Conning the Crowd

Equity crowdfunding allows companies to sell their stock or debt offerings directly to investors by placing the offerings on a website platform. No stockbroker or stockbrokerage firm is needed.

An industry of crowdfunding platforms, experts and attorneys has emerged to help these companies raise the capital they seek.  Some do it better than others.  There are several that I would recommend without reservation.  But at the same time, some people do it so poorly that they make a mockery of the whole idea.

Some of those who do it poorly are now suggesting that that equity crowdfunding is a failure.  In reality, those people were never equipped to do it correctly in the first place and never really understood what selling stock to investors entails.

The one idea that these people and others in the crowdfunding industry never embraced was that “no one wins unless the investors win”.  There will never be a shortage of companies looking for capital.  Connecting those companies with people willing to invest takes more than the passive approach that many of the crowdfunding platforms have adopted. If a platform says “we list any company” I would recommend that you find another platform.

There are a small number of platforms that are licensed brokerage firms or run by people who have experience in the mainstream brokerage industry. They seem to appreciate what it takes to make equity crowdfunding work. These platforms offer demonstrably better investments.

The better platforms take the time to carefully consider each company that comes to them seeking capital.  They will not just allow any company to list their offering on their website.  Funding only companies that have a chance of success and providing investors with a return on their investment is the key to success for any crowdfunding platform.

One of the assumptions that people who lobbied for the JOBS Act put forward was the idea that a crowd of investors has the ability to review the offering materials being put out by a new company, evaluate that information and make intelligent decisions about which companies to invest in and which to pass on by.  The crowd never had that ability. Unless you have a working knowledge of accounting, analyzing the balance sheet and income statements of any investment will always be difficult.

When I first looked at crowdfunding I wrote two separate articles about Reg. A+ offerings that I thought were deficient in a number of ways. My primary argument in each case was that the numbers just did not add up. I thought that each company was promising more than it likely could deliver to the investors.  If I owned the platform where these two offerings were listed, I would not have allowed either to list because if they smell like they may be scamming investors, they probably are.

Both of those companies, Elio Motors and Med-X were subsequently the defendants in regulatory actions.  There have not been that many Reg. A+ offerings to date and the fact that there have been several other regulatory actions concerning Reg. A+ offerings should raise the eyebrows of any serious people in the crowdfunding industry.  I have looked at a few other offerings that were clearly suspect as well, but which the regulators have not yet publicly questioned. For the most part, many in the crowdfunding industry just do not care if investors get a fair shake.

A great many people who own and operate crowdfunding platforms simply do not know what they are doing.  If the platforms do not reject these scams, how will they ever build the long term trust of the investors that the industry cannot live without?

Finally there was an idea that websites would develop where the crowd could share its evaluations of various offerings and where the issuers could respond to comments and clarify what they were offering to investors. A true give and take of information so that investors might make informed decisions.

In most cases this has not really happened.  For all the talk about the wisdom of the crowd, there are people who are so foolish that they will not listen when someone makes a cogent analysis of an offering that would lead anyone with an ounce of common sense to invest in something else.

Case in point.

Both Elio Motors and Med-X were listed on a crowdfunding platform called StartEngine.  As I said, neither should have been allowed to come to market because it was pretty obvious that neither was giving investors the whole story.

StartEngine (SE) is currently offering its own shares to public investors under Reg. A+. I wrote an article about StartEngine’s offering as well. I questioned why it was not making a profit in an industry that should be enormously profitable.  As with all my articles, I asked some hard questions, but I always try to be polite. That cannot be said for everyone.

In the name of transparency, StartEngine posts the comments people make about its offering right on its webpage.  Several people sent me this comment which was posted on the StartEngine offering page which I re-publish here verbatim:

-StartEngine is paying its founders $400k apiece per year. This is INSANITY.
-StartEngine is paying all of its EXECUTIVES over $1,000,000 per year!! This is also insanity.
-Half of that pay was in cash bonuses. This needs to be addressed by their CEO especially as they have not made any profits and are taking investor capital.
-Investors are being offered Common Stock NOT Preferred Stock as they should be offered.
-What does that mean? That means that the founders have significant liquidation preferences over the investors.
-You are asking your investors to assign their voting rights to the CEO. This may not even be completely legal.
-The valuation of the company is unheard of,especially for a company that has continually lost money without any profit.
-There is no road map or path to reaching a revenue breakeven point where you can even sustain operations without SIGNIFICANT additional capital commitments.
-Investors will be HEAVILY diluted after this raise or worse there will VERY likely be a down round.
-The fund raise leaves the company with VERY little cash reserves. Guaranteeing the need for more cash.
-StartEngine has to be in the process of registering as a  full broker dealer for what it needs to accomplish the goals stated.
-The language of the offering circular makes it appear that SE is doing everything it can to shield investors from knowledge of its current and actual future plans as well as prevent them from having any ability to have a voice in the company.
-Over $5,446,367 has been spent to date in deficit without any profits.
-StartEngine does not include any listing or sufficient breakdown on its technology
-There is a significant lack of data and information that you would find in a standard pitch deck of a seed stage startup
-There is no timeframe for the ending of this campaign.
-There is no coverage of an exit strategy or potential for one.
-StartEngine does rolling closings and does not disclose when or how it will go about these, directly in conflict with the traditional “crowdfunding” model of get to your goal or get your  money back.
-StartEngine does not cover much on its competitors or the competing models or market.
                Please address these issues.

Certainly this list includes some issues that the company would do well to address. This commentator is no idiot and he is one person of whom it can be said that there are people who can read and assess a crowdfunded offering. He is exactly the type of investor that the crowdfunding industry needs if it is going to succeed.

So did the company respond with a point by point explanation?  It did not.  This is the company’s response which I also republish verbatim:

Thank you for your comment. We believe our offering describes our business effectively, and clearly shows our goals for the future. In fact, your critique of the offering is only possible because we chose to be so transparent.  If you have a specific question about StartEngine that will help you to decide whether or not to invest, please ask. We’d like to provide all the information we can.

Personally, I never would have let a client of mine publish that response.  It strikes me as arrogant and treats a potential investor who asked intelligent questions as someone who can be ignored. To me it smacks of the Wizard of OZ saying “don’t look behind the curtain.”  I would have counseled a carefully worded point by point response that demonstrated respect for the potential investor.

In truth I would never have suggested that StartEngine prepare a Reg A + offering or seek public investors.  As the anonymous commentator points out for any number of reasons investors are going to have a difficult time making a profit on this investment. This is not a charity. The executives are taking out a substantial amount of money ever year.  Because the company is not profitable, some of the money they are taking home is likely to be the investors’ money.

Despite this, the same web page notes that StartEngine has over 400 new shareholders as a result of this offering.  If an active crowdfunding platform can successfully make this offering despite its flaws, why would it care if any of the offerings that were listing on its platform had any value or could possibly offer a return to the people who are investing in them?

In my mind Elio and Med-X were strikes one and two against StartEngine and this offering is strike three. I would not advise a client to list on their platform and I certainly would not advise a client to invest in any company that does. In my opinion, investors deserve and should demand better.

As I said, this offering and the commentary was sent to me by an acquaintance who has toiled in the crowdfunding industry and the commentary was also mentioned to me by others.  They privately say tsk-tsk but do not want to publicly say what needs to be said.

I look at it this way, not every stockbroker is honest or competent. When they do bad things investors lose money. No one hates to see a stockbroker taken away from his office in handcuffs more than the honest stockbroker working across the street.  Bad actors and stupid people just demean the reputation of the whole industry and make it more difficult for honest people to make a living. That is true in crowdfunding as well.

In the past two years I have spoken with a lot of hard working people in the crowdfunding industry who are trying to help small companies find investors by giving investors a solid chance to make a return commensurate with the risk they are taking. You know who you are. Keep up the good work.

 

 

 

Equity Crowdfunding 2018

I received year end 2017 reports from quite a few equity crowdfunding platforms and consultants. All were glowing with their accomplishments.  Several reported the number of offerings that had successfully raised money. None spoke of the offerings that paid the listing fees and failed to get funding.

Overall the equity crowdfunding industry continues to grow and become more popular with both issuers and investors.  Still, no one wants to look at the significant problems that still plague this industry.

There is absolutely no reason why any company that lists on a crowdfunding platform should not raise the money that it seeks.  There is no reason that investors should be offered the opportunity to invest in scams or in businesses that are unlikely to succeed.  The amount of effort that the crowdfunding industry expends to protect investors from scams and losses is virtually nil. The crowdfunding industry cannot expect to succeed if it does not get its act together and begin to address these issues.

