dealers using crowdfunding to raise billions of dollars. At the same time there are Title III funding portals where issuers have difficulty raising $50,000 and where their offerings languish for months. 

In place of stockbrokers, crowdfunding offers increasingly sophisticated digital e-mail marketing campaigns and advertisements aimed at highly targeted lists of potential investors. While I was originally skeptical of this approach, it has been demonstrated that it works.

If the content of the e–mails manage to send some investors to review the offering itself, and some percentage of those become investors, then a company can continue to send out e-mails and advertisements until it attracts all the investors it wants. If some people will invest in an offering based upon what they see on the website, others will invest as well.

Effective marketing will press the right rational or emotional buttons that will result in investors investing. A good campaign will reach out to more potential investors than it needs.

Funding a crowdfunding campaign has become just a simple numbers game. As marketing costs for raising $1 million on any crowdfunding platform or funding portal continue to come down, it has reached the point where any company that can afford a good marketing campaign, can “buy” $1 million in investment or more. 

That conclusion, which I reached after countless hours speaking with campaign marketing specialists, caused me to stop and ponder the consequences for crowdfunding, for banks and for small business. I believe that this crowdfunding marketplace is about to explode with the post-pandemic need for small business capital.  

I covered much of my enthusiasm for crowdfunding in a whitepaper I published last week.I promised some more practical advice and recommendations today. 

Crowdfunding is corporate finance, do the math  

The JOBS Act was specifically intended to operate within the framework of existing federal securities laws and an established universe of corporate financing techniques. The crowdfunding industry can only exist if investors are willing to invest. The crowdfunding industry needs to respect investors. The CfPA needs to lead this effort. 

The industry has foisted scam after scam on the investors it cannot survive without. It consistently offers investments into companies that have no reasonable expectation of success. FINRA requires a certain amount of quality control for the funding portals it regulates. Many of the funding portals just ignore that requirement.

I appeared on a podcast recently. The host made me so comfortable that I blurted out something that I probably would have said differently. I said that one of the main problems with the crowdfunding industry was that too many people in it thought Ben Graham had invented a cracker. 

Graham’s textbook has been the basis for analyzing investments for decades. It has, and continues to be used in business schools around the world. Trillions of dollars are invested every year by decision makers who are trained to apply fundamental analysis to investing and corporate finance transactions.

There are very few MBAs in crowdfunding. I do not think that is a requirement, but I do think that to advise a company seeking financing requires some amount of knowledge and experience. I have helped hundreds of companies raise money over the years and I have taught finance at the university level. Still, I collaborate with two colleagues, one a retired investment banker, the other a retired commercial banker on almost every offering I prepare.   

Financing can be nuanced; terms matter; mistakes can be costly; there are always other companies competing for the same investors. If you accept that crowdfunding is a form of corporate finance, then people experienced in finance are a pre-requisite. If you think crowdfunding is just another form of gambling, you need to be doing something else.

There are clearly crowdfunding platforms that get an A in Finance by helping to structure the offerings they host intelligently. Sadly, most of the industry, especially funding portals, have no clue.

Any investment offered to investors via crowdfunding is a speculative investment. The crowdfunding industry wants investors who understand the risks and who can afford to absorb the loss if the worst happens.

Crowdfunding syndicates risk. Higher risks should yield higher rewards. Risk, if you can get your head around it, is what crowdfunding sells. 

Too often, the risks are buried in the boilerplate. The CfPA should bring the discussion of risk out in the open. It should encourage industry participants to help issuers to mitigate those risks and to adequately compensate the investors willing to take those risks to fund these companies. 

The larger marketplace quantifies risk every day. For example: Pre-pandemic, a small business seeking a loan guaranteed by the SBA, with adequate collateral and a personal guarantee from the business owner, would pay about 8.5% interest on the loan. Today, while the pandemic has raised the risks for all small businesses, there are offerings on funding portals offering investors 6%, without the collateral or guarantee, wondering why they are having difficulty attracting investors.   

The funding portals are in the business of helping issuers get funded. There are way too many issues being offered that make no economic sense. If a company cannot demonstrate that it can execute its business plan with the funds it is seeking, no platform or funding portal should agree to host its offering. The CfPA needs to help its members to step up their game. 

Rather than purchase those skills, some prominent people in the crowdfunding industry have conjured a new type of mathematical masturbation to stroke the egos of the issuers by selling a delusion of value to investors. I have not heard a single word from the CfPA questioning this practice.

A lot of start-ups are still in the late stages of development. They have burned through $500,000 in seed capital. They do not have a final product, so they have no sales to report and at most a limited test of the market they intend to serve. They have no assets and even their IP is not finished or protected. 

