Reg. A+

How an IPO works- and Why Using Reg. A+ to Raise Funds Doesn’t

Capital Markets, equity crowdfunding, Issuers , ,
How an IPO works

I have spent a lifetime helping people who want to raise some capital for their businesses. It has never been easier and less expensive to do so.  The JOBS Act took care of that.

Most companies, especially those who want to raise $10-$50 million or more, will use a standard private placement. Many more companies elect to raise funds in the private market every year than in the public market because it is easier and less expensive than a public offering (IPO).

The SEC has provided for a stripped-down version of an IPO under Regulation A+.  It allows a company to raise up to $75 million from public investors.  Reg. A+ is intended to allow companies to manage the offering themselves, without the help of a Wall Street firm.

Many of the people who encourage small companies to use Reg. A+ believe that going public is easy. Most of those people have never worked at a Wall Street firm.

When Wall Street takes a company public it rarely fails to raise the capital it seeks. Using Reg. A+ without a Wall Street firm to underwrite the offering has resulted in many companies failing to get the funds they seek.  What is Wall Streets’ secret? 

Wall Street starts with the idea that no one really buys investments, but rather people sell them. Wall Street is built on the efforts of thousands of top-notch salespeople and a top-notch support system. 

Before any company goes public the investment bankers spend months getting it ready. Most importantly, they spend time introducing these companies to larger, institutional investors who will purchase a significant amount of shares in any public offering.

Dog and Pony

Those “dog and pony” shows help the company’s management address the questions investors want to ask.  Some of those institutions and hedge funds will be guaranteed to make a profit.  More on that below. 

About a week before the offering goes live the underwriters will turn the offering over to the sales department.  If a good stockbroker is trying to sell shares in an IPO, the conversation might go like this:

“Hello Charlie, this is Fred from Goodbroker and Company. I promised to call you when we had a red-hot IPO. We have one coming to market tomorrow.

The company is called the “Flavor of the Month” Co.  It uses blockchain to treat erectile dysfunction.  It is going to be a $20 billion global market in 5 years.

I spoke with one of the investment bankers who gave it two thumbs up.  He expects it to be priced at $30 per share.

I also spoke with the research analyst who covers this industry and he says this stock will be selling for $45 by the end of next year. That is why this IPO is hot.

It’s a 10 million share deal. My office was only allocated 120,000 shares. I can try to get you 1000 shares if you say YES right now. You have $30,000 in your money market account waiting for a good opportunity to make money. This is it.  Will you take 1000 shares? ”

A good stockbroker will have that conversation over and over until he gets to yes several times. Thousands of stockbrokers making thousands of calls will sell out the issue, every time. 

And then the secret that never appears in the textbooks, the underwriters will sell more shares than they have to sell. “Over-subscribed” is the most important attribute ever assigned to an IPO. Wall Street firms do it all the time.

The conversation that will take place the following morning, after the offering closes, illustrates the point: 

“Charlie, this is Fred. I was only able to get you 700 shares in the underwriting at $30 per share. They filled the remaining 300 shares in the aftermarket at $33 per share. You don’t have to take those 300 shares at that price. I can send them back to the trading desk. But the stock is already trading at $37 and like I said yesterday the analyst is predicting $45 per share. So please tell me you will do the smart thing and just keep those 300 shares.” 

So all the shares get sold and the underlying company gets the funding it needs. After that, as the shares trade, the underwriters provide research reports and trading support.   

You just have to follow the money, and the shares, to fully understand why it works and how it works.

This offering for 10 million shares was sold at $30 per share. On the morning of the underwriting, those shares were delivered to the accounts of the purchasers and the book closed. When the shares begin to trade, the first orders will fill the demand created by selling more shares than were available.

Retail investors who buy into an IPO tend not to sell it the same day. Those who do are frequently not invited to participate in the next IPO. To satisfy those customers who wanted to buy shares but were allocated less than they wanted, the underwriter needs to find a few large blocks for sale. 

I referred to dog and pony shows where the investment bankers would assure institutional investors that by investing in the IPO, the institution would make money. But not always as you may think.

When an IPO is over-subscribed it means that there are more willing buyers in the market and few sellers. That will cause the price to shoot up quickly. That “pop” in the share price has value and is treated as just another tranche in the cash flow. 

An institution that bought 100,000 shares in the IPO might be promised a quick profit of $ 3 per share for helping to fill those orders. Flipping those shares quickly might earn the institution a profit of 10%, with no risk to capital, in less than one hour. Hedge funds especially like to play this game. 

