The Start-up Funding Wars-Another Dispatch from the Front Lines

I speak with start-ups and business owners who are trying to raise capital for their businesses several times a week.  Some are my age or close to it; others are very much younger.  Most know their own business well, but few understand the ins and outs of raising capital which is why they call me in the first place.

If I take on the task of helping a start-up raise funds I can usually get them the funds they need.  That is not an idle boast. I will not even attempt to help a company solicit investors if I do not think that the company is a good investment.

That is unfortunately the case with the vast majority of the companies with which I speak.  I will review any pitch deck and offer comments and suggestions for free.  I will spend an hour of my time on the phone with any entrepreneur, no charge. Most simply do not measure up.

What I want to hear is that you have a business.  I want you to tell me that you have a product; that you know what it will cost to source your product and that you have actual customers who have bought or at least used the product and have reacted favorably to it.  If you are not yet at that stage, at the very least I want to know that you are close.

The difference between raising funds for a product that has been developed and raising funds to develop a product is huge. The number of investors who will take a chance on the latter is much smaller. It can still be done but it might take a little more time and money to reach them.

The two things that I do not want to hear is that your product will “disrupt” the market or that your company is destined to have a billion dollar plus valuation.  Neither is likely to come true.  I would rather hear that you have a good marketing and sales plan in place and have hired good, experienced people to execute it.

Please do not ask me to sign a non-disclosure agreement (NDA) before we speak.  In the first place, I am an attorney at law, so everything that you say to me is confidential if you want it to be.  In the second place, if your product or process is so novel, valuable and proprietary then get it patented.

Please do not send me a pitch deck that has no resemblance to a business plan. If your pitch is all flash and no substance it is not going to work. Investors want to see what you are going to do with their money and how and when your company will become profitable.

Please do not tell me that you have read all the books about funding a start-up and have attended several conferences featuring the best start-up “gurus”.  If you had read all the books that actually count, you would probably have an MBA in Finance.

Sometimes I can help a small company up its game by suggesting that it add some additional directors, patent its product, refine its business plan or change the terms or structure of its offering.  But more often than not, I find myself turning away business.

What I really want to hear most in that first phone call with any entrepreneur is that he/she can close the sale. If you are going to deal with investors, you are going to have to do more than tell them about the great company that you are building. You are going to have to ask them for a check. To get it, you need to tell investors how they are likely to profit from the investment in your company and why you can make it happen.

I am not a philanthropist. I charge for my services albeit less than I used to charge when I was paying rent for an office in a financial district high rise.  I will not work for stock in your business and you cannot pay me later after we raise money for you.

It takes money to raise money.  If you raised seed capital from friends and family to develop your product and did not raise enough to take you to the next level of fundraising at the same time, let me say this judiciously, you blew it.

I generally tell people to budget between $35-$50,000 if you need to raise between $5-$15,000,000.  So far none of my clients have gone over budget and most have spent less, but running out of money would be aggravating to all concerned.

A lot of people ask me to introduce them to VCs. I know a few VCs on both coasts and a few in between.  Most are serious investors meaning that they want to invest in companies that will succeed and produce a good return on their investment.  This is true of all investors, not just VCs.

For most start-ups seeking venture capital is a waste of time.  VCs actually fund very few businesses every year and each has its own funding requirements. The process is time consuming (even companies that get funded can be at it a year or more) and often political (like a lot of things in life it is often who you know that is important).

For most start-ups and small companies, equity crowdfunding would be the preferred way to raise funds.  It can be quick (90-120 days) and inexpensive ($35-$50,000).  I work with several equity crowdfunding platforms and several different marketing companies.  If you start with the idea that you are just going to slap an offering together as inexpensively as possible, put it up on a crowdfunding platform that has dozens of competing offerings and send out an e-mail or two to prospective investors, you are more likely than not going to fail.

I know a lot of people in the crowdfunding industry and I think that I know the best of the best.  I can usually direct a client to an appropriate crowdfunding platform and a marketing firm that will get the job done. I use different firms for different offerings of companies in different industries and at different stages of their corporate development.

Funding is always a team effort. That is why I like to pick the team.  I try to use the best people for each job.  Some charge more than others but like everything else in life, you get what you pay for.

To save time here are three types of offerings that I do not do.

