equity crowdfunding

Where Do You Go When The Bank Says No?

Capital Markets, equity crowdfunding, Issuers , ,

It is one of the most pervasive problems in American business.  Whether you are starting a new business or expanding an existing one, you will need to spend some money.  If you don’t have a savings account and can’t fund what you need out of cash flow, it is likely that you will end up at a bank.

Banks are the primary source of business capital in the US. To qualify for a bank loan, the bank will want good commercial credit, adequate collateral, and often a personal guarantee of the debt by the business owners. 

Most banks will want to know what you intend to do with the money you are borrowing. Some will need to be convinced that you can execute your business plan.  Bankers certainly want to know that you will have enough cash flow to make your loan payment every month.

When you borrow from a bank you do so on their terms. You will pay 2-3 % of the loan amount in “points” and other costs plus interest on the loan amount at the rate the bank wants to charge you.  Take it or leave it.

A lot of businesses do not qualify for bank loans, millions in fact. That does not mean that these businesses cannot borrow money or find a source of capital. There is an enormous private securities market that most business owners have never heard of and do not know how to access. 

Wall Street firms package and sell all kinds of debt instruments. They also package and sell various types of alternative investments that make periodic payments to investors.

The alternative investment market is huge. Much of it targets institutional investors or individual investors designated as “accredited”, generally people with a million-dollar net worth who can afford to lose the funds they are investing. All alternative investments are considered to be speculative investments. 

About 15 million households satisfy the accredited investor requirements but not all of the 15 million households are available as potential investors.  Some will never invest in anything that is as speculative as these offerings tend to be. Some will invest only in real estate offerings; others only invest in oil or gas wells or alternative energy projects. There are even some investors who repeatedly fund the production of independent films and a subset of those who only fund horror films.        

Wall Street has sold these investors on the idea that these alternative investments provide “passive income” and to a lesser extent “growth potential”.  Because the risk of loss is high, investors have been taught to expect a higher than the market return. 

Congress has eliminated the need for a company to use a Wall Street firm when raising capital in the private market in favor of a do it yourself model. Any business can post the details of their private offering on their website and solicit strangers to invest.

In the early days of crowdfunding, a lot of people focused on funding start-ups and companies that wanted to hit the proverbial home run. Many people in the crowdfunding industry thought of themselves as venture capitalists. The offerings they posted sought like-minded investors.

What they failed to realize is that venture capital was largely raised from institutional investors. The number of individual accredited investors who have invested in a new venture or venture capital fund is very small.

Syndicated real estate has always claimed the largest share of this market. There is an industry of sponsors who package real estate developments and re-sales for the stock brokers to sell.  Eliminating the stockbrokerage firms produced better terms for the investors.

For example, if a sponsor was raising $1 million for equity to buy a small office building for $4 million, the sponsor would need to raise at least 10% more to cover the stockbrokers’ commission. Eliminating the commission, and its dilution, means investors who might be promised a 10% return on this property, may now receive 11% or more. 

In 2021 the SEC amended its Regulation Crowdfunding (Reg. CF) to allow these private offerings to be sold to most middle-class people, not just the wealthiest households. That has added trillions of investment dollars to this market. The intent of that regulation was specifically to help direct more capital to start-ups and small and medium-sized businesses.   

There are many advantages for a small business funding this way. The terms offered to investors in a private offering are at the sole discretion of the company seeking funding. In no other form of finance is this true. The flexibility that a business can have in setting its funding terms cannot be overvalued.   

Post-pandemic a lot of companies have battered balance sheets and anemic income statements. Rather than be weighed down by their financials, there is a growing trend for companies to take these capital raises off their balance sheet.

Expect to see more offerings patterned after a revenue-sharing model that was already becoming popular before the pandemic. Virtually anything that produces an income stream can be funded.

Whether you are targeting your offering at wealthier investors or the larger pool that includes smaller, middle-class investors, you are going to reach potential investors by email. Modern data mining techniques help to create more highly targeted lists of potential investors. Email open and click-thru rates for alternative investments have soared in the last few years.

Investment rates per thousand emails are more dependent on the message those emails deliver. A personal observation is that the further a company’s offer to investors deviates from the basic “passive income” model, the fewer investors may be interested.  

Consider that a capital raise of $1,000,000 can be offered to investors in several ways. If you offer it to accredited investors only and set the minimum investment at $25,000, you will need at most 40 investors. Some investors will invest more than the minimum.

