Year: 2017

SEC v. Munchee – Will the crypto-currency community listen?

Capital Markets, Issuers, Law , , , ,

 Just about 2 years ago I wrote a blog article about the first Securities and Exchange Commission (SEC) enforcement action involving equity crowdfunding, SEC. v. Ascenergy.  The SEC action against Ascenergy highlighted the need for the crowdfunding industry to step up and protect the investors from fraud.  That made good common sense because the crowdfunding industry needs investors to survive.

Notwithstanding, most of the crowdfunding industry ignored that enforcement action.  It still largely refuses to carefully vet the offerings that are put on the platforms for investors’ consideration or conduct meaningful due diligence to verify that what the companies are telling investors is true.

Recently the SEC brought what is considered its first action against an Initial Coin Offering (ICO), SEC. v. Munchee Inc.  An ICO is essentially a sub-set of crowdfunding and each offering should be governed by the JOBS Act and the anti-fraud provisions of the securities laws.

A lot of people in the ICO industry will disagree because they believe that they can construct an ICO offering that is not selling securities. The SEC has been clear that it has not seen an ICO that was not a securities offering. Most good securities lawyers agree with the SEC.

Accepting that simple truth would put many people in the ICO industry out of business.  I am referring to the many ICO consultants who charge a lot of money for bad advice. Some of the people who advised Munchee are well known in the crypto industry. Anyone want to bet that they will never mention their participation in the failed, non-compliant and illegal Munchee offering when someone asks about their track record?

On the same day as it announced the Munchee Cease and Desist Order, SEC Commissioner Jay Clayton issued a statement about how the Commission will likely view ICOs. Much of the commentary since has focused on the Commissioner’s statement and not on the enforcement action. That is a mistake.

The Commissioner’s statement covers more ground and speaks in somewhat general terms. It represents the view of the most important regulator in the ICO world, but it is still a statement about generalities that is open to some interpretation.

The enforcement action actually gives more of the “meat” of what the SEC deems illegal conduct. A cease and desist order may become the subject of litigation or appeal. The SEC staff tends to choose its words carefully. It sets forth the facts and the offending conduct, the jurisdictional basis for the action and the reasons why the conduct violates the law.  It is a road map of how not to conduct an ICO offering and everything in it should be scrutinized carefully.

So what, exactly, did Munchee do wrong?

Munchee claimed it was offering “utility” tokens and not securities. It claimed to have performed an analysis of the offering using the test denoted in SEC v. Howey case. I suspect that it did not.  The Munchee white paper lists a dozen officers and advisors not one of whom is an attorney. It provides links to a half dozen PR pieces about the offering but not the attorney’s analysis that these tokens were not securities. The failure to provide a copy of that evaluation was not lost on the SEC staff. They mention that fact specifically in the order.

If an attorney had done the analysis Munchee would set forth the attorney’s name or provided a copy of the evaluation. “Advice of counsel” can be a defense to an SEC action such as this one and Munchee declined to set forth that defense.

A lot of people claim to understand Howey and a lot of articles have been written by people who are not qualified securities lawyers and are claiming to explain it. An evaluation of the offering under the Howey test involves a lot more than just reviewing Howey.

The Order in Munchee refers to Howey and also the SEC’s July 2017 Dao Report.  That report reviews over 30 other cases that have applied the Howey test to various investment offerings. The Order specifically refers to several of those cases which are important to any discussion of this subject.

A lot of people seem to think that if you can use the token for some commercial purpose it is a “utility” token. The Order in Munchee should dispel that idea once and for all.

Purchasers of a Munchee token (MUN) would join a network of people writing reviews of various restaurants. Munchee would pay users in MUN for writing the reviews and would sell both advertising to restaurants and “in app” purchases to app users in exchange for MUN tokens.

Munchee also said it would work with restaurant owners so diners could buy food with MUN tokens and so that restaurant owners could reward app users–perhaps those who visited the restaurant or reviewed their meal in MUN tokens. As a result, MUN tokens would increase in value.

Howey defines a security as an investment premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. The argument here might have been that MUN owners might get a profit based upon their own efforts.

But Munchee intended to do much more. It intended to cut off the number of MUN at a fixed amount.  It intended to facilitate a secondary market where people could buy and sell MUN. Because you could buy MUN, not use them or do anything and later sell your MUN for an appreciated price, it should be abundantly clear that your expectation of profits had nothing to do with you and must therefore be derived from the efforts of others.

Let me offer a simple example: You can purchase a membership in COSTCO. The membership allows you to shop in their stores and buy goods in bulk at a discount. You also get free snacks and inexpensive hot dogs. The membership is recorded on the company’s records and you get an ID card with your picture that is checked every time you enter the store so it cannot be transferred to anyone else.  No one would think that a COSTCO membership is a security. But the SEC has declared some other memberships to be securities.

If COSTCO decided to cut off the number of memberships and allow them to be transferred, it might be fair to assume that the price would appreciate. That alone might make them into securities. Transferability, or the lack of it, is not itself the only indicator. A lot of unregistered securities cannot be freely transferred. But once your token can be transferred at a potentially appreciated price, you should certainly consider that you have crossed the line.

The other big issue raised by the SEC staff in the Munchee Order was the way in which the MUN were sold. Munchee posted information about the offering and the MUN White Paper through posts on the Munchee Website, and on a blog, Facebook, Twitter, and Bitcoin Talk.

This type of general solicitation is specifically permitted by the JOBS Act and is the type of marketing that is needed when a company is trying to raise $15 million without a brokerage firm selling the securities for them. If Munchee had accepted the fact that these were securities, this would not have mattered as long as they did not exaggerate the facts or the potential return.

At the same time, Munchee did not advertise the offering of MUN tokens in restaurant industry media to reach restaurant owners and promote how MUN tokens might let them advertise in the future which is what you might expect if the tokens were being sold for their “utility”. The SEC staff picked up on that fact.

Instead, Munchee and its agents promoted the MUN token offering in forums aimed at people interested in investing in Bitcoin and other digital assets. Munchee made public statements or endorsed other people’s public statements that touted the opportunity to profit, not necessarily the opportunity to use the MUN.

The Order states: “MUN tokens were to be available for purchase by individuals in the United States and worldwide.”  It notes that Munchee intended to use “10% of the offering proceeds ($1.5 million) to make sure Munchee is compliant in all countries.” While that sounds fairly innocuous, as I said, the SEC staff chooses the language it puts into these orders carefully.

There are countries where no crypto-currency or tokens can be sold, so saying it can be sold “worldwide” indicates that the offering is a scam. In a securities offering, it is common for the offering materials to set forth the countries where the offering is being made.  Most telling is the fact that you need to be certain that you are “compliant” before you make the offering, not after. The Howey test does not apply anywhere except the US.