Equity crowdfunding allows a company to sell its shares, bonds or notes directly to investors through a website rather than through a licensed stockbroker. That can save a company a lot of money. It also allows start-ups and companies that are too small for most stockbrokers to handle efficiently to raise capital.

A stockbrokerage firm provides two specific and necessary tasks to any stock offering. First it provides investment banking services to the company to assist properly structuring the offering so that it will be accepted by investors.  Second, the brokerage firm provides the sales and marketing efforts that attract the investors, close the sales, and raise the money.  Both tasks are necessary. Offering a new issue of securities without either being done well is like changing a tire without a jack.

The platforms are remarkably passive as regards the structure and sales of any offering. They are content to accept listing fees from any company that wants to list. They do not care if the offering is successful. They do not care if the company is a good investment or if the investors will make a profit.  These are the crowdfunding industry’s biggest mistakes. For the crowdfunding industry to succeed it must reduce the risks to its investors.

The largest beneficiary from equity crowdfunding has certainly been the real estate industry. There are established real estate syndicators in this market offering investors participation in single properties and in public and private REITs.  Several have set up their own proprietary platforms to showcase their own offerings; others use public platforms where their offerings compete with other properties.

Many of these syndicators have always used private placements as a source of equity funding. Crowdfunding has enabled real estate syndicators to save the 10% -15% that stockbrokerage firms charge to fund their projects.  This lower cost usually provides more cash flow for investors.

Most of the platforms are using Regulation D private placements because there is no reason for an income producing property to be “public.”  Real estate is easy for investors to understand. Investors trust real estate not just as an asset class, but as an investment.

Start-ups have a more difficult time raising funds on crowdfunding platforms.  And before you say that is to be expected, when you compare most start-up offerings with real estate offerings it should become obvious that most of the deficiencies with start-ups are correctable.

If you are investing in the equity of a commercial real estate offering there is usually a bank that has done an appraisal of the property and a physical inspection.  With start-ups the valuations are often off the charts. Rarely has anyone actually tested the product to see if it is viable or conducted a patent search to determine if the product infringes on someone else’s patent.

With a commercial real estate offering there is usually a seasoned property manager to handle the day to day business affairs.  With many start-ups the management is often less experienced than it should be.  Asking for investors to fund your business if you have never run a business, or do not have good managers or advisors in place becomes an up-hill fight.

Real estate offerings are most often structured to provide income to investors. Simply stating that the property will be sold after 7-10 years is all the exit strategy most investors need.  Many start-ups would have a much easier time raising funds if they structured the offering as preferred shares or provided income through revenue sharing or royalty payments.

When I advise a start-up seeking to raise capital I always offer my sense of what they should do prior to the offering to strengthen the company. I advise them how they should structure their offering to increase the chance of success.  This is the advice that the crowdfunding platforms should offer to every start-up that is paying for the privilege of listing, but do not.

My hope for 2018 is that the crowdfunding platforms get on board and do the same.  The platforms handling start-ups just need to become more proactive. There is no reason that every offering that lists on a crowdfunding platform should not be funded.

When the JOBS Act was passed there was a lot of discussion about small investors being able to invest. Millennials, especially, were arguing that they were being denied the opportunity to invest in the next Facebook.   So at the end of 2015, the SEC promulgated changes in Regulation A allowing a slimmed down registration process for smaller offerings of up to $50 million.  By any standards Reg. A has been an abject failure.

It takes a lot more money and a lot more time to prepare and complete a Reg. A offering than a Reg. D offering. I will advise any company seeking funding to use the latter instead of the former.  A company that spends an additional 6 months and $200,000 to reach small investors is usually telegraphing that the more sophisticated accredited investors do not want to invest.

Reg. A has been used to raise a fair amount of money, but the issuers themselves have not prospered. Several of the most hyped offerings, such as Elio Motors, have crashed and burned taking the investors with them. The share price of most of the other companies that used Reg. A to raise capital have not been able to maintain the original offering price. And this is in the middle of an historic bull market.

The Reg.A platforms and advisors do not support the price, after the shares have been issued,the way a stockbrokerage firm would.  Again, my hope for 2018 is that they get their act together and provide all the services that a company issuing shares to the public needs, both before and after the offering.

Perhaps the most disappointing aspect of the crowdfunding market has been the lack of attention to the Reg. CF portals. These handle the smallest offerings of up to $1,000,000 that cater start-ups in need of seed capital.  They represent the very essence of what crowdfunding should be about; small investors helping small companies.

Unfortunately, only about 35 Reg. CF portals are operating.  Those that are operating also take a passive role. They fail to assist the companies with the structuring of the offering. They fail to assist with marketing.  The simple fact is that if you are going to raise $1,000,000 by taking one or two hundred dollars from a lot of small investors, then you need to reach out to tens of thousands of investors before you find enough who are willing to invest.  That takes both marketing money and muscle.

It is pretty clear that most start-ups will fail within 24 months and these investors will lose their money. It is these small start-ups that need the most help and these small investors who need the most protection from loss.  But again, the crowdfunding industry has just not provided that help in any meaningful way.

I hope to make a contribution to the crowdfunding industry in 2018.  I am working with a group that wants to provide a measure of protection to small investors that are investing in these small offerings.  They are discussing starting a new Reg. CF portal where small companies can raise $500,000-$1,000,000.

They intend to offer a program to buy back any shares of any offering that lists on their Reg. CF portal if the company fails within 24 months.  You know that they can only do this if they offer only companies that they think will survive and succeed.

This type of vetting is missing in the crowdfunding industry and I am pleased to be part of the team that is putting this together. Besides me the team includes people with years of investment and commercial banking experience and a young, dynamic marketing team.  The goal is to select only the best companies to offer to investors, help those companies get the funding they need and help them succeed thereafter.

Right now, the group is seeking a very small number of investors to help fund the platform itself.  It is using a revenue sharing model so these investors can expect their investment returned quickly with significant return thereafter. If you have an interest in participating with an investment, contact me and I will put you in touch with the CEO.

 

Behind the Crowdfunding Curtain- StartEngine Goes Public

StartEngine, one of the first and most active crowdfunding platforms has filed the paperwork to offer stock under Regulation A. They are raising $5 million, offering 1,000,000 shares to the public at $5 per share.

If you follow my blog, you know that I have written about several other Reg. A offerings; Elio Motors, Med-X, Ziyen, etc. which I thought were essentially scams run by people with questionable intentions.  I have my issues with StartEngine, but I never thought the owners were dishonest or trying to scam investors. Nothing of that sort should be inferred here.

The fact is that crowdfunding platforms, like most businesses, are not public. This offering is the first I have come across where a company that is actually active in this marketplace has published audited financial statements and made disclosures about its business and the risks inherent in that business. For someone like me, who is working in crowdfunding with some of StartEngine’s competitors, looking through this information was irresistible.

First and foremost, StartEngine itself is a start-up and is losing money funding other start-ups.The company lost $1 million in 2015, almost $3 million in 2016 and another $1 million during the first 6 months of 2017. The company had initially raised a little over $5 million in venture capital and has essentially burned through it. It now wants another $5 million to continue.

StartEngine’s business is basically a website and has 13 full time employees. It has no cost for goods sold and the bulk of its expenses are for administrative purposes and marketing.

The core premise of equity crowdfunding is that it facilitates the sale of new issue securities without the commissioned salespeople who perform this function at traditional stock brokerage firms. The commission savings are passed on to the companies who list their offerings on the platforms and ultimately to the investors. It is certainly fair to expect that because the offerings do not have a commission expense more of the funds that are raised will go to the company that is funding its business.

The JOBS Act permits three types of offerings to be funded on a website. StartEngine offers all three; Regulation A, Regulation Crowdfunding (CF) and Regulation D offerings.  At the end of August StartEngine announced that it also intends to offer crypto-currency offerings(ICOs) on its platform. With a full menu, StartEngine can offer more flexibility to a company seeking funds and a larger selection of investments for potential investors.

Under Reg. D a company can raise an unlimited amount of money from wealthier, accredited investors, under Reg. A up to $50 million and under Reg. CF up about $1 million. Reg. A and Reg. CF offerings can be sold to any investor albeit in limited amounts.

StartEngine was one of the first movers in the Reg. A market. The offering document notes that they have hosted the Reg.A offerings of ten companies.  StartEngine’s first offering, Elio Motors, eventually raised $16,917,576 from 6,345 investors.