By helping to provide market liquidity for the underwriter the institution will be allocated some shares in a better underwriting later on. Shares that it will want to hold and not flip.

Scratch My Back

Can you say “scratch my back”?

Many of the firms that advocate the use of Reg. A+ lack investment bankers, research analysts, and most importantly, stockbrokers who already have established relationships with millions of investors. Most of these firms cannot trade the shares or provide liquidity for an aftermarket.

Practitioners who advocate the use of Reg. A+ as a useful tool for corporate finance will need to demonstrate that these offerings attract enough investors to sell out the offerings every time. Nothing indicates that is about to be true or that the advocates of Reg. A+ are even moving in that direction.   

When someone comes to me thinking that they want to go public using Reg. A+ I tell them to stick with Reg. D and do a private placement of their securities.  They will save a lot of money upfront and are likely to have the investors’ funds in their account months sooner.

And just to drive home the point, as an attorney, I charge a lot less to walk a client through a Reg. D private placement and to prepare the necessary paperwork than any lawyer charges for a Reg. A+ offering.

If you want to go public and cannot emulate what Wall Street firms do to get your offering sold, stick with the private placement market. It is always a much better place to find the investors you need.

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

Lights. Camera. Bubkes.

Capital Markets, crowdfunding, equity crowdfunding, Investors ,
lights.camera.

I got an e-mail from a friend asking if I had watched any of the episodes of the online TV style show, Going Public.  My friend knows that I use crowdfunding to help companies raise capital. He also knows that I have referred to Shark Tank as entertainment, not finance.

Going Public is an interesting variant of the Shark Tank genre’.  It streams on the Entrepreneur.com platform.  It follows the founders of small companies as they look for funding.  Going Public featured four different companies that were looking for investors in its first season.

In total, the four companies hoped to raise more than $200 million. The total that was actually raised for all four companies was closer to $15 million. As a capital raiser, Going Public laid an egg.

I found the production to be professional and the founders sufficiently engaging. I would have thought that they would have raised more money. 

Oh, well. That’s show biz.  

Each of these four companies apparently paid $250,000 for the privilege of being featured on Going Public. The legal, accounting, and other costs likely added another $150,000 so each of these four companies spent approximately $400,000. None got the funds they were looking for to expand their business in the way that they had hoped. 

I help companies raise capital. I know that you can raise a lot of money with a budget of $400,000.  Direct-to-investor funding was the whole point of the JOBS Act.  Several crowdfunding platforms have raised more than $1 billion each for 3rd party issuers.

Crowdfunding has proven itself a legitimate method for companies to raise significant amounts of capital. It is easier and less expensive than virtually any other method. It is available to millions of companies.  That is why I counsel most companies that are looking for capital to consider crowdfunding first.

Like everything else in life, if you want to succeed at crowdfunding, you have to do it right.  

Where did Going Public go wrong?

What interested me about Going Public was that it allows viewers to ‘click-to-invest’ in the featured companies in real-time, live, while they watch the show. Had Going Public been successful, it would have identified and reached out to a new type of investor, one that invests on impulse rather than analysis.

Our entire system of finance is based upon the disclosure of financial information about the company seeking investors. We believe that investment decisions are generally made after some amount of thought and deliberation.

Going Public does provide investors with the information to which they are entitled. Each company provides a standard prospectus containing financial and other information. Most of the time a prospectus is more than 100 pages of fine print, and often, confusing details.

Going Public is suggesting that people will invest while the show is in progress. That implies that people will invest without actually reading that information. That implies impulse or emotion as the primary motivator that would turn a viewer into an investor.

I am not certain that people will invest on impulse, in the middle of the presentation, the way they do when shopping on the Home Shopping Network. At the same time, if investors are not really paying attention to the facts, you can sell some of them almost anything.

If Going Public can identify the story lines that cause people to invest impulsively, it might be on to something. Perhaps it is the next step in the evolution of the capital markets where Don Draper stars as the Wolf of Wall Street.

What do investors get?

I looked at one of the offerings just to see what was being offered. The company, Hammitt, Inc. sells luxury handbags and accessories. It was trying to raise up to $25 million by offering public investors up to 22,727,273 Class B common shares are $1.10 each. The minimum investment was $550.

The company has 3 classes of common stock outstanding and two classes of preferred shares. Each comes with specific “rights” that the shareholders receive. 

If 5 years down the road the company is purchased for $5 billion, who gets what is a problem that I might have included on the mid-term exam of one of my Finance classes. It is not something potential investors are likely to calculate or consider while watching the video.

