Ziyen Inc- Another Reg. A+ Question Mark

I have written several articles about specific Reg. A+ offerings. These offerings are targeted at small investors who are ill-equipped to judge their value as an investment, let alone, the accuracy of the disclosures.

I recently got a call from a colleague who works at a reputable brokerage firm.  He suggested that I look at the Reg. A+ offering of a company called Ziyen Inc.  He thought that it might be the grist for a blog article. He was not wrong.

Ziyen Inc. was incorporated in April 2016 to provide a suite of “cutting edge digital business intelligence, marketing and software services.”  By business intelligence it means information about available government procurement contracts, initially in Iraq and eventually globally.

The offering circular states: “Ziyen currently operates the B2B Procurement Portals “Rebuilding Iraq.net” and “Cable Contracts.net”.  “Rebuilding Iraq is our first B2B Procurement Portal, and the flagship service for the company. We are currently the number one international source for information on tenders, contracts, news and marketing services in Iraq.”

As far as I can tell, Rebuilding Iraq.net lists tenders for contracts that might be found elsewhere and does not charge for the information. It claims that 200,000 people visit the site every month.  When I checked Cable Contracts.net, which does charge for usage on a monthly subscription basis, I did not find any tenders listed. According to the financial statements in the offering circular the company has no revenue and roughly $7000 in the bank.

The company is selling up to 64,000,000 shares at $.25 per share. It is self-underwriting, meaning that there is no brokerage firm involved or even an established crowdfunding platform.  The offering circular mentions two crowdfunding platforms by name and the subscription agreement mentions a third, but I could not find this offering on any of them.

It appears that shares are being sold directly from the company website. The website actually uses shopping carts into which you can put a bundle of shares and check out using a credit card. And before you say that the shares are only $.25 a piece, the bundles go up to $25,000 so this is a serious offering of securities.

The subscription agreement also mentions an escrow agent where investors can deposit their funds, except that no escrow agent is being used.  According to the offering circular, “Subscription amounts received by the Company will be deposited in the Company’s general bank account, and upon acceptance of the subscription by the Company, the funds will be available for the Company’s use.”

No competent securities attorney would permit these types of inconsistencies. In truth, it appears that no competent securities attorney was involved in the preparation of this offering.  None is disclosed and no funds are allocated to pay an attorney to prepare the offering or deal with the Securities and Exchange Commission’s Division of Corporate Finance which reviewed it.

It appears the offering was prepared by the company’s principal, Alastair Caithness, a Scottish-American businessman.  You can tell he wrote the offering circular because he refers to himself in the first person – “I was Head of Sales in a company in the UK” although he never discloses the name of that company.

The offering circular also obliquely refers to other employees and a Board of Directors, none of whom are named. The Company does business in Iraq and for all you know the Company might have people on its Board of Directors whom the US government might not look upon favorably.

I did find six other Board members on the Company’s website, but their backgrounds were short on the type of detail I would have expected to see in an offering circular. The disclosures give incomplete employment histories and several fail to disclose where they were educated.  Nothing negative was disclosed about any of them and I am not suggesting that there was anything negative to disclose. I am only questioning whether Mr. Caithness would have known what disclosures the rules required.

For a little perspective, back in the late 1970s when I was writing registration statements I took some flak from the Division of Corporate Finance because one of the executives at an issuer had claimed to have a Bachelor’s degree and did not. It seems he got his draft notice right before his senior year final exams and decided that graduating was not that important. When he took the job at the company years later his resume said that he had graduated and no one had ever checked. The Division of Corporate Finance told me at the time that was a misstatement of a material fact.

I must have missed the memo where they subsequently decided that not disclosing the names of the members of the Board of Directors in an offering circular was not an omission of a material fact.  Nowhere in the offering circular does it suggest that investors should review every page of the company’s website or every subsequent press release.

The offering circular is dated mid-October of 2016. In mid-April 2017, the Company announced separately that it had established a “new investment division in the company to focus on financing unfunded construction projects in Iraq”.  It claimed to have “the capabilities to provide the finance for long-term projects.”  Financing for long-term projects?  According to the offering circular the company has $7000 in cash in the bank.

In June 2017, the Company announced that Ziyen Energy, a division of Ziyen Inc., had just secured over $36 million dollars of oil reserves in Indiana in the United States.  The deal includes 7 existing oil producing wells worth over $6 million dollars of proven reserves along with a support water injection well and a water producing well for injection purposes with a further potential for 20 new oil producers on undeveloped reserves on the site worth over $30 million.

That would certainly be big news, except the offering circular does not mention Ziyen Energy nor any intention to be in the oil production business, much less in the oil production business in the US. If you were to download and review the offering circular today you would have no idea you were investing in an oil company. Even if you tracked down the press release, it does not disclose how much the company paid for these reserves, whether they were financed, how much the wells are producing or if contracts are in place to sell the production.