Regulation CF went into effect on May 16, 2016. StartEngine has acted as intermediary for offerings by 58 companies; raising $7,383,960. According to Crowdfund Capital Advisors, of the 26 platforms registered with FINRA, StartEngine was second in terms of the number of Reg. CF offerings. Overall, in two years of operations, the StartEngine platform has raised about $40 million for issuers from over 17,000 investors.

For a little perspective I write the legal paperwork for crowdfunded offerings being made under Reg. D that are listed on various competing platforms.  I am on target to write the paperwork for $50 million worth of offerings during calendar 2017 and probably more next year. I work part time, out of my home on a 5-year old laptop.

My advertising budget is zero dollars. I get all my business through referrals or because someone reads one of my blog articles and thinks that I have some common sense. I take the time to speak with a lot of people who are starting new businesses and are seeking capital. I have referred a few to appropriate crowdfunding platforms, even if someone else writes the paperwork.

With a six figure per year advertising budget StartEngine should easily be able to host and sell $100 million worth of offerings per year or more.  If they did, the company would be profitable.  So what is the problem?

There are three parties to every transaction, the company seeking investment, the investors and the platform that introduces the other two. The intent should be that all three will ultimately make money from each offering. If the investors make money they will be happy, come back again to make additional investments and recommend the platform to friends.

Roughly 1/3 of StartEngine’s entire customer base invested in Elio Motors. I questioned Elio at the time that StartEngine put Elio’s offering on its platform.  It was obvious to me that Elio was not likely to ever put out its vehicle or turn a profit and I wrote just that.  If that was obvious to me, it should have been obvious to StartEngine as well.

StartEngine’s offering document mentions that it may be liable if a company that lists on its platform gets sued for securities fraud.  It states that even if StartEngine is a party to the suit and prevails, being a party to these suits might cause “reputational harm that would negatively impact our business” in addition to the costs of its defense.

Regulators have just begun to catch up with Elio. Elio was recently fined roughly $550,000 by the State of Louisiana for taking deposits for its non-existent vehicle without a proper license to do so. The lack of a proper license should have come up in the pre-offering due diligence investigation conducted by StartEngine.

Even if Elio is never alleged to have committed securities fraud, the company is insolvent and is unlikely to ever produce a vehicle or operate profitably.  Investors will lose the money that they invested.

Reputational damage for a company like StartEngine also comes from listing any piece of crap that comes along. Why should investors be expected to come back to StartEngine a second time, or a third, if the companies that StartEngine lists on its platform are not likely to succeed?

StartEngine defines its mission as: “To help entrepreneurs fuel the American Dream.” Its long term objective for 2025 is to “facilitate funding for the startup and growth of 5,000 companies every year.”

Assuming that each of those companies raises only $500,000 StartEngine is projecting that it can bring in $2.5 billion in new money every year.  Given that most or all of that money will be lost, I think that is a fantasy. StartEngine is likely to become known as a place where investors flush their money down the toilet long before 2025.

Had I been asked to write this mission statement I would have said something like “the company’s objective is to match investors with worthy companies that offer new technology and new products.”  The key word is “worthy”.

There is no way to sugar-coat the fact that 90% of start-ups fail and that many fail very quickly, usually within the first two years.  No one who I have met in crowdfunding denies that fact and most just accept it as a fact of life, even if they really do not want to talk about it.

An intermediary like StartEngine should be able to discern which companies are more likely to be part of the 90% that will fail and which have a chance of being part of the 10% that will succeed. That is what broker/dealers and investment bankers do every day and have done for decades.

The mainstream stockbrokerage industry has no difficulty identifying or funding new technologies. Stock brokers raised money for Apple and Microsoft when very few people owned personal computers. They raised money for Genentech at a time when no investor had ever heard the words “genetically engineered pharmaceuticals” before.

The offering suggests that StartEngine intends to harness the power and wisdom of “the Crowd”. To be blunt, no one has ever suggested that the crowd has any wisdom sufficient to discern which companies are worthy of investment and which are not. If they did, I doubt anyone would invest in StartEngine.

The lawyers who prepared the StartEngine offering included this statement as a risk factor: “none of our officers or our chairman has previous experience in securities markets or regulations or has passed any related examinations or holds any accreditations.” That, in one sentence, is StartEngine’s entire problem.

StartEngine’s customers are the investors, not the companies raising money. StartEngine has no idea how to give investors what investors want, a fighting chance at making money from the investments that they make.

Some of the other crowdfunding platforms understand this. MicroVentures has a reputation for turning away potential issuers that do not meet its standards.  I have worked with WealthForge which crowdfunds offerings to institutional investors. They would not consider offering those institutions any company that lacked the substance to succeed. Both were founded by or employ people with backgrounds in mainstream brokerage or investment banking.

Running a crowdfunding platform and funding companies without someone trained in investment banking is like running an animal shelter without a veterinarian on staff.  You can round up the animals, but you may not really be able to help them.  People who adopt the animals will never know if the animal is sick or healthy and that is something that they want to know.

Investing in start-ups is risky. You can run your platform like  newspaper want ads taking any ad that comes along or you can use some judgment and refuse ads for bottled water that claims to cure cancer because you know that your readers will not be happy. It is incumbent upon any crowdfunding platform to mitigate the risk for the investors that look at the offerings it lists.

I have personally resisted the idea of working for one of the crowdfunding platforms although I have advised a few. If you seriously want to invest in a crowdfunding platform, I could assemble a team and improve upon what StartEngine has to offer, without the baggage of offerings like Elio Motors, for a lot less than $5 million, probably around $500,000 (maybe even less if I do not replace my laptop).  I could operate the platform profitably and offer a return on your investment probably within a year. Interested? You know where to find me.

 

Crowdfunding Myths and Realities

I speak with people about crowdfunding every week. I learn a lot from others. But there is a lot of bad information about crowdfunding in the marketplace. Most of it comes from the mouths or keyboards of people who claim to be crowdfunding experts but lack a clear perspective of what equity crowdfunding is and how it should operate.  To make up for their deficiencies, these experts often pontificate about crowdfunding and disparage the capital market of which crowdfunding is a tiny, though useful backwater.

I have heard or read every one of the following statements about crowdfunding uttered by people who claim to be crowdfunding “experts.”  I have included my explanation of empirical reality after each one.  If you attend a crowdfunding conference and hear any one of these statements, ask for your money back.

1) “Wall Street is evil”

Reality:  I have probably seen more bad actors in the mainstream financial markets than most people.  I worked on close to 2000 arbitration claims brought by unhappy and defrauded investors against mainstream financial firms.  I wrote a book about the many things that Wall Street does wrong, so yes there are indeed bad actors in the mainstream financial markets.

But those markets also fund local governments, schools, roads and hospitals. The mainstream markets funded Apple and Microsoft, companies that developed life saving drugs, allowed a lot of people to buy homes and financed almost all of the innovative technologies that we take for granted.  Trillions of dollars worth of transactions take place every week in the mainstream capital markets. The overwhelming majority of those transactions settle without complaint or any reason for concern.

2) “Wall Street freezes out new businesses that deserve to get funding”

Reality: The key word here is “deserve.” Entrepreneurship has always been a core American value. A lot of entrepreneurs are passionate about their businesses.  But passion only gets you so far.  A lot of entrepreneurs fail because they do not have a good business plan, a good team or a good sense of what their market really wants.

Billions of dollars flow to new businesses every year.  There is actually more money available for small business in the US today than ever before and it is a lot easier to reach. The Small Business Administration (SBA) continues to make loans and groups like AngelList have made venture capital available where it was previously very hard to find.

3) “Crowdfunding democratizes the marketplace; it lets the little guy invest in great companies that were only available to wealthy investors”.

Reality: Most of the companies on crowdfunding websites have been or would be passed over by VCs and professional Angel investors. That money is cheaper to obtain and often comes with management and other assistance.  For many companies crowdfunding for capital is a last resort, not a first choice.  There are some good companies on crowdfunding websites, but the bulk would never be considered to be “great” by any standard and all come with a very high likelihood that investors will lose their money.

4) “People are being kept out of start-up investing and cannot profit from investing in the next Facebook”

Reality:  Show me the company listed on any crowdfunding platform that has the potential of becoming the next Facebook.  Facebook did not crowdfund for money and no crowdfunded company has approximated Facebook’s success.  It may happen or it may never happen.  Facebook, and Apple and others, all had IPOs which were open to all investors.  If there is a Facebook lurking on a crowdfunding website, it is currently hidden among a lot of offerings that I believe are absolute crap.

