Capital Markets

Satoshi was a Copycat and Maybe a Criminal

Capital Markets, Investors, Technology ,
Satoshi was a Copycat

When I started looking at bitcoins and cryptocurrency in 2015 I was already 65 years old.  Many of the early adopters and proponents of bitcoins were in their 20s and 30s.  Even today most BTC enthusiasts are shocked when I tell them that there was a popular digital currency a decade before Satoshi wrote his famous paper.

In 1999, at the tail end of the dotcom era, two aspiring entrepreneurs named Spencer Waxman and Robert Levitan launched a digital currency called flooz through their website called Flooz.com.  They promised that flooz would disrupt the new online retail industry and become the preferred medium of exchange for shoppers and merchants worldwide.

Flooz was backed by a lot of VC investors to the tune of $35 million. It had a celebrity spokesperson, Whoopi Goldberg, who appeared in radio and TV ads and in newspapers and magazines. Her face adorned the sides of NY transit buses, hawking flooz as the future of currency. Does any of this sound familiar?

A significant number of retail customers loved the whole idea. More than 125,000 new accounts were opened in the first 90 days.  In the first 12 months, roughly $25 million in flooz currency was purchased and used.

Flooz customers would sign up to Flooz.com. They would purchase flooz certificates for specific retailers, which they could then use themselves or pass along to a gift recipient via email. Because the flooz certificates did not fluctuate in value no one ever thought that these were securities or that they needed to be regulated in any way.

This helped the retailers build traffic in the new internet marketplace and a variety of names you would know signed up. You could buy chocolates from Godiva, cookies from Mrs. Fields, and clothing from J. Crew. Tower Records, Barnes and Noble and Starbucks signed on. You could buy Swiss Army knives, all kinds of delicacies to eat, and cigars to smoke.

There was an expanding group of retailers and continuing adoption by a fast-growing customer base. Notwithstanding the company filed for bankruptcy and went out of business within 2 years.

Business school students spend hours poring over the case studies of businesses that succeed and an equal time studying businesses that failed. The dot-com era gave us plenty of both.

The dot-com era, for those of you who were not there, was a heady time when arrogant VCs tried to put lipstick on every pig of a company that came along as long as the company’s business plan included the “internet”. If you replace the word “Internet” in that last sentence” with “blockchain” or “crypto” the similarities to what is occurring in the marketplace today will become obvious.

One of the great failures of the dotcom era was a company called Pets.com.  Its business model, selling pet food and pet supplies directly to consumers made a lot of common sense. Consumers spend a lot of money in this market every year. People who purchase pet food are usually repeating customers, month to month.  

There is also the fact that home delivery of a 20lb. bag of dog food made a lot of sense to people who were loading them into and out of the trunk of their cars every month.  Capped off by the fact that Pets.com actually charged less than most brick-and-mortar pet supply stores, this one had all the makings of a winner.

There were several VCs invested in this. One of the early investors was Amazon.com.  Amazon was still selling mostly books at that time. Pets.com sold far fewer distinct products. Amazon felt that with fewer products to sell, it could lend Pets.com logistical support.

Like Flooz, Pets.com had a large advertising budget and a celebrity spokesperson, in this case, a canine sock puppet. The spokes-puppet was everywhere, on the Today Show, the Tonight Show, and at Macy’s Thanksgiving Day Parade. There was even a Superbowl ad.

The company went public in February 2000 raising more than $80 million. The venture funds made a profit but the investors in the IPO lost big.  Nine months later, Pets.com closed its doors and liquidated.

The problem was that Pets.com never made a profit. It hemorrhaged money both before and after the IPO.  Its low prices, coupled with the fact that it absorbed shipping costs on those big bags of dog food and the fact that it spent a lot on its advertising campaign, meant that the company lost money on every order.

Why would an underwriter take a company public if it was losing money?  Why would the underwriter price the offering at $11 per share when that valuation was a fantasy? That is the question no one asked at the time. 

The answer was that the VCs and the underwriters were in bed together. Each IPO made a lot of money for both.  It was actually a con game. VCs invest in each other’s portfolio companies, bumping up the valuations with each round, hoping for an IPO to dump the grossly over-valued shares on the public.

Historically, at least since Ben Graham, earnings were the metric by which a stock’s price was judged. That began to change in the 1980s junk bond era.

Junk bonds were issued by companies that lacked the cash flow to make interest payments on bonds with lower interest rates. They promised that the infusion of cash would spur their growth to the point that they could make higher interest payments. Very few actually did. 

Carry that forward 10 years when research analysts at the big Wall Street firms underwriting the dotcom stocks started to value growth over income. They claimed that the new internet era required new metrics.

I asked many of the analysts, including several I cross-examined under oath if they had ever seen the idea that growth should supplant earnings as a metric in the valuation of a company in a peer-reviewed journal. I never got an affirmative answer, nor would I have expected to get one.

Then, as now VCs are self-serving con artists. The valuations they spit out mislead investors and are part and parcel of a scheme to defraud them.

Venture capital is a marginal activity in the capital markets. In many ways, the JOBS Act has made what they do obsolete.  Raising seed or growth capital has never been easier or less expensive. Unfortunately many people in the Reg. CF space have adopted the VC pricing model and mislead even the smallest, most inexperienced investors.  

There is one more thing about flooz. Before it closed its doors Flooz.com it was notified by the FBI that as many as one in five of its gift cards had been purchased by Russian mobsters using them to launder money. The same is clearly true about bitcoins.

My early investigations into BTC in 2016 produced reports of Australian law enforcement officers seizing $12 million in BTC from a human trafficking ring. That was followed by several thousand ICO offerings that raised multiple billions of dollars from unsuspecting investors and just disappeared.

Flooz was a template for the crypto crimes that are running today up to and including FTX.  People who tell me that I don’t understand crypto as the future of currency and finance never mention flooz. As far as the future of crypto as a currency is concerned, if you don’t know flooz, you don’t know squat.

The crypto con game follows the flooz game plan right down to the Superbowl ads and celebrity endorsements. The end game is the same, dump crypto onto small, uninformed investors.

I will continue to blow my whistle at Fidelity Investments which is trying to legitimatize BTC for retirement accounts. I have read the research reports that support that recommendation. They would make the worst of the dotcom era analysts blush. Fidelity was still claiming BTC is a superb store of value after the price dropped from $60 to $16.

Fidelity isn’t buying and then selling BTC to make a legitimate spread. They have been mining BTC since at least 2014.  They have a minimal cost basis on each bitcoin that they are selling at $20,000 each.

Markets run in cycles. There was a tech boom and bust in the 1960s that coincided with our race to the moon.  There were companies back then raising capital for the next shiny new tech products.

There were certainly scams and certainly victims of those scams. But nothing that had the power and reach of the internet and social media to falsely pump up valuations and make a lot of people believe them.

Perhaps the biggest red flag is Satoshi himself. There are people who worship at his feet. There are people who call him a modest genius who shuns the limelight. They refer to Satoshi as someone who changed capitalism forever.