1) Anything to do with cannabis. It is not that I am a wimp on the subject of marijuana. I was in college in the 1960s.  It is just that I can read the handwriting on the wall. Cannabis is illegal in all 50 states, no matter what the state legislature may have enacted.  The current US Attorney General, Jeff Sessions, seems to be getting ready to start enforcing federal law and closing down the retail stores and medical dispensaries.  He recently loosened the rules on asset forfeiture, meaning that nice warehouse where some company is growing cannabis might be seized and sold without a trial.  If I was an investor who helped to fund the purchase of that building I would sue the principals for using my money to participate in an illegal enterprise.

2) Any Reg. A+ offering. Reg. A+ requires the registration of shares with the SEC so that they can be sold to smaller investors. There is more than enough money in the Reg. D private placement market to fund your business. A Reg. A+ offering will likely cost you $150,000 or more to raise the same amount of money. That does not scream “look how smart I am” to any investor.

3) Any ICO. Recently I have been asked by more than one company to do an Initial Coin Offering (ICO).  These are offerings denominated in crypto-currencies. Several have raised significant amounts of money.  The SEC has declared that depending on how these offerings are structured they may be securities. Most of the lawyers with whom I spoke would err on the side of caution if they were asked to prepare an ICO. I got quotes in the range of $150,000- $250,000 just for legal fees. Again why spend that much more than you need to spend to fund your business.  And if you need a gimmick like an ICO to fund raise funds, what does that say about your business?

By refusing to fund businesses selling cannabis, any Reg. A+ or any ICO, I am leaving a lot of money on the table because these offerings, especially the latter two, pay well.  I have the expertise but I also have a reputation. I will not advise a client to use Reg. A+ or an ICO when a Reg. D offering will work just as well and cost them much less.

Good businesses get funded. While 90% of start-ups fail,  the key is to convince investors that you are among the 10% that will not.  If you are unsure, you are welcome to try to convince me first.

 

Reg. A+ Assessing the True Costs

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

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

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

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

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

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

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

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

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

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

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

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

Accredited Investors-Here Comes Direct Solicitation

The JOBS Act required the SEC to permit issuers of certain common private placements to greatly expand their marketing efforts. Issuers using the Reg. D exemption had been prohibited from using any form of “general solicitation” or “general advertising” to market their interests. The SEC has amended its rules to lift that prohibition.

“General solicitation” and “general advertising” were not defined terms, but the rule states that these may include, “any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.”

A private placement offering is frequently structured to be sold to accredited investors only. This includes banks and insurance companies and retail customers provided the latter have either a $1 million net worth or earn $200,000 per year.

Under the old rule, a stockbroker could not address a stranger with a solicitation for a private placement. There needed to be a pre-existing business relationship between the stockbroker and the potential investor. This was always a chicken and egg problem for the brokerage industry. Many brokerage firms and issuers found interesting ways to comply with the rule and still attract “new” customers.

Under the new rules, accredited investors will likely be bombarded with advertisements for Reg. D offerings of every kind. There will be print and website ads, U-Tube videos and infomercials. Seminars will be less informational and more focused on making sales.

This rule change is likely to launch billions of e-mails. Mailing lists with e-mail addresses for accredited investors are currently available from list brokers. The lists can be sorted geographically and will identify people who previously invested in Reg. D offerings.

If these advertisements emanate from FINRA brokerage firms there is at least a presumption of compliance with the rules that require the advertisements not to be misleading. If the ads emanate from the issuers themselves, there is less oversight.

More likely than not there will be more abuses. In the last cycle, we saw issuers put out glossy brochures offering interests in “Class A” office buildings that were not “Class A” and ads for oil drilling programs with “proven reserves” that were not “proven”.

Some ads will likely target seniors. It is not hard to imagine an advertisement for a Reg. D offering that asks: could you use more monthly income? I should not have to tell you that scam artists will be especially active.

The interests sold in Reg. D offerings are speculative investments. The ideal customer for a Reg. D offering is an accredited investor who is willing to take the risk of these investments and who can afford to take the loss if it occurs. They should be sophisticated enough to understand the offering materials and to make an informed decision whether or not to invest.

General advertising will cast a much wider net. It will undoubtedly bring more investors and more capital into this market. It will also bring more investors into the market who will not understand the offering documents or be able to accurately assess the risks.