5) “Millions of people would invest in crowdfunding if they understood it and they eventually will”

Reality:  This argument is usually used to convince people that the crowdfunding market will explode when people get the hang of it.  More than one crowdfunding “expert” has suggested that these regulations would open the crowdfunding market to as many as 220 million people in the US.  This, of course, ignores the fact that roughly 50% of US households live at or below the poverty line or are living paycheck to paycheck.

Yes, there is still a lot of disposable income in the US. The lines at Disneyland always seem to be long and the hotels in Las Vegas are perpetually full.  Both Disneyland and Las Vegas are selling instant gratification. Equity crowdfunding sites are not. The most successful crowdfunding sites are offering real estate to accredited investors seeking steady, passive income.  That is likely to continue.

6) “The crowd can discern good companies from bad ones”

Reality:  This is simply not true. Investors in the mainstream markets often depend on research analysts to parse through the financial and other information that companies present.  I have worked with investors for 40 years.  Most could not pass  the second mid-term exam that I used to give my freshman economics class. Most of the crowdfunding “experts” could not pass it either.

Even if the crowd spots a bad offering, there is no mechanism built in that would allow them to say so.  No portal has a place has a “comments” section next to any offering, nor would they be expected to have one.

7) “Due diligence is not necessary”

Reality:  I saw this statement in the very first article I ever read about crowdfunding. It was written by an attorney who claimed to be a crowdfunding “expert” and who wrote article after article on the subject although his resume indicated that he had never actually represented an issuer of securities or a broker/dealer.

Due diligence is how the platform or portal prevents the issuer from committing securities fraud.  There are good people who provide due diligence for the crowdfunding industry but there are many platforms and portals who do not even try to verify the claims that the issuers are making to investors. Due diligence protects the investors and it protects the platform or portal.

8) “There is very little fraud in crowdfunding”

Reality:  There have been only a handful of regulatory enforcement actions in the crowdfunding arena but more are clearly on the way.  Regulators use these actions to send a message about expected and aberrant behavior that the crowdfunding industry continues to ignore.

Some of the biggest lies that you will find on crowdfunding platforms concern the valuation and prospects of the business being funded.  I have seen start-ups with no sales and less than $1 million in development expenses value themselves at $20 million or more based upon sales projections of hundreds of thousands of units of a product that does not yet exist.  FINRA has already raised this issue, but the crowdfunding “experts” do not seem to want to address it.

Within the last few weeks, I saw one offering where an executive conveniently left out that he had twice been sanctioned for stock fraud, as if that fact would not be of concern to potential investors.  I recently reviewed a Reg. A offering that was structured like a classic pump and dump scheme and will probably turn into one.

It is not that there is not fraud or the potential for fraud in this market. The crowdfunding “experts” do not know it when they see it.

9) “Government rules make crowdfunding difficult”

Reality: The government rules make crowdfunding possible.  Several real estate funds have raised $25-$50 million and more using basic crowdfunding techniques and there are crowdfunding websites dedicated to films and entertainment that do not seem to be at a loss for investors. The problem is not the rules. The problem is that a lot of the “experts” do not know how to work with them. Those who do have no problem raising money in this market, but true experts are few and far between and compliance with the rules is sporadic at best.

10) “Investors understand that they will probably lose their money so none of this is important”

Reality:  Every new issue of securities, especially those being offered under Regulation D, will include the disclosure “These securities are a speculative investment.  Investors should be aware that they may lose all of the funds that they are investing.”  This is especially true given that most start-ups will fail.

But it is not a sustainable business model for the crowdfunding industry to blithely accept the fact that all investors will lose money. Several crowdfunding sites (most notably MicroVentures and WealthForge) spend a considerable effort vetting companies and are trying to list only the best companies on their sites.  If I were raising money through crowdfunding, those are the sites on which I would want to list my offering.  If I was considering investing in a crowdfunded offering, that is where I would want to spend my money.

Compare that with the statement recently made by an SEC Commissioner to the effect that there appears to be a “race to the bottom” in terms of listing crappy deals on many crowdfunding sites.  This market will become efficient when every company that lists its offering on a site gets the funding it seeks. It will only happen when the patently bad companies are weeded out. That will only happen when the patently bad platforms and portals are weeded out, either by competition or government action.

11) “Equity crowdfunding is disruptive”

Reality:  Crowdfunding may ultimately change the way in which some firms are financed but not in the way that a lot of people seem to think. The Wall Street firms are already positioning themselves to get into this market because it obviates the need to pay commissions to sales people.  Commissions have been on the way out since the 1970s, a trend that has been spurred on by the internet. Crowdfunding is just one more step on the ladder to lower and lower commissions.

It is much more likely that the Wall Street firms will take over the crowdfunding market than the crowdfunding market will supplant the Wall Street firms.  It is, in fact, already happening. I would not be surprised if Goldman Sachs, (some people’s idea of a financial Satan, see # 1, above) is already positioning itself to enter this market.

12) “Equity crowdfunding is new. The problems are just growing pains”

Reality:  Equity crowdfunding is the business of selling securities. There is nothing new about it.  Selling securities over the internet without using a traditional underwriter has been around for almost 20 years. The JOBS Act opened the door for people who are untrained and not knowledgeable about securities to sell them. These people are having growing pains, not crowdfunding. Many untrained people are making money for themselves at the expense of the issuers and investors.

All it takes to enter the crowdfunding market is to set up a platform which is relatively inexpensive and begin to solicit companies to list on it. Owning a platform or portal can be a lucrative business.  As this industry grows there should be a huge opportunity for skilled finance professionals and securities lawyers.

If you are a considering selling shares in your company by crowdfunding look for a platform that has people with experience in finance or the mainstream capital markets.  If the platform’s advertisements include any of the dozen statements highlighted above, pass them by.

 

Crowdfunding- Waving the Red Flag


There are lessons to be learned by crowdfunders from mainstream brokerage firms.  Just about one year ago, when Reg. A+ offerings were just beginning, I wrote two blog articles in which I questioned whether two of the earliest offerings that had been approved by the SEC, Elio Motors and Med-X, were kosher. The Med-X offering was subsequently halted by the SEC for failing to disclose required financial information.  Elio Motors, which was applauded by the crowdfunding industry for separating $17 million from small investors, is teetering on the brink of bankruptcy because it cannot get the government loan it promised but for which it never qualified.

In the ensuing year, a lot of people have told me that these two patently lousy offerings were a result of the immaturity of the crowdfunding industry; just “growing pains”.  So I thought that I would take a look around at some of the current offerings and see if the industry has gotten its act together. Sorry, not yet.

I recently finished preparing the paperwork for a solar energy fund that is conducting an institutional private placement.  I am a fan of renewable energy and I was pleased to see that a crowdfunding portal dedicated to that industry, Gridshare, had opened for business.

Two of the first three offerings listed on that portal are from a company called Pristine Sun.  The company is run by a gentleman named Troy Helming.  Mr. Helming was the subject of two cease and desist orders by the State of Missouri in 2002 and 2005.

The portal is aware of these past transgressions but chose not to require Mr. Helming to disclose them.  Mr. Helming’s biography in the offering covers this time period and leaving out the disclosure is misleading to investors. There were some other questionable things about Mr. Helming’s disclosures that I brought to the attention of the attorney who runs this portal.

The attorney told me that Mr. Helming was a personal friend who “agreed to put an attractive offering on Gridshare to assist us.  Pristine is an outstanding developer of quality projects, notwithstanding Troy’s legal problems in the past.”  I have no reason to doubt this attorney’s word but I still question the non-disclosure.

What he meant by “attractive” was that investors are being paid 20% interest on the loan that they are making to fund one of these projects.  Pristine Sun claims to have over $80 million in assets and cash flow from its over 200 solar projects that generate electricity and money whenever the sun comes up.  I read the 20% return as a red flag. It is significantly higher than the rate that junk bonds pay.

This offering is being made under the new Reg. CF meaning that the securities are being offered to smaller, basically uneducated investors.  If an investor asked my advice, I would wave them off any loan paying 20% interest as a matter of course.  To me, a return that high, coupled with the questionable disclosures about Mr. Helming’s past, is a clear “red flag” from a  due diligence perspective.

Someone asked me to look at the offering for the GreenLeaf Investment Fund (GLIF). This is a Reg. A+ offering that is listed on a platform called CrowdVest. The fund intends to purchase commercial warehouses and rent them to the cannabis industry in states where cannabis is legal.  The website says: “When industrial properties are retrofitted for cannabis cultivation they have shown an increase in value by 5 to 10 times.”

The only research I could find suggested that, in Colorado, re-purposing a warehouse for cannabis cultivation might increase the value by 50%, not 500%. But I am willing to assume that CrowdVest asked the fund to provide support for its advertising.