The simple truth is that I would have been happy to help this company raise $15 million for a lot less than $1.5 million in full compliance with securities laws. I would have advised them to sell stock in the company and then memberships separately. They would have had a successful offering and money to market and sell memberships at a lower, more reasonable price where many more people might have joined.

The lesson here should be obvious. If you are claiming to offer a utility token, demonstrate its utility and sell it to people who may want to use it. If you are seeking investors, then stop telling yourself you are not selling a security. Hire lawyers and comply with the rules.

The time, effort and expense that the founders of Munchee expended developing their app and their business, went nowhere.  With the JOBS Act the opportunity for funding a small business has never been greater. If you want money from investors, stay between the white lines.

Remembering Bre-X- The First Big Internet Stock Scam

Issuers, Law , ,

It has been 20 years since the Bre-X stock scam.  It may not be completely accurate to call it the first internet stock manipulation, but it was certainly the largest for its time. The scam was based upon false information that the company originally circulated on the internet. After a while large companies and the mainstream media jumped on the bandwagon. Then large investors followed.

Bre-X was a Canadian penny stock company whose share price went from about $.30 per share in 1993 to over $250 in 1997. The stock was originally traded on the Alberta Stock Exchange and later the Toronto Exchange and then moved to NASDAQ.

At the end, it took only about one month or so for Bre-X to unravel completely.  When the stock collapsed, investors had lost somewhere in the neighborhood of $5-$6 billion.

Bre-X has a fairly simple story. The company claimed to have located a huge deposit of gold, perhaps the largest single deposit ever discovered, deep in the jungle on the island of Borneo which is part of Indonesia.

People have been scamming investors with claims of huge gold discoveries for a long time. And as they say “greed is a powerful motivator”.

As far as anyone knows the entire a scam was the product of no more than 3 people.  The primary players were David Walsh the founder and largest shareholder of Bre-X, John Felderhof the chief geologist and Michael de Guzman the on-site geologist in Borneo.

Walsh purchased the property located in the middle of a jungle in 1993 on the advice of Felderhof.  The on-site geologist, de Guzman, took samples which were assayed. He initially estimated that the deposit was equal to 2 million Troy ounces of gold. The estimate of the site’s size and worth increased over time. In 1995 the estimate was raised to 30 million ounces, in 1996 it was raised to 60 million and finally in 1997 the estimate was 70 million ounces.

There was actually no gold at the site. It was later revealed that de Guzman was “salting” the samples he was sending to be assayed, i.e. he was adding gold shavings to the samples.  There is nothing particularly new about this scam. People had salted gold and silver mines to gain investors before. What was new is that the fake information was disseminated over the internet.

The internet in 1994-1997 was very different than it is today. Computer screens still had no color. You could not upload or attach documents. There were no search engines.  E-mail was primitive and very few people had an e-mail address. There were 3 primary services that you could use for internet access; America On-Line, Prodigy and CompuServe.

I was an early CompuServe user. I say early because my account number had only six digits. I would usually access CompuServe in the evenings via my dial-up modem.  It was primarily a collection of forums and primitive chat rooms where users could swap information and discuss various subjects.  There was a section dedicated to stocks.

Bre-X was certainly one of the most often talked about stocks during this period. There might only be one or two dozen people who left comments but you knew that many more were silently lurking and reading them.  I was reading the comments late in the evening on the West Coast. There were certainly people who were writing comments and other people reading them on the East Coast the next morning.  There was a lot of information about Bre-X to post and discuss.

As new assays were supposedly being taken and the estimates about the size of the potential strike went up and up, larger players tried to put their hand into the cookie jar.

First there was a failed take-over attempt by Placer Dome which was a much larger mining company. Next, the government of Indonesia (then a corrupt dictatorship) tried to bring Barrick Gold on board. The government claimed to be concerned that a small company like Bre-X might not be able to handle a large mining operation,

Later, the government brokered a deal whereby Freeport-McMoran a third large mining company, would have a majority interest and run the mine.  Members of Indonesian President Suharto’s family and their cronies got a cut of that deal as well.

Once the shares were on the NASDAQ in 1996, Lehman Brothers and other big firms started to follow the stock. There were articles about it in the Wall Street Journal and the mainstream media.

Everyone seemed to think that the gold deposit that had been discovered in the middle of the jungle on Borneo might be larger than expected and that other sites in the jungle might be the next to be explored.  The “smart money” seemed to think that it was only a matter of time before more gold was discovered.

Freeport-McMoran began its due diligence by drilling samples in early February 1997. The internet chat rooms were on fire with the speculation that the results might show richer deposits than did previous samples.  But it was not to be.

The scam ended abruptly in mid-March when the geologist, de Guzman, supposedly fell (or was pushed) out of a helicopter over the jungle. The body that was recovered days later was badly disfigured and identified through dental records.  The body quickly disappeared from the local morgue. People have claimed to have sighted de Guzman in Canada and elsewhere in the years since.

Freeport McMoran reported the results from its test a few weeks later stating that there was little or no gold on the site.  There were a few subsequent tests which concluded that the gold in the original samples had come from elsewhere which is how we now know that the early samples were salted.

The stock, of course, collapsed.  Trading was suspended in Toronto and on NASDAQ and the company filed for bankruptcy. The bankruptcy revealed that three large Canadian public pension funds had been big investors and hence, big losers.

Walsh claimed innocence of the whole affair, moved to the Bahamas and died of natural causes. Felderhof was charged with insider trading (he had apparently sold millions of dollar’s worth of stock along the way) but was eventually acquitted.  Class actions brought on behalf of shareholders returned virtually nothing to them.

Just before the end, Bre-X had blamed the meltdown of the share price on the internet.  Walsh claimed that the rumors that the company had no gold had emanated from enemies of the Indonesian government and that the people in the internet chat rooms were short sellers who wanted to see the company fail.

It is certainly correct to argue that the stock would never have run-up if the “news” about the alleged gold discovery had not circulated in the chat rooms.  It is certainly fair to assume that the stock price would have gone higher if many more people had visited these chat rooms.  As the share price went up, more and more people became convinced that the people saying it will go higher must know what they are talking about.

It is appropriate to consider just how high the price of Bre-X might have gone if there had been as many internet users then as there are now.  In the 1990s the internet was just flexing its muscles. Today it can easily move the price of any investment up or down. People who know nothing can sound like geniuses if the the stock price goes up after they say that it should.

Bre-X is actually a model for a modern pump and dump schemes.  All you need to do is acquire a lot of shares in a penny stock, set up one or more investment newsletter websites and drive traffic to those sights by sending e-mails to lists of investors.  The SEC has closed down internet investment sites that have done just that.

