crowdfunding

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

Or you can book a time to talk with me HERE

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

 

September 2021- Crowdfunding at the Crossroads?

crowdfunding, equity crowdfunding, Issuers , ,
September 2021

The crowdfunding industry is about to announce that more than $1 billion has been raised from investors on the Regulation CF (Reg. CF) funding portals. It is a milestone worth noting for everyone involved in the crowdfunding industry.  

Right now there are approximately 63 Reg. CF funding portals in various stages of the licensing process. Of those, only 27 are operating with 5 or 6 dominating the Reg. CF market. The great bulk of that billion dollars was raised on only a handful of funding portals. 

Also this week the SEC has brought its first case against a Reg. CF funding portal, TruCrowd, headquartered in Chicago.  Among other things, TruCrowd is accused of allowing a company to list its offering on the TruCrowd portal after TruCrowd became aware of some significant “red flags” about one of the people who was associated with the company.

TruCrowd had been alerted to the fact that this person had a criminal past, promised to look into it further, and then did not. TruCrowd apparently allowed the offering to continue, simply ignoring the warning. TruCrowd and its owner have now been accused of participating in the fraudulent offering.

News about TruCrowd’s difficulties with the SEC began to circulate on Monday 9/20.  That same afternoon I got an e-mail from TruCrowd informing me that Shark Tank celebrity Kevin Harrington has endorsed a company raising money on TruCrowd’s funding portal.   

A week earlier Harrington and his partner Mr. Wonderful (Kevin O’Leary) were sued by a group of 20 entrepreneurs claiming that they were defrauded by the pair who had promised to help them get funding but failed to deliver. Mr. Wonderful, of course, shills for StartEngine, one of the largest funding portals. 

The crowdfunding industry is remarkably resourceful. Lacking in funds, many of the participants trade in favors and goodwill. There is a lot of investors’ money splashing around and it is always interesting to see where some of it pops up. 

Last week I published an article about a crowdfunding “rating service” named KingsCrowd that is raising funds from investors using a funding portal named Republic. KingsCrowd, which is little more than a shell, claims a $45 million pre-money valuation.

KingsCrowd’s business is to “rate” companies who are themselves using crowdfunding to raise capital.  All of KingsCrowd’s “value” is tied up in the proprietary algorithm that produces these ratings. 

Yet when asked about KingsCrowd’s own $45 million valuation at a company sponsored Q&A last week, the CEO likened it to values assigned by VCs to other high flying companies. Apparently, he was not asked why he did not seem to trust his own algorithm to rate or value his own company.

The KingsCrowd rating system considers, among other things, an issuer’s management team. Save for the CEO, KingsCrowd has no employees, directors or management team. Is the CEO failing to disclose that his own rating system gave his company a bad score?

The CEO was asked why he was selling his own stock at the same time he was soliciting other people to invest in his company. He apparently disclosed that he needs the funds for personal expenses, including his upcoming wedding. No one asked him why the transaction was structured to put more than $1 million into Republic’s pocket for the company’s Reg, D offering, funds that the company did not need to spend.  

KingsCrowd has been reviewing offerings on Republic’s portal since at least 2020.  Republic has had plenty of time to determine exactly what the algorithm can and cannot do. If Republic has a 3 inch file full of documents that verify that KingsCrowd’s algorithm “works”, then I am certain I will hear about it.

The “notice” of the bad actor’s past, came to TruCrowd from a securities lawyer who was not formally affiliated with the portal. I applaud that effort. It serves no one in the crowdfunding industry, if we let investors invest in scam after scam. Unfortunately, TruCrowd did not listen.

I connected with Republic’s CEO and sent a copy my article suggesting that KingsCrowd’s valuation was way too high.  I am going to punctuate that by offering my opinion, in the words of an old friend, that only “an idiot on acid” could come up with that $45 valuation for KingsCrowd or try to defend it.

The very last thing the crowdfunding industry needs is a corrupt rating system. KingsCrowd’s “independence” from Republic, after this game of “you take a million and I take a million” that KingsCrowd and Republic are playing, is certainly suspect.  If the ratings are not “independent” they have no value at all.