Will Satoshi come out of the shadows if he gets a Nobel Prize for his achievement? Will he fly to Stockholm and humbly thank his mother for pushing him to study and his mentors for inspiring him to think?

Personally, I think Satoshi is a construct of Russian oligarchs who created a system to launder their money and a narrative to legitimize it. Satoshi’s paper came about only 8 years after Flooz.com shut down.

Am I being too cynical?

Actually, I am just following the money. Un-named “whales” dominate the market bitcoin trading market. It is certainly plausible that bitcoins were created by mobsters as a way to launder their money and not the other way around.

Besides, I would rather think of Satoshi as an international criminal than a shy, misguided genius.

It’s the romantic in me. 

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

Or you can book a time to talk with me HERE

Where Do You Go When The Bank Says No?

Capital Markets, equity crowdfunding, Issuers , ,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Or you can book a time to talk with me HERE

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

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

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

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

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

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

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

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

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

Dog and Pony

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Scratch My Back

Can you say “scratch my back”?

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

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

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

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

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

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

Or you can book a time to talk with me HERE

Lights. Camera. Bubkes.

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

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

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

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

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

Oh, well. That’s show biz.  

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

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

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

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

Where did Going Public go wrong?

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

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

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

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

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

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

What do investors get?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Or you can book a time to talk with me HERE

Republic’s Restaurant Razzle Dazzle

Capital Markets, crowdfunding, equity crowdfunding, Issuers , ,
Republic’s Restaurant Razzle

A pizza restaurant in Houston filed for bankruptcy last week. While that might get a yawn from people who think that 90% of restaurants fail anyway, there is a story here that is a little different; one centered on its crowdfunding campaign.  

There is a world-renowned cooking school in San Francisco, the California Culinary Academy (CCA). It offers professional chefs a semester-long course in restaurant management. It includes how to price menu items, how to sell the menu items that produce a higher margin (typically appetizers and desserts), how and where to advertise, and items of “kitchen economics”. The latter includes how to select and deal with vendors and manage multiple chefs in a kitchen.   

There are established formulas regarding the ratio of food/beverage sales that guide restaurants to greater profitability. There are myriad case studies reviewing both successful restaurants and failures available for review.   

Pizza restaurants are used as a basic example of a simple and profitable restaurant operation. I offered the same breakdown of a pizza restaurant to my students when I was teaching Economics to business school students. It is a simple demonstration of superior efficiency and profitability. 

The owner of a pizza restaurant can stop by the market in the AM and pick up everything needed to make enough pizzas for one day’s business.  Your one-day inventory will be turned back to cash by the end of the day.

Very few businesses offer the opportunity to profit from that type of high-speed inventory turnover.  Too much Inventory in the freezer can impact a restaurant’s cash flow. 

Selling pizza and beer together is almost always a winning combination.  A $30 check for a large pizza and a pitcher of beer might cost the restaurant less than $5.00-$7.00 in ingredients, a very high mark-up, combined with the very high turnover. 

The Houston pizza restaurant that filed for bankruptcy was called Shoot the Moon. It opened in the middle of the pandemic which clearly increased the difficulty of filling the seats. But that is not what killed it.

NextSeed

The crowdfunding campaign for Shoot the Moon, and several other Houston-based restaurants, was hosted on a crowdfunding portal called NextSeed. NextSeed is now part of Republic, one of the largest crowdfunding portals.  

Shoot the Moon was trying to raise $535,000 to finish construction of its restaurant, purchase equipment and train its staff.  The offering was structured to give investors 10% of the revenue, that is, $1 for every $10 that rang through the cash register.

This type of revenue-sharing agreement is common in crowdfunding. NextSeed used it over and over to fund other restaurants. With proper marketing, Shoot the Moon’s offering might have sold out quickly.

Instead, the offering initially stalled at $140,000. According to the owner of Shoot the Moon, NextSeed suggested that he offer “perks” such as free beer to investors as an inducement to invest. NextSeed had used this same gimmick to help at least one other tap room in Houston raise capital.

The owner of Shoot the Moon apparently told NextSeed that he thought that he was not allowed to offer free beer because it was illegal. NextSeed advised him to offer free pizza instead.

Let me stop the narrative at this point. If one Houston restaurant that is selling food and beer can accept NextSeed’s advice and give away free beer and another selling food and beer thinks that it cannot, it should certainly raise a red flag that one or the other is incorrect.

Mr Chu

One of NextSeed’s founders, Mr. Abraham Chu, has an MBA from a very fine business school. I would think that something like this might have gotten his attention and the correct answer ascertained. 

Put aside for a moment the fact that no business school teaches that modern finance requires that you should give investors “perks” in order to raise capital. Business schools still teach that investors seek ROI more than anything else. The owner of Shoot the Moon says that supplying all the free perks that NextSeed advised him to offer negatively impacted his working capital.

The perks were enough to increase the total amount raised to $410,000. The owner of Shoot the Moon has said it paid a total of $80,000 to raise $410,000 which is more than a Wall Street firm would have charged to raise the same amount as a private placement. Wall Street firms don’t require issuers to give away free beer or pizza.

The raise netted Shoot the Moon closer to $330,000. The offering was clear that it was trying to raise $535,000, the amount it said it would need to get its business off the ground. That too should have been a pretty big red flag, which NextSeed ignored as it permitted the offering to close and took its fee. 

Shoot the Moon did open its doors and it made sales, 10% of which should have been paid to the investors. Its owner acknowledges that the payments were due from day one, but that he has not been able to make them.

NextSeed, for its part, interposed itself between the restaurant and the investors as the “collateral agent” for the transaction. I haven’t reviewed the exact paperwork, but it does raise some questions why the portal thought that it needed to do so. 

It seems that the only “collateral” supporting the offering from which investors might recoup their investment if the restaurant fails, would be the used restaurant equipment, some of which might be sold at $.10 on a dollar; the rest simply discarded. Calling it “collateral” is somewhat misleading.

It is clear that NextSeed was supposed to monitor the payments and notify the investors if there was a default. NextSeed was clearly aware of the default at Shoot the Moon and at other restaurants it had helped to fund but decided not to notify investors or declare a default. 

Mr. Chu has been quoted as saying that NextSeed’s policy regarding defaults was changed several times after offerings had closed.  Republic, which purchased NextSeed in 2020, apparently thought this was a good idea because it did not begin to send out notices of the defaults until April of this year.

In the real world, if you can negotiate the deferral of a payment that has come due, there is usually a penalty to be paid. I have seen nothing to indicate that NextSeed/Republic negotiated any additional payments to the investors to compensate them while waiting for their payments. Had there been a formal contract providing for a deferral of payment by each of the restaurants, they might not be in default today, and Shoot the Moon might not be in bankruptcy. 

Two things stood out to me.

First, If Shoot the Moon had an initial capital requirement of $535,000 but settled for $410,000 the first question should be: “what got cut from the budget?”  In all likelihood whatever got cut from the budget increased the risks of failure of the venture.