If there is anything that any investor should learn from the Bre-X scam it is that you should only take investment advice from people that you know and trust.  A lot of what you hear on the internet is just not real.

 

Fake Business News

Capital Markets , ,

I think I first heard that we were entering the “Information Age” in the 1990s. The internet was just coming on-line. It promised that every book ever written would be available without a trip to the library. It promised that I could view every painting in every museum in the world without ever getting on an airplane.

In just two decades we have become inundated with information that is simply false. I am not talking about political “fake news” or “fake facts” spewed by politicians. No one in their right mind expects politicians to be truthful.

The internet has become a prime source of financial information and anyone can add to the growing library, even if they have no idea what they are talking about.  The world is full of information about finance that is pure fantasy.

For a great many years I got my business news daily from the Wall Street Journal. When I moved to San Francisco in the1980’s I started reading the San Jose Mercury News because it had the best tech reporters around.

I admit that I am somewhat of an information junkie especially as it regards business, the economy and the financial markets.  I currently watch the national news on PBS or CNN. I have been known to watch Bloomberg TV especially the shows focused on European and Asian markets. I read scientific and tech journals and law review articles. I am an old dog trying to learn new tricks. I want to keep up with what is going on in finance, law and technology.

That is one of the reasons that I like LinkedIn.  I have connected with people all over the world and through them I get articles about many things that are going on in the global marketplace that I would not otherwise read.  But not every one of those articles has any value at all.

Some of the articles are written by people who call themselves strategists, influencers, gurus, visionaries, evangelists and futurists.  Many seem to be self-appointed experts without credentials or experience.  Some just regurgitate stupidity because they cannot discern good information from bad information or ask intelligent questions about what they are reading.

Is it unfair to expect that someone who holds themselves out as an expert in finance have an MBA or have worked in finance?  Is it unfair to expect someone commenting on a fairly complex legal issue to have graduated from law school?

This seems to have carried over to the mainstream financial press. There are “experts” contributing columns to Forbes and Fortune who could not find their way out of a paper bag. They lack context, perspective and expertise.  So much is the need for content that quality has gone out the window.  The desire for “views” and “likes” is more important than the quality of thought that goes into the writing.

This has also migrated over to the conference circuit. When I go to a conference, I want to learn something valuable from people who know what they are talking about. I want to hear speakers who have been in the trenches; those who have walked the walk.

Many conferences refuse to pay for the best speakers opting instead for those who will speak for free and pay their own way in exchange for “exposure”.  Some conferences charge speakers to appear. This eliminates many of the best academics and usually people from big companies who do not need the exposure and certainly are not going to pay for it.

There has always been some amount of fake news about some businesses. Tobacco companies said that smoking did not cause cancer; coal and oil companies deny global warming.  You would expect a salesperson or CEO to say that their company’s product is the best or their service the fastest and that is not troubling. But there were always rules.

For any company with investors the dissemination of financial information is regulated. Every press release and often every advertisement is usually vetted by  the company’s lawyers to assure accuracy and compliance.

When a public company published financial information it was presumed that the information was accurate. There would be auditors looking over managements’ shoulders in any event.  There are quarterly phone calls with analysts who ask questions. If management gets a reputation for being too optimistic on a recurring basis, people know about it and begin to discount what they are saying.

If you worked for any large company, when you made a statement in public you always represented that company. You were expected to maintain a professional demeanor, to go out of your way not be controversial or say something that might make the company look bad.  You were always expected not say something that was stupid or inaccurate. That is still true in many cases but it is far from universal and it seems to be less and less true as time goes on.

This becomes a serious problem when a small company is trying to obtain funding from investors.  Investors are entitled to a full and fair disclosure of the actual facts.  Most of the Wall Street firms take care to verify the facts that they are passing on to investors but this has become a significant problem on the fringes of finance like Crowdfunding and investors are getting ripped off every day.

I speak with people every week who want to raise funds for their business. I appreciate that many of the people who contact me have done some research first. But just because you heard something at a Ted Talk or read an article in Inc. does not make it real.

One of the core premises in the Crowdfunding market is that the investors can fend for themselves or that the crowd will be able to separate good investments from bad ones. That is simply not true, has never been true and is unlikely to become true.  The vast majority of investors have no idea what questions to ask and if they do, they have no ability to verify whether the answers they get from the company are true.

This “fake” news often shows up in the company’s sales projections. Projections in an offering are always rosy but the projections need to have some basis in fact. I have asked people who are Crowdfunding their offering how they arrived at their sales projections and many have no idea if their product is priced correctly or what their competition is offering.

I try to be pretty careful about what I write on this blog. I limit my articles to areas which I know fairly well, finance, law, investments and economics. I do a fair amount of research for any article. When I write articles for this blog, all of which are read over by a colleague before I publish them, I always ask myself “would I be willing to say that to a judge?”

I have been taught to be a critical thinker. I think that the best lawyers are. I was taught to question facts and assumptions. As a lawyer I try to understand the underlying transaction and the expectations of the parties whether I am writing the paperwork or litigating over someone else’s.  It carries over to this blog and other articles that I write.

When I started this blog I said that I was constantly amazed by the vast amount of patently foolish investment advice in the marketplace and promised to call out financial foolishness whenever I see it.  I never expected that so much of that false information would present itself or that so many people would accept that information without question.

So far I used the blog to point out the obvious facts that 1) robo-investment advisors, in part because they are looking backwards not forwards, are virtually useless; 2) investing in a cannabis related company has the extra risk of investing in a business that is patently illegal; 3) the Crowdfunding industry needs to act like responsible intermediaries because the offerings are either bad investments or fraudulent and 4) crypto-currency has limited utility as a method of finance in part because it is a very expensive way to raise money.

You should certainly be aware that there are a great many articles out there that see the world very differently on each of these subjects. The more time I spend reading what is out there, the more I know that I have my work cut out for me.  The simple truth is that markets need accurate information in order to operate efficiently.

 

The Future of Investment Advice

Investors , , ,

In order to understand the future of investment advice I think it is essential to understand how the industry has developed to where it is today.

When I started in the financial services industry back in the 1970’s retail customers got advice about what to buy and sell from their stockbrokers.  At the larger brokerage firms that usually meant that your broker would call you and tell that they or the firm’s research department had identified a stock that was a “buying opportunity”. This was often accompanied by a recommendation of what you should sell to pay for your new purchase so your broker would make not one, but two commissions from the recommendation.

When the stock market suddenly crashed in 1987 a lot of customers asked their stock broker why the broker had not seen the crash coming. The brokers really had no good answer. The crash took a lot of money out of the market and caused a lot of customers to lose faith in their broker’s ability to select investments for them.