KingsCrowd claims “Wall Street has Morningstar, S&P, and Bloomberg; the equity crowdfunding market has KingsCrowd”. Having followed those services over the years, I think it safe to say that none would place a value of $45 million on KingsCrowd today.

I suspect that the active and retired compliance professionals who follow the blog are all shaking their heads thinking that it is time for Republic to put a halt to both the public and private offerings that KingsCrowd is selling. When a transaction runs up against a regulation, a good compliance officer helps to re-structure the transaction until it complies.

It is certainly time for someone to sit down with KingsCrowd’s CEO and tell him that he needs to be picking out a CFO and Board of Directors at the same time he is selecting his Best Man and ushers. I might suggest taking his algorithm and data over to EY, or similar consulting firm, and see if they will take a look and issue an independent report on what the algorithm does and with what accuracy.

I had no idea that the SEC was about to sanction TruCrowd when I wrote the article about KingsCrowd last week.  Against the backdrop of the TruCrowd complaint, I expect that Republic will halt both offerings unless they do not think that I am waiving a red flag.

To me, this boils down to a question of whether or not Republic will take some amount of ownership for the ridiculous, unnecessary, and misleading valuations featured on its own portal. It would be a signal to other portal operators to do the same.

FINRA has previously expelled two other funding portals, each time questioning the valuations attributed to the companies seeking investors’ funds. The argument can certainly be made that a grossly exaggerated valuation is itself a red flag that the company making the offering lacks substance. 

The ball is in Republic’s court. Like I said, this may be one of crowdfundings’ crossroads moments, or not.

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

Crowdfunding Professional Association – An Open Letter

crowdfunding, equity crowdfunding, Investors, Issuers ,

Crowdfunding Professional Association (CfPA)

To: The Board of Directors

I appreciate that I am a person who no one wants to hear from; a New York lawyer with an attitude and a big mouth.  Fortunately, I have made it work by finding clients who appreciate not only my advice, but the reasoning and experience behind it. Still, I know that people would rather suck an egg than listen to a lawyer.

I worked on Wall Street and helped finance companies for 20 years before I understood finance. That understanding came from teaching finance to college students. There is nothing like going back to the textbooks to create a framework for understanding the nuances of any subject.

I have made no secret of my dislike for the CfPA. I see nothing of value being discussed and certainly nothing of value produced by your organization.

I have been invited to make some practical recommendations to the CfPA Board of Directors. I have no illusions that most of the CfPA Board will simply ignore me. I have been saying many of the same things since 2015. 

To soften the discussion, I think it better that you think of me not as a lawyer but rather a college professor, albeit one who does not give credit for wrong answers. These are my thoughts.

What is best for the investors is best for the crowdfunding industry

There is a great pool of capital available for investment into all kinds of projects and businesses. The job of the crowdfunding industry is to connect companies looking for capital with investors who will provide it.

The JOBS Act was intended to provide capital for small businesses to expand and grow. The Regulation D Title II platforms have demonstrated that investors will invest $25,000-$50,000 or more based largely upon information they learn from a website. Crowdfunding, as a method to source investment capital clearly works. 

Crowdfunding operates in a unique niche market. It competes with banks and commercial lenders for companies seeking funds. At the same time, crowdfunding competes for investors with the mainstream stockbrokerage industry. Those are huge markets full of tough competitors.

Title II private placements went online and immediately competed with the traditional stockbrokers who sold similar offerings to investors face-to-face. There are Title II platforms and broker/dealers using crowdfunding to raise billions of dollars. At the same time there are Title III funding portals where issuers have difficulty raising $50,000 and where their offerings languish for months. 

In place of stockbrokers, crowdfunding offers increasingly sophisticated digital e-mail marketing campaigns and advertisements aimed at highly targeted lists of potential investors. While I was originally skeptical of this approach, it has been demonstrated that it works.

If the content of the e–mails manage to send some investors to review the offering itself, and some percentage of those become investors, then a company can continue to send out e-mails and advertisements until it attracts all the investors it wants. If some people will invest in an offering based upon what they see on the website, others will invest as well.

Effective marketing will press the right rational or emotional buttons that will result in investors investing. A good campaign will reach out to more potential investors than it needs.