One item that was apparently absent from the budget was any cash reserve.  Even if Shoot the Moon sales were $10,000 in its first week of operation, it could not spare $1000 to pay investors.  Because the smaller raise probably added to the risk of failure, Shoot the Moon might have been better advised to up the ROI rather than provide free pizza to attract investors. 

Second, was the question of whether it was legal to give away free beer in support of the offerings.  Confronted with that assertion that it was not, NextSeed did not say that it was legal, or even, “let us check with our lawyers” but rather advised that the restaurant give away pizza instead, which was much more costly. 

NextSeed has clearly advised other restaurants that free beer was okay.  Did NextSeed’s failure to help Shoot the Moon understand that free beer was permissible to torpedo its opportunity to raise more money? Should NextSeed have told Shoot the Moon that there were less expensive ways to attract investors?

Crowdfunding

Let me repeat something that I have been saying for quite a while now: every well-run crowdfunding campaign should be able to raise 100% of the funds it seeks, 100% of the time.  The idea that a company should offer free beer, pizza, or other perks in order to have a successful campaign is simply false.

NextSeed apparently gave that very bad marketing advice to a number of companies. I wonder how many companies spent their money foolishly following the advice and who now wish that they had never engaged in these expensive, unnecessary promotions.

Republic has positioned itself between the restaurants and the investors. Does Republic intend to act as the investors’ champion or is this just damage control on Republic’s part?

If investors begin to question Republic’s financial responsibility for the very bad advice that NextSeed gave, again and again, they are likely to get stone-walled.  With reports that investors in NextSeed offerings may have already lost $2.4 million, I suspect that Republic will tell those investors to go cry in their beer. 

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

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Fidelity’s Folly- Part II

Capital Markets , ,
bitcoin

I stopped writing about Bitcoin (BTC) in October 2020 because by then most people realized that, as an investment, BTC is foolish at best. My last article on the subject was about Fidelity Investments which was an outlier because it was a cheerleader for cryptocurrency.

At that time Fidelity was proposing to allow its brokerage customers to keep their BTC in Fidelity’s custodial “vault” and see their holdings valued on their Fidelity statement.  I suggested then that by just taking custody of its customers’ BTC, Fidelity might be considered a “facilitator” of its purchase.  Adding crypto holdings to the statement of mainstream investments might give people the idea that BTC is a mainstream investment, which it is not. 

Predictions

By October 2020 most of the predictions made by BTC self-styled experts in 2016-2018 had failed to come to pass. Banks had not been disrupted.  The US dollar and other fiat currencies were still accepted virtually everywhere. There was not a BTC ATM on every street corner.  No real change in the world banking system was on the horizon. Much of the hype in 2020 came from the same people who had been hyping BTC since 2016 and earlier.

My article was in response to a report published by Fidelity’s Director of Research that suggested that BTC was a “potentially useful” asset for “uncorrelated return-seeking investors”. The report said that “in a world where benchmark interest rates globally are near, at, or below zero, the opportunity cost of not allocating to bitcoin is higher.”   

Stock brokerage firms that merely execute their customers’ orders to buy and sell owe very little duty toward those customers. They are expected to handle the execution and bookkeeping by industry rules and practice, but little more.  Consequently, these “discount” brokerage firms have little liability if a customer loses money because they invested incorrectly. 

The report from Fidelity’s Director of Research in 2020 further suggested that bitcoin’s market capitalization “is a drop in the bucket compared with markets bitcoin could disrupt.” As I noted at the time, that report certainly sounded to me like a “buy” recommendation for BTC.

When a stock brokerage firm issues a recommendation more rules come into play. There must be a “reasonable basis” underlying the recommendation.  The rules governing research reports require more than a crystal ball look into the future.

Get Rich Quick?

Then as now, there is no real data about BTC for anyone to research. You cannot analyze BTC in any traditional way. They are merely a few lines of computer code, generated by a computer.  You can plug in and get rich but that is not going to disrupt the global banking system. 

Fidelity’s Director of Research based his recommendation to buy BTC, not on facts, data, or any traditional analysis, but rather on his speculation that BTC would result in a titanic disruption in the global financial system.  And that is what BTC is, not an investment but speculation. 

That fact is important because last week Fidelity announced that beginning mid-year it will permit financial advisors managing 401(k) retirement plans to invest in BTC as well.  Fidelity has about 23,000 of these advisors on its platform. If only 10% of those purchase BTC in the amount of 10% of the funds they are managing, the price of BTC is likely to sky-rocket.

Congress created 401(k) plans under the Employee Retirement Income Security Act of 1974 (ERISA).  Managers of ERISA plans are held to a fiduciary standard and are expected to invest the funds entrusted to them as a “prudent” person would. No one considers speculation in a retirement account to be “prudent”.

DOL Says NO

Congress assigned regulation of these retirement plans to the Department of Labor (DOL). There are about 800,000 different private pension plans in the US covering about 140 million people. Total assets held by these plans exceed $10 trillion, so it is pretty easy to understand that this is a big business. 

Fidelity has been planning this move for some time. It has been inching up to accepting crypto in 401(k) accounts for at least 2 years.  What is interesting here is that just about one month before its announcement, the DOL essentially told Fidelity, and all ERISA account advisors, not to purchase crypto in 401(k) accounts.

On March 10, the DOL issued Compliance Assistance Release No. 2022-01(CAR) on the subject of “401(k) Plan Investments in “Cryptocurrencies”.  The DOL is aware that firms were marketing investments in cryptocurrencies to 401(k) plans as potential investment options for plan participants.  The CAR lays out the DOL’s reasoning why cryptocurrencies do not belong in retirement plans.

The first reason the CAR lists is because an investment in cryptocurrencies is highly speculative. Highly speculative investments are never prudent for a 401(k) retirement plan.

No one asked Fidelity to respond to the CAR, but they did.  In this case, we get a rare glimpse of Fidelity’s rationale supporting this bold move to offer BTC to ERISA accounts and account managers. 

While Fidelity says that it understands that the CAR “effectively deems the selection of cryptocurrencies for investment in a 401(k) plan to be imprudent” it suggests that the DOL can’t possibly mean ALL cryptocurrencies. Fidelity suggests further study and guidance for the DOL as to which cryptos may be OK for 401(k) plans and which are not.

Notwithstanding its request for more clarity and its request that the CAR is withdrawn, Fidelity’s response can only be read as an admission that it understands the DOL means that crypto of any kind does not belong in a 401(k) or any retirement plan.

Fidelity also argues that it is not specifically designating BTC or any crypto as investments that they are offering to these plans. If a plan manager wants to add some BTC to the portfolio, Fidelity will guide the manager to a different landing page, where the purchase will be made through a different Fidelity company, not the ERISA plan funnel.

That argument is unlikely to hold water as what the DOL was complaining about in the first place, was people marketing crypto to these retirement plans. However Fidelity books these trades, it is still Fidelity’s cheer-leading for BTC that is causing those trades to occur.

To be clear, even though the primary regulator of these 401(k) plans has said no, Fidelity has gone ahead and decided that it will facilitate the purchase of BTC in these accounts. The lawyers and compliance officers who gave Fidelity the green light, need to stand up and explain themselves.  