If you want to include smaller non-accredited investors, you might reduce the minimum to $10,000 and need to find as many as 100 investors. Accredited investors can purchase as much as they want and smaller investors can invest more than $10,000, subject to income and net worth requirements. A raise of $1,000,000 under Reg. CF might require only 60-75 individual investors.

Either way, the people who will respond to your advertisements will consider themselves to be investors with money to invest. If your closing rates are low, you can send more emails without breaking the bank.

The SEC which eliminated the stockbrokers from these transactions has seemingly acknowledged that data-driven advertising campaigns are the logical replacement. The regulator has included a provision where a company can test its email campaign to see if it gets interest from investors. Making adjustments after the test has led to even higher open, click-through, and investment rates.

These data-driven campaigns were working when I first looked at them 4 years ago, are more efficient today, and will likely be more efficient a year from now. Every well-run crowdfunding campaign should be successful and garner the investment capital it seeks. 

The average small business loan is less than $1 million. As banks tighten lending requirements small businesses are going to be looking at crowdfunding as a quick, cheap and available source of capital.  

A raise of $5 million (the Reg. CF limit) will provide the equity (at 3/1 LTV) to syndicate the purchase of a $20 million property.  As the market re-prices next year sellers, especially, will appreciate the ability to set the sales price and offer shares to the public rather than negotiate with buyers seeking to buy good properties cheaply. 

I was excited when the SEC opened this market to smaller investors a year ago. I dubbed the new regulation Reg. CF+ and wrote a small paper to express my thoughts. If you would like to get a copy of the paper, just send me a note in the comment box. 

Since I wrote that paper the data-driven marketing industry continues to evolve. It continues to place ads that cause people to respond, “yes I am an investor and I would like to invest “. For most companies, crowdfunding can deliver investors at what represents a reasonable cost of capital.

That fact, together with the trillions of dollars made available by the SEC and the re-pricing of real estate at the higher interest rates, are likely to give crowdfunding the kick in the pants it needs.  So much so, that I think this market cycle will see a Reg. CF Revolution where a lot more investors’ funds come into play. 

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

Or you can book a time to talk with me HERE

Please STOP Funding Start-ups with “Impractical” Business plans

crowdfunding, equity crowdfunding ,
Please STOP Funding Start-ups

Too many people in the crowdfunding community seem to think that the crowdfunding industry exists solely to provide access to capital to small entrepreneurs who have previously been denied access by the evil banks and brokers on Wall Street. 

I think that the crowdfunding industry will eventually grow and compete with the mainstream banks to fund the same credit worthy companies. The industry just needs to point itself in that direction, something it has been reluctant to do.

Fundraising for start-ups has become remarkably easy with the JOBS Act and equity crowdfunding.  A good, well-funded and professional crowdfunding campaign should receive the funds it seeks every time.

Still many small companies struggle to raise even $50,000 on a Reg. CF funding portal.  Too many of these small Reg. CF offerings fail to raise all of the funds they seek. Part of the reason is that, statistically, 90% of start-ups will fail.

The total universe of investors who might invest in these start-ups is a very small segment of the total number of investors and represents a limited pool of capital. The challenge for any issuer that is crowdfunding for capital is to reach out to enough of the right investors and deliver the right message about your company to them.

Many of the crowdfunding “experts” seem to view investing in start-ups and small businesses as gambling, not finance. That is because many of the funding portals and “experts” know very little about finance.  Some of the portals seem to list any company that can pay the upfront fees.

A great many of the start-ups that seek funding on the Reg. CF funding portals do not deserve to get funded. The offerings are, for want of a better word, crap. The business model they present is unlikely to succeed. Investors are likely to experience a total loss. These companies need to either get their act together or just give up on the idea of getting strangers to fund their business. 

When I read a business plan, I can usually tell if the company has at least a good chance of success or not. It is more than me making an educated guess because there are usually clear signs. Operators of Reg. CF funding portals are supposed to make the same judgment and refuse to host an offering that presents an “impractical” business plan.

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

I recently joked that what the crowdfunding industry needed most was an introduction to Benjamin Graham because most people operating funding portals think Ben Graham invented a cracker. It is only funny because it is true. 

Several years ago, FINRA expelled crowdfunding portal UFP (uFundingPortal), in part for listing companies with “impractical” business plans. Despite FINRA’s clear warning to the funding portals not to host these types of offerings, many of the funding portals continue to ignore FINRA. 