As with many of these small offerings, Hammitt is offering to entice investors by giving them a handbag in return for their investment. Some of the handbags Hammitt sells cost more than $550 each. In a situation like this, when Hammitt asks for a minimum investment that is less than the price of one of their products, it cheapens the value of both.

From an investor’s point of view, the best thing about selling luxury goods is the high mark-up.  Hammitt has sold over $30 million worth of goods in the prior two years, with a gross mark-up of close to 100%.  The central question that any investor should ask is, “how much of that mark-up does the company keep?”

The prospectus says that the company has an online, direct-to-consumer focus. If it is selling its products online all the company needs are a warehouse and a healthy advertising budget.

Despite its online focus, the company has opened two retail stores and intends to open more. Obviously, the cost of operating retail stores cuts into the profits. So too, does selling its product wholesale, to other luxury retailers. That too is part of the business plan. Exactly what the management intends to do is unclear.     

A large part of the problem with Hammitt’s attempt to raise capital is the fact that it wanted to be “public”. By doing so, it set itself up to fail.

If each investor purchased the minimum amount of $550, Hammitt would have needed to have sold shares to more than 45,000 people.  If the minimum had been $1000 per investor it would have needed to accept investments from only 25,000 investors. Obviously, it costs less to reach fewer people to sell out your offering.

If they had asked me, I would have advised Hammitt to stay private for this round. Given that most of its customers are wealthier and its financials suggest that it is on the cusp of profitability, I would have counseled a minimum investment of between $10,000 and $25,000 which would have required no more than 1000 to 2500 distinct investors.

Given that Hammitt spent $250,000 to be on Going Public and raised very little, those funds would have been better spent by reaching out to accredited investors who rarely need a video to convince them to invest. A properly funded crowdfunding campaign if correctly targeted can be successful 100% of the time.

If you read through the prospectus, the reason that Hammitt opted for a public offering becomes obvious. One of its founders included $1 million of his own stock in the offering. That sends the wrong message to seasoned investors. It is something that rarely finds its way into a private placement targeted at institutional investors. 

From an investment banking standpoint, the offering poses a lot of questions. That is not a sleight on the investment bankers who put this offering together. It does not appear that there were any.

Even police dramas have technical advisors to advise the writers about proper police procedures. Going Public, if it is going to succeed, is going to need an investment banker or two to construct the offerings that it is trying to sell to the public.

One thing that stood out to me was that these $1 per share offerings were reminiscent of the “penny stocks” touted by Blinder, Robinson in the 1980s and Stratton, Oakmont in the 1990s. Both Meyer Blinder and Jordan Belfort the head of Stratton went to jail for securities fraud. The people behind Going Public should take notice.

I know some of the people who work at Going Public. They are smart enough to figure out a way to entertain potential investors and also get them to invest. If they had called me I would have been happy to have suggested ways that might have helped them not flush their first season down the toilet.

I do not see any reason for a TV style show to follow founders who are looking for financing and don’t get it.

I prefer happy endings where the guy gets the girl, Lassie comes home, or the founders get their funding. Its the romantic in me.

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

Crowdfunding Successfully

Capital Markets, Investors, Issuers , , , , ,

Over the last 3 years’ equity crowdfunding has evolved into a fairly easy and inexpensive way to fund a business. More and more businesses, including start-ups, are attracting millions of dollars from investors without having to deal with Wall Street stockbrokers who charge hefty commissions or venture capitalists who want a hefty portion of their company.

I speak with companies every week that are considering crowdfunding as a way of finding investors.  The questions they asked a year ago centered on what crowdfunding is and how does it work. Today the questions are much more practical. They want to know how to get it done and how much it will cost.

One of the great mistakes that people make when they consider seeking outside investors is failing to consider the investment they are offering from an investor’s point of view. Investors expect that you are going to use their money to make more money.  Investors want a return on their investment and they expect some of the money that you make to find its way back into their pockets.

It is very important that you structure your offering to maximize the probability that investors will actually get the return you are promising. It is equally important that you clearly tell them what you are going to do to get there.

Structuring the offering correctly is a balancing act between an investment that will stand out from the pack and be attractive to investors and one that does not promise too much of the company’s profits that would stifle its growth or cause cash-flow difficulties. You can have a great little company with a great product and a huge upside but that does not mean you can attract investors if the offering itself and the return they will get is not attractive to them.

You can use crowdfunding to sell debt or equity in your company.  If you chose debt you get to set the terms and the interest rate. You get to decide whether the debt will be convertible to equity later on and if so when and on what terms. You can also sell common stock, preferred stock, convertible preferred or preferred stock that is callable. In many cases you can keep the financing off of your balance sheet by using a revenue sharing model or licensing your IP.