As I was researching this article I was prepared to give Mr. Caithness the benefit of the doubt. I thought he was just a businessman trying to raise some money for his own company on the cheap, i.e. without hiring a competent securities attorney.

Then I found this offering on a crowdfunding platform that specializes in Reg. A+ offerings called Wall Street Capital Investment. It is owned by Mr. Caithness who holds himself as an expert and offers to help raise money for others.

Ziyen Inc. is actually the second offering on that platform. The first is a company called Novea Inc. which shares the same address in Cheyenne, Wyoming as Ziyen. (Mr. Caithness is actually in California and presumably operates Ziyen from there. I have no reason to believe that Novea is actually in Cheyenne either.) The offering circulars for the two are remarkably similar and no attorney was apparently paid to prepare the Novea offering either.

Novea Inc. also has neither revenue nor cash in the bank and is in the business of offering warranties that “disrupt” the warranty industry.  One of its largest shareholders is Mr. Carlos Arreola who is Mr. Caithness’ partner in Wall Street Capital Investment. As an aside, the advertising for both companies feature the same actor and the marketing plan and press releases are also very similar.

I also suspect that this is about more than just saving some money on legal fees. Had Mr. Caithness come to me I would have suggested that he raise his funds through a Reg. D offering to accredited investors. He would have spent about the same as he anticipated (the offering budgets $20,000 for crowdfunding and related expenses) whereas the average cost of a Reg. A+ offering is in the neighborhood of $150,000 and much of that is for the lawyers.

Personally I think this offering might have been difficult to sell to accredited investors given that its business plan is weak. But if its Rebuilding Iraq.net website gets 200,000 views per month there would be a steady stream of non-accredited potential investors who are pre-disposed to the idea that Iraq needs rebuilding and might put a few shares in their shopping cart, even though they would actually be investing in a US domestic oil producer.

And that is really the point. Since there is neither a competent securities attorney nor broker/ dealer involved with this offering it is up to the individual investors to investigate this offering and make their own decision. No one has vetted this offering and no one can say whether every material fact is disclosed or accurate. The crowdfunding industry needs to stop deluding itself into thinking that small investors can actually perform due diligence.

Given the internal inconsistencies and inaccuracies, the failure to disclose the names of the Board of Directors and the fact that this was a DIY Reg. A+ offering I would have expected a little more scrutiny by the SEC’s Division of Corporate Finance before it was approved. But that no longer matters.

I know that about two dozen senior staffers at the SEC receive this blog through Linked-in, as do people at FINRA and the offices of state securities administrators in more than a dozen states. I know that people in a few Congressional offices that have oversight on the SEC and crowdfunding receive it as well. This one is a no-brainer.

From the company’s own press releases it is obvious that the information being disseminated to prospective investors in the offering circular does not reflect the current state of the company’s affairs. If a cease, desist and disclose order is not appropriate here, I cannot imagine that it will ever be appropriate anywhere.

I am older than most of my readers. I was around and litigated matters involving Stratton Oakmont and before them Blinder, Robinson and First Jersey Securities, so I think I have a pretty good idea of what a micro-cap fraud looks like. I was not certain that I was looking at one here until I got to the press release about the potential for 20 new producing oil wells. There have been quite a few micro-cap frauds involving oil stocks over the years. Mr. Caithness and his partner are registering a lot of their own stock. My gut tells me that there will be an enforcement action here sooner or later.

I am not a whistle blower. I know a lot of lawyers and others who are trying to navigate the Reg. A+ waters specifically because they believe that more companies need access to capital and that smaller offerings should be open to smaller investors. Their hard work will go for naught if the investors are drawn into scam after scam.

I am not the world’s biggest fan of government regulators. But if you want the fire department to show up and put out a fire, you need to scream FIRE at the top of your lungs. That is really all that I am trying to do.  I am optimistic that some securities regulator will hear me. There have already been far too many examples of fraudulent Reg. A+ offerings that the crowdfunding industry does not want to talk about.  Here is an opportunity for the SEC to re-enforce the need for compliance with the rules. Investors should be able to look at an offering circular and at the very least get accurate disclosures of all of the facts.

 

ShiftPixy – A Reg. A+ Question Mark?

 I frequently get into discussions with proponents of Regulation A+ who believe small investors should be encouraged to invest in start-ups.  The proponents argue that small investors are being deprived of the opportunity to invest in new companies that may turn into the next Facebook.  Why, these proponents ask, should these “opportunities” only be available to Wall Street fat cats and the wealthiest 1% of the population?

The proponents of Reg. A+ shine the spotlight on those companies that have made successful offerings. That is a function of the sales and marketing effort. They fail to discuss the fact that just because an offering is successful does not mean that the company itself is a good investment.

Proponents of Reg. A+ and especially those who suggest that start-ups are suitable investments for small investors have convinced themselves that these small investors have the skills necessary to evaluate investments.  They constantly tell me that small investors can judge a company and separate the good investments from the not-so-good ones.