In its most recent research, (April 2022) Fidelity asserts that BTC is an “aspirational store of value”. Fidelity’s argument for BTC is specious at best, but that does not matter. In that report, Fidelity specifically acknowledges that BTC is a speculative investment. Notwithstanding, Fidelity continues to target retirement fund administrators with positive commentary about BTC.

I would suspect that the DOL was addressing Fidelity when it issued the CAR.  As any lawyer will tell you, Fidelity is essentially telling the regulator to shove it. Fidelity knows that the CAR has not been withdrawn.  In my experience, regulators hate to be ignored. 

I also suspect that the DOL has a contingency plan for this. It has already gotten support from the AFL-CIO which has specifically and publicly supported the issuance of the CAR. The CAR alone will dissuade some of the fund administrators Fidelity is targeting, but Fidelity apparently intends to offer crypto to any retirement account that wants it.

The DOL also has the benefit of several US Supreme Court decisions that support the idea that ERISA accounts require “prudent” investments and that plan fiduciaries need to help eliminate “imprudent” investments.  As Fidelity can be shown to be trying to influence plan administrators to purchase imprudent investments, some courts might just agree that Fidelity has stepped into a fiduciary relationship with the plan investors.     

I suspect that any court that looked at the facts presented here might support a cease-and-desist order against Fidelity. I would not be surprised if it came from the securities regulators in Fidelity’s home state of Massachusetts.   

I cannot for the life of me figure out how Fidelity got itself into this mess. Fidelity enjoyed a reputation as a company that sold mutual funds to mom-and-pop investors. There are more than 25 million people in the 401(k) plans that Fidelity services. Why would Fidelity go against the DOL for the right to sell highly speculative investments that most of those people would never want in their retirement plan?

Sooner or later, I suspect someone will write a book about Fidelity’s attempt to put lipstick on the pig that is BTC and pawn it off on retirees.  The SEC has been threatening to hold compliance directors responsible for allowing practices that harm investors. If Fidelity moves ahead, as I suspect this would be an ideal opportunity for the SEC to make a statement and demonstrate that they are serious and ask the compliance director at Fidelity to explain himself.

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

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What the Women’s Movement can learn from Cesar Chavez

Capital Markets, Life ,
What the Women’s Movement can learn from Cesar Chavez

I got into an interesting discussion with a businesswoman who had posted on LinkedIn about the difficulties that women have in the workplace. Among other things, she commented that women are significantly under-represented in the executive suites and on the boards of directors of most large companies. I certainly agree.

Any intelligent person in the workforce today can see that women have more difficulty getting hired and promoted, are penalized for resume gaps when they take time off to have children, and overall, still get less pay for doing the same jobs as men. Women are too often exposed to toxic work environments, off-color jokes, inappropriate comments, and sexual overtures. That women face this type of discrimination in the workplace is a fact.

Some people approach the treatment of women in the workplace from the standpoint that this is a “gender’ issue. They assert that this conduct by men is our problem. Male business owners already know better than to discriminate against women. The simple truth is that men pay women less because they can get away with it.

I see this gender pay disparity as a labor issue. It is past the time for women to flex their economic muscles and actively purge this type of discrimination from large companies. If women were properly represented on the boards of directors of more companies, they would be in a far better position to rectify the actual problems of unequal pay and toxic work conditions at each company.

When I started law school my first-year class had 120 students including 12 women, exactly 10% based upon a pre-determined quota. Each of the women had been interviewed at the school before acceptance. None of the men had been required to sit for an interview. From the beginning, it was obvious to me that this small group of women was a little sharper than many of the men. That should have been expected as each of the women faced stiffer competition for each seat in the class.

Last week I saw the picture of a young woman wearing a tee-shirt that said: “I became the lawyer that my mother wanted me to marry.” To me, that one sentence encapsulates a generation of progress for women in the legal profession.

When I was in school it was commonly thought that women could only be trained to become nurses or teachers. Untrained, women might become waitresses, secretaries, or flight attendants. The uniforms of flight attendants were tailored to accentuate their figures and they were often fired as they got older and deemed to no longer be attractive to male passengers.

There is no question that women have broken through the glass ceilings put in their way in a great many industries. Women now work in construction and other traditionally male blue-collar jobs that would have been unthinkable not that long ago. Teachers, nurses, and flight attendants are now covered by union contracts that have raised their pay, improved their working conditions, and provided benefits and job security.

Women manage large numbers of employees within big corporations across all industries. As managers, they make decisions that define the company’s operations and impact its bottom line. Still, it is rare to find a woman as the CEO at a Fortune 500 company and virtually impossible to find a Board of Directors where women make up the majority of the directors.

Women represent one-half of the US population. The impact of women as consumers cannot be overstated. Even companies operating in niche industries deal with vendors, customers, and employees who operate in the much broader markets.

Shouldn’t seats on boards of directors be handed out equally to men and women so that the boards represent not just the perspective of the management, but the broader market that the companies serve and in which they operate?

Greater representation on corporate boards would seem to be an effective way for women to deal with issues regarding equal pay and toxic working conditions. Taking more control at the very top of the corporate governance pyramid would help women to rewrite the workplace rules at all levels.

Labor unions exist specifically to deal with issues like wages and working conditions. Unions representing workers with far worse conditions and far less power have been able to get what they want using a variety of tactics and strategies.

The last great strike, by the United Farm Workers (UFW), took place against the lettuce growers while I was in college and law school. The tactics employed by the union were quite different from those other unions had used in the past. The lettuce strike offers lessons that might help women successfully break into and take over corporate boardrooms.

Farm labor may be the world’s second-oldest profession. Growers have always had all the power and used that power to accumulate more power. Farm laborers had been excluded from the Fair Labor Standards Act and Social Security in the 1930s. Any attempt to organize farm workers was always met with a stacked deck.

In 1970, when the lettuce strike began, the working and living conditions of the lettuce workers were still medieval. Their pay was inadequate and provided only the barest necessities. The farm workers occupied the lowest rung on the ladder of American workers.

The lettuce strike organized by Cesar Chavez and the UFW was truly a David v. Goliath battle. Throughout, the growers used their considerable influence and deep pockets to thwart the workers.

Chavez succeeded because he did more than just throw up a picket line and negotiate as steel and automotive workers had done in the past. He used very different tactics to leverage support from larger groups to provide financial and logistical support.

Most importantly, the UFW successfully enlisted the lettuce consumers to alter their diets to support the strikers. The union effectively delivered a message that said 1) our working conditions are horrific and 2) don’t buy lettuce.

Traditionally unions and management negotiate contracts focused only on the numbers. Each side calculates how much each incremental boost in wages will cost the company. The union calculates the effect of lost wages on its members if there is a strike. Management calculates the effect of a strike on its bottom line.

By addressing lettuce consumers directly Chavez added the impact to the company’s reputation and customer base to the equation. The cost of winning back consumers after these boycotts would now need to be considered.

