I spent a good part of 2018 reading the white papers for hundreds of Initial Coin Offering (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.
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 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’ 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
began experimenting with companies selling their shares directly to the public utilizing
the internet with the successful funding of the Spring Street Brewery in New
York City in 1996. Several other companies followed suit.
teaching finance at the time. Netscape had gone public a year earlier. There
was a lot of discussion about using this new World Wide Web to sell offerings
directly to investors. Some people
thought this new process of distributing stock would “disrupt” financings forever. One “expert” suggested that JP Morgan and the
other investment banks would be priced out of the marketplace within a few
true then, is still true today. If investors will buy the shares, this new direct-to-investor
method of selling those shares will succeed. All these years later, we can safely say that investment
crowdfunding, as it has come to be called, works.
One of the
first things I learned when I began working on Wall Street was the saying: people
do not buy investments, rather people
sell investments. The stockbrokerage industry is still largely
a commissioned based system. When a new issue of stock comes to market,
stockbrokers, then and now, will pick up the telephone and “sell” shares to
their customers. That is the “meat and potatoes” of the traditional
crowdfunding eliminates those stockbrokers and the commissions they are paid. At
the same time, crowdfunding eliminates the one-on-one conversation between the
investor and the salesperson. It uses the internet to reach out and draw
failure of these self-underwritten offerings rests almost solely upon the
marketing campaign that puts each offering in front of potential investors.
What a company offers to investors and to how many potential investors that
offer is made are the “meat and potatoes” of investment crowdfunding.
ample evidence that investment crowdfunding has quietly become a legitimate
tool of corporate finance for small and medium-sized businesses and projects.
Like any other tool, it works best when you know when to use it and how to use
Investment Crowdfunding Today
crowdfunding has demonstrated that it can attract investors and their money.
Several of the crowdfunding platforms have each raised more than one-half
billion dollars from investors for the offerings they have listed. Sponsors of
several individual real estate funds have raised a hundred million dollars or
more on their own websites. The number of investors who have made an investment
on a crowdfunding platform and the total amount they invest continues to
increase year over year and still has a long way to go.
JOBS Act in 2012, Congress told the SEC to regulate and legitimatize direct to
investor financing. The SEC responded with three regulations, one new and two
modifications of existing regulations, Regulation D, Regulation A+ and
regulation covers financings of different amounts (Regulation CF up to
$1,070,000; Regulation A+ up to $50 million and Regulation D is unlimited) and
each has its own requirements for the process of underwriting the securities.
There is a small, and very good group of lawyers actively assisting companies
who are crowdfunding for capital to stay within the regulatory white lines.
of companies have raised capital under these regulations. That does not imply
that every offering has been successful, far from it. But it does suggest that
there is capital available for companies that navigate the crowdfunding process
The cost of
capital, when funding a company through crowdfunding, is competitive with
commercial and investment banks. Unlike any type of institutional funding,
companies that fund using crowdfunding get to set the terms of their offering
to investors. That flexibility is especially important to the small businesses
that the JOBS Act was intended to serve.
technology of maintaining a crowdfunding platform or conducting an individual
offering has continued to evolve and costs continue to come down. More and more
companies are raising funds by adding a landing page to their existing website.
can provide all the documents the investor needs in order to consider the
investment. Investors can make the payment for their investment with the touch
of a button. The “back end” vendors, such as an escrow agent that holds the
funds until the offering is complete, plug right in.
costs vary with the content. The “INVEST” button is usually leased by the month
for a three to four-month campaign. The overall costs set up a DIY campaign seem
to be in the range of $10,000-$20,000. I have seen companies spend more and
acquisition costs have been slashed with new data mining techniques and
automated solicitation. Highly targeted database development, e-mailing and
social media advertising have become much more efficient. Crowdfunding
campaigns can now reach out to far more potential investors, for far less money,
than even one year ago.
costs come down and the numbers of investors who have made a purchase on a
crowdfunding platform continue to rise, investment crowdfunding will continue
to move into the mainstream as it has in Europe and Israel. More and more companies will fund themselves
as the process continues to become quicker, easier and less expensive.
Good Investments Get Funded
rules and the basic mathematics of investing and the capital markets apply to
crowdfunded offerings. Investment crowdfunding is corporate finance.
always wants to reduce its cost of acquiring capital. Crowdfunding has
demonstrated that its costs can be substantially less than obtaining the same dollar
amount through either a bank or traditional stockbroker.
always expect a return on their investment (ROI) and will often gravitate to
investments that provide a greater ROI.