To structure an offering correctly you need to understand the company’s financial situation, cash flow and anticipated growth both of revenue and expenses.  You also need a good understanding of your competitors and how they approached their financing and the market if you are going to be competitive.

Serious investors look at your spread sheet first. They expect that you will be able to support the projections you are making with real facts and rational assumptions. If you are using investors’ funds to expand your business or introduce a new product into the market, you should have a good idea of what that market looks like, how you intend to reach it and what your competitors are doing.

Unless you have a finance professional on your staff or on your board of directors, you will need someone to help you structure and correctly set the terms of your offering. Very few of the crowdfunding platforms offer this type of advice, but that does not mean that you do not need it. The failure to understand finance is the root cause of the absurd valuations that are everywhere in crowdfunding and are a primary reason that serious investors will not look at your offering.

If you do not have a finance professional to help you, and the platform does not provide this type of advice, by default it is going to come down to the lawyer who is helping you prepare the offering paperwork. I have this discussion with clients almost every time I prepare an offering for crowdfunding.  If you are thinking about using a template to create the legal documents for your offering instead of a lawyer who can give you good advice you are likely to create an offering into which no one wants to invest.

Contrary to what any platform tells you very few platforms have a large audience of loyal investors ready willing and able to write you a check. I work with one platform that caters to institutional investors. Their investors are loyal because the platform is very picky about the companies that it will allow to list. Serious investors want this type of pre-vetting. Serious entrepreneurs want this type of investor.

Some of the worst advice you will get about raising money through crowdfunding is that you can use social media to build a community of potential investors or that crowdfunding for investors is a way to build your brand and solicit new customers at the same time. This actually makes no sense at all.

Customers and investors have divergent interests. Customers want you to sell them your product at the lowest price. They are consumers and think like consumers. Investors on the other hand want you to maximize your profits. They want you to sell your product for as much as the market will bear.

There are a significant number of people in the crowdfunding community who believe that the whole purpose of the JOBS Act is to allow small investors to invest in new companies. Both Regulation A+ and Regulation CF which were promulgated under the JOBS Act specifically allow for small investors.  Both are expensive and cumbersome. In my mind neither is worth the effort.

If you want to raise $1 million using Reg. A+ or Reg. CF you might expect an average investment of $250. That means you will need to reach 4000 investors. To obtain an investment from 4000 investors, your marketing campaign might need to reach 1,000,000 distinct prospects.

If you use Regulation D and make your offering to only accredited investors, you might set your minimum investment at $25,000. That way you need only 40 investors or less to raise the entire $1,000,000 and may need to reach out to only 10,000 prospects to do so.

I have worked with several of the marketing firms that specialize in equity crowdfunding. Some are more expensive than others. I always recommend spending your money on creating a good offering and a good presentation and not spending it on trying to reach 1,000,000 people or more

There are a lot of different crowdfunding platforms. Some specialize in funding real estate, some in solar projects and alternative energy projects. Sometimes a company can benefit by being on one of the larger, national platforms; often a local platform will work just as well.

There is technology available today that allows a company to set up its offering on its own website. You can set it up with what is essentially a drop box where the prospective investors can look at your offering and supporting documents. If an investor wants to invest, it will present the appropriate documents, accept his/her signature, verify the investor’s identity and qualifications and place the funds into an escrow account until the offering is completed.

You lose the advertising that a platform would do but you may gain from the fact that your offering is not competing with a dozen others all looking for investors. The fact that this technology is available has driven down the cost of listing on a platform.

Overall, if you want to raise between $1 and $5 million for your business using equity crowdfunding, legal and marketing costs and platform fees should run in the neighborhood of $50,000 more or less. Legal fees are usually the same but marketing costs increase with the number of investors you are trying to reach. Compared to the 10% fee that a stock brokerage firm would get, you can see why crowdfunding is becoming more and more popular.

 

Conning the Crowd

Capital Markets, Investors, Issuers , , ,

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

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

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

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

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

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

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

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

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

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

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

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

Case in point.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

 

Equity Crowdfunding 2018

Capital Markets, Investors, Issuers , , , , ,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Behind the Crowdfunding Curtain- StartEngine Goes Public

Capital Markets, Investors, Issuers , , ,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Ziyen Inc- Another Reg. A+ Question Mark

Investors, Issuers, Law , , ,

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?

Investors, Issuers , ,

 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

Capital Markets, Investors, Issuers , , , ,

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

Capital Markets, Investors, Issuers , ,

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.