Chavez had tested out his new tactics during a 4-year strike against the grape growers. In that campaign Chavez, vowing to be non-violent, had tried out tactics adopted from the civil rights movement including long marches, prayer vigils, and a hunger strike. Local rallies in support of the union were scheduled. Media coverage of these events and the sometimes-violent protests by people opposed to the UFW kept the strikers in the public’s eye.

Chavez used the grape strike to garner support from church groups and other decent people who were horrified when exposed to the working conditions in the fields on television. By the time the strike against the lettuce growers began, Chavez already had all these tools in place. People who mattered, especially the media, had already been educated about the critical issues.

Opposition to the lettuce strike came primarily from the Teamsters Union which had negotiated sweet-heart contracts with some of the lettuce growers   The UFW strikers were physically attacked, and rallies and the union offices were firebombed. Chavez, the “pacifist” of the grape strike was much more aggressive. As the tempo and temperature of the strike increased Chavez was arrested for the first time.

Within a few days Ethel Kennedy, widow of Sen. Robert F. Kennedy visited Chavez in jail. As she was leaving a small riot broke out and Mrs. Kennedy needed to be rescued by the local police. It made for great television. Mrs. Kennedy’s appearance at the courthouse had been intended to be a carefully choreographed stop on the campaign trail. The violence ensured that every television station reported on it.

At this time, I was living in Brooklyn which was about as far from the California lettuce fields as one might get. After a while, it seemed that every telephone pole had a simple sign that said “BOYCOTT LETTUCE” stapled to it. That did not happen by accident.

The “BOYCOTT LETTUCE” signs had been stapled to those telephone poles as part of a well-thought-out and well-managed PR campaign. Originally, they appeared in about thirty cities and later in thirty more. Later signs went up urging consumers to boycott two supermarket chains, one east of the Mississippi and one to the west,which bought lettuce from growers not represented by the UFW. The PR campaign was targeted and periodically expanded to ensure that the number of supporters of the strike constantly increased.

Chavez won his strike and he won it not on the picket line. He kept the conditions of the farm workers in front of consumers, daily, for an extended period. Sympathetic consumers boycotted the product, and the growers took a far bigger hit to their bottom line than they would have if they had just paid the workers from the beginning.

It is fair to consider that similar tactics would get more women on the boards of directors of more companies. Women are the dominant consumers making the decisions whether to buy Tide or Cheer,Luvs or Huggies and whether to take the kids to Burger King or McDonald’s and many, many other products as well. Women can certainly utilize their economic power to have themselves appointed to the boards of directors of these companies.

Most consumers have no idea how many women are on the board of directors of the companies that make these products. Very few consumers know whether those companies are taking advantage of women by paying them less. But, as the UFW demonstrated, consumers can be educated, and they can be mobilized. And the UFW was working within the confines of 1970s technology and media.

I can certainly envision an organization seeking to fill many more directorships with women initiating a correspondence that said: “Dear Fortune 500 company: We have noticed that ten of the 11 people that you have nominated for your Board of Directors are male. Please replace five of the men with women. If you are having difficulty finding qualified women, we will be happy to send you the resumes of thousands of women who are more than capable of contributing to your board. If you have not replaced the five male directors with 5 females in 20 days,we will begin a national campaign advising women to boycott your flagship product.” 

I have no illusion that one tweet from Oprah or one of the Kardashians would be enough to sustain a national boycott of any product. I do believe that both could be included in a carefully planned, targeted, and executed campaign that includes a simple message spoken repeatedly by thousands of “influencers.”

I do not see a way for a large company can come out ahead from a public fight with its most important customers about board representation. There is no satisfactory answer to the question: “why can’t more women serve on your board of directors?” 

The success of the UFW and the tactics it employed will be a lesson to the unions when the next big strikes come along. Women have been fighting for equal pay and better working conditions since at least the 1970s. Despite all the progress they have made, I think they may need some new tactics and some “out of the box” thinking to finally get what they deserve.

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

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Seeking “reasonable” people in crowdfunding

Capital Markets, crowdfunding, equity crowdfunding, Investors

First-year law students encounter what is called the “reasonable man” test. It is usually explained as what an average, reasonable person would do in a similar situation. It is applied as a standard of care in cases where the fact finder is trying to assess the conduct of one of the parties. You can find the “reasonable man” test in patterned jury instructions used every day all over the country.   

There are often a lot of precedents that help judges and juries decide what is reasonable and not. Sometimes a jury will be asked to place themselves into the shoes of one of the parties and ask themselves “what would you do”. That is where things can get a little cloudy.

My law professor described it this way. If your spouse is having an affair with your neighbor, they likely feel that their conduct is reasonable at least as they view the surrounding circumstances. You are likely to view their conduct differently. So how you view the situation often depends on your perspective of the conduct at issue which is based upon your own experiences and beliefs.

There is also conduct that is judged against a higher standard of care. Professionals like doctors, because they are specifically trained and licensed, are expected to follow established medical protocols. Others, because of their training or title are expected to perform their tasks as other “reasonable” professionals would if faced with the same facts or situation.   

In securities law, the conduct of those people who are in the business of selling securities to the public (intermediaries) is regulated. Laws passed by Congress and rules adopted and enforced by the SEC and FINRA define the conduct that is reasonable for both mainstream stockbrokers and Regulation CF funding portals.

What do regulators expect from Reg. CF funding portals?

I speak with portal operators and other lawyers working in the Reg. CF market. I get that question a lot, and I cringe whenever someone asks. The answer should be settled by now but it is not. 

Many of the portal operators with whom I have spoken (and some of their lawyers) have very diverse views are regarding the portals’ obligations under the regulatory scheme in which they operate. Some seem to think that a funding portal’s role is primarily passive. They believe that the portals do not need to take steps to see if what investors are being told about the offerings they host is true. 

More than one portal operator told me that they are most often satisfied with the initial representations made by most of the companies that list on their portals after a conversation or two because the managers at these companies sound “credible”. They do not see any “red flags” because they are not looking for them.  

There have always been scam artists in the capital markets. Four decades before the federal securities laws in the 1930s, states were fighting fraud with “blue sky” laws so-named because people were selling stock in companies whose prospects were worth little more than the “blue sky” up into which the price of the stock would surely go. 

Blue sky laws were not a response to a need to protect rich, money center investors. Rather, they were enacted to protect small, Main Street, rural, mom and pop investors. These were people who we now call the “crowd”.  

If you have operated a funding portal for a year or two, a scam artist or two has likely come knocking on your door.  Some portals turn away offerings because the companies cannot provide good answers to the questions the portal asks.

Other portals list any offering that comes along and allow these companies to make any number of false and misleading statements to sell the offering to investors. These portals ask few questions. They cite the SEC’s own statement to support their hands-off approach.

The SEC specifically states that it expects funding portals to take such measures to reduce the risk of fraud. Reg. CF specifically requires a portal to have a “reasonable basis” to believe that each issuer is complying with the law. That should include the laws that require an issuer to make all necessary factual disclosures to investors and to present the offerings in such a way that investors will not be misled.