Partially to placate those customers with something new and partially to make more money the industry introduced wrap accounts. A wrap account places the customer’s account into the hands of a professional money manager for an annual fee which is shared with the introducing stockbroker.

Wrap accounts introduced the idea that the individual brokers would be compensated on the customer assets under management (AUM) rather than the commissions that their accounts generated. This let the brokers do what they do best (sell) and let the professional money managers manage the accounts.

It also created a conflict of interest. Managers kept investors fully invested because that is what they had been hired to do. If the managers started to accumulate large cash positions in customers’ accounts, the customers might withdraw the cash. That would be counter-productive to the brokers who were being paid to bring in more and more new assets.

By the mid-1990s the market had recovered nicely and people started asking how long the boom would last.  At the end of 1996 Fed Chairman Alan Greenspan attributed the sharp run up in stock prices to “irrational exuberance”.  Neither the brokers nor the money managers advised the customers to sell when they had large profits and maintain a cash position

Much of the run-up in the 1990s was attributed to new tech companies that not everyone understood. Consequently, the firms hired highly qualified research analysts to parse through the various issues and recommend what they considered to be the best.

At the same time, the brokerage firms were making a lot of money by underwriting new issues of these tech stocks. In many cases the research analysts were working to support the efforts of the firms’ investment bankers. They only wrote reports describing why their firm’s banking client’s offerings were a “buying opportunity”.

That also created conflicts of interest.  When the market finally crashed it was revealed that some analysts had never suggested that the price of any of the stocks they covered would not go higher. Some analysts never recommended a “sell” on any stock they followed even when fundamental analysis told them that they should be selling.

Again, when the market crashed in 2001 a lot of people asked their broker why they did not see the crash coming or take some defensive action to protect their profits.  And again, the brokers did not have a good answer other than “no one can really predict the market” which, of course, is exactly the skill that the stockbrokers and money managers had been espousing to customers all along.

The brokers themselves got more than a little frustrated with the large wire houses and many jumped ship. Sometook their clients and set up shop as independent investment advisors.

The accounts were still housed at a brokerage firm that got paid a commission on each trade but the advisors now kept all of the annual account management fees. This was a better deal for the advisor even if they now needed to pay their own rent and overhead. The idea that no one can really predict the market suited these independent advisors well because they were more interested in acquiring new customers and assets than picking good investments.

That led to a concept that as long as a portfolio was diversified it really did not matter which stocks were in it. By diversifying the stock portion of the portfolio into different asset classes the advisors were trying to avoid what had happened in the tech wreck. The theory was that if you bought stocks in different asset classes, the collapse of one sector, like tech, would not hurt you too badly.

This did not help investors when the market crashed in 2008. This crash was caused by a bubble in real estate and foolish lending in the financial sector. Most companies are affected by what occurs with banks and real estate as both effect business and consumer spending. Diversification only mitigates certain risks. This crash involved a systemic risk, not an asset sector risk, a fact that many brokers never understood.

It should not surprise anyone that investors again asked their advisors why they did not get them out of the market before it crashed.  Again the response was “no one can predict the market”.

Since 2008 the advisor industry has seen the rise of robo-advisors.  These are popular with millennial investors who do not trust the Wall Street professionals after 2008.  Robo-advisors select portfolios based upon algorithms. This makes as much sense as throwing darts at a list of stocks and bonds even if you are a champion dart thrower.

Robo-advisors are not even attempting to predict the market and they are not programmed to ever sell the portfolio if the market starts to crash, which we all know, it will. They are just selling diversification at a lower price. They achieve “diversification” by buying mutual funds or ETFs. These contain so many stocks that mathematically, there is no actual diversification.

Robo-advisors advertise that people pay too much for investment advice. I would argue that most customers pay too little.  My current advisor spends countless hours poring over financial statements and research reports to pick individual stocks.  He gets the same 1% of AUM as advisors who put all of their clients into pre-selected diversified portfolios of various funds and ETFs without really knowing a lot about them or how they might be expected to perform. With investment advice, like everything else in life, the rule should be that you get what you pay for.

What I think may be an intelligent alternative going forward is for people to just put their investment advisor on a fixed monthly or yearly retainer.  It would cost more for a larger portfolio than a smaller one because all portfolios need to be constantly monitored and larger portfolios require more time. Advisors would keep their customers and get referrals by keeping their customers happy.

And what makes customers happy?  They want to have more money in their accounts at the end of the year than they had at the beginning of the year. That is true even if the market crashes because there is nothing more foolish than staying in the market when the market is going down.

The customers will never truly be happy and get the results they truly want until advisors thoroughly analyze and review the stocks they recommend and purchase and hold only those that they believe are likely to appreciate. They will never get there if advisors refuse to take profits and move to cash when the market indicates that they should. They will never get there if advisors diversify to mitigate some risks, but not all.

People actually do predict the future performance of individual stocks and the market in general. I doubt that you would be surprised if I told you that the ones who do it well get paid a lot of money by investment banks, mutual funds and large institutions.

The advisor industry needs to understand that parroting the phrase “no one can predict the market” every time the market corrects is the fastest way to be demonstrate that you do not know what you are doing. Providing beneficial investment advice takes time and effort. Advisors are entitled to be paid for their efforts. But first they have to actually do the work and that work is accurately predicting the future price of individual securities and the market in general.

 

 

Any Good Business Can Get Funded

Capital Markets, Issuers , , ,

I am always amazed when I get negative feedback to the premise that any good business can get funded. This is especially true when people tell me that businesses owned by women or minorities cannot get funded or that businesses locate outside of New York, Silicon Valley or some other money center have limited access to capital.

Frankly I think that a failure to get funding demonstrates ineptitude on the part of the entrepreneur. Inexperience is a greater impediment to attracting capital investment than gender, race or location.

When I was younger a business had two choices for funding, banks or Wall Street.  Wall Street would not take a company public until it was profitable. Companies often used an IPO to pay down debt and improve cash flow to pay dividends to the shareholders. If you wanted to get funded on Wall Street, it helped if you went to Princeton or Yale or your father did. It was very much a “who you know” network.

Banks provided the bulk of the capital that was available for small business. They still do. They do not care who you are as much as they want to know that you will pay them back.

When I graduated law school in the 1970s women could not get credit cards and minorities could not get even a loan application at any bank. So you cannot tell me that it is more difficult for women and minorities to get funded today.

The US Small Business Administration (SBA) has programs which will guarantee bank loans for about 20,000 small businesses every year.  I speak with entrepreneurs seeking capital all the time. I always ask if they have tried the SBA.  Most of the people I speak with never heard of the SBA or never considered it.  If you are looking for funding for your business, that is mistake number one.

