Reg. CF

Where Do You Go When The Bank Says No?

Capital Markets, equity crowdfunding, Issuers , ,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Or you can book a time to talk with me HERE

Investment Crowdfunding Can Offer Better Investments Than Stockbrokers

Capital Markets, Investors, Issuers , , , ,
Investment Crowdfunding

Investment Crowdfunding

Someone in the crowdfunding industry should put that sentence on a coffee mug and send me one.

I have been writing about and working in investment crowdfunding for more than 3 years.  I find it interesting to watch this fledgling industry mature.  It is certainly attracting more and more new money every year and is past the point where it can be ignored by any company in search of investors.

I have looked at a great many offerings on a great many crowdfunding platforms.  I read a lot to keep abreast of new offerings and industry developments. I take the time for conversations with platform owners and their lawyers and several of the better investment crowdfunding marketing executives.

I also speak with a lot of companies who are considering investment crowdfunding to raise capital.  Any company that would raise capital in this new DIY crowdfunding marketplace wants to know if it spends the money to list its offering on a crowdfunding platform will enough investors show up and invest?  From the company’s perspective, little else really matters.

The JOBS Act was intended to be a different approach for corporate finance using the internet instead of a stockbroker to reach potential investors. The internet allows companies to reach a lot of prospective investors, very cheaply. Success or failure in investment crowdfunding is more about what you have to say to those potential investors than anything else.  

Selling securities issued by your company to investors is not the same as selling your product or service to potential customers. Investors will have different expectations and will respond to different things.  

People who sell securities for a living will tell you that any new issue of a stock or bond needs two things: good numbers and a good story. Investors want a return on their investment. 

So the best stories are always about how much money the investors will make and what the company will do to provide that return.   

There are two distinct branches of investment crowdfunding. First, there are the private placements sold under Reg. D to institutions and other larger, accredited investors.  This marketplace is healthy and growing rapidly.  Professional money-raisers have caught on that they can use investment crowdfunding, to substantially reduce the cost of capital and use that savings to enhance investor returns.

Reg. D offerings have been sold through stockbrokerage firms since the 1980s.  Most are sold to institutional investors.  Some are sold to individual, accredited investors. Minimum investments of $50-$100K or more per retail investor are common. 

Many of the retail Reg. D offerings will fund some type of real estate (construction or purchase), energy (oil, gas and alternative energy) or entertainment (films, music, and games) project. There are professional sponsors; people who package and syndicate these projects, often being paid to manage the business on behalf of the investors after the funding.

The costs of selling a Reg. D offering through a stockbrokerage firm, including commissions, run 12%-15% of the funds raised. That would be up to $1.5 million for each $10 million raised.. Most Reg. D offerings sold through brokerage firms just raise an additional $1.5 million and dilute the investors’ return.  Using investment crowdfunding a company can raise that same $10 million and not spend more than $100,000 in legal and marketing costs and frequently a lot less. 

The Reg. D crowdfunding platforms compete with stock brokerage firms for projects to fund and for investors to fund them.  The same institutions and accredited investors who have been purchasing Reg. D offerings from their stockbrokerage firm for years are catching on to the fact that they can get good offerings and better yields without the need to pay the very high commission.

The other branch of investment crowdfunding is the Reg. CF or regulation crowdfunding. This allows offerings which can help a company raise up to $1 million from smaller, less experienced investors. Reg. CF allows smaller businesses to sell small amounts of debt or equity to small investors.

The Reg. CF market was the SEC’s gift to Main Street American small businesses. There are always a great many small companies that could benefit from a capital infusion of a lot less than $1 million, the Reg. CF upper limit.

To put down a layer of investor protection the SEC required that these portals that are dealing with small investors become members of FINRA. FINRA dutifully set up a crowdfunding portal registration system and has audit and enforcement mechanisms in place.

As a reward for joining FINRA, the SEC allows Reg. CF portals to be compensated by taking a percentage of the amount the company raises which the Reg. D platforms cannot. Several of the portals also take a “carried interest” in every company in case the company is eventually re-financed or sold.

The SEC looks at Reg. CF as a tool of corporate finance for small business. It provides a mechanism where a great many small businesses should have access to a pool of capital every year, potentially a very large pool. It provides for a market structure for these small offerings and incentivizes the portals help raise that capital. All in all, not too bad for a a government regulation.

Sadly, the Reg. CF industry is still foundering. There are still fewer than 40 registered portals operating and several have closed up shop.  So why are these portals not successful? Because the people who operate them are not listing better investments than stockbrokerage firms.

When I first looked at investment crowdfunding there were a lot of people proclaiming that it would “democratize” capital raising.  They believed that the crowd of investors could discern good investments from bad ones and that the crowd would educate each other as to the pros and cons of each.  That was never true.

The Reg. CF portal websites are full of bad information and consequently, bad investments.   “Comments” about any offering that lists on a portal, if any, are always overwhelmingly positive.  Investors will not do any due diligence or other investigation of the company because they do not know how.

The Reg. CF portals compete with banks, which are the primary source of funding for small business.  Here too, a Reg. CF portal can have a competitive edge.  When you borrow from a bank you do so on the bank’s terms. On a Reg. CF platform you can set the terms of your financing.  Done correctly, you can get the capital infusion you want for your company without giving up too much equity or pledging your first-born child to the lender.

What the portals should be offering investors are bank-like products that stress the ROI that investors reasonably might expect to receive.  The portals should be telling investors how each company mitigated the risks that the investors might face. Instead, too many portals and too many people in the Reg. CF marketplace are still selling fairy tales and lies.

The big lie, of course, is that by buying equity in any of these companies an investor might hit the proverbial home run.  Suggesting that investors can or should think of themselves as VCs is patently absurd for any company that I have seen on a Reg.CF portal.  I always tell people who ask that if even one valuation on a Reg. CF portal seems very outlandish, then they likely cannot trust that the portal operator knows what they are doing. I would question anything told to investors by any company that lists on that portal.

If a company wants to raise $1 million on a Reg. CF portal, it might end up with 2000 distinct investors each investing an average of $500.  To secure subscriptions from 2000 people, the company might need to put on a marketing campaign that will put its offering in front of hundreds of thousands of investors if not more.  Success or failure of your fundraising campaign will depend on what you say to these people. 

The cost of the marketing campaign is the major upfront cost of the offering. The good news is that marketing seems to be more data- driven and more efficient as time has gone by reducing the cost of the marketing.

Sooner or later these  Reg. CF portals will wise up to the idea that they cannot succeed unless the investors can make money. They, too, could offer better investments than stockbrokers, but do not seem to have bought int the idea.    

Until that happens, I expect more portals to fail and close up shop and the SEC’s “gift” to small business to remain largely unwrapped.