So what, exactly, does FINRA mean when it is telling funding 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, following its business plan, management has a reasonable chance of making it happen.   

The presentation of an offering on a funding portal should eliminate much of the hype and exaggeration. Notwithstanding, many entrepreneurs are clearly being encouraged to “dream big and promise big” by funding portal operators. If a company is raising capital from investors by making promises it is unlikely to keep, then its business plan is “impractical”.

I think that 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 I think that they will find that a company that intends to market a product that infringes on another company’s patent has an impractical business plan. But not every case will be as clear cut.

Can the Management Deliver?

Investors know that 4 software developers writing code and a CFO do not equal an operating company. It helps if the company has people with experience in the industry in which the company will be operating. At a bare minimum, every company seeking investors should have managers that have experience in managing people. 

With start-ups, it is a red flag if the CEO does not have experience managing a lot of people. It is one thing to get people to work well together and produce the work that needs to be done. It is another in this day and age to comply with often complex workplace rules.

Investors like to see that a company has a marketing director with real experience selling similar products. If the company is not yet ready for a full-time marketing director then the company should at least have someone with marketing experience as an advisor or on the board of directors. For many companies the cost of new customer acquisition is a key metric and may be a foundation for all financial projections.   

I listen when a company tells me that its product will sell millions of units or become a ubiquitous part of everyday life. A company should be able to demonstrate not only that people will want to buy its product but that it can produce it profitably, deliver it efficiently and sustain both.

I always ask about a company’s supply chain.  It is fine if all the company has is a prototype at this point, but if it expects to sell 100,000 units in the first year, it should be ready to explain where the company will get those units, what they will cost and how those units will be distributed.

For a pre-revenue or unprofitable start-up, I always ask the company when, in terms of revenue, will the company breakeven. A company that claims it will see double or triple-digit growth needs to be able to support those claims and demonstrate how and why they will come true.

“If we build it, they will come” is not the best approach for realistic sales and sales growth. Even a start-up should be able to make realistic assumptions based upon proposals give by outside marketing firms.

All of the above is encompassed by FINRA’s rules governing how a Reg. CF funding portal is supposed to operate. The regulations include provisions that are firmly rooted in the idea of investor protection and textbook finance.

New rules allow the funding portals to raise up to $5 million for every company. There has been a significant uptick in funding portal applications.

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. The last thing the industry needs is more small companies with dubious products and inexperienced managers competing for investors’ dollars.    

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 need to be made. Equity crowdfunding is not a caveat emptor marketplace. 

A funding portal is a regulated financial intermediary. It is a very small industry with a single regulator, FINRA. Widespread disregard of those regulations is not good for the industry’s long term health.

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

Or you can book a time to talk with me HERE

Making the New Capitalism Efficient

Capital Markets, crowdfunding, equity crowdfunding
Making the New Capitalism Efficient

Economic theory teaches us that in a perfect world capital would always be allocated to its best use. The best use is always viewed from the perspective of the person or entity that is deploying the capital. Consequently we normally calculate the best use as the highest rate of return that the capital can reasonably achieve. The object is always to use money to make money.

To further this goal, capital has always been deployed to companies that have had the best chance of success. A due diligence process is employed to separate the best companies from those that the market deems less worthy. While far from perfect, this system has historically worked well enough to create our modern society with few truly innovative ideas left by the wayside, meaning unfunded.

In the last 20 years, some people with capital have been content to deploy it for other, more altruistic reasons. Specifically, they want to make capital available to people who have no access to the mainstream capital markets and others who for a variety of reasons could not get funded.

This new capitalism has taken two innovative forms, micro-lending and crowdfunding. Each has the potential to put capital into the hands of people who otherwise would never have access to it. Both have the potential to be transformative at the lowest tier of the global economic system. Neither is focused on highest rate of return as its primary goal.

In its purest form a micro-loan is very small and will often help a subsistence level individual transform into a capitalist. Micro-loans are frequently used to purchase one sewing machine to create a manufacturer; one shipment of goods at wholesale to create a merchant. Some micro-loans are used by a rural community to purchase one used truck or tractor. The benefits of these loans are obvious.