There are other cannabis related, real estate funds available that are not suggesting that renting to the cannabis industry will increase the property value 5 or 10 times.  Most of those funds are structured as LLCs so that the income that is generated from rents can flow directly to the investors.

The GreenLeaf Investment Fund is structured as a corporation, specifically as a penny stock offering.  There is nothing inherently wrong or illegal about this, but neither is there any obvious reason that this fund should deviate from the norm and not pass the income it will receive to the investors.

The fund certainly spent more on legal fees for a Reg. A+ offering than it would have for a Reg. D offering and I do not believe that it was money well spent.  “CrowdVest shall be entitled to receive an administration fee of $10,000 per month and a one-time consulting and due diligence fee of $125,000 from GLIF that will be due upon completion of the offering.” If CrowdVest did not question the penny stock structure for this offering, I do not think that money was well spent either.

When I wrote about both Elio Motors and Med-X, I was of the opinion that I was looking at two companies that were intent upon scamming investors. That is not the case with either Pristine Sun or the GreenLeaf Investment Fund.  I am not questioning their integrity, just their approach to corporate finance.

When a company is paying 20% to borrow money it is telegraphing the fact that it is not a creditworthy company.  When a company structures itself as a penny stock, a market that has been full of fraudsters over the years, it is saying that it could not structure itself better.  In both cases, the crowdfunding “professionals” at the portal and platform should have set these issuers straight before they released these offerings to the public.

Please do not tell me that the JOBS Act prohibits Title II platforms from giving “advice” to issuers.  As counsel for a platform, I always have a conversation with the attorney representing the issuer and I always ask a lot of questions about the company and the structure of the offering.  The issuer and the platform share a desire to see that all appropriate disclosures are made and that the offering is structured to be well received by investors. Attorneys are always charged with acting to further their clients’ interests.

There are really 3 levels of responsibility in crowdfunding. A registered portal (and the Title II platforms and the issuers) are in the business of selling securities.  They need to appreciate that this is a highly regulated process and they need to take their responsibilities as sellers of securities seriously.

In the first place, there is compliance with the federal securities laws and the myriad rules and regulations that have been enacted by the SEC and FINRA. The primary rule is to not offer securities without full and fair disclosure. The only way that compliance is possible is with a comprehensive due diligence investigation. The portal or platform should also take care to ascertain that the company’s website and other advertising comply with the rules.

Next, offerings need to have practical business plans. FINRA was clear about this when it expelled a portal called uFundingPortal.  FINRA specifically questioned the business plans and the valuations of the companies that listed on this portal.  A portal should be able to evaluate a company’s potential for success at least with the money that they are raising. If a company suggests that they are going to raise $1 million and can cure cancer with that amount of money, I would not expect the offering to be listed on any crowdfunding website.

Finally, an offering should make sense from a corporate financing perspective, which is where the two offerings I discussed above fall short. The portal or platform should appreciate that the size, structure and terms of the offering are important to both the issuer and the investors.

An offering for a real estate fund, a restaurant, a film, a tech company and a company selling consumer products would all likely be structured differently. Companies rarely have the expertise to fashion an offering that investors find attractive which is why many are having trouble selling the offerings and raising the funds that they want.  Portals and platforms should have that expertise available for every offering.

I am constantly amazed how many people operate portals without any real experience dealing with investors.  A Title III portal, because they are dealing with small, inexperienced investors, should always have an experienced broker/dealer compliance person either on staff or on call.  They should also be able to assist companies in structuring and pricing their offering.  They should have marketing people available who understand what excites investors, which is not always the same thing that will excite the end user of the company’s product.

Complying with the rules, funding companies with a better chance of success and structuring offerings in such as way as to benefit both the issuers and investors will lead to more success for the industry and happier investors. This will never happen unless and until the industry steps up.  The way in which the mainstream brokerage firms would approach the same offerings should be a model for the crowdfunding industry.

The mainstream brokerage firms are already beginning to appreciate that they can sell securities to investors from a website without paying sales commissions and make a lot of money doing so.  Unfortunately, until that happens or until the current participants up their game, issuers will continue to have difficulty raising the funds that they need and thousands of investors will lose tens of millions of dollars to bad deals that could have been made better if only the crowdfunding industry would hire people who knew how.

 

 

Crowdfunding – Letter to the SEC

The SEC and New York University recently held a dialogue on securities crowdfunding.  SEC Commissioner Kara M. Stein offered closing remarks and asked some questions that need to be answered. https://www.sec.gov/news/statement/stein-closing-remarks-sec-nyu-dialogue.html. These are my thoughts and responses to Commissioner Stein’s remarks.

Dear Commissioner Stein:

By way of background I am a securities attorney with 40 years of experience representing broker/dealers, issuers of securities and large and small investors.  I have also taught economics and finance at a well reputed business school.

My interest in securities offerings that are made directly to investors over the internet goes back to the late 1990s when the first offering was made by the Spring Street Brewery company. I have spent the better part of the last two years studying and writing about crowdfunding under the JOBS Act.

I currently advise clients who are issuers, Title II platforms and Title III portals.  I believe that crowdfunding can work and that it can be a valuable tool in aid of the capital formation process especially for smaller companies.

To this point in time, a large percentage of successful offerings involve various forms of real estate investments. The vast majority are being offered under Regulation D. Several real estate funds have raised $25-$50 million from accredited investors on Title II platforms. Thousands of smaller real estate offerings have also been successful. These offerings are proof that funding is available outside of the traditional broker/dealer sales network.

Small companies and start-ups on the other hand, have had a much more difficult time attracting investors.  Start-ups, of course, are far riskier investments than most real estate offerings.  There are far fewer investors in the market place who are looking for that risk.  Some will take on the risk if they are satisfied with the potential for the company’s success.

There has been a push to offer securities in these companies to smaller investors under Regulations A and CF on Title III portals. The question that you asked in your remarks at the SEC-NYU dialogue: “Are registered portals appropriately considering the companies and offers hosted on their platforms?” is the appropriate question to ask.

There are fewer than 2 dozen registered portals today. I have reviewed offerings on most and have had direct contact with several. The answer to your question is that some of the portals do indeed act appropriately and several clearly do not.

You can easily identify those portals that do not comply with the rules. Most of those do not have a well trained and experienced professional in the role of compliance director.  The compliance director at any Title III portal should, at the very least, have a complete familiarly FINRA’s due diligence and advertising rules.

There are several portals who do not even attempt to conduct a due diligence review. There are also several consulting firms that provide due diligence investigations to the crowdfunding industry that lack the experience or expertise to do it correctly. These consultants get a lot of work from the portals because they charge very little.

You asked whether there should be minimum and uniform standards for vetting companies seeking to be hosted on a portal.  FINRA already has very specific rules for due diligence that require the member firm to verify the facts that the issuer is presenting to investors.  New rules are not needed; just compliance with and the enforcement of the existing rules.

One FINRA member portal in particular that has specialized in Reg. A offerings has listed several issues which are questionable in terms of their disclosures and economic viability. That portal makes no attempt to vet the offerings it lists.  One of these offerings is currently the subject of an SEC enforcement action.  I cannot know if the Commission’s enforcement staff intends to sanction the portal for its participation in that offering.  In my opinion, it should.  This portal unfairly competes with the portals that take their responsibilities seriously.

This portal does not spend money on due diligence. It does not care whether the issues it lists misrepresent their prospects for success to prospective investors.  It has a track record of successful offerings because the issuers are making promises to investors that they are unlikely to keep.

You suggested that some people have registered their concern at what may be a “race to the bottom” as portals compete for offers. That is exactly what is happening.  That same portal is currently offering a one day Reg. CF workshop that provides issuers with accountants, lawyers, copywriters and other vendors to get their campaign to “go live” on the same day as the workshop with no cost.

I cannot imagine that the SEC staff or FINRA would believe that adequate due diligence is being done if the offering is going live on the same day that the portal is first introduced to the issuer. I cannot personally believe that a competent securities attorney would participate in the preparation of these offerings or that the attorney’s professional liability carrier would approve.

Your presentation also noted that FINRA had expelled a portal for listing 16 questionable Reg. CF offerings. Those offerings were essentially done with a “cookie cutter” approach. What besides a cookie cutter approach can be expected when a portal is proposing to create and list multiple offerings on a single day at a workshop?

I have singled out this portal because its conduct is so egregious that I suspect that the Commission staff has already taken note.  I am not the only person in the crowdfunding industry who would understand if FINRA or the Commission did its job and closed this portal down.  If the crowdfunding industry is to succeed, investors must be able to look to this market with confidence.