Funding a crowdfunding campaign has become just a simple numbers game. As marketing costs for raising $1 million on any crowdfunding platform or funding portal continue to come down, it has reached the point where any company that can afford a good marketing campaign, can “buy” $1 million in investment or more. 

That conclusion, which I reached after countless hours speaking with campaign marketing specialists, caused me to stop and ponder the consequences for crowdfunding, for banks and for small business. I believe that this crowdfunding marketplace is about to explode with the post-pandemic need for small business capital.  

I covered much of my enthusiasm for crowdfunding in a whitepaper I published last week.I promised some more practical advice and recommendations today. 

Crowdfunding is corporate finance, do the math  

The JOBS Act was specifically intended to operate within the framework of existing federal securities laws and an established universe of corporate financing techniques. The crowdfunding industry can only exist if investors are willing to invest. The crowdfunding industry needs to respect investors. The CfPA needs to lead this effort. 

The industry has foisted scam after scam on the investors it cannot survive without. It consistently offers investments into companies that have no reasonable expectation of success. FINRA requires a certain amount of quality control for the funding portals it regulates. Many of the funding portals just ignore that requirement.

I appeared on a podcast recently. The host made me so comfortable that I blurted out something that I probably would have said differently. I said that one of the main problems with the crowdfunding industry was that too many people in it thought Ben Graham had invented a cracker. 

Graham’s textbook has been the basis for analyzing investments for decades. It has, and continues to be used in business schools around the world. Trillions of dollars are invested every year by decision makers who are trained to apply fundamental analysis to investing and corporate finance transactions.

There are very few MBAs in crowdfunding. I do not think that is a requirement, but I do think that to advise a company seeking financing requires some amount of knowledge and experience. I have helped hundreds of companies raise money over the years and I have taught finance at the university level. Still, I collaborate with two colleagues, one a retired investment banker, the other a retired commercial banker on almost every offering I prepare.   

Financing can be nuanced; terms matter; mistakes can be costly; there are always other companies competing for the same investors. If you accept that crowdfunding is a form of corporate finance, then people experienced in finance are a pre-requisite. If you think crowdfunding is just another form of gambling, you need to be doing something else.

There are clearly crowdfunding platforms that get an A in Finance by helping to structure the offerings they host intelligently. Sadly, most of the industry, especially funding portals, have no clue.

Any investment offered to investors via crowdfunding is a speculative investment. The crowdfunding industry wants investors who understand the risks and who can afford to absorb the loss if the worst happens.

Crowdfunding syndicates risk. Higher risks should yield higher rewards. Risk, if you can get your head around it, is what crowdfunding sells. 

Too often, the risks are buried in the boilerplate. The CfPA should bring the discussion of risk out in the open. It should encourage industry participants to help issuers to mitigate those risks and to adequately compensate the investors willing to take those risks to fund these companies. 

The larger marketplace quantifies risk every day. For example: Pre-pandemic, a small business seeking a loan guaranteed by the SBA, with adequate collateral and a personal guarantee from the business owner, would pay about 8.5% interest on the loan. Today, while the pandemic has raised the risks for all small businesses, there are offerings on funding portals offering investors 6%, without the collateral or guarantee, wondering why they are having difficulty attracting investors.   

The funding portals are in the business of helping issuers get funded. There are way too many issues being offered that make no economic sense. If a company cannot demonstrate that it can execute its business plan with the funds it is seeking, no platform or funding portal should agree to host its offering. The CfPA needs to help its members to step up their game. 

Rather than purchase those skills, some prominent people in the crowdfunding industry have conjured a new type of mathematical masturbation to stroke the egos of the issuers by selling a delusion of value to investors. I have not heard a single word from the CfPA questioning this practice.

A lot of start-ups are still in the late stages of development. They have burned through $500,000 in seed capital. They do not have a final product, so they have no sales to report and at most a limited test of the market they intend to serve. They have no assets and even their IP is not finished or protected. 

This company put an offering on a funding portal offering 5% of the company for $2 million. If successful, they claim that because 5% of the company was worth $2 million, the entire company must be worth $40 million. There is no excuse for this bullshit.  

In addition to the standards for analysis evidenced by Ben Graham there are GAAP accounting rules governing valuations. There are experienced business brokers around the US who help to buy and sell businesses every day who could not place anything close to a $40 million valuation on this business.    