Advertising appeals to our emotional nature. Emotions are never a good tool for evaluating risky investments.

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Reg. A+ – Exuberance and Reality

The JOBS Act mandated the creation of new rules to help smaller companies obtain funds for development and expansion. One result is the SEC’s new Reg. A+.

Many people see the new regulation as an opportunity for small companies to gain access to the capital markets. It has created a fair amount of excitement and a plethora of seminars and experts.

There are groups prepared to assist businesses owned by women and minorities to take advantage of new sources of capital. There are bio-tech companies with patents (and those still developing their patents) looking for funds. There are consultants pitching Reg. A+ to the cannabis industry.

The sales pitch for Reg. A+ goes something like this: small investors will help to fund small companies that Wall Street ignores. Reg. A+ is a way for companies that could not get funded elsewhere to raise money from Main Street investors.

Some people seem to suggest that thousands of small companies will be able to take advantage of this new regulation. They seem to believe that there is a vast pool of underutilized capital eager for this type of speculative investment.

Reg. A+ will permit companies to raise a maximum of $50 million. Many of the offerings will be smaller; some a lot smaller. These are unlikely to attract the attention of any of the large investment banks. There will be some brokerage firms that will occupy this space, but they too are likely to be smaller.

The anticipation seems to be that many issuers will try to sell the shares to the public themselves without the help of an underwriter. Direct to the public securities offerings have been around for 20 years. Raising a relatively small amount of money from family, friends, suppliers and customers has always been an option.

The up front costs of a new Reg. A + offering are likely to be high. Lawyers and accountants who take companies public are specialists and frequently expensive ones. How little a Reg. A+ offering raise and still justify those costs has yet to be determined.

Underwriters provide essential services to every offering. Underwriters conduct due diligence about the issuer and the offering. Underwriters participate in preparing the registration statement. They make the important pricing decisions and provide research and aftermarket support. All of these tasks will still need to be performed if the company decides to go it alone.

All of this will fall to the issuers, their attorneys and accountants. Issuers who do not use an underwriter will need to assemble an experienced team from scratch. The attorneys and accountants are not going to be much help in the effort to sell the shares. That is what the underwriters do best.

Liability under the federal anti-fraud statutes will rest with the issuers as well. Insurance companies are already advising management that raising funds from public investors without appropriate coverage is fool-hardy.

Proponents are looking to social media to create interest in these offerings. Reg. A+ has a provision allowing a company to use a preliminary prospectus akin to a red herring to obtain indications of interest before the offering becomes final.

As a practical matter, potential purchasers will likely be directed to a website that will allow them to read the preliminary prospectus and which will likely contain a video about the company. The latter is a modern version of what used to be called the “dog and pony show”.

The lawyers who are moving the registration statement through the SEC are likely to make certain that those videos are toned down. That does not mean that a company cannot generate some real excitement in a video. It means that the videos will need to be compliant with the regulations anbd offer a balanced presentation including the fact that investors could lose all the money that they invest.

Given the reach of social media, the video might be viewed by a great many potential investors. Success of a direct to the public offering may hinge upon how many people are excited enough to direct their friends and contacts to the website. At least with an underwriter the offering is likely to be funded.

Any investor willing to assume the risk will be able to purchase shares offered in a Reg. A+ offering. That is the point. Mom and pop can help fund a small business that might eventually turn out to be big. Investors will further benefit because sales made directly by the company will not be subject to sales commissions.

Institutions and accredited investors (wealthier individuals with $1 million net worth or $200,000 in income) are also expected to invest. Angel investors and professional venture capital funds may invest as well. These investors are currently purchasing offerings being made under Regulation D which frequently have substantial loads and commission costs. Direct from the company offerings that are commission free will certainly appeal to some accredited and professional investors.

Unlike Reg. D, investors in a Reg. A+ offering come away with freely trade-able shares, just like they would in an IPO, but not quite. The Reg. A+ market is brand new. Reg. A+ shares may be legally trade-able but if you wish to sell them the question will be: to whom? It may take a while for a truly liquid secondary market for these shares to develop.

Certainly there will be successful offerings made under Reg. A+ both underwritten and direct from the issuer. How many there will be and how much money they will raise remains to be seen.