You also asked what needed to be done to ensure that crowdfunding opportunities are accessible to everyone from the businesswoman in Missouri to the immigrant in West Virginia.  I have personally been contacted by potential issuers from all over the country. I know that Title II platforms exist in many states and several portals are “under construction” outside of major money centers.

Many of these issuers lack the knowledge and skills to put together an offering that might attract investors.  They lack experienced managers, quality boards of directors and well thought out business plans.  The Small Business Administration (SBA) has an existing mentoring program (SCORE). The Commission would be doing the marketplace a service by partnering with the SBA to make accurate information about crowdfunding available to more potential issuers.

There is currently a lack of good information about crowdfunding in the marketplace and much of the information that is available is inaccurate.  Much of the information about crowdfunding is being disseminated by a remarkably small group of people.  Many of these people have no experience selling securities and treat the process as if they were selling soap powder.

You expressed a desire on behalf of the Commission to improve this marketplace. There are those who are advocating making these very risky investments more accessible to small investors. I urge the Commission to reject that approach.  The risk should be allocated to those investors who can afford to absorb the loss.

As you noted, “portals that are effective at vetting issuers and offers are important as both gatekeepers and facilitators of repeat investment.” Keeping the portals focused on that task is the best thing that the Commission can do for this market.  Investors will come when there are better offerings. Better offerings will come when the portals insist that issuers demonstrate that they have real potential for success.

Respectfully,

 

Irwin G. Stein, Esq.

 

 

 

Crowdfunding – Impractical Business Plans

There seems to be an overriding attitude in the crowdfunding industry that it exists solely to provide access to capital to small entrepreneurs who have previously been denied access by the evil barons of Wall Street.  Many people in the industry are amazed when I tell them that under the regulatory scheme in the US, the owner of an equity crowdfunding platform or portal is in the business of selling securities and every sale that they do is highly regulated.

The regulations include provisions that are firmly rooted in the idea of investor protection. The regulators will never accept the idea that investors in the crowd can be left to fend for themselves or that proper disclosures do not have to be made. Equity crowdfunding is not a caveat emptor marketplace.

Small investors are being hyped with the idea that crowdfunding portals are offering opportunities for them to invest in the next Facebook or Amazon that will turn their modest investments into huge profits. Investors are actually being offered shares in breweries, distilleries and a lot of small companies with dubious products and often inexperienced managers.

In the mainstream financial market, virtually all of the brokerage firms are members of FINRA so the rules are uniform one firm to the next. In the crowdfunding marketplace only those Title III portals that sell offerings to small investors under Reg. A or Reg. CF need to apply for FINRA membership.  That was intended to provide an extra level of protection for smaller investors.

Unfortunately, some of the portals do not seem to understand their responsibilities as FINRA members.  Several have no personnel on staff with any experience in any aspect of selling securities, let alone compliance with the regulations.

When FINRA expelled crowdfunding portal UFP (uFundingPortal) late last year, in part for listing companies with “impractical business plans”, I expected to see some articles or at least comments from some members of the crowdfunding community about impractical business plans.  The silence from the industry and industry experts has been deafening.

So what, exactly, does FINRA mean when it is telling crowdfunding portals not to list a company that has an “impractical” business plan? It starts with what the company that is raising money is trying to accomplish and whether or not the business plan has a reasonable chance of getting them there.

Everyone would agree that a company that is raising $100,000 and promising that it will be enough money to build a skyscraper in Manhattan or to develop a drug that will cure all cancers has an impractical business plan.  The same would be true if the skyscraper was not designed by an architect or the drug was intended to be sold without FDA approval.

A business plan that suggests that the company will sell one million units of its product using social media would be impractical if the company did not have some way of backing-up that assertion.  FINRA has a consistent policy that requires that there be a reasonable basis for all sales and revenue projections.

As the regulators move forward they will likely find that a company that intends to market a product that infringes on another company’s patent has an impractical business plan. It is also impractical to raise funds to operate a business that is illegal, like a brothel. But not every case will be as clear cut.

The FINRA regulations governing these portals are in addition to the regulations that stem from the federal securities laws. They require additional work and additional skills. Being able to identify and eliminate impractical business plans is one of those skills.

This will make it more expensive to operate a Title III portal than a Title II platform.  Potentially, it is also far more lucrative to be able to accept investments from a larger group of smaller investors.  If you are operating a FINRA portal but you do not have people on staff or as advisors who have experience working at FINRA firms and a clear understanding of what is expected, then I suspect that FINRA will tell you that it is your business plan is “impractical” and put your portal out of business.

In the mainstream markets, FINRA and the SEC have begun enforcement actions signaling that they intend to hold the compliance directors at the brokerage firms personally liable for unlawful transactions that took place on their watch.  I would wager that at least a few of the compliance directors at the 2 dozen or so crowdfunding portals already have regulatory targets on their backs.

I just completed the paperwork for a client who is making an offering through one of the better crowdfunding firms. The offering documents, risk factors, and advertising materials were all reviewed by the firm and the comments demonstrated to me that the reviewers were knowledgeable, competent and well-versed in the rules and requirements. It is not all that hard to comply with the rules if you know what you are doing.  The portals who follow the rules are generally the ones who hire people with some relevant experience.

At the same time, it is very easy for anyone to find crowdfunding portals that are actively inviting small investors to invest in companies that are, for want of a better word, crap.  A portal that lists even one company that would garner this distinction is not doing its job. To my mind, it makes every other offering listed on the portal suspect.  If you cannot make that distinction, you should not be investing at a crowdfunding portal and you certainly should not be operating one.

Please do not push back and tell me that it does not really matter because most start-ups will fail anyway or that investors in these companies know that they are really gambling.  Even casinos are regulated and are expected to operate correctly and in accordance with the rules.

This issue is not that most start-ups fail. The issue is that any start-up funding on a crowdfunding portal should have at least a legitimate chance of success.  They should know how much money they will need and how they will spend it. There is nothing wrong with raising funds to conduct research and development for a new product as long as there is a demonstrable market for the product and the company has people on staff or on hand to conduct the research.

I realize that insisting on “practical business plans” will eliminate a fair amount of the companies that are currently trying to get funded on the crowdfunding portals. That is exactly the point. The JOBS Act was supposed to help companies that could provide sustainable jobs.  Funding companies that are here today and gone tomorrow was never anyone’s idea of what this legislation was intended to do.

The capital  markets, like all markets, work best when they are efficient.  Funding companies that are not likely to succeed is never efficient.  Efficiency results when the companies that have the best chance of success  get funded and those with little or no chance of success do not.

People in the crowdfunding industry tell me that the problem is that the industry is new and just finding its way.  They want to be excused from regulatory compliance until they figure out what to do.

Except that what the crowdfunding portals are doing is not new. People have been selling securities to investors for a long time. The only reason some of the portals are not following the rules is that they do not want to spend the money to do it right.  If they do not believe me, they can explain it to FINRA and the SEC, who are not likely to give them the fair warning that I keep trying to offer.

 

Crowdfunding Fraud –Lessons from Elio Motors

A colleague suggested that the demise of Elio Motors would be a “teachable moment” for the crowdfunding industry. This lesson is necessary because too many people who are active in the crowdfunding arena would not know a scam if one bit them on the butt.

The lesson is that people who operate crowdfunding platforms or portals should have some background in corporate finance. The lesson is being paid for by the investors who made a $17 million investment in Elio and got nothing for it. These are losses that would have been avoided if the crowdfunding portal that listed Elio had operated correctly and refused to list it.

I raised questions about Elio when it was making its offering last spring. At the time it seemed to be a lot more hype than substance. That offering was ongoing at least until March.

By the end of September Elio was already bankrupt even if it has not formally filed the paperwork. Its balance sheet showed less than $5 million in current assets and more than $30 million in current liabilities. Elio had less than $100,000 in unrestricted cash on hand on September 30. Elio would likely have already closed its doors if it had not borrowed another $3 million at the end of last year.

Elio spent all of the money that investors put up and more in less than 6 months. That money was spent on “soft costs”, mostly administrative costs and R&D. Elio actually needs more money to get its vehicle into production now than before the offering.

Elio has been held out as one of the first great successes of the crowdfunding industry. It was one of the first offerings to file under the new Reg. A and one of the first to come to market. The offering was deemed a success because it raised $17 million from thousands of small investors.  Elio attempted to raise $25 million and raised $17 million. In the world of finance that is a failure, not a success.