That some VC might adopt this math is not relevant. VCs have a different agenda. They are looking for growth, not the profits that majority of investors who might invest via crowdfunding look for. An offering on a crowdfunding platform or funding portal should not mislead potential investors that a VC valuation is correct. There are no reasonable mathematics to support it.

It is also misleading to suggest “we expect to cash out in 5 years by doing an IPO or selling out to a Fortune 500 company”. That is not a fact, it is wishful thinking.  In many cases, the odds are actually better over the next 5 years that one or more of the top executives will go through a divorce and lose focus and productivity.

The CfPA has been talking about writing best practices for the crowdfunding industry for years and produced nothing. And, no, I do not want to participate in drafting them at this time, but I do have some suggestions on how the CfPA can make itself useful.

Recommendation: It has been suggested to me that the CfPA is considering creating a “test” to certify some individuals as “qualified” to perform certain tasks regarding an offering. I think that a waste of time. There are plenty of qualified people in finance who would come to crowdfunding if properly incentivized. There are qualified consultants available who could offer the issuers and the industry everything it needs. 

The CfPA first needs to define the talents needed.  The reality is a far cry from anything I have seen from the CfPA to date.  I have written about the crowdfunding process. I have offered to allow the CfPA to post or re-print anything that I have written. A more definitive guide telling issuers and investors what to expect should come from the CfPA. 

Shine light on the scams 

The JOBS Act was adopted to facilitate capital formation under the Securities Act of 1933. It specifically incorporates the anti-fraud provisions of the Securities and Exchange Act of 1934. Operators of crowdfunding platforms, funding portals and virtually anyone else involved in the crowdfunding industry should have at least a working knowledge of what can be said about a company offering its securities to investors, what cannot be said, and what must be said to potential investors. The crowdfunding industry simply ignores these requirements.

Several of the crowdfunding marketing companies insist that issuers pay me to review their final offering materials and especially the marketing materials and adsbefore the offering goes live. I have performed this task, reviewing advertising content, for large wire houses. Like these marketing companies, the Wall Street firms want to have their advertisements reviewed by a lawyer, to protect themselves and their clients from regulators and litigation. 

The Reg. A+ market has been a cesspool from the get-go. By now, I suspect that you could fill up a stadium with people who have invested in a Reg. A+ offering.  Ask that crowd for a show of hands from those who have sold their holding at a profit and very few hands will go up, even though we have been in the midst of a raging bull market.

My very first blog article that discussed crowdfunding was about ELIO Motors which was the very first Reg A+ offering.  The company purported to have a 3 wheeled, electric car.  ELIO brought one prototype to a crowdfunding conference and the crowdfunding “professionals” in attendance went into a sugar shock over it.

I read the prospectus thinking I might write something positive about it. I did not believe what I read to be true and made a single phone call to confirm my suspicions. Once I knew that ELIO Motors was a scam, I wrote it up in no uncertain terms. 

I was thinking, foolishly, the honest people working in the crowdfunding industry would do the same and shine light on ELIO and some of the other obvious frauds since then. I should have known better.

There is a saying in the mainstream markets to the effect that “no one hates to see a stockbroker being dragged out of his office in handcuffs more than the honest stockbroker across the street.”  I have not seen anything from the CfPA that even cautions prospective investors. Given the fact that the Reg. A+ market is going “show biz” to reach a wider, uneducated audience, more and more scams, enforcement actions and bad publicity is inevitable.

There is no shortage of scam artists in the Title II and Reg. CF markets either. The platforms and funding portals need to reject every offering where the issuer cannot support the claims it is making. Too many of the platforms and funding portals claim that they thoroughly “vet” each offering they host. Most have no idea what that actually takes.

When the SEC brought the first enforcement action regarding crowdfunding, Ascenergy, I discussed it with an attorney who had reviewed that offering and rejected it. It was the right call; one that I would have expected an experienced SEC attorney to make. But four platforms were mentioned in the Ascenergy order as having listed the offering. That would not have happened if every platform had access to that first attorney’s report or was at least aware of her concerns.

If a scam artist gets rejected by one platform or funding portal, they just move on to the next one. That is what happened in Ascenergy.That could have been avoided, with a little bit of intra-industry communications.