Even if you do not qualify for a bank loan the cost of capital should be your primary concern. Shopping for a loan will give you an idea of how much money costs and how loan payments would impact your cash flow.  If, for example, you intend to borrow $1 million at 6% for 10 years, then the loan will cost you $600,000 and you will need to take $1.6 million out of cash flow to pay it back.

Many people think that venture capitalists will fund their business. That is simply not true. There are actually very few VC funds and they fund very few businesses every year. Some VCs specialize, i.e. they only fund biotech companies. That is great if you are a biotech company and know where to find those VCs with the expertise to evaluate your company. Randomly chasing after VC funds is a waste of time.

The serious money in venture capital is controlled by people who do a lot of analysis and extensive due diligence. Consequently, they like to invest in somewhat larger slices of $10 million or more. If they get 10% of your equity for that amount you are going to have to sell a lot of your product to bring the real value of your company up to the point where they will make a sizeable profit.  Consequently, not many companies will qualify.

The start-up world and especially Silicon Valley are full of stories about start-ups that become unicorns that exceed a $1 billion valuation but they are few and far between. If you are going to swing for the fences, fine. But for most companies this is not an option.

What makes the statement “any good business can get funded” true is the JOBS Act or what most people call equity crowdfunding.  It affords any company the opportunity to sell debt or equity securities directly to investors.

The JOBS Act opened the door for smaller companies to reach investors.  For most companies Reg. D is best because it is the least expensive and it has the largest developed market. Over $1.7 trillion is raised by businesses using Reg. D every year. If you want to raise money for your business, logic would tell you to go where the money is.

The best thing about equity crowdfunding is that the business owner controls the process. You hire an attorney to prepare the legal paperwork for you, prepare the marketing materials, list it on one of many crowdfunding websites and use your marketing program to attract investors.  You do not have to wait for the loan committee at a bank or for a broker/dealer to put you on their calendar. You can usually start raising money in 4-6 weeks from when you start the process.

Despite what you may have heard about crowdfunding campaigns that are not successful, it is really not that difficult if you hire people who know what they are doing.  Business owners call me about crowdfunding all the time. I always ask them the same four questions.

Questions 1 and 2. How much money do you want to raise and what do you intend to do with that money?  If your answer to the second question is that you intend to “disrupt” this industry or that industry, you better be able to demonstrate that you know a lot about that industry and especially about your competitors.

What investors really want to know is that you have a good business plan and that you are raising enough money to execute it.  It is always better to stick with what you know and hire people who know what you do not.  You should be able to show that you are not just building a better mousetrap but that you are building a good, profitable business.

Question 3. What is in it for the investor?  Investors are often disrespected in the crowdfunding universe. This is partially because the crowdfunding platforms compete for issuers and partly because many crowdfunding platforms are operated by people who do not understand what investors want.  In truth all investors want the same thing; they want to end up with more money than they originally invested.

People who are willing to invest in a start-up understand that most start-ups will fail.  It is important to distinguish yourself and convince investors that your company has a better chance to succeed because you have mitigated some of the risk.

Over the years, I have used a variety of financing tools including preferred shares and revenue sharing models to help start-ups manage their cash flow and still make the investment attractive to investors.  No two companies are the same. If you are thinking that you can just download a template for your offering without some real advice about how to structure it, you are not likely to be successful.

Question 4. What is your fundraising budget?  This is what really separates successful fundraising programs from unsuccessful ones.  You should always be prepared to spend a little more than you think you may need.

What is an adequate budget?  Enough to prepare the legal paperwork, marketing materials and to drive enough potential investors to your offering to get it funded. For a Reg. D offering, few companies spend as much a $50,000 unless they are raising $10 million or more.

One of the common mistakes people make is selecting the wrong crowdfunding platform.  Several advertise that they have had 10,000 investors or more but most crowdfunding investors are not loyal to a particular platform. Only a very few platforms are right for any particular offering. You need to make a decision about which platform to use based upon a number of factors including the size of your offering, the industry that you are in and how your offering is structured.

Under the JOBS Act you can make a Reg. D offering on your own website if you wish.  Given the fact that you will be paying for the marketing costs, it may make sense to be on your own platform where there will be no competition from other offerings.

I speak with about a dozen companies every month and I only take on one or two because I do not want to work full time. If I take you on I will walk you through the process and usually get you funded. That goes for companies owned by women and minorities and those located in Toledo or Tallahassee.

Using the JOBS Act any good business can get funded. If you are going to run a business, then you have to get things done and not make excuses. That goes for financing your business as well.

If you cannot fund your business with equity crowdfunding then it is on you not the market. It is actually a lot easier, faster and more certain than chasing venture capital.

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.

 

Why the Panic of 1893 is Relevant Today

Economics , , ,

The difference between studying economics and economic history is simple. In the former you learn how markets work and how to work within markets. In economic history you study all the times that the markets failed to work, including the market crashes, depressions and panics. The latter are far more interesting.

When I was teaching economics I would throw in a discussion of a panic or depression just to keep the students awake.  A good financial panic can get and keep your attention in the same way that motorists will never fail to look at two cars parked along the side of the highway that have been involved in an accident.  The more damage to the cars, the more people just cannot look away.

I frequently discussed the Panic of 1893 because it was at the same time a relatively simple and complex affair.  It was the worst economic disaster in the US up to that time and it came at the end of a period of prosperity and expansion the likes of which the US had not previously seen.

The events that led up to the Panic of 1893 and the measures taken by the government to deal with it are all relevant today.  There was a lot being discussed back then that is still being discussed today.

A lot of people who favor crypto-currencies frequently tell me that our current financial system is flawed and doomed because of the crash in 2008. That our economy survived 1893 and was still around to crash in 2008 is an indication of the market’s resiliency.  The reforms that took  place in the century after 1893 only made the US financial system stronger.

During the period 1870-1890 the railroads opened the west and people moved onto the Great Plains.  Farmers, not the industrialists, were the foundation of the US economy and were apparently too busy farming to have children because the food supply actually grew faster than the population.  Wheat was the primary commodity and whether the farmers understood it or not, the price of wheat was very much determined by a global economy.

US farmers borrowed heavily to finance their own farming operations. As production went up, prices came down and the depressed prices made it difficult for them to pay back the banks that had lent them money.  The same was true of cotton farmers in the South. Cotton was a major cash crop both before and after the Civil War. By 1890 the price became depressed as growers in Egypt and India added more and more tonnage to the world markets.

Since the farmers could not sell their wheat or cotton, there was no need to ship it anywhere and railroad revenues also dried up. The Philadelphia and Reading Railroad went bankrupt as did the several other large railroads. All were big employers and unemployment started to climb.  Part of this was due to the fact that as the railroads had been building more and more track and added to capacity that outgrew their market.