Successful crowdfunding campaigns strike a balance between what the
issuers are willing to offer and what the investors are willing to buy.
rule is that the greater the risk, the greater the reward investors need to be
offered. Virtually every offering that is currently being made on any
crowdfunding platform is very risky. Companies that do not offer investors a
return commensurate with that risk are likely to have a more difficult time
up to each company to demonstrate how they intend to mitigate the risks that
their business presents. For any capital raise to be successful, it is
important that the company demonstrates how the return they are promising will
be generated and when the investors may expect to receive it.
remain the largest source of capital for small business. Any business owner
that wants to get a bank loan will need to walk in with properly prepared
financial statements, a business plan detailing how the proceeds of the loan
will be used and a detailed cash flow projection sufficient to convince the
bank that there will be enough cash to make the loan payments when they are
due. Investors who might be expected to provide those same funds are entitled
to that and more. Offerings that are too light on the details are harder to
fund as well.
crowdfunding platforms will list similar offerings promising widely disparate
returns. If a platform offers participation in any of three office buildings,
one promising to pay investors a 10% return, one 12% and one 14%, it is likely
that the higher-paying offering will sell out first. Good projects may go
un-funded because of competitive offerings on the platform upon which they
chose to list. This is another reason that many companies are starting to do
their fundraising utilizing their own website.
Good Marketing Works
investment is offered under Regulation D, Regulation A+ or Regulation CF,
everything that the company says to prospective investors is regulated. That
includes what the company says elsewhere on its website, in press releases,
advertisements and interviews. Projections of sales and profits need to be
realistic. All claims need to be supported by real facts.
with the disclosure requirements and marketing regulations protects the company
issuing the securities from regulators and investor litigation if something
goes awry. Making outrageous statements, promises or projections to investors
is more likely to get a company into trouble than to get it funded.
mainstream stockbrokerage industry has shaped what investors know about investing.
The money that is being invested in ventures on crowdfunding platforms is
largely coming from wealthier investors under Regulation D. Many of these
investors have prior investing experience, often in similar investments.
are accustomed to dealing with stockbrokers. The offerings that the
stockbrokerage firms present to these same investors are professionally
packaged and presented by sales professionals.
was exclusively targeted at these wealthier, accredited investors. From the
beginning, the crowdfunders were competing with the established stockbrokerage
industry for these same investors.
JOBS Act stockbrokers could only offer private placements to investors with
whom they had a prior business relationship. Sponsors of real estate and energy
programs would host seminars about their products and invite prospective
purchasers. There were already list brokers who supplied e-mail addresses of
known accredited investors to invite to those seminars.
Act removed this restriction for both stockbrokers and issuers. Crowdfunding
enables these issuers to advertise specific offerings to the same targeted,
The first crowdfunders
used those same e-mail lists to reach those same investors and tried to get
them to invest without the seminar or the stockbroker. Overall, they were
successful. They demonstrated that investors would make investments based upon
what they read and saw on the website alone.
for crowdfunding today, like all cold e-mailing, is still very much a numbers
game. If a company sends out one million
e-mails and raises only one half the capital it seeks then logically it will
continue to send out e-mails until the offering is completed.
virtually any company can run a successful crowdfunding campaign to raise
capital. The determining factor is often whether they are willing to spend what
it takes to reach out to enough investors to complete the offering.
D investors are different from Regulation A+ investors and in turn Regulation
CF investors are again different. The best marketing firms target the right
investors and send them the right message.
of whether the campaign is for an offering under Regulation D, Regulation A+ or
Regulation CF, e-mails lists can be targeted with greater accuracy than ever
before. Marketing materials can be
tested for click-through conversion rates and campaigns can be effectively laid
out to get the desired funds.
of a good, successful marketing campaign have dropped on a cost per investor
basis. I always counsel clients to budget high for marketing and be happy when
they spend less than they had anticipated spending. The alternative, running
out of money mid-campaign, guarantees failure.
Regulation D Offerings Will Continue to Dominate
1930s, any security that is sold to investors in the US is supposed to be
registered with the SEC. The SEC has specific forms for different types of
D offerings are “exempt” from registration with the SEC because they are not
considered to be offerings that are being made to the “general public”. The
vast bulk of Regulation D offerings are intended for “private placement” to
larger institutional investors. Consequently, the SEC does not provide a
specific form or format for the disclosure documents. The SEC does require that
investors get “all of the material facts” that investors need in order for them
to make a decision whether to invest their money or not. Consequently, no two
offerings are exactly alike.
been a growing retail market for smaller private placements since the 1970s.