As originally envisioned, micro-loans were often interest free or loaned at an interest rate low enough to cover only the lender’s overhead and the costs of defaults. Even though no one who gets a micro-loan has a FICO score, statistics show the rate of default worldwide to be very low. As much as 97% of the loans are repaid. As conceived, micro-lending is a model of market efficiency.

Unfortunately, as this industry has developed and matured, there are some places where micro-loan programs are managed by bloated bureaucracies. There are stories of interest rates that would make loan sharks blush, corruption and exploitation in the lending process and misappropriation of funds intended for borrowers.

Crowdfunding

Crowdfunding is a remarkable tool for capital formation. Its successful utilization still eludes too many small businesses who might benefit most from an infusion of capital.

The crowdfunding industry still suffers from “experts’ who have no idea how to raise capital. Fraud remains a problem because no one really vets the companies that seek funding. The process itself can be expensive and is often hit or miss even though it does not need to be.

Investors who buy into the equity of a small company on a crowdfunding platform must understand they may take a total loss. Even if the company is initially successful, there is no liquidity for the equity that investors purchase.

There is, I would think, a way to combine the micro-loans with crowdfunding in a way that would remove much of the inefficiency. I think it would be welcomed in the developing world.

In most developing countries there are universities whose students are themselves often making the transition to the middle class. They should appreciate that strengthening the underclass will provide a greater market for the products and services that they themselves will eventually make and/or sell.

What I would propose is that each university in developing countries create a crowdfunding program to enable students to fund micro-loan programs in their own communities.

Most peer-to peer lending platforms allow companies in need of loans to borrow from multiple individuals, essentially syndicating each loan. I envision the university students creating a single fund from which to make micro-loans to many borrowers.

I would ask the students to fund the program by purchasing shares in the fund with a small yearly tithe for the 4 years that they are students and for a few years after they graduate. Call it a 10 year voluntary commitment to purchase shares.

Additional funds would come from sale of shares to faculty, alumni, local banks, businesses and importantly, each country’s expatriate community. University students in western countries could partner with university students in developing countries. All anyone need do to participate is buy one share.

I have intentionally left out any local government involvement or participation. Direct government participation rarely adds efficiency to anything.

Business students and volunteer faculty at each university would administer the fund. This would remove much of the costs and corruption. It would give these students valuable experience evaluating business proposals and detailed knowledge about the local economy that will not be found in their textbooks.

Borrowers would pay a fixed interest rate. A rate of 6% might be sufficient to cover the risk of defaults and provide some amount of internal growth. Real growth for the fund will come from new students who will join the program each year as they enter college.

At some point each fund would reach a predetermined principal amount and be closed. In the US and elsewhere a closed-end mutual fund can become registered and be listed and traded in the regulated securities markets. This would provide liquidity to these crowdfunded investments where none exists.

Even after it is closed, a fund can continue to collect payments on existing loans and make new loans year after year. There would be no reason or requirement for it to liquidate.

As the fund grows after it is closed the per-share value will continue to appreciate. Providing for growth and a liquid market would mean that shareholders could expect to make a profit from their investment.

The closing of one fund will be followed by the opening of a new fund to replicate the process. Over time, multiple funds will exist in every country that wants them, sponsored and funded by university students and others who will see both the benefits of the program and the potential for their own modest profit.

Replicated university to university and country to country a program like this would have a demonstrable effect within a decade. On a continuing basis it has the ability to transform communities and economies in the developing world from the bottom up.

It is an opportunity to demonstrate that altruism and capitalism are not mutually exclusive.

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

Or you can book a time to talk with me HERE

What is a dream worth?

Capital Markets, Economics, equity crowdfunding, Issuers
What is a dream worth

A long time ago, when I was a young lawyer fresh out of school, I was walking with a friend along a side street in Manhattan, probably in the West 30s. There were brownstones on both sides of the street. We stopped in front of one that had a small shop on the street level.

In the window were two shelves on which were displayed a series of antique dolls, doll clothes and doll carriages and furniture. Many seemed to be from the early 20th Century, if not earlier. The shop was dark and the sign on the door said: Hours by Appt. Only.

“Interesting business” I remarked. My friend responded: “That isn’t a business, it is someone’s dream”.

In some ways, every entrepreneur and small business owner is a dreamer. They try to turn the intangible, an idea, into something tangible, a business. Assigning a value to any business is not an easy task. While the business is still a dream it is virtually impossible.