When I was a young lawyer, the compliance officials for the Wall Street firms would have lunch once a month, bring in speakers and schmooze. It was a venue where lawyers at competing firms could get together for the common good.

Recommendation: The CfPA should sponsor a simple bulletin board where lawyers working in crowdfunding and compliance officers at the platforms and funding portals can post questions to each other. Had the due diligence attorney who rejected Ascenergy posted something simple like: “Regarding the offering for Ascenergy. I spotted some red flags that I could not resolve. Call me for details” likely the offering would not have gotten off the ground, investors would not have been burned and four crowdfunding platforms would not have found themselves discussed within the pages of an SEC enforcement action.

The cost to the CfPA for this is nil. The benefit to the platforms, funding portals and crowdfunding industry is immeasurable. Reducing fraud increases investor confidence and the amount of money they will invest which is the crowdfunding industry’s first and common goal. 

Warn investors by telling them the truth

Let me suggest that the very last thing the CfPA needs to do is to form a committee to discuss investor education. Let me offer instead a homework assignment for the CfPA Board of Directors. Create a list of 10 things that an investor who is thinking about making an investment on a crowdfunding platform or funding portal should consider and publicize the hell out of it.

Let me help:

Crowdfunding Investors Beware:

1) Avoid any company that claims a value many times its projected sales, unless supported by an appraisal from a licensed business appraiser. 

2) Avoid any company that claims it will conduct an IPO or be bought out in the future unless it has a letter of intent in hand.

You get the idea. The CfPA Board of Directors should be able to supply the rest. This assignment is due before Labor Day. I will be happy to review your list and make suggestions before you publish it. And remember, I don’t give credit for wrong answers.

Respectfully,

Irwin Stein

Please STOP Funding Start-ups with “Impractical” Business plans

crowdfunding, equity crowdfunding ,
Please STOP Funding Start-ups

Too many people in the crowdfunding community seem to think that the crowdfunding industry exists solely to provide access to capital to small entrepreneurs who have previously been denied access by the evil banks and brokers on Wall Street. 

I think that the crowdfunding industry will eventually grow and compete with the mainstream banks to fund the same credit worthy companies. The industry just needs to point itself in that direction, something it has been reluctant to do.

Fundraising for start-ups has become remarkably easy with the JOBS Act and equity crowdfunding.  A good, well-funded and professional crowdfunding campaign should receive the funds it seeks every time.

Still many small companies struggle to raise even $50,000 on a Reg. CF funding portal.  Too many of these small Reg. CF offerings fail to raise all of the funds they seek. Part of the reason is that, statistically, 90% of start-ups will fail.

The total universe of investors who might invest in these start-ups is a very small segment of the total number of investors and represents a limited pool of capital. The challenge for any issuer that is crowdfunding for capital is to reach out to enough of the right investors and deliver the right message about your company to them.

Many of the crowdfunding “experts” seem to view investing in start-ups and small businesses as gambling, not finance. That is because many of the funding portals and “experts” know very little about finance.  Some of the portals seem to list any company that can pay the upfront fees.

A great many of the start-ups that seek funding on the Reg. CF funding portals do not deserve to get funded. The offerings are, for want of a better word, crap. The business model they present is unlikely to succeed. Investors are likely to experience a total loss. These companies need to either get their act together or just give up on the idea of getting strangers to fund their business. 

When I read a business plan, I can usually tell if the company has at least a good chance of success or not. It is more than me making an educated guess because there are usually clear signs. Operators of Reg. CF funding portals are supposed to make the same judgment and refuse to host an offering that presents an “impractical” business plan.

Unfortunately, some of the portals do not seem to understand their responsibilities as FINRA members.  Several of the funding portals have no personnel on staff with any experience in any aspect of selling securities, let alone compliance with the regulations. 

I recently joked that what the crowdfunding industry needed most was an introduction to Benjamin Graham because most people operating funding portals think Ben Graham invented a cracker. It is only funny because it is true. 

Several years ago, FINRA expelled crowdfunding portal UFP (uFundingPortal), in part for listing companies with “impractical” business plans. Despite FINRA’s clear warning to the funding portals not to host these types of offerings, many of the funding portals continue to ignore FINRA. 