Elio executives made the rounds at crowdfunding conferences last year, basking in that success and telling attendees how to raise money. Elio attracted investors the same way that Bernie Madoff did; by making promises about their future performance that they knew that they could not keep.

Elio has been taking deposits for its 3 wheeled, gas efficient vehicle and was first promising to deliver the vehicle before the end of 2014, then 2015 and then 2016.  Let’s be clear, there is no vehicle; certainly not one ready for production that could be delivered to the 65,000 people who put down a deposit to get one.  If you take someone’s money promising to deliver a product that you know you will not be able to deliver it is fraud.

Elio had also very publically promised to have its manufacturing facility in Shreveport, LA operational before the end of 2015 creating more than 1500 jobs. That promise of “we are getting ready to start production” was one way in which Elio bolstered its claim that it could deliver the vehicles. A lot of people in Shreveport were excited at the time, but those jobs never materialized. Today, a lot of people in Shreveport are very angry.

That same financial statement indicates that for the entire year of 2016, Elio spent about $1 million less than the year before on maintenance, insurance and property taxes for that Shreveport facility. Elio has been selling off manufacturing equipment at that facility to pay its bills, not gearing up to produce its vehicles. The financial report says that it still needs $300 million before it can start manufacturing. If it does not get substantial additional financing soon Elio admits that it may have to cease operations.

You can go to Elio’s website today and still put down a deposit believing that you are purchasing one of the vehicles at a reduced price. If a thousand people would each send me $100, I promise to send each of you a picture postcard from a beach in Bali. That is not much but it is more than you are likely to get from Elio.

At the time of the Reg. A offering, Elio represented that it hoped to obtain a $165 million loan from the US Department of Energy and still mentions that loan program in its recent financial statement. Elio does not qualify for that loan program, then or now.  Mentioning the program in the offering is what is known as “window dressing”; something that makes the company look more substantial or potentially successful than it is.

The fact that Elio did not qualify for the loan at the time of the offering and the fact that Elio had been taking deposits for a vehicle that it could not afford to manufacture should not have escaped the due diligence review conducted by StartEngine, the portal that listed Elio’s Reg.A offering.   The compliance director of StartEngine told me that they do not even attempt a due diligence review of Reg. A offerings based upon the mistaken belief that they are not required to do so.

Any crowdfunding portal that fails to conduct an adequate due diligence investigation does not care if investors who invest through their portal get ripped off.  I speak with start-ups that are interested in crowdfunding every month.  I only refer them to platforms or portals that follow the rules.

What will the regulators do about this? Perhaps nothing.  Regulators do not rectify every situation.

Still, as regards Elio it is not hard to imagine the conversation between someone in Shreveport who put down a deposit for a vehicle that will never be built who happens to share a duck blind with an Assistant US Attorney. As I said Elio is still taking deposits and apparently will continue to do so until some government agency stops them.

The SEC has already issued an order halting the Reg.A offering of Med-X, another offering listed on StartEngine. That case is still under investigation and it should be a lot easier for the SEC to prove that StartEngine did not act appropriately as the facts in the Med-X case are fairly clear cut.

FINRA recently expelled another portal claiming its offerings presented “impractical business plans.”  Exactly what FINRA meant by that would take another article. Suffice it to say that raising $17 million when you need $250 million and claiming most of the rest will come from a government program for which the company does not qualify is a business plan that is “impractical”.

Secondary market liquidity is an important aspect of Reg. A offerings. Companies that register their shares under Reg. A can also list those shares for trading in the OTCQX market. Investors who take a chance on these small companies have a way of selling their shares which investors in private placements cannot.

As of last Friday, the bid and asked for Elio shares was over $8 despite the fact the financial statements have been public for 2 months. Regulators might reasonably look at the liquidity and efficiency of that market as well.

Some people will tell you that crowdfunding is for start-ups most of which will fail anyway, so why bother to follow the rules and do it right? That is like saying everybody dies sometime, so why not drive around drunk.

The capital markets work because they are regulated. Regulation gives investors confidence.  If Elio turns into a well publicized scandal it is likely to scare investors away from the entire crowdfunding marketplace.

If you are operating a crowdfunding platform or portal and are too ignorant or too arrogant to follow the rules that keep scam artists out, please find another business. Neither the issuers nor investors want them around.

FINRA Expels a Crowdfunding Portal

FINRA has expelled its first crowdfunding portal. The firm, UFP (uFundingPortal) of Herndon, Virginia has only been active since May 2016. In five months it apparently listed 16 offerings which FINRA found to be questionable. UFP signed a consent order agreeing to allow FINRA to expel it from membership. The settlement illustrates how FINRA expects crowdfunding portals to operate.

A central allegation in FINRA’s action against UFP was that the portal knew that none of the 16 issuers had made the filings with the SEC that the issuers were required to make. It is as straightforward as an enforcement action can get; either the required filings were made or they were not. If the portal had asked for copies of these filings it would have known that the filings had not been made and, presumably, declined to list the offerings which is clearly what it should have done.

This is the third regulatory action against crowdfunded offerings and the first against a portal.  The organized crowdfunding industry has greeted this action with a yawn as it did the first two.  The industry has its head buried in the sand because it is populated by a lot of people who have never worked in finance and who keep telling each other that they know what they are doing when they clearly do not.

The first regulatory action against a crowdfunded offering, filed by the SEC in October 2015, was against a company called Ascenergy which raised money from investors on four crowdfunding websites. Ascenergy claimed it was going to drill for oil on land where it had no rights to drill. The principals of the company essentially stole the investors’ money. The SEC did not name the websites in the action. If the websites had conducted appropriate due diligence on the offering investors would not have been defrauded.

I wrote, at the time, about the SEC action against Ascenergy and suggested that it was only a matter of time until the regulators would sanction one of the crowdfunding sites. The crowdfunding industry ignored it. Now it has happened and the industry still does not understand that it is a target for regulators and what to do about it.

In October 2016, the SEC filed its second action against a crowdfunding offering. It halted the Regulation A offering of a company called Med-X. The allegation was that Med-X had not made its required filings to the SEC about its financial condition. The Med-X case is ongoing and an action by FINRA or the SEC against the portal may still be filed. Again, if the portal had merely asked for a copy of the filing, it would have known that the filing had not been made.

The FINRA action against UFP paints a pretty clear picture of what FINRA expects from a funding portal.  FINRA said that it expects “a funding-portal intermediary such as UFP to, among other things, deny access to its platform if the intermediary has a reasonable basis for believing that the relevant issuer or offering presents the potential for fraud or otherwise raises concerns about investor protection.”

Thirteen of the 16 issuers listed by UFP did not have any assets or history of operations and each claimed an unrealistic and unwarranted $5 million equity valuation. FINRA was concerned because these companies had “an impracticable business model, oversimplified and overly-optimistic financial forecasts and other warning signs.”

Obviously, the portal cannot know if it should be concerned about fraud if it does not look.  Federal and state law is crystal clear that the portal or other intermediary is liable for a fraudulent securities offerings if they do not investigate the offering with “due diligence.” Most of the portals do not have a full time due diligence department and there seems to be a lack of understanding across the crowdfunding industry as to what is really required.

When FINRA highlights the fact that the issuers offered by UFP had no assets or history of operations, it is reminiscent of the actions that the SEC brought against so-called “penny stocks” back in the late 1970s.  I represented one of the brokerage firms offering penny stocks back then and the SEC was all over them for taking companies public that were not ready to go public. Nothing in the JOBS Act changed that.

The same is true for financial projections. FINRA requires that there be a reasonable basis for the projections given to investors. If the company has yet to make a sale, what basis is there to project the sale of 2 million units in the first two years?  It is usually wise to conduct a test marketing campaign or prepare a good marketing study before an offering is made. Those are few and far between for crowdfunded offerings.  But if you do not have a reasonable basis to make a projection, you should not make it.

There are fewer than two dozen Title III portals registered with FINRA and I have spoken or corresponded with management, compliance officers or lawyers for a few of them. Some are up to the task and some clearly are not.

The lawyer for one of the portals told me that he saw a gap in the regulators’ thinking. He said: “on one hand (the portal) was not supposed to ‘discriminate’, whatever that means, at the same time they were supposed to reject fraudulent offerings.”

I do not see a gap or a problem. If the offering is questionable or has an “impractical business plan” you do not put it on your website, period. The overriding regulation for the crowdfunding industry is not to allow fraudulent offerings to reach the public. No platform should believe that the SEC would sanction them if they refused to list an offering that they thought was going to be a fraud. Just the opposite is true.