One thousand Reg. A+ offerings per year at the maximum of $50 million each would add only $50 billion to this end of the market. I suspect that the actual amount of funds raised under this rule will be less.

 

Due Diligence and Reg. D

Due diligence was originally a judicial construct that provided a defense for underwriters who were jointly and severally liable for fraud perpetrated by the companies they brought to market. If the underwriter could not have discovered the fraud after a diligent investigation of the issuer, then the courts reasoned that there was not much more that the underwriter could do.

The due diligence investigation fell to the lead underwriter who was well paid for its efforts and upon whom other members of the selling group could rely. The underwriter’s due diligence investigators would consult with the issuer’s attorneys and accountants, pour over legal documents, ledgers and spreadsheets and visit factories, properties and sales offices. A good due diligence investigation included a look at the company’s customers, suppliers and competition, as well.

Due diligence has been a staple for underwriters for more than 40 years. The SEC has acknowledged the process in its new crowdfunding rules. Every legitimate brokerage firm underwriting new issues of securities employs some kind of acceptable due diligence process with one glaring exception: firms that underwrite Reg. D offerings sold to retail accredited investors. .

FINRA has codified the requirement of a diligent investigation by member firms selling private placements under Reg. D. The FINRA standard is specific; the member firm should verify the facts that are being given to investors. In a great many cases, a diligent investigation just does not happen.

When Reg. D was enacted, in the early 1980s, the vast majority of private placements were purchased by large institutional investors. These firms had the ability to review and analyze the offerings by themselves. Institutional purchasers would send their own lawyers and accountants to the issuing company before they sent their money.

Reg. D allowed wealthy individuals to invest in private placements as well. The rule set the threshold for “wealthy” investors at above a $1 million net worth. Wealthy individuals, it was reasoned could afford to sustain the losses if they occurred. Reg. D calls these wealthy individuals accredited investors. At the time there were fewer than 1 million millionaires in the US. Today there are 10s of millions.

A due diligence investigation of a company seeking to raise capital from investors is not difficult. My partner and I conduct due diligence investigations for VC funds, angel investors, family offices and broker/dealers. Individual investors, unless they are making a large investment, rarely call us.

The SEC estimates that $800 billion dollars worth of private placements are now sold every year, a very significant the vast majority of the funds coming from individual accredited investors. Experience has shown that some brokerage firms, including those that sell billions of dollars of private placements to individual accredited investors, do not diligently investigate the offerings that they sell. Hundreds of billions of dollars in investor losses are directly attributable to that fact.

After the credit market crash in 2008, many companies that had used Reg. D to raise billions of dollars were shown have been frauds. More than a few were Ponzi schemes. The latter, in many cases, were facades that had no business, just a good story about how investors were going to get paid high returns.

In some cases, more than 100 FINRA broker/dealers signed on to raise money for these Ponzi schemes. If they had done any investigation of these companies, they would have seen that the represented business did not exist. Selling a Ponzi scheme is usually a prima facie example of a firm that did not conduct a diligent investigation and probably conducted no investigation at all.

FINRA, the SEC and the state regulators did not impose significant penalties against firms that sold Ponzi schemes to investors. Civil recoveries by investors against the brokerage firms that sold the Ponzi schemes have been negligible. There is nothing in the market to incentivize a brokerage firm to conduct a real due diligence investigation; nor anything detrimental if they fail to do so.

The Dodd-Frank Act requires the SEC to re-consider the threshold for accredited investors every four years. If the SEC raised the threshold for net worth to $5 million, it would simply be an adjustment for inflation during the 30 plus years since the $1 million figure was set. It would also reduce the number of potential investors and the amount of capital that is available to this market.

The SEC seems intent upon expanding the amount of capital available to this market rather than contracting it. The Commission has already approved a change to Reg. D that makes it easier for firms to solicit potential Reg. D investors. No new protections for individual accredited investors seem to be forthcoming.

Many real estate and energy companies are serial issuers; they fund project after project using Reg. D. You can spot these professional sponsors at meetings and conferences where they wine and dine brokerage firm executives to get their offerings noticed and sold.

Brokerage firms will continue to give lip service to due diligence investigations but not perform them diligently. Ponzi schemes and other fraudulent offerings will continue to be sold to investors under Reg. D. Individual accredited investors will continue to bear the brunt of the losses.

Some things about the future of markets are easier to predict than others.