Unfortunately, the SEC added the following sentence to the regulation: 

“In satisfying this requirement, an intermediary (portal) may rely on the representations of the issuer concerning compliance with these requirements unless the intermediary has reason to question the reliability of those representations”.

Some portals rely upon that statement to support their idea that they can just pass on whatever information the issuers provide to the investors without questioning its content. 

Taken in the context of the regulators’ desire to foster investor protection, the above statement should raise the question; how would an intermediary know if it had reason to question the reliability of the representations made by the issuer unless they dug a little deeper?

FINRA, which regulates both broker-dealers and the Reg. CF funding portals requires broker/dealers to conduct reasonable due diligence investigations of all offerings, especially when an issuer seeks to finance a new speculative venture. In that case, FINRA warns that broker/dealers “must be particularly careful in verifying the issuer’s obviously self-serving statements.”

New, speculative ventures are the meat and potatoes of the Regulation CF marketplace. Aren’t the younger, less sophisticated investors who are being solicited to fund these companies entitled to the same protections as the more sophisticated, accredited investors who might invest in a new venture through a broker/dealer? Are the accredited investors being lured to Reg. CF portals now that the portals have become less restrictive being told that the due diligence they get at the portal is much less than they would get at a BD?

For the record, the SEC originally included that statement about relying on the representations of issuers, in part, because the staff recognized that a true due diligence investigation can be expensive for a company raising only $1 million. As the limit has now been raised to $5 million the Reg. CF funding portals are earning 5x per offering and can certainly conduct a reasonable due diligence investigation of at least these larger offerings. 

Given that 2000 fraudulent ICOS were funded and many just took the money, closed up shop, and crept away, it is easy to imagine a thief posting phony offerings on 4 or 5 portals at the same time raising $25 million and doing the same. Since the regulators cannot catch these offerings in real-time and the portals are not looking, I think that scenario is inevitable.

When is a funding portal compliance director being reasonable?

I trained in broker/dealer compliance while working at a large, national wirehouse. It took me a while to learn the rules and procedures that were already in place. It took longer for me to understand why each of those rules and procedures existed, and how and when they were being applied.

I have consulted with quite a few compliance professionals and departments over the years. The job requires them to make judgment calls and give advice that, if wrong, can be very costly to the firm.  Many of these professionals are guided by their understanding of the rules and a healthy amount of common sense.

Lawsuits and problems with regulators are signs that compliance is sub-standard.  Being ordered to pay investors back $5 million because of a fraudulent offering would hurt any funding portal’s bottom line. Good compliance, and not just trusting the issuers to make representations without verification, would reduce the costs of lawsuits and regulatory problems to zero.

A compliance director at a funding portal must also take into account that the portal must also answer to regulators other than the SEC and FINRA. Remember those pesky blue sky laws? 

State securities laws apply in the state where the portal operates and also any state where any investor in an offering on the portal resides. The Uniform State Securities Act (adopted in more than 30 states) takes a completely different approach towards liability in cases involving a fraudulent offering. 

Under federal law, the person who purchased the security has the burden of proving that they would not have made the purchase but for some important fact that was either omitted, false or presented in such a way that it caused the purchaser to be misled.

Under the state law, the seller must sustain the burden of proof that the seller did not know, and, in the exercise of reasonable care, could not have known of the untruth or omission.  Given that the seller (intermediary) has done no investigation or asked any questions, it is difficult to demonstrate where the investigation would have led if it had been guided by the documents that could have been requested. 

Sooner or later a portal owner will be sitting in front of a state securities administrator who is asking how some purely fraudulent offering got listed on the portal. The portal owner might take out a file of documents that record its investigation of the offering which, while not thoroughly comprehensive, is at least sufficient to sustain a conclusion that “having gotten responsive answers to the questions we asked, and seeing no red flags, we have a reasonable basis to believe the representations being made by the issuer are accurate.”

Other portal operators will pull out a letter from their lawyers advising them because of the SEC’s apparent green light, the portal can list any issuer relying only upon the issuer’s representations and presumed reliability.  (Spoiler alert- state securities administrators really hate that response.)

I write a lot about scams in crowdfunding. A lot of people tell me that the problems I see are just growing pains for this new industry. 

By next summer, if not sooner, thanks to new technology and techniques, 5-million-dollar offerings listed on Reg. CF funding portals will sell out in a matter of hours.  Going forward, a lot of money is going to change hands very quickly with little scrutiny. That should attract more scam artists, not fewer.

The only way to reduce the presence of scam artists and scam offerings from the Reg. CF market is for the portal operators to push back against the idea that a portal can be passive when it comes to investor protection. 

Portal operators need to ask a lot of questions about each offering that is presented to them. They need to be satisfied with the answers they get. It does not need to be an expensive due diligence investigation. A portal just needs to make a reasonable inquiry as judged from the perspective of a professional funding portal compliance officer.

The portals I advise are told to reject offerings when they are not comfortable with the answers they get. If something sounds too good or not quite right, a funding portal compliance officer should be expected to inquire further. The compliance officer should be expected to be satisfied with the veracity of the answers before passing the issuer on to the public.

You will not find words like “comfortable” and “satisfied” in the legal dictionary. Rather they are the result of a feeling of relief that compliance officers get when they have created a paper trail that supports their approval of a questionable offering.

“Comfortable” and “satisfied” are the result of a funding portal compliance officer having taken a practical, not legal approach. Quite often the most practical approach is also the most reasonable. 

What will never be “reasonable”, “practical”, “satisfying” or “comfortable” is the idea that a funding portal could host an offering that did not tell investors the truth or which lure investors with fallacies and fabrications.

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

Or you can book a time to talk with me HERE

KingsCrowd – Again

Capital Markets, crowdfunding, equity crowdfunding, Investors , ,
kingscrowd-again

A few weeks back I wrote an article about KingsCrowd, a company that claims to have an algorithm that can “rate” the offerings that are listed on the Regulation CF funding portals. I called KingsCrowd’s ratings bullshit. In my mind, I was being charitable.  I wanted to call them “scam artists of the first magnitude” but my editor calmed me down.

Investment crowdfunding is still in its nascent stages. As I have written before, all of the mechanics are in place for any issuer to use crowdfunding to raise capital.  With an adequate budget, some professional assistance, and a little common sense, every crowdfunding campaign should successfully raise the funds that it seeks.

KingsCrowd’s ratings do little more than stroke the egos of the founders who bask in their artificial light.  They support the absurd claims of many founders that because they spent a year staying awake all night writing code they will be able to turn that code into a profitable business that will disrupt this or that industry.

Over the years, I have helped quite a few professional chefs raise funds for a restaurant. Several of those chefs had egos that would make Elon Musk blush.

Year in and year out, restaurants have the highest failure rate of any small business. Good food and good reviews will get people in the door. Chefs are frequently proud of their signature dish. The number of beverages, appetizers, and desserts they sell will actually dictate their profitability.  I would tell the chefs that profit margins are not on the menu but that is where their focus needs to be. Some get it, some do not.

These are some of the things that people brought to my attention about my last article. These are the issues that they raised and these are my thoughts:

1) You cannot fund a start-up without some type of valuation.