This company put an offering on a funding portal offering 5% of the company for $2 million. If successful, they claim that because 5% of the company was worth $2 million, the entire company must be worth $40 million. There is no excuse for this bullshit.  

In addition to the standards for analysis evidenced by Ben Graham there are GAAP accounting rules governing valuations. There are experienced business brokers around the US who help to buy and sell businesses every day who could not place anything close to a $40 million valuation on this business.    

That some VC might adopt this math is not relevant. VCs have a different agenda. They are looking for growth, not the profits that majority of investors who might invest via crowdfunding look for. An offering on a crowdfunding platform or funding portal should not mislead potential investors that a VC valuation is correct. There are no reasonable mathematics to support it.

It is also misleading to suggest “we expect to cash out in 5 years by doing an IPO or selling out to a Fortune 500 company”. That is not a fact, it is wishful thinking.  In many cases, the odds are actually better over the next 5 years that one or more of the top executives will go through a divorce and lose focus and productivity.

The CfPA has been talking about writing best practices for the crowdfunding industry for years and produced nothing. And, no, I do not want to participate in drafting them at this time, but I do have some suggestions on how the CfPA can make itself useful.

Recommendation: It has been suggested to me that the CfPA is considering creating a “test” to certify some individuals as “qualified” to perform certain tasks regarding an offering. I think that a waste of time. There are plenty of qualified people in finance who would come to crowdfunding if properly incentivized. There are qualified consultants available who could offer the issuers and the industry everything it needs. 

The CfPA first needs to define the talents needed.  The reality is a far cry from anything I have seen from the CfPA to date.  I have written about the crowdfunding process. I have offered to allow the CfPA to post or re-print anything that I have written. A more definitive guide telling issuers and investors what to expect should come from the CfPA. 

Shine light on the scams 

The JOBS Act was adopted to facilitate capital formation under the Securities Act of 1933. It specifically incorporates the anti-fraud provisions of the Securities and Exchange Act of 1934. Operators of crowdfunding platforms, funding portals and virtually anyone else involved in the crowdfunding industry should have at least a working knowledge of what can be said about a company offering its securities to investors, what cannot be said, and what must be said to potential investors. The crowdfunding industry simply ignores these requirements.

Several of the crowdfunding marketing companies insist that issuers pay me to review their final offering materials and especially the marketing materials and adsbefore the offering goes live. I have performed this task, reviewing advertising content, for large wire houses. Like these marketing companies, the Wall Street firms want to have their advertisements reviewed by a lawyer, to protect themselves and their clients from regulators and litigation. 

The Reg. A+ market has been a cesspool from the get-go. By now, I suspect that you could fill up a stadium with people who have invested in a Reg. A+ offering.  Ask that crowd for a show of hands from those who have sold their holding at a profit and very few hands will go up, even though we have been in the midst of a raging bull market.

My very first blog article that discussed crowdfunding was about ELIO Motors which was the very first Reg A+ offering.  The company purported to have a 3 wheeled, electric car.  ELIO brought one prototype to a crowdfunding conference and the crowdfunding “professionals” in attendance went into a sugar shock over it.

I read the prospectus thinking I might write something positive about it. I did not believe what I read to be true and made a single phone call to confirm my suspicions. Once I knew that ELIO Motors was a scam, I wrote it up in no uncertain terms. 

I was thinking, foolishly, the honest people working in the crowdfunding industry would do the same and shine light on ELIO and some of the other obvious frauds since then. I should have known better.

There is a saying in the mainstream markets to the effect that “no one hates to see a stockbroker being dragged out of his office in handcuffs more than the honest stockbroker across the street.”  I have not seen anything from the CfPA that even cautions prospective investors. Given the fact that the Reg. A+ market is going “show biz” to reach a wider, uneducated audience, more and more scams, enforcement actions and bad publicity is inevitable.

There is no shortage of scam artists in the Title II and Reg. CF markets either. The platforms and funding portals need to reject every offering where the issuer cannot support the claims it is making. Too many of the platforms and funding portals claim that they thoroughly “vet” each offering they host. Most have no idea what that actually takes.

When the SEC brought the first enforcement action regarding crowdfunding, Ascenergy, I discussed it with an attorney who had reviewed that offering and rejected it. It was the right call; one that I would have expected an experienced SEC attorney to make. But four platforms were mentioned in the Ascenergy order as having listed the offering. That would not have happened if every platform had access to that first attorney’s report or was at least aware of her concerns.

If a scam artist gets rejected by one platform or funding portal, they just move on to the next one. That is what happened in Ascenergy.That could have been avoided, with a little bit of intra-industry communications.