This market is serviced by mainstream stockbrokerage firms. Private placements
are among the highest commissioned products that a stockbroker can sell. It is
not unusual for a company engaged in a private placement to pay a sales
commission of 6%-10% to the individual stockbrokers who make these sales and an
additional 3%-5% to the brokerage firms that employ these brokers for marketing
D private placements can only be sold to individuals who are defined as
“accredited investors”. That includes individuals whose earned income exceeded
$200,000 (or $300,000 together with a spouse) in each of the prior two years
and reasonably expects the same for the current year. It also includes individuals
with a net worth over $1 million, either alone or together with a spouse
(excluding the value of the person’s primary residence). There are about 12-15
million households in the US that are accredited investors.
households are the prime targets for mainstream stockbrokerage firms who have
better advertising and more credibility than any crowdfunding platform.
Stockbrokers have the benefit of face-to-face personal contact with their
customers and offer advice regarding other investments like stocks and bonds.
If an accredited investor has been a customer of a stockbrokerage firm for most
of the last 10 years, it is likely that they have made money.
task for the crowdfunding industry has been to pry these accredited investors
away from their established stockbroker or financial advisor relationships. It
is absolutely clear that they can do so.
private placements are structured to provide investors with passive income.
These have been especially popular in the last decade of very low-interest
rates. Real estate offerings are popular
because they are easy for investors to understand. They can be structured to
provide passive income at several multiples of what savings accounts currently
D offerings in the $1-10 million range for all types of companies (not just
real estate) have become the main products of the crowdfunding industry. As the
costs of a successful campaign continue to come down more and more companies
are likely to come to this market for funding.
Crowdfunding Costs of Regulation D Offerings Should Continue to
crowdfunding campaign, the issuer has two main costs: the costs of preparing
the legal disclosure documents and the costs for the creation and execution of
the marketing campaign that brings in the investors. Most lawyers (myself
included) insist on being paid before the offering begins.
standard disclosure document for a Regulation D offering is called a private
placement memorandum (PPM). The overriding requirement is for full, fair and
accurate disclosure of the information that an investor would need in order to
make an informed decision on whether or not to make the investment. There is no specific form of disclosure
been presented as a bound booklet for decades. Much of the specific legal
language evolved in the 1980s and 1990s when the securities regulators in
various states would actively review every offering. Several states would
require specific language before approving the offering for sale to investors
in their state or pose additional restrictions on who could invest or how much
any individual retail investor in their state might purchase. The bound booklet
PPM is the normal format for disclosure that most practitioners still use.
websites have begun to change the format and to use landing pages to spread out
the information about offerings rather than present it as a standard booklet. This
format makes the offerings more readable and investor friendly while still
making all of the necessary disclosures.
page will provide investors with the terms of the offering, a description of
the business and its principals and a table showing how the company will use
the money it is seeking. Most include links to current financial statements and
revenue projections. The same information about the business, its competitors
and the particular risks of the investment that would appear in a bound booklet
are all laid out.
key documents relative to the offering are provided and viewed with a “click”.
For the purchase of an office building, the webpage might offer copies of the
purchase agreement, title report, appraisal, physical inspection, rent roll, etc.
Other types of businesses might offer copies of patents, key employment and
business agreements, etc.
The most important
tool on any crowdfunding page is the “chat” button. It is not unusual for an
investor considering an investment to want to ask some questions or speak to
someone at the company. The person who the company puts on the phone with
prospective investors must be very knowledgeable about the company, its
prospects, competition, etc. They should also understand the regulatory
guidelines so that they do not say more than they legally can say.
importantly, the person that is chatting with prospective investors should be skilled
at closing the sale. If all else has been done correctly, there comes a point
where issuers need to ask a prospective investor for a check.
If an offering
is going to be made through a mainstream stockbrokerage firm the costs of
having a PPM for a private placement prepared by a mid-sized law firm can run
$50,000 and up. Costs can run up with the complexity of the offering, the
number of documents that need to be prepared and the client’s ability to
respond to questions in a timely manner.
the paperwork for a Regulation D offering formatted for a crowdfunding platform
should require less of an attorney’s time, especially if the issuer and the
marketing company preparing the landing page understand what is required. The
legal costs for preparing the disclosure documents for a simple Regulation D
real estate offering on a crowdfunding platform start in the neighborhood of
$15,000. Offerings with multiple
properties and complex or tiered offerings, operating businesses, and start-ups
can cost a little more.
marketing costs of setting up the website for an offering can vary greatly.