I have helped all kinds of companies raise capital from investors for over 4 decades. Only the large bond offerings were rated by Standard and Poor’s and Moody. Investors in both the public and private (Regulation D) market have never had a problem parting with their funds to invest in a company that was not “rated”. A rating would, in fact, be an anomaly.

Investors are universally concerned with one metric and one metric only, the return that they can expect on their investment (ROI). One of the true benefits of crowdfunding is that it allows a company great latitude and creativity when it prepares its offering. If the investors’ funds will help a company generate revenue, then the company can share that revenue with the investors.

Again, using crowdfunding, every campaign can be successful, every time. It starts with structuring an offering that investors will find attractive and then putting that offering in front of as many investors as it takes to obtain the funds the issuer needs. You do not need to lie about your company’s prospects, fantasize that it will disrupt an established industry, or come up with a phony rating. End of story.

2) There are no other metrics to value a start-up or small business. 

The SEC mandated that all but the smallest issuers using Reg. CF funding portals have their financial information audited so investors get the facts about the company’s finances.  Those financial reports are presented using what are called Generally Accepted Accounting Principles (GAAP). There are GAAP rules that cover valuations of a myriad of balance sheet items and they apply to all companies.

At the same time, there are business brokers all over the US who help people value, buy and sell businesses every day.  Over the years I have heard many of those business brokers say that a good business is “worth” roughly 3 times next year’s projected earnings. Many of the highest-paid research analysts at the largest investment banks use a similar formula when projecting the future price of a publicly-traded security.

Suddenly all those professionals are wrong and KingsCrowd’s new method of valuation is right? That does not hold water. 

3) KingsCrowd’s ratings are patterned after what VC’s do

I moved to San Francisco in 1984 to join a small boutique law firm that represented a European-based VC fund. The fund was actively investing in some cutting-edge Silicon Valley tech companies and some more run-of-the-mill consumer product companies as well.

I sat in on a lot of pitches that were made by a lot of really interesting and intelligent people. The Managing Director of the VC fund told me that he liked to include me because I asked a lot of questions that cut to the bottom line. I still do.

VCs have been playing a game with each other to reach the insipid valuations that they claim for the companies they hold in their portfolio. VC No. 1 buys 1,000,000 shares in a start-up for $10 per share in the seed round.  His good buddy VC No. 2 invests in the next round buying shares for $20 per share. VC No. 1 can now claim that the “value” of his investment has doubled, even though in many cases the value has been diluted.  

Their good buddy VC No. 3 buys into the next round at $30 per share making the first two VCs look like geniuses by claiming the value of their holdings in the first two rounds have gone up. The roles of these VCs reverse in the next deal that comes down the pike and people rain praise on the VCs for their “vision”.

There is no liquidity in this market. Those “valuations” are meaningless. Once I understood the game, it was pretty easy to spot. Peel back the VC funding for WeWork and similar scams and you will see what I mean.  I call it “frat-boy finance”.

Worse, companies funded this way claim to be “unicorns” a cynical description that too often means the valuation is a fantasy. It creates a false reality in the minds of the people the VCs will screw when they ultimately take the company public.    

4) Normal valuations do not apply to tech firms like Microsoft.

If you develop an essential software package, license it to IBM for $100 a box, and put the sales power of IBM behind you, you may be right. Professional analysts who follow MSFT, of course, use the same metrics as all securities analysts everywhere, using the same methods and formulas taught in all business schools.

If your background is in tech, I promise to never, ever comment about your ability to write code. This article is about finance. Please consider that I have the home-court advantage.  

More importantly, I have the ears of the investors you want, angel and accredited investors, family offices, etc. I can get your company in front of those investors, but they will place their own value on your company no matter what KingsCrowd says. 

5) The new generation of investors needs new methods of valuation

From the beginning of investment crowdfunding, people suggested that the crowd can evaluate the offerings listed on a funding portal. That was never true.

If we learned anything from the Robinhood fiasco it is that young investors are motivated by the same thing that motivates all investors, they invest money to make money.

In the mainstream markets, most small investors do not even try to analyze a company’s financial reports or attempt to determine its true value.  Smaller investors most often buy mutual funds or work with a stockbroker or investment advisor.  I am not suggesting that these professional advisors necessarily know what they are doing. I am suggesting that most small investors realize that they need help.

Why do I even care? 

Working in the crowdfunding industry it has been my pleasure to work with some extremely bright and hardworking people. Day in and day out they roll up their sleeves to help start-ups and businesses of all sizes get the funds they need to grow and prosper. I consider these people to be the unsung heroes of modern capitalism.

Every week I take calls from business owners and entrepreneurs who want to raise a few million or more based upon a “valuation” they computed based upon some article they read, a conference they attended, or a company like KingsCrowd. In many cases, people seeking capital through crowdfunding do so because traditional sources of capital are unavailable to them.

If you can qualify for an SBA loan you will take it. If not, investment crowdfunding is a viable alternative to get the capital that you need. Just send me an e-mail or fill in the form on my blog.

When someone calls and tells me that their pre-revenue start-up, with no assets, patents, or customers should be “valued” at $10 or $20 million I think “yeah and my you-know-what” is 12” long. (Yes, my editor revised my original number.) I am not trying to be inappropriate.  I am just looking for an analogy that will drive my point home.

What is to be done about these fraudulent and misleading valuations?

These false claims about valuations proliferate right out in the open and the primary regulator, FINRA, does nothing.  FINRA (and I choose my words carefully) often has its head up its ass.     

Some scams are difficult to spot. Enron was sophisticated accounting fraud. To uncover it required knowledge of specific inside information. 

Elio Motors, a Reg.A offering hosted by StartEngine a few years back was easy to spot with a modicum of due diligence because its claims could easily be investigated and debunked.

Phony valuations like the ones issued by KingsCrowd are just false advertising right out in the open that anyone at FINRA could easily spot. FINRA does have specific advertising rules that funding portals are expected to follow. The compliance director of any portal that signs off on KingsCrowd’s valuations should be banned from the industry.

Case in point:

StartEngine, which itself has never shown a profit, perpetually raises capital to fund its operations. It needs to pay its spokesperson, Mr. Wonderful, (who was recently accused of defrauding the founders of multiple start-ups) several hundred thousand dollars per year.

This year, as part of one of its several fundraising campaigns, StartEngine claimed a valuation of over $780 million based upon KingsCrowd’s algorithm.  Someone suggested to me at the time that valuation would make Warren Buffet puke.

I did some shopping and found that you could buy a fully licensed and operational broker/dealer for about $200,000, perhaps $2 million if the firm had a few stockbrokers who would agree to stay on with new management.

It is not like StartEngine has a stable of stockbrokers to sell investors other products. I suspect that very few of the people who have invested once on StartEngine’s funding portal have come back and invested twice.

Both StartEngine and Republic that use KingsCrowd ratings are conflicted. Each has benefited from its relationship with KingsCrowd. These ratings, even if they were valid are not independent and no disclosure of that fact is made anywhere.

