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

The ICO Is Dead

Rewind to 2018

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

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

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

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

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

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

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

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

Smart Lawyers & Tax Breaks

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

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

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

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

Judgement Day

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

The ICO Is Dead

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

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

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

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

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

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

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

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

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

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

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

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

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

Or you can book a time to talk with me HERE

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

Cruising Down the Information Highway

information highway

It is virtually impossible to explain what the world was like, pre-internet, to a younger generation that is so totally enmeshed in it. The cultural and economic effects of the internet permeate everyday life in many different ways. Unless you are familiar with the world in the days before the internet it may be difficult to get some perspective. 

Personal computers did not really become a mainstream reality until the 1980s. As the market developed through the 1970s, many people looked at computers as computational machines. We had just put men on the moon using slide rules. At that time, much of the focus was on big computers solving far more complicated problems.

There were certainly articles that showed people were thinking about computer applications for business. Word processing and basic bookkeeping applications were introduced. Bar codes made controlling inventory easier. Suffice it to say that the pre-internet world functioned well enough to invent the internet and help it develop.

CompuServe

By the mid-1990s, I was an early member of CompuServe. At the time, CompuServe offered little more than a series of simple bulletin boards, labeled by subject, where anyone could post a message or reply to one. I would dial-in after dinner for an hour or so most evenings.

I read through a lot of posts and comments for several years. At no prior point in history could any one person be exposed to so many different voices emanating in so many different places funneled into their home.

Originally there were no pictures attached but there was little doubt that both still pictures and moving pictures would be coming soon. The technologists assured us that there would be an ever growing amount of bandwidth (traversing fiber-optic cables, they thought) so that we could send all the bits of data that were collected anywhere in an instant. 

I remember discussing CompuServe and the “world wide web” with my students. There was a general feeling that it was a positive development. The students (and many of the “experts”) saw the internet as a way to give a lot of people access to a lot of information. A lot of people believed that all this information should be free and available to everyone. Terms like “information highway” were commonplace.

There were ongoing projects to put all the books in the Library of Congress “on-line”. There were predictions that the internet would provide walking tours of the great art museums of the world; that people would “sit” in lectures and watch performances in concert halls remotely in real time or from a catalog.    

It was obvious then that the internet would evolve to the point where my students could sit through the same course in freshman Economics at Harvard, Yale or the London School of Economics without leaving home. I, and others, saw education as something that would be available to the masses who would sit in front of a screen in their pajamas. I was surprised when the students rejected that idea.

I had this discussion with several classes over a period of a few years and year after year the students seemed reluctant to get their education at home and give up the “college experience”. It took a while for me to understand that they were referring to the interpersonal relationships that they were having with their classmates. (Do I have to spell it out?)

Dotcoms

When the internet finally opened for business in earnest with the dotcoms in the late 1990s there was certainly a sell side perspective. A lot of people saw the internet as a tool for advertising and direct to consumer distribution. Early websites were the equivalent of the Sears or LL Bean catalogs reproduced as pages to a website with a telephone number if you wanted to place an order.   

Pioneers like Jeff Bezos did the math. Selling anything direct to consumers eliminated the costs of a typical retail operation starting with the rent and retail employees. Bezos sold books because the bookstores with which he competed had high inventory costs and low inventory turn-over.

As early as 1995 a lot of people were beginning to predict the demise of retail stores and the malls they occupied. That trend is certainly evident today but it has been 25 years in the making and the parking lot at the local mall was still overcrowded on the day after Thanksgiving this year.

Napsters

I think the first truly disruptive website was Napster. The internet was specifically intended to facilitate the dissemination of information. When the recording industry pushed back against Napster it was saying that it “owned” the information and wanted to control it and people started to look at information a little differently.

Throughout the 1990s, as people were thinking about the internet, its uses and effects, no one was thinking about what has become known as “social media”. Facebook and the other social media platforms have become all pervasive in commerce and in social interaction and very few people saw it coming.  

information highway

Social media is also personal media. The various social media platforms allow access to the marketplace for new businesses, new writers, musicians, artists and entertainers. They also allow any individual to post: “this is who I am; this is what I can do; this is what I charge.”  That describes a labor market far different from the labor market that existed before. 

Love it or hate it, Facebook and the other platforms have demonstrated that what consumers do and what they like can be collected, analyzed and used as a powerful marketing tool. That data is also on the information highway, just going in the opposite direction. Very few people in the 1990s were thinking about all that customer data that is now so valuable.  

I hope that students a generation from now appreciate the contribution to marketing made by the Kardashians. As a group they have ingeniously dominated social media, literally day after day. They have used that daily media attention to sell billions of dollars worth of very high mark-up goods and develop a very valuable brand.

Finally, the social media platforms have demonstrated that they can lie to consumers with impunity, sell products and suffer no consequences. I am amazed how much snake oil is sold on even the “better” platforms. The amount of bad or patently false information available on the internet is frightening.

Fact checkers seem to have gone the way of the farriers. I have read articles that have been “published” on websites that are so factually incorrect, I question how the authors got out of high school.  

What I think is missing from this discussion of marketing to the masses, is the fact that the internet has facilitated one-on-one conversations that would not otherwise have occurred. I began to use LinkedIn as a way to distribute this blog and sell my book in mid-2015. Since that time I have connected with almost 5000 people from all over the world.

Of those 5000, I find myself constantly having telephone conversations with a small but interesting few. I speak with people involved with businesses from all over the world. I ask them a lot of questions. I cannot think of a better way for me to keep abreast of what is going on in the marketplace. 

The internet is not going away. Every year it reaches more and more people. Each year it handles more and more commerce. But it is still a new media. All of the information it delivers still needs a human filter to be valuable. It still needs some common sense which is in short supply. It is great to be cruising down the information highway, but somebody needs to ask where we are going and if we really want to go there.

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