When I was a young lawyer, the compliance officials for the Wall Street firms would have lunch once a month, bring in speakers and schmooze. It was a venue where lawyers at competing firms could get together for the common good.

Recommendation: The CfPA should sponsor a simple bulletin board where lawyers working in crowdfunding and compliance officers at the platforms and funding portals can post questions to each other. Had the due diligence attorney who rejected Ascenergy posted something simple like: “Regarding the offering for Ascenergy. I spotted some red flags that I could not resolve. Call me for details” likely the offering would not have gotten off the ground, investors would not have been burned and four crowdfunding platforms would not have found themselves discussed within the pages of an SEC enforcement action.

The cost to the CfPA for this is nil. The benefit to the platforms, funding portals and crowdfunding industry is immeasurable. Reducing fraud increases investor confidence and the amount of money they will invest which is the crowdfunding industry’s first and common goal. 

Warn investors by telling them the truth

Let me suggest that the very last thing the CfPA needs to do is to form a committee to discuss investor education. Let me offer instead a homework assignment for the CfPA Board of Directors. Create a list of 10 things that an investor who is thinking about making an investment on a crowdfunding platform or funding portal should consider and publicize the hell out of it.

Let me help:

Crowdfunding Investors Beware:

1) Avoid any company that claims a value many times its projected sales, unless supported by an appraisal from a licensed business appraiser. 

2) Avoid any company that claims it will conduct an IPO or be bought out in the future unless it has a letter of intent in hand.

You get the idea. The CfPA Board of Directors should be able to supply the rest. This assignment is due before Labor Day. I will be happy to review your list and make suggestions before you publish it. And remember, I don’t give credit for wrong answers.

Respectfully,

Irwin Stein

What is a dream worth?

What is a dream worth

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.

Valuations

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.

IP

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.

1990’s

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

Or you can book a time to talk with me HERE

Reg. CF – Will Fools Rush In?

Reg. CF – Will Fools Rush In?

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

REG CF

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

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

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

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

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

Top Ten REG CF Portals Ranked By Capital Raised 2020

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

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

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

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

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

Portals

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

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

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

FINRA

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

Reg. CF – Will Fools Rush In?

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

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

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

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

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

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

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

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

Rules Are Rules

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

Reg. CF – Will Fools Rush In?

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

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

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

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

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

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

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

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

Or you can book a time to talk with me HERE

Start-ups Don’t Have to Fail

start-ups don't have to fail

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.

Economics

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.

Start-ups Don't Have to Fail

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.

Start-ups Don't Have to Fail

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

Or you can book a time to talk with me HERE

The “Real” Costs of Crowdfunding for Capital

the real costs of crowdfunding

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

the real costs of crowdfunding

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 of $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

Or you can book a time to talk with me HERE

I Would Gladly Pay You Tuesday

I would gladly pay you

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

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

Equity Crowdfunding

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

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

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

Free or Pay Later?

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

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

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

I would gladly pay you

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

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

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

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

Bull Market

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

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

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

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

I would gladly pay you

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

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

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

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

Assholes a Plenty

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

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

I do not want to discourage any entrepreneur.

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

I would gladly pay you

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

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Observations on the state of investment crowdfunding-January 2020

Investment Crowdfunding

Introduction

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

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

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

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

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

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

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

Investment Crowdfunding Today

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

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

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

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

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

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

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

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

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

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

Good Investments Get Funded

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

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

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

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

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

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

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

Good Marketing Works  

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

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

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

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

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

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

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

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

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

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

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

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

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

Regulation D Offerings Will Continue to Dominate

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

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

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

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

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

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

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

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

Crowdfunding Costs of Regulation D Offerings Should Continue to Come Down

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

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

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

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

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

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

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

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

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

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

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

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

Real Estate Offerings Will Continue to Dominate

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

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

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

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

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

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

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

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

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

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

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

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

The Next Thing in Regulation D Crowdfunding is Globalization

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

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

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

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

Regulation A+ Continues to Fail

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

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

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

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

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

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

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

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

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

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

Regulation Crowdfunding(CF) Will Continue to Mature

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

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

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

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

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

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

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

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

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

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

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

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

Startups Are Different

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

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

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

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

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

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

You Can Still Fool Some of the People

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

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

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

Takeaways

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

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

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

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

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

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

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

Or you can book a time to talk with me HERE

Crowdfunding after ICOBox

Crowdfunding after ICOBox

SEC Complaint: ICOBox and Nikolay Evdokimov

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 these 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.

Crowdfunding After ICoBox

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.

Crowdfunding after ICOBox

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 followed? 

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

Crowdfunding After ICOBox