Real estate offerings, for example, are fairly simple and straight forward. A
photo of the building and a floor plan are typically the only graphic enhancements.
The crowdfunding campaign for a start-up or new product might include a video
of the founder or a product demonstration. Still, a cost of $10,000- $20,000 is
reasonable to set up the website and the marketing campaign.
Regulation D offerings have a minimum investment of $25,000. That equates to a
maximum of 40 investors for every $1 million raised. A rule of thumb suggests
that for Regulation D offerings, an expenditure of $10,000 on the marketing
campaign for every $1 million dollars raised seems reasonable.
Real Estate Offerings Will Continue to Dominate
real estate offerings are mainstream investments. Many real estate funds and real
estate investment trusts (REITs) trade on the NYSE. Mainstream stockbrokers and advisors have recommended
real estate private placements as alternative investments to accredited
investors for years. Investors are offered equity participation in existing
properties or new construction and fund real estate debt through mortgage
are familiar with real estate. Using limited partnerships and LLCs, it is easy
to structure a real estate offering to pass the income and tax benefits through
to the investors.
any commercial property changes hands there is an opportunity to crowdfund the
purchase price. Real estate brokers and property
managers of all sizes are using crowdfunding to build portfolios of properties that
generate substantially higher initial real estate commissions as well as
ongoing commissions and management fees.
If no two
properties are exactly alike, the same can be said for any two real estate
syndications. The success of any real estate venture is more likely than not to
rest with local market conditions.
estate syndication offerings are sold based upon the promise of current yield
or projected distributions. Review the
marketing materials fora thousand real estate projects sold by mainstream stockbrokerage
firms and you will find the current or projected income is always highlighted.
That is where crowdfunding the same offering will always have a competitive
sponsor wants to raise a $10 million down payment to purchase a $40 million
office building using a mainstream stockbrokerage firm, the sponsor will need
to raise as much as $11.5 million to cover the costs of the sales commissions
and fees that the stockbrokers receive. That dilutes the return the investors
will receive on their investment.
that same offering and eliminating the sales commission will increase the
payout to investors by 10% or more. From the investors’ point of view, the
payout (ROI) is the thing that they usually consider first. Crowdfunding any
offering should give investors a better ROI.
on ROI has also caused many of the syndications to migrate away from
crowdfunding platforms where multiple offerings from different sponsors are
lined up side by side. A sponsor is often better off making the offering from
its own website where it does not compete with offerings that might offer
investors a higher payout and where they can control the marketing campaign and
platforms, unless they are licensed as a broker/dealer, cannot take a fee based
upon the success of the offering. Two years ago, most of the platforms were
happy with a straight listing fee based upon how long the issuer wanted to keep
its offering active on the platform.
more the Regulation D platforms are obtaining a broker/dealer license and are
charging based upon the amount that the issuer is raising. The difference can
listing fee to place an offering on a platform for 3 months might cost $10,000,usually
paid by the issuer upfront. A success
fee to place an offering on the same platform once it has a broker/dealer
license might be 3% of more of the funds actually raised. A raise of only $2 million would cost the
company (ultimately the investors) $60,000. That is another reason that many
companies are crowdfunding from their own websites.
crowdfunding industry has evolved, the crowdfunding platforms compete with
established stockbrokerage firms and the DIY offerings made on a sponsor’s own
website compete with the crowdfunding platforms. In the end, the issuers,
investors and the crowdfunding industry itself all benefit as costs come down.
The Next Thing in Regulation D Crowdfunding is Globalization
Foreign companies have
always looked to the US capital markets when they have been able to do so. Interest
rates and costs of capital are frequently lower in the US compared to an issuer’s
home country. Before crowdfunding, the opportunity for foreign companies to
obtain funding in the US was limited to the largest companies. Foreign companies seeking to introduce their
products to the US market or to set up operations here will often consider
funding those operations through a US subsidiary.
firms often recommend that 5% or more of an individual’s portfolio be diversified
and held in the shares of “foreign” companies, often through a mutual
fund. US investors also appreciate that
they can get a greater value if the money they invest is spent in a country
where overhead, labor and operating costs are likely to be substantially less
than the equivalent line items in the US.
At the same time investing
across borders can be subject to additional risks including the risk of
currency fluctuations and changes to the local economy ofthe country where the
company operates. That can mean additional rewards for investors who should expect
to be rewarded for taking those risks.