In the mainstream markets the task of judging the potential for success of a private company that is about to go public is left to very highly paid investment bankers and research analysts.  It takes a great many hours of hard work and in the end these highly paid professionals do not always get it right.

Simply put, evaluating a new company as an investment is a lot like sizing up a doughnut.  You are attracted to the sweet frosting which is the reward, but you really need to focus on the hole. The hole is what is left out. No company can succeed if key components are absent.

Whenever you evaluate a start-up as an investment the essential question is always the same; given the information presented, can the management make it happen?  Can they execute their business plan with the talent on their team and the money that they are going to raise?

This brings us to a company called ShiftPixy, Inc. which is currently making a Reg. A+ offering of 2 million shares that will be priced at between $6 and $8 per share.  Although the company is only 2 years old, it shows sales of $65 million in the last six months and may have gross sales of $125 million in 2017. There is even a research report from Zacks which suggests that the shares could be worth $12.60 in 2018. Not bad for a start-up. There is a lot of tasty frosting on this doughnut.

According to the registration statement the company is “a leading provider of employment law compliance solutions for businesses and workers in an environment in which shift or other part-time/temporary positions, commonly called ‘gigs’ are performed.”

Essentially, the company provides shift workers, currently in the restaurant and hospitality industries.  Customers move their workers over to be employed by ShiftPixy which then acts as a staffing agency for the customer. By pooling the employees of many smaller companies, ShiftPixy can administrate the human resource management function with economies of scale.

“In return for providing insurance, payroll processing, benefits, and compliance services these enterprises pay ShiftPixy a fee based on their payroll that is much less than the cost of doing these functions in house.”

The registration statement says: “A significant problem for employers in the Gig Economy involves compliance with regulations imposed by federal, state and local governments, including requirements associated with worker’s compensation insurance, and other traditional employment compliance issues, including the employer mandate provisions of the Affordable Care Act.”

I agree that this is a significant problem and any company that can solve a significant problem is worthy of attention.  Government regulations and the attendant paperwork can be expensive and strict compliance is a requirement at every level. A company that can provide employees to other companies while retaining the burden of benefits and paperwork would seem to have a good chance of success.

But can they?  The move to the “gig” economy is being fueled by the employer’s desire to reduce the cost of employees.  According the financial reports in the registration statement, ShiftPixy had deployed fewer than 1800 employees to other companies through the end of February 2017.  How much of an extra fee per employee do they charge?  How much of an extra fee will employers be willing to pay?

The financial reports in the registration statement are not audited. This is not a requirement for a Tier 1 Reg. A+ offering and it is one of my pet peeves.  I have seen too many questionable financial statements over the years.  Proponents of selling Reg. A+ shares to smaller investors necessarily assume that those investors are adept at reading and analyzing a financial statement even as accounting and MBA students struggle to learn how to do it properly.

How does ShiftPixy’s gross margin of compare with competing firms?  Do the smaller investors in this offering know enough to ask that question? Do they know how to find the answer?

For this offering, let’s stick with the more simplistic: can the management make it happen?

In this case the company has two founders; Scott Absher and J. Stephen Holmes. Mr. Absher is the current CEO. The only other executive officer is a newly appointed CFO.  There is a single outside director from another industry.  Since February 2010 Mr. Absher has also been President of Struxurety, a business insurance advisory company.  Neither Mr. Absher, the CFO, outside director or anyone else at the company seems to have any connection to the staffing industry.

There are several well known staffing companies from whom an executive or two might have been acquired. That does not seem to be a priority and it is the primary reason why I have trouble answering the question “can management make it happen?” in the affirmative.

The other founder, Mr. Holmes is not an officer or employee of the company. He is an independent contractor focusing upon building a sales network and providing consulting in relation to worker’s compensation programs as well as Affordable Care Act health insurance programs that the company will offer.  The registration statement notes that he is not involved in any part of the accounting or taxpaying and IRS return filing areas of ShiftPixy’s operations.

I suspect the reason for that disclosure is Mr. Holmes was convicted “for acts related to making false statements in relation to two quarterly IRS Form 941 Employer Federal Quarterly tax returns, one in 1996 and the second 1997, for a company for which he was an officer at the time.” That disclosure is in the registration statement. It does not disclose that Mr. Holmes was sentenced to 15 months of incarceration and apparently served at least part of it.

In order to find out the actual disposition of the case, I had to do some additional research. If you are evaluating any investment, you always need to look at facts outside of the offering paperwork in order to give what you are reading proper context.  That is what is meant by looking at the hole in the doughnut.

I am not here to sling mud. I, for one, think everyone who serves their time is entitled to a second chance. Mr. Holmes, because he owns over 12 million shares of the company will remain a “control person” of the company. He is going to be building up the sales force, not dealing with the paperwork involving taxes or employees. Being able to do that paperwork is this company’s critical task.