Valuations

Of all the things that we teach business school students, corporate valuation is given very little time or attention. When a business needs to be valued because it is being bought or sold the task is relegated to accountants. Accountants plug data about earnings and assets into established formulas and come up with a value. 

Accountants can determine the “book value” of a business by subtracting the company’s liabilities from its assets. That rarely tells the whole story. What if there is little or no data? What if the business has no earnings or assets?

Assets are placed on a balance sheet at cost and are then depreciated over time. The true value of the asset is not always represented in the financial reports. Some assets, especially real estate can often appreciate over time to greatly exceed their cost.

We teach that real estate should ultimately be valued at its highest and best use. A developer may see a dilapidated old farm as the site of a shopping mall or residential development. Still, the current owner carries the farm on its books at cost minus depreciation. The value of any parcel of real estate can change dramatically in the time it takes to hold a press conference announcing a new development.

Accountants will often add a line item for the company’s “good will” which is more often than not the accountant’s way of capturing the value of the business as a going concern, including the value of its brand and customer base. This, too, is far from perfect.

I have helped many clients buy or sell a business over the years. If they use a business broker to facilitate the transaction, they are likely to hear that a business is “worth” 3 times next year’s projected earnings.

This may not be a proper method of valuing a small business either. It is modeled after the way that many research analysts predict the future price of publicly traded securities. But with privately held companies, the risk is often higher so the price for which it sells, logically should be lower. 

Yes, I know that this is the antithesis of the view practiced by venture capital firms who are often dealing with companies that have little more than an idea that they want to bring to market. These companies do not have earnings or assets. The values assigned to portfolio companies by venture capital firms have no basis in reality nor are they entitled to be included in any serious discussion of finance.

IP

Intellectual property like patents, copyrights and trademarks are very hard to value at the time they are first obtained. No author knows that they have a best seller on the day their book is published. Few know that their book will be made into a movie or that anyone will pay to see it. So, what is the “value” of any book on the day before the manuscript goes to the publisher?

As an example, I have a friend who is a noted cartoonist. Her characters were originally published in the US for an American audience but have found a huge following in Japan. Was that in her business plan when she sat down to draw those characters for the first time? Hardly.

One of the interesting things about intellectual property such as copyrighted material, is that it can be segmented in myriad ways. A novelist can sell the right to have his book published in the US to one publisher and the rights to publish the book in a dozen other countries, or a dozen other languages to a dozen other publishers. The theatrical rights and film rights to the same novel can also be segmented and sold. In the right circumstances, the rights to produce and sell merchandise that derives from the novel may be the most valuable rights of all.

The value of intellectual property can vary greatly based upon how it is used and how it is sold. Young Bill Gates might have sold the operating system he purchased from a third party to IBM for a nice profit and gone on to do something else. Instead, he licensed the software and received a royalty every time IBM sold a PC with the operating system in it. The result was the Microsoft Corporation which made Gates the world’s richest man. We use a lot of royalty or revenue sharing arrangements in crowdfunding because they are clean and simple.

1990’s

Back in the 1990s when there was a new and disruptive technology introduced every day, I would ask my students if they could identify the most valuable intellectual property that was in use in the 20th Century. It had been a century of tremendous innovation, much of which had been superseded by even better innovation. Many very valuable patents and other IP had become worthless.

The object of the exercise was for them to identify a simple idea that had been patented, trademarked or copyrighted, that had become very valuable even though no one could have predicted the magnitude of its success on day one. I wanted to demonstrate just how difficult it was to value things that had never been done before. Two pieces of IP stood out.

The first was the copyrighted image that is Mickey Mouse. The media giant that is Disney today started with an animated short film of a mouse whistling.  Maybe the most recognizable face on the planet, I do not believe that even Walt Disney would have valued the ownership of the copyright at anything close to its true value.

The second was the patented formula for Coca Cola. I have been in a Jeep in the middle of a jungle where the guide said that there was a village up ahead where we could stop and get a Coke. Pour yourself one and try to imagine how many cans and bottles they have sold. How would you have valued that patent on the day it was filed?

I think that I have made the point that placing a value on any business, especially a start-up, is a waste of time and effort. I will encourage any small business owner to dream big, but you just cannot put a number on it. 

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

Or you can book a time to talk with me HERE

Reg. CF – Will Fools Rush In?

Capital Markets, equity crowdfunding, Investors, Issuers , ,
Reg. CF – Will Fools Rush In?