Utilizing data-mining and
other modern marketing techniquesfacilitatesfinding US investors interested in
investing inother countries. More and more foreign issuers are looking to
crowdfunding for US investors and more are likely to follow.
Regulation A+ Continues to Fail
A+ was the SEC’s modification of an underutilized form of a registration
statement. To date very few Regulation A+ offerings have been filed and sold. It
remains a very expensive and inefficient way for any company to raise capital.
of Regulation A+ offerings that have sold shares to investors find those shares trading for less today than
their original offering price despite a raging bull market. Virtually every
investor who has made an investment in a company selling its shares under
Regulation A+ has lost money.
using Regulation A+ may never get past its abysmal beginnings. Several of the
earliest and heavily promoted Regulation A+ offerings were out and out
scams. The crowdfunding platforms that
hosted these offerings demonstrated a total lack of respect for the investors
and their money and left a bad taste in the mouths of investors who were
willing to give crowdfunding a try.
A+ requires a form of a registration statement to be filed with the SEC which
will be reviewed and approved. There are specific disclosure requirements. The approval process can take 4 months or it
might stretch into 8 or 10 months. The SEC will make comments and depending on
the answers and the SEC staff’s concerns the approval process can drag on.
of comments adds time to the process and increases time spent and of course, the
lawyer’s bills. It would not be unusual
for a law firm to ask for a $75,000 retainer for a Regulation A+ offering
against a total bill for legal services that can be 2 or 3 times that amount
A+ provides for offerings of no more than $50 million and has slightly easier
requirements for companies raising less than $20 million. A company raising
even $10,000,000 under Regulation A+
with a $500 minimum investment may need to secure investments from as many as 20,000
no restrictions as to who may invest or how much, so the pool of potential
investors is very large. The marketing costs of reaching out to a large pool of
potential investors can be prohibitive.
Marketing costs for a Regulation A+ offering can reach $200,000 and
A+ promises that after the initial offering its shareholders can freely sell or
trade their shares. The shares can even list on the NASDAQ. The continuing problem is that at least up to
this point in time no one wants to buy these shares once the offering is completed.
company wants to support a post-offering secondary market for its shares it
will have to secure market makers from the stockbrokerage community and absorb
the costs of continuing press releases and lawyers to review them. These costs
can be substantial.
still plenty of time for the Regulation A+ market to gets its act
together. In the broader market, however,
the trend is away from public offerings, IPOs, in favor of more private
offerings under Regulation D. The trend is driven by the fact that Regulation D
is far quicker and less expensive. That trend is being reflected in the
crowdfunding market that serves both.
Regulation Crowdfunding(CF) Will Continue to Mature
Crowdfunding (CF) was the last of the regulations that the SEC adopted under
the JOBS Act and the one most specifically targeted at helping small businesses
raise capital. These are small offerings being made by small companies. They
are designed to spread the risk of small business capitalization among a lot of
CF created a new type of financial intermediary called a “funding portal.
Portal operations are regulated as they are required to become members of FINRA.
All transactions using Regulation CF are required to be executed on one of the
portals. There is no “DIY from your own website” using Regulation CF.
still fewer than 50 registered portals and a small handful of the portals host
the bulk of the transactions. A company can use Regulation CF to raise up to
$1,070,000 from investors every year.
Many of the Regulation CF offerings seek less than $100,000. A
Regulation CF offering in the $200-$300,000 range would seem to be the most
efficient. No individual investor can
invest more than $2200 in Regulation CF offerings in a 12-month period.
Regulation D platforms compete with the mainstream stockbrokers for the same
types of financings that the stockbrokers had always sold, the Regulation CF portals
compete with banks to provide funding to the same types of companies that banks
provide most of the capital for small businesses in the US. Banks have
commercial loan officers in virtually every branch office aggressively seeking
to write small business loans. There are always tens of thousands of small
businesses around the country seeking some type of capital infusion.
portals will eventually satisfy more and more of that demand. They will be attractive
because the company seeking the funding writes the terms of the financing, not
CF portals, because they are licensed by the SEC, can charge a fee based upon
the amount actually raised rather than a listing fee charged by the Regulation
D platform. A portal may charge 6% or more of the amount actually raised and
some take a warrant or carried interest in the company as well.