That brings us back to Mr. Absher, the CEO, who apparently has also had some issues with government required paperwork.  The registration statement discloses that: “On June 25, 2013, the Alabama Securities Commission issued a Cease and Desist Order (the “Order”) against Scott W. Absher and other named persons and entities, requiring that they cease and desist from further offers or sales of any security in the State of Alabama. The Order asserts, regarding Mr. Absher, that he was the president of a Company that issued unregistered securities to certain Alabama residents, that he was the owner of a company that was seeking investments, and that in March 2011 he spoke to an Alabama resident who was an investor in one of the named entities. The Order concludes that Mr. Absher and others caused the offer or sale of unregistered securities through unregistered agents.

Per the registration statement: “While Mr. Absher disputes many of the factual statements and specifically that he was an owner or officer of any of the entities involved in the sale of the unregistered securities to Alabama residents or that he authorized any person to solicit investments for his company, in the interest of allowing the matter to become resolved, he did not provide a response.”

If Mr. Absher was not an owner or officer of the company in question, he likely could have contested it by filing an affidavit with the State of Alabama.  In my experience, intentionally taking a default, usually indicates that the allegations are true and not worth the effort of fighting. By allowing this order to be entered these facts are deemed to be true.  Saying that he disputes them now has no legal effect and, to me, raises a “red flag”.

There is no prohibition against selling unregistered securities in Alabama (or anywhere else) as long as you file a form with the state, pay the filing fee and make the proper disclosures.  Given that the state of Alabama says that some of that did not happen, it seems difficult for me to imagine that Mr. Absher is well suited for the difficult world of employment law compliance.

I claim no expertise in employment law. I do know that it can be complex and that some aspects of it vary location to location. San Francisco, for example, prohibits employment discrimination and harassment based on the employee’s height and weight. That cannot be the law everywhere.

I would have expected to find an experienced employment lawyer, or more than one on the payroll of this company.  They do not disclose that they have one, nor do they seem intent on hiring one after the offering although “employment law compliance solutions” is what they sell.

Much of the current focus of ShiftPixy is in the restaurant and hospitality industry. Reporting and collecting taxes on tips paid to employees in those industries is another burden.  The IRS requires that an employer must ensure that the total tip income reported by employees during any pay period is, at a minimum, equal to 8% of the total receipts for that period.

ShiftPixy has responsibility to file the paperwork because they are the employer but they have no access to the cash register to see if the information they are reporting is correct or in line with that requirement.  The financial reports also note that there has already been a $280,000 reversal of a charge for workman’s compensation expenses that were “misclassified”. So to me this company has not demonstrated that it can solve the problem that it claims to solve.

ShiftPixy is a staffing/HR company that seems to lack any employees with significant expertise in this often complex field. I would have expected to have seen several people with this expertise in senior management and there is no mention of the need or intent to hire any at the culmination of the offering.

The company sells employment law compliance without employment lawyers and accounting services where everyone important to the company has prior problems with government paperwork.  There are other staffing companies and there is nothing here that screams “we are better.”

Any start-up that is going to compete in an established industry needs to distinguish itself.  To me, this company distinguishes itself by the size of the hole in the doughnut. I think that it specifically lacks the people who can get the job done.

It would seem to have been in Mr. Asher and Mr. Holmes’ best interest to fill this company with knowledgeable employees.  Each of the two founders owns in excess of 12 million shares. If the offering is completed at $7 per share it will increase their net worth by $90 million each. If the share price goes to over $12 in a year as Zacks suggests, by over $150 million each.  With that much on the table I find it surprising that the company seems to be so careless about hiring people with appropriate skills.

Finally, I noted that the attorney who prepared the registration statement was given rights to buy 200,000 founder’s shares at par value $.0001. No other legal fees were charged.

There is nothing illegal about this. Some securities lawyers accept stock in lieu of cash; personally I do not.  I think that it creates the appearance of a conflict of interest.

In a money center like New York or San Francisco, a lawyer preparing a Reg. A+ offering might charge $150,000.  If this lawyer’s gamble pays off and the share value does top $12 per share, he might walk off with more than $2.5 million.  He will be on his yacht while I am still writing blog articles.

Of course if the disclosures later prove to be somehow deficient and a regulator comes in and investigates, an allegation that the lawyer cut corners to get the offering sold may be hard to avoid.

In my opinion what this company lacks is the internal talent to perform the complex tasks that it is selling. It is talent that its more established competitors certainly have and without which I do not think this company can succeed.

The talent at this company is so thin and the payday so concentrated, there is certainly enough here for me to have considered that this offering may be nothing more or less than two people with checkered pasts trying to put one over on unsuspecting investors.  I am more skeptical than most people, but skepticism is what people who evaluate start-ups are supposed to have.

 

 

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 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.

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.

 

 

 

 

The SEC Halts a Crowdfunded Cannabis Offering

In the year I have been blogging I have written several articles about the problem that the Crowdfunding industry does not want to address, fraud.  My thesis is simple: if the investors get screwed enough times they will take their money elsewhere.