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

REG CF

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

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

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

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

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

Top Ten REG CF Portals Ranked By Capital Raised 2020

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

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

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

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

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

Portals

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

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

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

FINRA

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

Reg. CF – Will Fools Rush In?

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

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

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

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

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

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

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

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

Rules Are Rules

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

Reg. CF – Will Fools Rush In?

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

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

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

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

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

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

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

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

Or you can book a time to talk with me HERE

The “Real” Costs of Crowdfunding for Capital

Capital Markets, equity crowdfunding, Issuers , ,
the real costs of crowdfunding

Most people who consider crowdfunding to raise capital for their business are first-timers. A great many have never even been investors themselves nor considered investing in any of the companies whose offerings are currently on any of the crowdfunding platforms.

Economic downturns always present opportunities for people with the capital to exploit them. I get more calls from CEOs and CFOs interested in crowd finance every week. Many have become interested because the banks they would normally turn to are not lending.

A crowdfunding campaign, if executed correctly can be an excellent source of capital for most businesses. Like any other corporate task, it requires preparation, an adequate budget, and professional execution. Not surprisingly, everyone wants to know what a successful campaign to raise capital from investors will cost.  

The “Real Cost”

Most companies will rely heavily on their CFO or outside financial advisor to execute this financing. The CFO needs to consider how the financing will affect the company’s balance sheet, cash flow, and capital structure. The company will need to decide if it should offer investors debt, equity, or another form of financing instrument.

The question of “what do we offer the investors” necessarily comes up early in the planning stages of every offering. The right terms can save a company a lot of money and make subsequent financing easier. The wrong terms can result in an expensive or failed campaign now or may erupt into a costly mess, years later.

For many CFOs the desire to offer investors as little as possible is at odds with the reality that if you do not offer investors enough, they will put their money elsewhere. This is where the “real cost” of any financing is determined.  

Investors in every Regulation D offering are always advised that the securities they are purchasing are “very high risk” or “speculative” to the point that investors should be prepared, both mentally and financially, to lose their entire investment. When the risk is high, investors expect to receive a high return as well. Some risks can be mitigated and should be. 

The process of deciding the terms investors will be offered usually starts with a series of spreadsheets. How much the company can afford to pay is in the revenue projections. How much the company may need to pay to attract investors requires a good idea of the cost of capital from other sources and a good idea of what other companies are offering in the crowdfunding universe. 

I frequently participate in this process. This is because most of the platforms fail to offer this type of advice which most companies sorely need.

I like to ask the questions that investors are likely to ask. I try to help each company see the investment from the investors’ point of view. Wall Street firms sell billions of dollars worth of these private placements every year. They know what needs to be said to get investors to invest.

Regulation D securities will only be sold to US “accredited” investors, mostly those who have a net worth above $1 million (excluding their primary residence). For years the mainstream stock brokerage industry has conditioned these same investors to look at the return that is being promised to them first, and most do. 

Investors want to know how you will use their money to make the returns you are promising come true. How you price and present your offering tells serious investors a lot about how serious and professional you are. 

What to look for in a lawyer (if you don’t hire me).

Once you have decided on the terms you will offer to investors you will have 3 major out-of-pocket expenditures. The first is a securities lawyer to draft the offering documents. What you say to potential investors in the offering and marketing materials is regulated. A good lawyer will keep you within the regulators’ white lines.

The standard disclosure document for a Regulation D offering is called a private placement memorandum (PPM). The overriding requirement is for full, fair, and accurate disclosure of the information that an investor would need to make an informed decision of whether or not to invest. 

PPMs have been presented as a bound booklet for decades. The bound booklet PPM is the normal format for disclosure that most practitioners still use.  In booklet form, the cost for a PPM is typically $50,000 and upwards.

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

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

It usually takes less drafting and less time for a lawyer to use the landing page to “lay it all out” which is one of the benefits of crowdfunding. I usually bill in the neighborhood of $20,000-$25,000 for a Regulation D offering done in this manner rather than the traditional booklet form.

Paying for the Platform

Many crowdfunding platforms advertise that tens of thousands of investors have invested in at least one offering that they had hosted. Unless the platform can deliver those investors to you, such claims are irrelevant. You are going to need to execute a marketing campaign sufficient to bring in the capital you seek.

Platforms usually charge a “hosting fee” that covers two or three months for you to use their platform to attract investors to your offering and process them.  The processing will include a vendor to verify that your investors are actually “accredited” and an escrow agent to hold the investors’ funds until closing.