A company called National United Cordage which made rope out of hemp also went bankrupt.  The company had sold bonds to finance its operation and used the money to try to corner the market on hemp.  National Cordage was the most actively traded stock on the New York Stock Exchange at the time until rumors that the company had over extended itself caused the lenders to call the bonds and the company collapsed.

As National Cordage and the railroads went under, the stock market became uneasy and crashed.  Somewhere in the neighborhood of 500 banks closed as did thousands of businesses and farms. Unemployment shot up.  By some counts as many as 50% of the able bodied men who had been working in factories in Ohio were out of work.

In 1890 there was a drought in Argentina which killed off the wheat crop. This should have been good for American farmers but was not, for reasons that few people saw coming.  Years later when there was a similar drought and famine in the Ukraine, Herbert Hoover engineered the purchase of wheat from US farmers and shipped it to Russia. That would have helped the farmers in 1893, but no one apparently had the foresight to come up with this solution until 30 years later.

The Argentinean farmers were largely financed by British and European banks. In order to obtain the investment, the banks in Argentina originally hired Baring Brothers, one of the oldest English merchant banks, to assist them.  When I was giving this lecture to my economics students in 1995-1996, Barings had just been put out of business by a single young trader on its derivatives desk in Singapore who had made huge bets with Baring’s money and lost.

Barings was a little smarter in the 1890s because at the same time it was steering its clients into Argentine bonds, it was also buying US treasury bonds which were backed by gold.  European investors, panicked by the losses in South America, began to cash in the US bonds and demand gold as repayment. Almost immediately the US gold reserves fell to 100 million ounces which, by law, they were not supposed to fall below. The government actually borrowed gold from JP Morgan to make up its deficit.

The US was in the midst of a decade long debate about fiat currency.  At the time, fiat meant anything that was not gold or convertible into gold. The primary alternative was silver and many economists disregarded it out of hand simply because it was not gold.  You can only imagine how an economist from in the 1890s would feel about Bitcoins as an alternative currency today.

In 1890 the Congress had passed the Sherman Silver Purchase Act which required the US to purchase silver from mines in Western states. The idea was to deflate that value of US currency so that farmers could re-pay banks with currency that was worth less than it was when they borrowed it.

This encouraged silver mining and an over-supply of silver which helped to reduce the price of silver in the marketplace. It actually got to the point where a $1 Morgan silver coin had only about $.60 worth of silver in it.

The Silver Purchase Act was passed in conjunction with the McKinley Tariff, a very protectionist law that caused taxes on imports to rise dramatically and prices on many common goods to increase.  Certain protected industries such as wool and tin plates did well but overall prices went up for ordinary consumers.

At the time tariffs were the primary source of tax revenue for the US Government because the income tax had not yet been enacted. Tariffs were taxes that impacted small people buying common goods and aided the rich industrialists whose businesses were protected.

One of the interesting things about the Panic of 1893 is that it happened very quickly.  The railroads filed for bankruptcy, the banks closed and the stock market crashed all in a period of about 10 weeks. It led to several years of a deep depression.

Just prior to the 1893 collapse there had been a growing Populist movement that supported an agrarian economy and chastised Eastern elites, banks, railroad interests and gold. The Panic should have helped their cause, but did not. The Populists won 5 states in the Presidential election of 1892 and 9 seats in the House of Representatives in 1894 but had largely faded away by the end of the decade.

Not much in the way of reforms came out of this Panic but it was not the last. The Federal Reserve Act followed the Panic of 1907 when a few hundred more banks failed and securities market regulation and the FDIC originated after the stock market crash in 1929.

What I personally find interesting is that the issues present in 1893, globalization of finance and trade, the over-extension of credit, over supply of commodities and services, droughts, tariffs and protectionism, fiat currency, railroads and transportation, Populism and regional politics and even hemp are still in the headlines and issues surrounding them still on the table.

The overriding lesson is that finance is about trust and value.  It took 100 years after this Panic and several subsequent panics until the phrase “irrational exuberance” entered the economic lexicon but that phrase only explained what we should already have known.  The best lesson of 1893: “Do not build what you cannot use. Do not borrow what you cannot re-pay”.

 

Cannabis and Crypto-Currency-The Blind Leading the Blind

Capital Markets, Investors, Issuers , , ,

A few weeks back I wrote a blog article where I stated that I was not interested in preparing the legal paperwork for any company that was raising funds for a cannabis related company. In the same article I said that I would also decline the opportunity to prepare the paperwork for an initial coin offering (ICO).  Either would be lucrative for me but in both cases I saw significant problems for the investors.

I might have predicted that people would start sending me the paperwork for ICOs that were looking to fund cannabis businesses seeking my thoughts and comments. Two stick out as examples of how not to raise money for your cannabis business.

In July, the US Securities and Exchange Commission (SEC) issued a report on ICOs. Crypto-currency is all the rage this year with some offerings raising millions of dollars in a matter of minutes and coins when issued quickly appreciating in price. Bitcoins for example have been appreciated significantly this year and some people think that Bitcoins are a legitimate investment, an assertion that is questionable at best.

The SEC correctly concluded that most crypto-currency offerings would fall within the definition of a security and thus its jurisdiction.  There was really no surprise as the SEC initiated about a dozen enforcement actions against crypto-currency issuers before it wrote its report.

Because an ICO is the offering of securities it is required by law to either 1) register with the SEC or 2) be exempt from registration assuming that an exemption is available. In either case, the issuer of the coins is required to give potential investors all the facts that would be material to making an investment decision.

If investors who purchased the coins got a discount on an ounce or two of marijuana the coins might not be securities. These two cannabis ICO offerings are clearly offering securities.  In both of these cases, investors profit if the underlying business profits which is more than enough for these to be securities and the SEC to have jurisdiction.

There are some facts which the SEC and any securities lawyer would consider to be material. This would include who is running the company; how much money is being raised and what will it be used for; the basic structure of the company’s ownership; how investors get paid and how much they might expect; an idea of the size of the market in which the company intends to compete and the names of the companies that are its major competitors.

Nothing really earth shattering,but the SEC has been reviewing offerings and ruling on how these facts are disclosed for decades. Making the disclosures correctly requires a fairly good idea of what the SEC expects and an equally good idea of the operation of the business offering the securities which is why securities lawyers who prepare offerings really have to know what we are doing.

The first cannabis ICO I looked at was for a company called Growers International.  Like all ICOs it uses a “White Paper” (which it prefers to call a “Green Paper”) instead of a traditional prospectus.  I doubt that it was prepared by a securities attorney. (I would suggest that you might add the words “Like, cool” or Yeah, man” between the sentences and it would read like the script of an old Cheech and Chong movie but I do not want to insult Cheech or Chong.)