As stories of Crowdfunding scams begin to proliferate, the industry’s reputation is likely to go down the toilet.  If the investors leave, people will be sitting around in bars saying: “I used to work for a Crowdfunding platform” the same way that people sat around in bars in 2009 saying “I used to be a mortgage broker”.

Back in February when Regulation A+ offerings were just getting underway, I wrote several articles raising some questions about specific offerings. The Crowdfunding industry was very gung-ho about Reg. A+ because these offerings could be sold to smaller investors. The bulk of Crowdfunded offerings are still private placements which can be sold to wealthier accredited investors only.

I wrote a blog article specifically about Med-X, Inc. which was attempting to raise $15 million under Reg. A+ to “research and develop, through state of the art compound identification and extraction techniques,  market and sell medically beneficial supplements made from the oils synthesized from the cannabis plant.”

I questioned the offering, in part, because cannabis is still illegal at the federal level.  But that was not the only reason.

Med-X had acquired an exclusive license from another related company, Pacific Shores Holdings to market NatureCide® herbicide and pesticide products to the cannabis industry in exchange for 10,000,000 shares of Med-X stock. As I noted at the time, an exclusive license can be valuable. In this case, because the products are readily available on Amazon.com the value of the “exclusive” license was questionable.  Both Med-X and Pacific Shore holdings were controlled by the same person, Mathew Mills.

To me, Pacific Shores Holdings looked like a classic penny stock. Mr. Mills had been sanctioned, twice, first in Pennsylvania in 2011 and later in California in 2013 for selling shares in Pacific Shores Holdings to investors to whom he had no business selling shares. The structure employed here, with one penny stock company acquiring a large block of stock in another pursuant to a licensing agreement is also a classic penny stock tactic.

Last week, September 16 to be exact, the SEC issued a temporary halt to Med-X Reg. A+ offering. The company was required to file an annual report on Form 1-K for the fiscal year 2015. Med-X operates on a fiscal year ending December 31. As such, Med-X was required to file its annual report by April 30, 2016. On September 16, Med-X had still not filed the annual report, so the SEC put a halt to the offering.

The clear message here is that information that investors were entitled to receive, as a matter of law, was not provided to them between May 1 and September 16. Failing to provide material information to investors is the textbook definition of securities fraud.

Med-X did file its Form 1-K within days of the SEC order halting its offering. What that filing discloses about what Med-X is doing with the money it has raised so far validates my earlier suspicions.

Back in February, Med-X reported that it had received $3.6 million in reservations from over 1100 prospective investors for their Reg. A+ campaign on StartEngine, a Crowdfunding portal.  Those reservations were apparently meaningless.

As of June 17, 2016 the Company had sold 1,124,038 common shares. The Company received net proceeds of $430,430 from this offering. Med-X has committed to spend $150,000 of that money with a company based in London to develop a mobile platform for its marijuana media site among other things.  How it will pay for the research it promised is anyone’s guess.

Next month the SEC will conduct a hearing to determine whether or not it will allow Med-X to resume its offering.  Since the Form 1-K has now been filed, they may let it proceed. If the SEC has other concerns about the company, it may keep the halt in place while it investigates further.

The SEC has a long history of leveraging its budget for enforcement actions by going after small companies like Med-X where the facts are clear-cut, where it is not likely to find a high-powered law firm defending and where it can make big headlines. With this action, it is likely to make bigger headlines in the cannabis industry than with the Crowdfunders.

An enforcement action against Med-X would send a message to the cannabis industry which should want to seek Crowdfunded financing as banks are generally closed to them as a source of capital.  Despite what you may think about cannabis as a legal industry, the federal government’s policy is to wipe it out.

I have spoken with several people involved with the cannabis industry who report that the Crowdfunding industry, at least in the US, is already skittish.  Given the publicity surrounding cannabis and its thirst for capital, you would expect to see many cannabis related businesses raising funds on Crowdfunding sites but you don’t.

The SEC specifically cautioned brokers, dealers, shareholders and prospective purchasers that they should carefully consider Med-X’s failure to file its annual report on a timely basis along with all other currently available information and any information subsequently issued by the company. Let me translate.

This is the second enforcement action that SEC has brought against a Crowdfunded offering. The first action, SEC v. Ascenergy, was based on the fact that the company was raising money to drill for oil on land where it did not have the rights to drill.  The SEC called out the four Crowdfunding platforms on which offerings took place by name but did not sanction them in any way.

I wrote a blog article about SEC v. Ascenergy which was reprinted on several Crowdfunding media sites. What I wrote was that this was the SEC’s way of telling the Crowdfunding industry to get its ducks in order. I believed and I still believe that sooner or later the SEC will sanction a Crowdfunding platform or portal that lists a fraudulent offering. For the most part the industry looked at the Ascenergy case with a yawn and declared it to be an isolated instance of fraud.