Key individuals at each company are required to get a background check to verify that they are not “bad actors” who cannot use the JOBS Act to raise money. Platforms charge for this and the better platforms charge to conduct due diligence on the company as well. 

Most platforms charge more the longer your offering is live.  A well planned and executed marketing campaign should get you the funding you want faster. Expect to spend $10,000 more or less for the platform hosting and the background checks.

Never Take Marketing Advice from Your Lawyer

the real costs of crowdfunding

Working in financial services where so much of what you must say and cannot say is regulated; I came in contact with a lot of advertising and marketing professionals over the years. In the 1980’s, when stockbrokers went searching for accredited investors they would buy subscription lists from “Yachting” magazines.

A modern-day marketing campaign is skillfully targeted at a pre-selected group of prospective investors. Content is pre-tested and the campaign will target more potential investors than you should need. 

The costs of setting up the landing page for an offering can vary greatly. I think that $10,000 is reasonable for setting up the website and preparing the marketing campaign.

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

So for a crowdfunding raise of $3 million, you might spend $20,000 for a lawyer, $10,000 for the platform and related fees, and $40,000 for the marketing campaign for a total of $70,000 more or less.  I always tell clients to keep a little in reserve as well, just in case the marketing campaign needs to be extended.

If you borrow $3 million from a bank, the bank will charge 2 or 2.5 points (percent of the loan) as well which is roughly the same.  And in truth many of the companies that chose crowdfunding did so because bank financing is not an option for them.  

The crowdfunding world has evolved from “put the offering on the platform and see who invests” to a world populated by legal and marketing professionals who get the job done and the money raised.  If you want your crowdfunding to be successful, be prepared to pay for them.

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

Or you can book a time to talk with me HERE

Creative Crowdfunding

Capital Markets, equity crowdfunding, Investors ,
Creative crowdfunding

A mentor of mine used to refer to the process of preparing a securities offering for public investors as a “craft”. He would explain to me:“Before you can sit down and write the offering based on your clients’ specifications, you need to be able to see the offering through the eyes of the prospective investors.”

Crowdfunding is creative finance.  Crowdfunding comes with endless possibilities for creating a variety of unique financing transactions. Each company sets the terms that they will offer to investors. Investors get to say “no thank you” to those terms if other investments are more appealing.   

Many people who work in crowdfunding don’t know the first thing about finance. This limits their creativity and often dooms a crowdfunding campaign that should have been successful.

Crowdfunding Experts

When speaking with a company seeking an infusion of capital, many crowdfunding “experts” give cookie-cutter advice. Some companies use templates to create their offering instead of lawyers. Those companies will never know that there is usually a better way to approach their financing that will be more attractive to investors and at the same time save them a lot of money.  

Creating an attractive investment for an audience of targeted investors on a crowdfunding platform involves a series of tasks. Much of it involves a lot of time looking at spreadsheets.  If you don’t, at the very least, do the following while preparing your crowdfunding campaign, you are likely wasting your time and money. 

Before I structure an offering I expect to review the company’s current financial position. Only then can we decide whether the financing should be debt or equity, whether it should be on or off balance sheet and whether the offering should be for more or less.

You need to be able to demonstrate how you will use the investors’ money and how that money will generate revenues. Your revenue projections need to be supported by real world data and real world assumptions. “We’re going to capture 50% of a billion dollar market in 2 years” is fantasy, not finance.

Every financing transaction has a risk of default or sub-standard performance. You need to understand the specific risks of your business and how to mitigate those risks. You will need to estimate how much of a reward it will take to compensate your target investors so that they will accept those risks. 

Crowdfunding overwhelmingly operates in the Regulation D market selling private placements to accredited investors.  A great many of the accredited investors who you are likely to pitch for your offering have more likely than not, already been pitched to purchase a private placement.

Since the 1980’s the mainstream stock brokerage industry has sold private placements to millions of individual accredited investors. Various types of real estate offerings are the most popular, followed by energy (oil, gas, and solar), films, entertainment and events and equipment financing. 

For over 40 years the mainstream brokers have been selling investors on the idea that private placements provide passive income. Accredited investors are also used to being pitched that private placements come with higher returns. Most crowdfunding is directed at these same accredited investors. You need to give them the information and the pitch they expect to hear. 