From the Green Paper: “Q: Why should I trust the team? How do I know this isn’t a Pump & Dump situation?  A: We ask that all investors do their research on the people behind Growers International. Our lead developer has found success in both the cryptocurrency arena as well as in the cannabis industry. If there is any question regarding the legitimacy of the project, we encourage investors to reach out to Ryan (Lead Dev) personally on slack.”

It is always a good idea to research the people who are running any company into which you are making an investment.  In this case the “Green Paper” discloses the management to be: “Lead Developer: Ryan Wright (34, California / Taipei); Blockchain Programmer: Eddie E. (48, New Zealand); Web / API Developer: Michael J. (32, Maidenhead, England); Social Media Director: Devvie @Devnullius (40, Sweden); Community Coordinator: Jeremy Toman @MadHatt (37, Canada) who prefers the name ‘Tyler Dirden’ or ‘MadHatt’;Graphic Designer & Cryptocurrency Consultant: Chris S. @Elypse (26, Detroit); Community Manager: @DayVidd and Bitcointalk Manager & Financial Consultant: Dr. Charles @drcharles (26, USA).”

I suspect that if you contact Mr.Wright as suggested he will vouch for them all if he bothered to ask their last names. Do not bother to ask about Members of the Board of Directors as they have apparently not yet been appointed, so one Director might turn out to be Pablo@Escobar.

The other cannabis related ICO I reviewed is prepared more professionally but still, in my opinion, misses the mark by a good country mile. The company is called Paragon Coin, Inc. It is in the process of raising $100 million through the ICO. Just to be clear Paragon supports the cannabis industry, it does not appear that it intends to grow or distribute cannabis itself.

Paragon intends to bring block chain to the cannabis industry.  It intends to use a distributed ledger to bring order to this fragmented industry. According to the White Paper the company intends to “offer payment for industry related services and supplies through ParagonCoin; establish niche co-working spaces via ParagonSpace; organize and unite global legalization efforts through ParagonOnline; bring standardization of licensing, lab testing, transactions, supply chain and ID verification through apps built in ParagonAccelerator.”

All that is fair enough and the names and pictures of the operating personnel are included. Their education and work histories going back 10 years which I would have expected to see are not present.

The White Paper clearly notes that cannabis is not legal at the federal level and asserts that it will only operate in states where it is legal. This is the prime oxymoron of the cannabis industry.  Illegal at the federal level is illegal everywhere. Marijuana is a Schedule I drug and possession or sale is a felony in all 50 states. That is a fact about which that the cannabis industry does not want to think and largely ignores.

The Paragon White Paper describes one of the Risks of investing in its coin offering as follows:

CERTAIN ACTIVITIES INVOLVING MARIJUANA REMAIN ILLEGAL UNDER US FEDERAL

LAWS. SUCH ACTIVITIES INCLUDE BUT ARE NOT LIMITED TO: (A) DISTRIBUTION OF MARIJUANA TO MINORS, (B) TRANSPORTING MARIJUANA FROM STATES WHERE IT IS LEGAL TO OTHER STATES, (C) DRUGGED DRIVING AND OTHER ADVERSE PUBLIC HEALTH CONSEQUENCES, (D) GROWING MARIJUANA ON PUBLIC LANDS, (E) MARIJUANA POSSESSION OR USE ON FEDERAL PROPERTY, AND

(F) OTHER CRIMINAL ACTIVITY OR VIOLENCE ASSOCIATED WITH THE SALE OF MARIJUANA. TO THE EXTENT THE COMPANY AND/OR PARAGON COIN, INC. MAY NOT PREVENT CERTAIN OF ITS USERS FROM USING PRG TOKENS IN VIOLATION OF US FEDERAL LAW, IT MAY SUBJECT THE COMPANY AND/OR PARAGON COIN, INC. TO CIVIL AND/OR CRIMINAL LIABILITY AND THE UTILITY, LIQUIDITY, AND/OR TRADING PRICE OF PRG TOKENS WILL BE ADVERSELY AFFECTED OR PRG TOKENS MAY CEASE TO BE TRADED.

This derives verbatim from the Cole Memorandum which was written in 2013 as a direction from the US Department of Justice to Federal prosecutors as to how they should allocate their resources when they decide who to prosecute and for what. It never made cannabis legal anywhere.

More importantly, the Cole Memo it is not an Act of Congress or Federal regulation and not binding on the current administration in any way. Any suggestion that it will continue to be followed under the current administration is wishful thinking given the Attorney General has repeatedly stated that it will not.

Medical marijuana has been legal in California for more than a decade. That did not stop the federal government from raiding and closing down a large medical dispensary in Oakland, CA in 2012. Parenthetically, Paragon’s initial co-working space is slated to open in Oakland, California.

Perhaps the most troubling aspect of this offering is that it intends to fund the use of block chain, a relatively unsecure distributed ledger to link the many growers and suppliers in the cannabis industry. If successful it may well deal a serious blow to the cannabis industry it is trying to support.

One of the leading ICO platforms, Coinbase, has been engaged in a two year battle with the Internal Revenue Service which wants a list of all the people who use its platform to trade Bitcoins. The IRS alleges that people are trading the coins profitably and not reporting the gains and paying the taxes. The US government has also alleged that drug cartels and other bad actors use crypto-currency to launder money.

If you are in the cannabis industry you have certainly heard stories of how the DEA would obtain the customer lists of hardware stores that sold supplies for hydroponic growing. Everyone who was a customer did not use these supplies to grow cannabis but the government used those lists to identify and prosecute people who did.

If you have a “decentralized” list of a large group of people who are on the list only because they are affirmatively in the cannabis business as Paragon wants to create, how long do you think it will take for the US Government to obtain it? Think that will be difficult because Paragon never touches any marijuana or sells it?

The CEO of Paragon, Jessica VerSteeg, is also CEO of AuBox which the White Paper describes as “an upscale marijuana delivery service in the SF Bay area”. That is more than enough “probable cause”for the DOJ to get its hands on Paragon’s distributed ledger and the names of every company that uses it. The icing on the cake will be when they tell the judge that the cannabis industry is full of drug cartels and money launders which, of course, it is.

When you write the risk factors for a securities offering, it is important to disclose all of the things that might reasonably occur.  Assuming that this ICO raises the $100 million that it seeks, it is certainly within the realm of possibility that the Attorney General might just seize that money under the federal asset forfeiture provisions. The people behind this offering somehow refuse to accept that there was an election last November and that there is a new sheriff in town.

What I took away from these two offerings was a sense that they were prepared by amateurs who were attempting to do something that was way over their head. In this current administration, raising money for a cannabis company waves a red flag in front of the US government. Compounding that fact by raising money through an ICO just increases the size of that red flag, exponentially.