StartEngine has gone to the trouble to become registered with FINRA specifically to be able to offer Reg. A+ offerings to mom and pop investors. They are required to follow FINRA’s rules when listing offerings and that includes the requirement for a significant amount of due diligence. In my mind the Med-X offering raised a number of red flags, not the least of which was the NatureCide® licensing agreement.

More directly, FINRA and the SEC have every reason to expect StartEngine or any other registered Crowdfunding portal to have known that regulations required Med-X to have filed its annual report by April 30 and that it was late. The SEC may justifiably ask StartEngine why it did not close the Med-X offering down instead of forcing the SEC to use taxpayer funds to do it.

It is not always possible to determine what a government agency will do next. In the SEC’s mind the matter may simply be over or they may take action only against Med-X and Mr. Mills. He has, after all, already been sanctioned by two state regulators and has apparently not learned his lesson.

The SEC may give StartEngine a pass or it may not. It may leave the matter to FINRA which also has a history of going after smaller firms while its largest members often get away with fraudulent offerings that impact thousands of people for large amounts of money.

One thing is clear; the standard for the SEC would be to plead that StartEngine “knew, should have known or was reckless in not knowing” that Med-X did not file its annual report in a timely manner.  I do not see that StartEngine has a cognizable defense.

StartEngine did list another offering, Elio Motors which I also questioned in another blog post. My issue with Elio was that it was taking deposits from and promising delivery to consumers for a product that did not exist and which it could not hope to deliver with the funds it had on hand or which it was likely to raise. I am pretty certain that taking deposits and promising delivery of a product that does not exist and is not very likely to exist violates some regulation under the Federal Trade Commission Act or a similar statute.

The Crowdfunding industry has hailed Elio as a success because it raised $17 million from investors.  The people who helped raise the funds speak at various industry conferences to an audience of Crowdfunding participants who want to know how it is done.  (Spoiler alert: In Elio’s case it was done by making promises that they were not likely to keep but that is not what you will hear at the conferences.)

No one invites me to speak at any of the ever present Crowdfunding conferences because the Crowdfunding industry does not want to hear what I have to say.  If I were thin skinned, I would be concerned that the Crowdfunding industry really does not like me.  I’m not.

In all fairness to the Crowdfunding industry, I was solicited a few weeks back by one of the larger platforms. They wanted me to write a series of articles and an occasional white paper for them. When I spoke with the Director of Marketing, the firm’s Compliance Director was on the call. He knew that he would have final approval of anything that I wrote.  I was not surprised to learn that he had learned compliance at a mainstream brokerage firm.  It is not that difficult to stay complaint with the rules if you know what you are doing.

If the SEC or FINRA come calling to any Crowdfunding portal or platform, including P2P lenders, the first thing they will ask for is the firm’s written procedure manual.  There should be written standards and procedures for listing companies. There should be standards and procedures for reviewing the videos and marketing materials that accompany many of the offerings. Far too many of those videos are not compliant with the rules for anyone to think that the industry is serious about the business in which it is engaged; selling securities.

What is likely to happen at the hands of regulators is the industry’s own doing. They are too busy telling themselves that they are being “disruptive” to actually take notice that investors are being ripped-off.  Fraudulent offerings are not going to stop until the industry takes steps to make them stop. The SEC is not going to wait forever.

Med-X – Crowdfunding, cannabis and chicanery

As a college student during the 1960s, I was exposed to marijuana and had friends who were out and out stoners. As a young lawyer I represented a wholesale head shop company that Time Magazine referred to as “the Dunhill of the industry”. Through them I met many entrepreneurs who had profited in the wholesale and retail paraphernalia industry.

Being a cancer patient I am familiar with medical marijuana. I have read the literature and discussed it with my doctors. I know many people who have used marijuana as part of their recovery from cancer and other illness.

This article is not about the pros and cons of legalizing pot. It is about Crowdfunding, the cannabis industry and a questionable investment.

Sales of marijuana in states where it is legal are expected to top $5 billion this year. Still, I cannot see the loan committee of a major bank or any Wall Street firm step up to finance the cannabis industry in any major way. Even though its use is legal in an increasing number of states, the cultivation, distribution or sale of marijuana is still a federal crime and banks and brokerage firms are regulated by federal agencies.

It is not surprising then, that the cannabis industry has found Crowdfunding to be a source of new capital to fund its growth. Rewards based Crowdfunding campaigns for new vaporizers and similar products are easy to find.

What surprised me was that the Securities and Exchange Commission (SEC) has recently approved a $15 million offering for a cannabis related company under the new Reg A +. The offering for a Southern California based company, Med-X, became effective in early February.

The company has no sales or current business to speak of. The company states that it will use the money from investors to: “research and develop, through state of the art compound identification and extraction techniques, and market and sell medically beneficial supplements made from the oils synthesized from the cannabis plant.”

The Company’s planned compound identification and extraction research and development operation will be conducted primarily at the Company’s existing 600 square foot indoor cultivation center in Chatsworth, California, where controlled quantities of high quality cannabis are being grown, harvested and stored for research and medical use to the extent permitted by California law.