At the heart of this problem is that in terms of dollars raised, StartEngine and Republic dominate the Reg. CF portion of the crowdfunding industry. I consider these valuations to be a cancer on the crowdfunding community. They scare away serious investors that the crowdfunding industry desperately needs. They unfairly compete with the many hardworking people in the crowdfunding industry who are trying to help companies raise capital honestly. 

Perhaps FINRA will eventually step in and put an end to KingsCrowd’s ratings.  FINRA has previously expelled only 2 funding portals, uFundingPortal and DreamFunded. In both cases FINRA questioned valuations that were much, much lower than KingsCrowd spits out. 

This is the third article I have written about KingsCrowd in short order. I have no intention of going away. Hopefully, FINRA will intercede before I need to pick apart individual offerings that advertise these ratings that they do not need to raise capital in the first place.  Hope springs eternal.

If you’d like to discuss this or anything related, then please book a time to talk with me HERE

 

KingsCrowd- selling ratings for fun and profit

Capital Markets, equity crowdfunding , ,
kingscrowd

The thing about crowdfunding is that it attracts people who are paid to introduce investors to companies that have little to offer. The worst, of course, are those who know that the companies have little chance of success and hype the hell out of them anyway.

So I was particularly interested in a Reg. A+ offering filed by KingsCrowd, a publication that covers the Reg. CF marketplace and companies that are seeking funds.  KingsCrowd has a “patent-pending AI-driven startup rating algorithm” from which it intends to rate the various offerings on the Reg. CF funding portals.  

In its own words, KingsCrowd will “empower individual investors to make intelligent startup investment decisions on platforms like Republic, Wefunder, SeedInvest, Netcapital, etc., by providing institutional-grade research tools for assessing the thousands of investment opportunities available to investors at any one time.”

Given that 90% of start-ups will inevitably fail, any algorithm that can sort likely winners from likely losers would be welcome.  Even if unable to identify the 10% that will succeed, eliminating the bottom 10% or more that have no chance at success would benefit investors as well. 

KingsCrowd already tracks and rates “every Reg. CF investment opportunity in the United States.” It has a system to research and rate Reg. CF issuers. The only question is does their algorithm work?  How good is their research? What constitutes “institutional-grade” research anyway?

CalPERS, the largest public employee’s pension fund manages a multi-billion dollar portfolio.  It employs several hundred research analysts to oversee that portfolio and to make specific buy/sell recommendations. Other funds and money managers around the globe use much the same data and much the same methods to analyze that data.  Generally accepted methods of securities analysis are taught in business schools and have been for decades.

If that is “institutional-grade” research and analysis then I needed no more proof that KingsCrowd does not provide it than the fact that it gave itself a “pre-money” valuation of $45 million.  There is no way that analysis that produced that valuation can be called “institutional-grade”. The numbers just do not add up.

KingsCrowd says that it collects “more than 150 data points on each issuer, including information relating to its team, its market, financial statements, traction with consumers, and competitors. Our investment research team collects data from multiple sources such as the issuers’ pitch decks, capital raise pages on all of the funding portals (including all Reg CF funding portals such as Wefunder, Republic, Netcapital, SeedInvest), news articles and announcements, social media, founder profiles and resumes, recruitment websites, the SEC filings, growth data provided by the companies and information derived from alternative data sources.” 

I do not think that I need tell you that data in “pitch decks” and “growth data provided by companies” is often exaggerated. Information on the funding portals is often unverified.  What I was hoping for was for KingsCrowd to bring some amount of real financial analysis to this marketplace.  To even begin the process it would be necessary for the data used on Reg. CF funding portals to be accurate.  It isn’t.

KingCrowds’ “algorithm uses a comparative modeling approach to rank and score all companies actively raising capital from the markets across the various key dimensions deemed notable in the rating algorithm and traditionally utilized by venture investors to make informed investment decisions.” 

Forget for a minute that the phrase that ties “venture investors” with “informed investment decisions” is itself an oxymoron.  I worked for VC funds and I have dealt with them as a representative of a company being funded, repeatedly, beginning in the 1970s. Funding has always been more about who you know than what you were selling. The days of an MBA as a requirement to be a “venture capitalist” are a receding memory.

I would think that if KingsCrowd’s algorithm really identified better investments, one of the VC funds would have scooped it up.  When you break down what they do, you can see that it is more smoke and mirrors than mathematics.

At the end of the day, KingsCrowd’s patent-pending AI-driven startup rating algorithm yields a rating that is a number between 1 (lowest score) and 5 (highest score) for every aspect of the issuer, including price, market, differentiation, performance, team, and risk, as well as an overall score for the issuer at a specific funding round.

Given that many of the start-ups being funded have neither income nor profits, the metrics of “performance” may be more subjective than one might expect. KingsCrowd seems to intimate that what they are identifying are companies that had a successful capital raise, not successful companies.  If that is true, they are on a fool’s errand. And, while I always help clients structure their offering to present an investment that will be attractive to investors, success in crowdfunding is often about how you market the offering and how much money you put into your marketing campaign.

Giving a numerical score to a “team” also seems quite subjective. KingsCrowd itself has only 3 employees and a “team” of outside advisors. Christopher Lustrino is a founder of the Company, Chief Executive Officer, President, Chief Financial Officer, Treasurer, and also a member of the Board of Directors. If these positions had been filled with qualified people would the “pre-revenue” valuation have been $60 million? More?

Some VCs and angel investors like a founder to have some skin in the game and invest their own money. Lustrino is selling $1 million worth of his stock in KingsCrowd as is one of the early investors. The fact Lustrino needed to sell his shares costs the company an equal amount.

KingsCrowd is also concurrently offering the same shares to investors in a private placement offering under Regulation D. They are raising a total of $15 million which, if the company had something to offer, would have been cheaper and easier to accomplish using only the private placement.

Under current law, however, Lustrino cannot sell his shares or those of the early investor, using Regulation D. To sell his shares, Lustrino needed to have the company prepare and file the offering using Regulation A+.

In the normal course, the shares being sold under Reg. A+ would be the subject of a commission, here 7%.  Shares sold on a crowdfunding platform using Reg. D do not pay a commission unless the platform is a licensed broker/dealer.

Lustrino arranged to have this offering placed with a broker/dealer affiliated with one of the Reg. CF funding portals, Republic. He has agreed to pay that broker/dealer 7% of the entire $15 million or more than $1 million. That is the fee the company will pay to liberate 2,000,000 shares being sold by Lustrino and his partner.     

The issue is more than the fact that KingsCrowd is spending money that it did not need to spend. The funds would certainly be better spent hiring a CFO to watch over the investors’ money.

KingsCrowd is essentially giving $1 million to a company whose offerings it will rate. This kind of conflict of interest would, in my opinion, negate any rating KingsCrowd issues on a company listed on Republic and likely its competitors as well. As importantly, by selling his shares, Lustrino gives the impression that he has one foot out the door, ready to ditch the algorithm with little utility and ready to fund his next company.

If you’d like to discuss this or anything related, then please book a time to talk with me HERE