The vast majority of accredited investors are baby boomers. They still control the bulk of the money in the Reg. D market. They have grown up with new tech and new companies and they are not afraid to invest in either. But new tech is always risky. You have to offer a return commensurate with the risk.

Crowdfunding as we know it today began with a rewards based model. A company would sell its product on a platform like Kickstarter and use the proceeds from the sales to manufacture the product. Much of the time, the product never got delivered. 

Revenue Sharing

During 2016-2017 there was a lot of discussion among Crowdfunders about a financing model called “revenue sharing”.  In its basic form, a company would raise money from a pool of investors, manufacture the product and then share the revenue with the investors.

Revenue sharing is actually a mainstream tool of modern finance. Many oil drilling programs pool investors’ money to cover drilling costs with the investors and land owners, sharing in the revenue if and when it strikes oil. 

Many franchisers use a revenue sharing model with their franchisees. The parent gets a percentage of the franchisee’s gross revenue structured as a franchise fee, rent, or a royalty on intellectual property. The parent often provides advertising support or promotions to help build sales.

Accredited investors that have purchased Reg. D offerings are familiar with this “slice of the revenue pie” structure. They understand that they will earn less if their oil well pumps 10 barrels a day than they will if it yields 100 barrels a day.  

As I have already mentioned, there was for a while a lot of discussion about revenue sharing.  Several platforms were going to come on line to specifically offer revenue sharing programs. Revenue sharing is a natural for a crowdfunding audience.  Unfortunately it never really took off in the way that I would have expected.  

The crowdfunding industry is still focused on the “buy equity in the business” model, It has gone out of its way to create derivatives like SAFEs to complicate what should be simple capital raising projects.

The crowdfunding industry needs to accept the fact that businesses with no sales or assets are not “valued” at hundreds of millions of dollars in the real world. Insane valuations actually hurt the crowdfunding industry because they drive away serious investors.  Many of those same companies could use creative revenue sharing models instead of trying to sell equity.    

I recently spoke with a business owner willing to sell 10% of his business for $2 million. He wanted to syndicate a Reg. D offering and raise the money on a crowdfunding platform.  He was having a good year and wanted to expand.

The company sells an automated HR suite to businesses with at least 100 employees.  Its customers pay monthly, per employee. The company wants to use the $2 million to open more accounts, each with a large number of employees.    

The company knows the cost of account acquisition and expects at least $10 million in additional revenue in the first year from its $2 million expenditure. Those new accounts are likely to stay customers for many years. 

Instead of selling 10% of the company, I suggested that he share the income stream with investors, pay them back quickly with a generous return and move on. It makes perfect sense.

The company might give the investors 60% of the revenue from these new accounts until the investors get distributions equal to $3 million and then cut them off. They can pay the investors more or less and carry the payments into the future, if they prefer. The company should easily be able to attract $2 million with the promise of paying back $3 million in only a few months.

In this case I would advise the company to take the investors into a separate limited partnership or LLC. Investors like this structure for a number of reasons, not the least of which is that can get paid on the gross sales. They are not concerned about executive pay or management issues. How the company spends its 40% the first year is not the investors’ concern. 

The company does not have to deal with investors on its books and all that entails. This relationship operates and terminates by contract.  If the company wants to sell 10% of its stock later, it will get more if the sales have been increased by $10 million per year.  

I have seen many advertising campaigns funded this way. I have seen companies with multiple products fund one product or even one cargo of its product this way. Most of the crowdfunding “experts” have never recommended this type of revenue sharing arrangement because this type of offering rarely shows up on crowdfunding platforms.

This $2 million gets you $3 million model does not work for every company, but there are other “fund the transactions, not the company” models that may.  These are only one alternative to the traditional equity method. There are others.

As I said, crowdfunding offers opportunities for creative finance, but you need to understand finance, in all its forms, before you can really get creative. 

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

Or you can book a time to talk with me HERE

I Would Gladly Pay You Tuesday

Capital Markets, Issuers ,
I would gladly pay you

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

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

Equity Crowdfunding

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

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

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

Free or Pay Later?

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

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

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

I would gladly pay you

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

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

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

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

Bull Market

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

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

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

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

I would gladly pay you

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

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

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

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

Assholes a Plenty

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

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

I do not want to discourage any entrepreneur.

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

I would gladly pay you

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

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

Or you can book a time to talk with me HERE