The company has several physicians on its Board of Directors. However, none has disclosed any published research paper on cannabis and none, apparently, works fulltime at the company’s 20’x30’ cultivation center to direct that research. Cannabis is apparently being grown, although the equipment needed to conduct the promised research will not be purchased until the offering is funded. In any event, the research is for future products.

In the meantime the company will use some of the investors’ money “to acquire, create and publish high quality cannabis industry media content through the Company’s media platform, (a website) to generate revenue from advertisers as well as through the sale of industry related products.”

If this were styled as a media company I would not question it. But the website is only a few months old, has no revenue and again the company lacks personnel with a media background to run it.

The company’s other revenue generator will be sales of a product called NatureCide® to cannabis cultivators throughout the world. NatureCide® is an insecticide and pest repellant. This product is owned, manufactured and distributed by a company called Pacific Shore Holdings, Inc. an affiliated company that is controlled by the same person who controls Med-X, Mathew Mills.

Med-X acquired an exclusive license from Pacific Shores Holdings to market NatureCide® products to the cannabis industry in exchange for 10,000,000 shares of Med-X stock. An exclusive license can be valuable, however, in this case the products are readily available on Amazon.com making the value of the exclusive license questionable.

Pacific Shores Holdings is a classic penny stock. Mr. Mills was sanctioned, twice, first in Pennsylvania in 2011 and later in California in 2013 for selling shares in Pacific Shores Holdings to investors he had no business selling shares to. The structure employed here, with one penny stock company acquiring a large block of stock in another pursuant to a licensing agreement is also a classic penny stock tactic.

Like any Crowdfunded offering, shares of Med-X are being sold by the company directly to the public. In theory investors should be able to make an informed evaluation of the company before they invest their money. But most investors cannot.

I expect that many people will line up to send their money to invest in this company’s shares. It certainly will not be because this company represents a good investment.

More likely, if you will forgive the pun, the buzz about this offering will be about its asserted link to the cannabis industry. The minimum investment is $420. (No kidding).

Stop to consider that its main product, NatureCide®, was pre-existing. Its only connection to the cannabis industry is the statement that it can be used by cannabis growers in the same way that people growing virtually anything else can use it.

Mr. Mills was apparently content to sell shares of Pacific Shores Holdings without adequate advice from a securities lawyer. He now proposes to conduct cannabis research without a cannabis researcher on staff and publish a website without an experienced website publisher.

Remember, I want the Crowdfunding industry to succeed. To do so it will need to offer investors the opportunity to invest in companies that at least have a likelihood of success. I do not believe that investors will find that here.

Instead, Med-X is poised to give both the evolving Crowdfunding and cannabis industries a black eye and to leave many investors holding the bag. The cannabis industry will survive.

If Med-X turns out to be a $15 million scam, (and there are others) investors may begin to realize that there are better places to invest their money than a Crowdfunding portal.

Elio Motors- A Crowdfunding Clunker?

A colleague asked me to look into the securities offering of Elio Motors in Phoenix, Arizona. The company is one of the first to register shares to be sold under the new Regulation A.

Reg. A allows smaller companies to raise up to $50 million without the use of an underwriter. Elio is selling its shares directly to investors through a Crowdfunding platform called StartEngine.

Elio is attempting to raise $25 million making it one of the largest direct to investor financings to date. Many people in and around the Crowdfunding industry are anticipating the offering’s success.

Elio claims to be a designer, developer and manufacturer of highly efficient, low cost automobiles. The company intends to offer a 3 wheeled, gas powered vehicle that will get 84 MPG and cost roughly $6800.

It certainly sounds good and from the pictures that accompany the offering the vehicles look pretty good as well. The company says that it hopes to be delivering its vehicles to consumers by the end of this year.

Unfortunately, that seems highly unlikely. The company currently has only a few drive-able early prototypes of its vehicles. It does not have a full production prototype, a final design, a built-out manufacturing facility or manufacturing processes. Even with this financing, the company will still need another quarter of a billion dollars to get its manufacturing facility into production.

I reviewed the prospectus and made a note of a number of “red flags” – items that seemed a little off base to me. A number of things caught my eye.

First, the company is insolvent and will continue to be insolvent even after investors put in $25 million. Investors will pay $12 per share and each share will have a negative book value and no liquidity for a long time to come.

Roughly $10 million is owed and due to an affiliate of a large shareholder within the next 6 months. That loan is already over due and subject to a forbearance agreement. If the agreement is not renewed roughly 1/2 of the proceeds of this offering will revert to the lender.

The company hopes to obtain a $165 million loan under a federal government program intended to help existing auto manufacturers expand their businesses. If unsuccessful in obtaining this loan Elio will need to find that much and more, elsewhere.

The government program was intended to help Ford and GM when they were having financial difficulty back in 2008/2009.The program is specifically designed to have low upfront borrowing costs. Elio is paying a lobbyist $1 million to help them to get funding under the program in addition to the lobbyist presently on staff. Perhaps the company does not believe that it could obtain the loan if the government agency judged the company solely on its merits.