The compliance director at another portal told me that their FINRA registration applied only to the Reg. CF (Title III) offerings it listed. “With respect to Regulation A offerings” she told me, we are “solely a technology platform established to host those offerings. Our FINRA membership has nothing to do with Reg. A offerings and imposes no diligence obligations result from such hosting.”

When I asked if she had a letter confirming that FINRA saw it the same way, she failed to respond.  It was a rhetorical question because FINRA was very unlikely to issue that opinion.

When a firm agrees to join FINRA as a Title III portal, it agrees to abide by all of the rules that are authorized by FINRA’s by-laws. Those rules include a requirement that the firm conduct all of its business in accordance with just and equitable principals of trade and not to commit or “aid and abet” securities fraud in regards to any aspect of its business. A registered representative can be expelled from FINRA for a DUI. The idea that FINRA is only concerned with a firm’s Reg. CF offerings is preposterous.

What, exactly does FINRA expect from crowdfunding portals? Three things. FINRA wants to know that each firm 1) has systems in place and written procedures to foster compliance; 2) has trained compliance personnel in place to carry out those procedures and 3) is vetting the offerings to make certain that what they tell investors is true, reasonable and represents a real business with at least a chance of success.

At the same time, there is no excuse for a Title II platform which is not a FINRA member not to adopt the same procedures and to take the same care that they do not list a fraudulent offering.  These procedures are expenses and few platforms want to pay what it takes implement them correctly.

There is some fraud and the potential for more throughout the crowdfunding industry on both Title II platforms and Title III portals.  I see it. Other people see it and the regulators see it. More than one “knowledgeable” person in the crowdfunding industry has told me that fraud is minimal because the regulators have brought only these three actions. That, too, is preposterous because fraud is fraud whether the regulators catch it or not.

The industry for the most part is in denial because it does not want to see fraud.  In many cases people in the industry would not know a fraudulent offering if they did see one. I am certain that the crowdfunding industry is not interested in eliminating offerings with “impractical business plans” because that describes a great many offerings that appear on both Title II and Title III sites.

Only about 30% of the equity offerings that list on crowdfunding sites actually achieve their funding goals. Issuers incur many costs to list these offerings. The crowdfunding sites are doing no one a favor by listing offerings that investors should not want to consider in the first place.

If crowdfunding platforms exercised some judgment and discouraged companies from raising funds until they were ready to do so, it would help the industry raise that percentage of funded offers. There would be fewer offers but each would stand a better chance of fulfilling the promise of crowdfunding for small businesses and the jobs and opportunities they create.

Crowdfunding Mailbag

Without investors Crowdfunding will become a footnote in financial history.  The Crowdfunding industry continues to demonstrate that it just does not care about playing by the rules or giving investors a fair shake.

A few weeks ago, I wrote an article about Med-X, the first equity Crowdfunding campaign that the SEC stopped mid-offering. It was only the second time that the SEC’s Enforcement Division had gotten involved in a Crowdfunded offering and I thought it was worthy of an article.

Among other things, Med-X was raising money to research and sell products derived from cannabis. One of the larger cannabis websites re-printed the article and I got e-mails from a lot a people in the cannabis industry.

Several people suggested that the SEC’s action was part of a larger government effort to hold back the cannabis industry by denying it funding. They suggested that some Crowdfunding sites would not accept cannabis related offerings before the Med-X action. They thought that this enforcement action would have a chilling effect on their efforts to raise capital.

Frankly, I doubt this is the case. The SEC originally approved Med-X to sell its shares and there are a number of public companies in the cannabis industry. The SEC cares more about disclosure issues than it does about drug enforcement.

My article was also re-printed on a financial website. I got e-mails from several securities lawyers and people in the mainstream financial markets, many of whom, like myself, marvel  about the fact that the Crowdfunding industry offers securities to investors seemingly thinking that the body of law surrounding the sale of securities does not apply to it. The JOBS Act gives some relief from the registration provisions of the securities laws. The anti-fraud provisions of the securities laws still apply.

My real issue with the Med-X action was with the Crowdfunding portal that offered it, StartEngine. Med-X had failed to file financial information that it was required to file, meaning that investors were not getting information that they were required to get.  StartEngine is registered with FINRA as a Crowdfunding portal.  FINRA’s rules certainly impose a duty on its members to disclose all material information whenever they offer securities to the public.

I got an e-mail from the Compliance Director at StartEngine who told me that the SEC’s action against Med-X was about a missed filing date and the SEC did not mention the word “fraud” in its paperwork. Under the securities laws, fraud is defined as the omission of material facts. The failure to provide required financial information to investors fits that definition like a glove.

The Compliance Director told me that StartEngine was represented by competent counsel which I have no reason to doubt. Regulatory compliance in the securities industry is not something that they teach in law school. You are not likely to become well-versed in day to day compliance issues working for a law firm or regulator. You learn compliance the same way that a surgeon learns surgery; by doing it under the guidance of someone who knows what they are doing.

I was trained in compliance when I worked at two large brokerage firms. I offered to explain the problem that she apparently did not see to the Compliance Director or her counsel, without charge. I told her that I really hated to see someone step in it when this was such an easy problem to fix. She respectfully declined.

There are only about a dozen Crowdfunding portals that have registered with FINRA to conduct Regulation A+ offerings. I have corresponded or been on the telephone with the Compliance Directors of four of those portals. Three of the four had no experience with FINRA compliance.  The one who did have experience stood out like a rose in a garden of weeds.

One correspondent asked me why I brought up Elio Motors, another StartEngine offering in the article as well. Elio has become the poster child for the Regulation A+ offerings because it successfully raised about $17 million from investors. The marketing director from Elio recently spoke at one of the Crowdfunding conferences presumably to regale the attendees with Elio’s fundraising success.

I consider Elio Motors to be a nasty problem that will come back to bite the Crowdfunding industry on its butt. In my opinion Elio is a scam. I am not the only person who thinks so.

I base that opinion on the fact that Elio has been taking deposits and promising to deliver a vehicle to customers since at least 2014. Elio has no vehicles to deliver and is not actually building any. Taking deposits for and promising delivery of a product that you cannot hope to deliver is a deceptive business practice under state and federal laws.

In its Reg. A+ filing Elio disclosed that it was trying to get a loan from the Department of Energy to fund production. To qualify for the loan, Elio would have had to demonstrate that it had a strong balance sheet and that it could reasonably be expected to repay the loan.  Elio is insolvent.

Elio has taken deposits from approximately 65,000 people. I would not bet that these customers will receive delivery of their vehicle in 2017, if ever.

Rather, I would bet that a regulatory action (or a bankruptcy, or both) is going to occur in 2017.  Elio has raised a lot of money from the Reg. A+ offering and the deposits but does not seem have a lot of the cash on hand.  It still needs between $200-$500 million more to deliver on its promises.

Is it possible that a VC fund will make a substantial investment in Elio and bail them out? Yes, but I do not see it. Elio still has not demonstrated that even if developed its vehicle will be street legal.

To me Elio does not pass the smell test. I cannot imagine how a competent due diligence officer gave Elio’s offering a green light.

Another e-mail came from a person who suggested I should not be concerned with Med-X’ failure to make proper disclosures because “everybody” knows that most Crowdfunded businesses will fail and that investors treat Crowdfunding as if they were gambling in Las Vegas.  While I acknowledge that most Crowdfunded businesses will fail, the odds in Las Vegas are actually substantially better that the player will walk away with some of his money.

That person also told me that I do not appreciate that Crowdfunding is intended to “disrupt” the way in which capital is raised. I do appreciate that Crowdfunding is intended to allow companies that would not have access to that market to raise money from investors. I also appreciate that there is a correct, legal way accomplish this.

At the end of the day owning a Crowdfunding portal can be a lucrative business.  All I ever suggested was that every portal needs to play by the rules and offer good investments to investors.

In just one year the SEC has acted twice against issuers who broke those rules. In both cases the issuers were enabled by the Crowdfunding industry “professionals” who were not acting professionally.  If there is any take-away from this article it should be that I offered to set the Compliance Director at StartEngine on a straight path, without charge, and she declined.

There is a lot of promise in Crowdfunding that may be eclipsed by inappropriate behavior. Unless investors are willing to invest, and invest again because it worked for them, Crowdfunding will not fulfill this promise.

The SEC’s Enforcement Division is clearly looking for scam artists who are raising funds in the Crowdfunding market and for legitimate companies that fail to follow often complex rules.  It will keep finding them until the Crowdfunding industry gets serious about its business and makes an effort to protect the investors it cannot survive without.