I personally do not think that there is any hope for Green International but Paragon did not demonstrate that it needed $100 million and could have certainly raised a lesser, more reasonable amount in a more traditional fashion which is what I would have advised them to do if they had asked me.

 

 

Is Technology Changing Finance?

Capital Markets, Economics , , , , , , ,

A lot of people seem to believe that technology will fundamentally change or disrupt finance and the financial markets.  Many, if not most, of those people seem to be developing technology, selling it or using it to sell products to investors and financial consumers.  Most of these people seem to have degrees or backgrounds in technology not finance.

Having a background in technology does not give you an understanding of finance or the financial markets.  You cannot fix or disrupt what you do not understand and the lack of understanding behind many of these products is simply ridiculous.

I only write about the law and the financial markets. I spent my career as an attorney working in and around the financial markets. I also taught Economics and Finance so I have a pretty well rounded idea about how the capital markets work and how they are evolving.

So I feel perfectly justified to call out the many techies who think they understand the financial markets even though they have never worked in the markets or studied finance. Nonetheless many seem hell-bent to create products that they think are making these markets better and are quick to label the products that they sell as “disruptive”.

I call these people the “algorithms fix everything” crowd.  It is an interesting thought, except that these mathematicians have no math to back up much of what they say about finance.

At the same time, there is an ongoing narrative that suggests that everyone who works in the financial markets is evil. I find it amazing how many people actually think that all bankers and stock brokers get up in the morning thinking “who can I screw today?”  I have personally brought more than 1000 claims on behalf of aggrieved investors against Wall Street firms and written a book about some of the really bad things that Wall Street firms can do, but even I know that Wall Street firms are not evil.

The capital markets handle millions of transactions every day involving trillions of dollars and the almost all of those transactions settle with both the buyer and seller happy. Banks and stockbrokers fund schools, universities, roads and hospitals and virtually every company since WWII, again without serious problems or complaints from anyone. Banks aggregate and intermediate capital and over all they do it quite well.  So what, exactly, needs disrupting?

Still there is a never ending stream of new products and services which claim to be revolutionary and which promise to disrupt the capital markets. On closer examination many of these innovations are more hype than substance. Say what you will, there is nothing disruptive here.  A few examples for your consideration:

1) Algorithmic stock trading – This is a good place to start because it is pure technology applied to the existing markets. “Quant” traders use computers to evaluate trends and trading patterns in the market of various securities. They attempt to anticipate the price at which the next trade or subsequent trades will occur.  Logic says that computers should be able to take in more information that is pertinent to stock trading, analyze it almost instantaneously and execute transactions in micro seconds.

It sounds right, but the reality is that all stock trading is binary; every buyer requires a seller. No one buys a stock unless they believe that the price will appreciate; sellers generally will only sell shares when they think the price will appreciate no further. Both sides to any trade cannot be correct.

Analyzing the information or executing faster is of no use unless each trade you make is profitable.  No one has yet figured out how to accomplish that, nor are they likely to do so.  What we are talking about is predicting the future which is difficult to do even if only a micro-second or two ahead.   And please do not suggest that artificial intelligence will change this.  If there is one right answer based on the current information, e.g. buy APPL, then who is going to sell it?

2) Robo investment advisors- These are similar but much less sophisticated. Robo-advisors do not actually attempt to anticipate future market performance. They make investment recommendations based solely on the past performance of the markets. Anyone who has ever bought a mutual fund is required by law to be told that past performance is not a basis for future results. But that is all you get with a robo-advisor.

FINRA did a study of a half dozen robo investment platforms and found that they provided widely divergent portfolios for the same types of investors. No robo is any better than any other and none is really worth anything.

3) Crypto currency- It was a discussion about Bitcoins that was the initial impetus for this article. Aficionados of crypto currency actually think that they are developing an alternative currency for an alternative financial system. People seem to want to just print their own money and on one level I can understand that.  But that level is more of a fantasy than reality.

The reality is that I can buy food or virtually anything else in most places in the world with US currency. Why do we need Bitcoins? What exactly, is their utility?   When I ask that question I get any number of weak responses. More often than not, I get a tirade about banks and/or governments being evil.

What proponents of crypto currencies never want to face is the fact that the crypto currency market has been full of people laundering money from illegal activities.  The banks that crypto currency fans love to hate are required by law to know their customers and have systems in place to prevent money laundering.  It costs money to follow the law and have those systems. It is money that the crypto currency platforms do not want to spend. If there is a common thread in the crypto currency world, it is that people want to skirt or simply ignore the regulations that keep the markets safe and functioning.

4)  Crowdfunding Platforms- Crowdfunding clearly works and works well as evidenced by the significant amount of money that it has raised for real estate and real estate development projects.  At the same time the crowdfunding industry is populated by a great many people who fall into the “I do not care what the rules say, I am in this to make a buck” crowd.  I have written several articles about how some of the crowdfunding platforms do not take the time to properly verify the facts that they give to potential investors.  Due diligence can be expensive and some of the platforms just refuse to spend what it takes to do it correctly.

Crowdfunding replaces the role that stockbrokers typically fulfill in the process of raising capital with a website and do it yourself approach.  With a stockbroker, the company that was seeking capital got that money the vast majority of the time because the brokers were incentivized to sell the shares. With crowdfunding it is very much hit or miss whether the company will get funded. Many of the better crowdfunding platforms charge close to what a brokerage firm would charge and the investors get none of the protections or insurance that they would get with a stockbroker.

5) FinTech and FinApps – I can go to my bank’s website and send a payment to my electric utility company. I can do the same at the utility company’s website. I admit that it is convenient, but it is hardly disruptive.   Remittance companies like PayPal merely move money from my bank to a vendor’s bank.  And PayPal posted a $3 billion profit in the last fiscal quarter.  So they may charge less of a fee per transaction than a bank, but is not essentially different, and again while PayPal holds my money, I get no insurance against hacking or theft.

Apps that allow me to apply for a mortgage on my phone are really doing no more than eliminating a bank employee who would enter the same information from a written application into the bank’s computer. Again, it is convenient but not necessary.  And the money for the mortgage comes from either a bank or stock brokerage firm so there is nothing disruptive here, either.

Is there nothing truly new and disruptive in finance? Of course there is. They deservedly gave the 2006 Nobel Prize in Economics to Muhammad Yunus for developing a system of micro-finance that continues to create millions of entrepreneurs and lift millions more out of poverty. I doubt that one line of computer code was needed.

Micro-finance has the ability to put globalization on steroids.  Who will be disrupted?  Quite of few people with big school pedigrees and enormous student debt who write code to disrupt finance but who never understood finance in the first place.to

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

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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.