There does not appear to be a single dollar of professional venture capital in this company. The company says this is because the venture capital industry moved away from investing in new vehicle startups. Personally, I believe it was because the venture capital industry spotted Elio as a loser or worse, a scam.

There are no patents. Despite years and millions of dollars worth of designs and modifications Elio does not have anything that it deems to be worth patenting. That always begs the question of whether or not their designs infringe on anyone else’s patents.

Perhaps the most disconcerting issue is that the company currently funds itself by taking vehicle deposits from consumers. The company has taken in more than $20 million in deposits from in excess of 45,000 people promising to deliver vehicles for which it does not yet have a final design and still needs up to a quarter of a billion dollars to produce.

The sales projections seem very rich. In order to get its retail price to $6,800 the company is projecting 250,000 units sold annually, meaning sales would be about $1.7 billion. With competition from other larger automotive manufacturers this number even if attainable would seem difficult to sustain.

No one apparently conducted a real due diligence review. StartEngine is not a FINRA firm and cannot be expected to conduct a due diligence review that is up to FINRA standards. The name of the law firm that prepared the offering is not disclosed. Experience suggests that this prospectus is not the product of one of the large Wall Street law firms.

Interestingly, Elio will pay a FINRA firm, FundAmerica Securities, to conduct due diligence on the investors to make certain that they comply with the SEC’s rules regarding how much they can purchase. FundAmerica Securities will receive up to about $950,000 for this service. (For the record, I would have cheerfully performed this administrative task for about ½ the cost).

No similar fee is being paid to anyone to verify the statements in the prospectus and to make certain that all appropriate disclosures have been made. Due diligence can be expensive and the amount spent, if material, would likely be disclosed.

If fully subscribed, this offering will cost Elio about $2.4 million which is about what it would have cost if the offering had been done in the traditional way by a FINRA firm using salespeople. The offering would have been subjected to real due diligence and if it passed more likely than not would have sold out before the end of last year.

I suspect that the “crowd” will buy up all of the shares that Elio is selling, not because the crowd knows what it is doing, but because most people would not know an investment scam if it bit them on the butt.

As I said, a lot of people in the Crowdfunding industry are waiting for Elio to sell its shares as an indication of how the Crowdfunding industry has progressed. The industry would be better served if got behind companies that offered investors a better chance of success.

Reg. A+ Assessing the True Costs

From the laptop of Irwin G. Stein, Esq.Many small and mid-sized companies seem to be assessing their option to raise equity capital using the SEC’s new Regulation A+, which was promulgated under the JOBS Act. The regulation allows companies to register up to $50 million worth of their shares with the SEC and then offer them for sale to members of the general public.

Until now, companies seeking equity capital at this low end of the market could only seek funds from wealthy, accredited investors using a different regulation; Reg. D, the private placement rule.

The upfront costs of preparing a private placement offering will always be less than the costs of a Reg. A+ offering. In both cases competent securities attorneys will prepare the prospectus. Reg. A+ requires that the company’s books be audited as well. This is an added expense. The true costs however, will be determined by who sells the offering and how it is sold.

It is not unusual for a private placement being sold under Reg. D to have an upfront load of 15% of the total amount of the offering or more. The issuing company only receives 85% or less of the funds that are raised by the underwriter.

One percent of the load might repay the company’s costs of preparing the offering. Another one percent might cover the underwriter’s marketing and due diligence costs. The rest is the sales commission and other fees that the underwriter is charging for selling the private placement.

Many accredited investors are currently purchasing Reg. D offerings and paying the 15% or more front-end load. There is no incentive for the brokerage industry to charge Reg. A+ issuers any less.

When you purchase shares in a private placement you generally cannot re-sell them. Even if the company does well at first, if it fails in later years, you still lose your money.

With Reg. A+ the shares are supposed to be freely trade-able, except that they are not. The market in which they are supposed to trade is not yet fully developed. It may not develop for quite some time.

How much will the underwriters charge for a fully underwritten Reg. A+ offering? The rule of thumb has always been that commissions go up as the risks go up. Shares issued under both Reg. D and Reg. A+ are speculative investments.

Since both regulations will yield securities that are speculative investments that cannot be re-sold, it is reasonable that underwriters will charge the same for both types of offerings.

Some companies will attempt to sell their shares under Reg. A+ directly to the public without an underwriter. Investors who purchase these shares will get more equity for their investment. That does not necessarily mean that they will get greater value. If many issuers can self-fund without an underwriter it might cause downward pressure on loads and commissions that underwriters can charge.

If commissions on Reg. A+ offerings turn out to be substantially less, many accredited investors may shift to the Reg. A+ market. More likely, some brokerage firms will sell both Reg. D and Reg. A+ offerings side by side. If they do, the commission structure and total load on each should be similar.