Only companies incorporated in the US, with their primary
place of business in the United States or Canada can use Regulation CF. The SEC
requires that specific information about the business and its finances be
prepared, filed with the SEC and provided to investors. For offerings in excess of $500,000, the
financial statements must be audited. The total cost for the preparation of the
offering material and financial statements should be in the $10,000-$20,000
Unlike Regulation A+ there is no pre-offering review by the
SEC. The paperwork, Form C, can be filed with the SEC on the same day that the
offering goes live.
If a company is seeking to raise $300,000 using Regulation
CF and sets a $500 minimum investment, then a maximum of 600 investors is needed.
Early on people were suggesting many companies could crowdfund their business
just by using their own social media contacts. Most companies start with a list
of family and friends, customers and suppliers.
Still, a professional fundraising campaign should have a
better chance of success. The advances
in data mining and automated e-mail technology have certainly reduced the cost
of these Regulation CF campaigns as well.
For many mid-range Regulation CF fundraising campaigns, a
total budget of $30,000- $35,000, with a reserve for more advertising just in
case, would cover all legal, accounting and offering costs. Those costs are
recouped from the offering proceeds. The owners of smaller cash strapped
companies are beginning to realize that they can obtain the cash infusion they
need and cover the costs of obtaining those funds by taking a short term loan
on their credit cards.
Startups Are Different
Many of the Regulation CF offerings are very small start-ups
seeking initial seed capital to get their business off the ground. Obtaining
funds for a start-up will always be more difficult than obtaining funds for an
Many of the companies structure their offerings as if they
were “pitching” to a venture capitalist rather than their high school history
teacher or fellow high school classmates. Good marketing would tell a simple
story, but tell it to a great many people.
Regulation CF is designed to help small businesses get
started, become established and grow. Not every small business will grow to
have the annual sales of Apple or Amazon.
Many companies that will never reach anything close to that can still be
An ongoing problem that turns off more seasoned investors is
the extreme valuations that some companies claim for themselves on the portals.
Just because a company is selling 10% of its equity for $1 million does not
make give the company a “valuation” of $10 million.
Operating businesses are bought and sold all over the US every
day. The rule of thumb for most businesses in most industries would support a
valuation of three times next year’s projected earnings. Companies with no earnings can still raise
money if they can raise enough to become profitable. Valuations, especially
ridiculously high valuations are unnecessary and will likely fall out of favor
as time goes on.
Several of the Regulation CF portals encourage issuers to
put a valuation on their company when they make an offering. More times than
not, it is a rookie mistake.
You Can Still Fool Some of the
If I learned anything from the crypto-currency ICO craze is
that some investors will invest their money into anything that sounds good even
if it is nonsensical. Billions of dollars were invested through ICOs into projects
that never had a hope of success. Way too many of the ICOs were outright scams
where investors’ money was simply stolen. It was a triumph of hype over reason.
Scamming the investors is not a way to continue to develop crowdfunding
as a sustainable method of finance. It does demonstrate that with aggressive
marketing virtually any company can successfully crowdfund for capital.
The ICO craze also demonstrated that these investors were
willing to look beyond borders acknowledging their belief that good companies
can grow wherever there are good people to grow them. I believe that will
become one of the more significant, if unintended consequences of the ICO craze
and will benefit crowdfunding in general.
Investment crowdfunding in the US has matured to the point where
companies from all over the world can look to this market to obtain capital. As
costs continue to come down more and more companies will take advantage of this
market to reach out to investors.
Right now, many of the platform and portal operators are
themselves an impediment to further growth.
Focused more on hosting any company that comes along, the operators do
too little to provide these companies with much needed know-how. These are
financing transactions. Someone with a good understanding of finance needs to
be involved if the ultimate goal is for 100% of the offerings listed are to be
I speak with start-ups and small businesses every week. Many
know only what they heard at a conference or read in a book. Few have a
financial professional working with them to advise them what investors want and
expect. As a result, many companies offer investors too little or in some
cases, too much.
The key takeaway should be that crowdfunding replaces the
traditional Wall Street stockbroker with a marketing company. There are more
marketing “experts” out there than you can imagine but I have run into only a
handful that seem to have one successful campaign after another.
The costs of good campaigns have come down, but they are not
free. If you are determined to fund your business and do not have the funds for
a professional campaign, be prepared to max out your credit cards or ask your
friends and family to do so.
I worked on Wall Street when it went from handwritten paper order tickets to computers and watched those computers speed up trading to the point no one imagined possible at the time. I honestly believe that as crowdfunding continues to grow and mature it is likely to have a similar long-term impact on small business capital formation in ways unimagined today.
If you’d like to discuss this or anything related, then please contact me directly HERE
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.
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?)
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.
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.
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