So what, exactly, does FINRA mean when it is telling funding portals not to list a company that has an “impractical” business plan? It starts with what the company that is raising money is trying to accomplish and whether or not, following its business plan, management has a reasonable chance of making it happen.   

The presentation of an offering on a funding portal should eliminate much of the hype and exaggeration. Notwithstanding, many entrepreneurs are clearly being encouraged to “dream big and promise big” by funding portal operators. If a company is raising capital from investors by making promises it is unlikely to keep, then its business plan is “impractical”.

I think that everyone would agree that a company that is raising $100,000 and promising that it will be enough money to build a skyscraper in Manhattan or to develop a drug that will cure all cancers has an impractical business plan. The same would be true if the skyscraper was not designed by an architect or the drug was intended to be sold without FDA approval. 

A business plan that suggests that the company will sell one million units of its product using social media would be impractical if the company did not have some way of backing-up that assertion.  FINRA has a consistent policy that requires that there be a reasonable basis for all sales and revenue projections. 

As the regulators move forward I think that they will find that a company that intends to market a product that infringes on another company’s patent has an impractical business plan. But not every case will be as clear cut.

Can the Management Deliver?

Investors know that 4 software developers writing code and a CFO do not equal an operating company. It helps if the company has people with experience in the industry in which the company will be operating. At a bare minimum, every company seeking investors should have managers that have experience in managing people. 

With start-ups, it is a red flag if the CEO does not have experience managing a lot of people. It is one thing to get people to work well together and produce the work that needs to be done. It is another in this day and age to comply with often complex workplace rules.

Investors like to see that a company has a marketing director with real experience selling similar products. If the company is not yet ready for a full-time marketing director then the company should at least have someone with marketing experience as an advisor or on the board of directors. For many companies the cost of new customer acquisition is a key metric and may be a foundation for all financial projections.   

I listen when a company tells me that its product will sell millions of units or become a ubiquitous part of everyday life. A company should be able to demonstrate not only that people will want to buy its product but that it can produce it profitably, deliver it efficiently and sustain both.

I always ask about a company’s supply chain.  It is fine if all the company has is a prototype at this point, but if it expects to sell 100,000 units in the first year, it should be ready to explain where the company will get those units, what they will cost and how those units will be distributed.

For a pre-revenue or unprofitable start-up, I always ask the company when, in terms of revenue, will the company breakeven. A company that claims it will see double or triple-digit growth needs to be able to support those claims and demonstrate how and why they will come true.

“If we build it, they will come” is not the best approach for realistic sales and sales growth. Even a start-up should be able to make realistic assumptions based upon proposals give by outside marketing firms.

All of the above is encompassed by FINRA’s rules governing how a Reg. CF funding portal is supposed to operate. The regulations include provisions that are firmly rooted in the idea of investor protection and textbook finance.

New rules allow the funding portals to raise up to $5 million for every company. There has been a significant uptick in funding portal applications.

Small investors are being hyped with the idea that crowdfunding portals are offering opportunities for them to invest in the next Facebook or Amazon that will turn their modest investments into huge profits. The last thing the industry needs is more small companies with dubious products and inexperienced managers competing for investors’ dollars.    

The regulators will never accept the idea that investors in the crowd can be left to fend for themselves or that proper disclosures do not need to be made. Equity crowdfunding is not a caveat emptor marketplace. 

A funding portal is a regulated financial intermediary. It is a very small industry with a single regulator, FINRA. Widespread disregard of those regulations is not good for the industry’s long term health.

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

Investors: Be Careful Walking Down CrowdStreet

crowdfunding, equity crowdfunding, Investors ,
Investors: Be Careful

2016

Back in early 2016, when the first Regulation A + offerings were being made to investors, I wrote a series of articles questioning the veracity of some of the disclosures that were being made. I called out 6 offerings and within a few months, 5 of the 6 had problems with regulators.

Someone suggested to me that I had a talent for spotting scams. It isn’t a talent, it’s a skill, one which I learned when I was a young attorney still working on Wall Street. I was taught how to conduct a due diligence investigation of any company, even when the technology the company was developing was out of my area of expertise.

It is the skill that originally brought me to California in 1980s. I was hired by a law firm to prepare due diligence reports for a venture capital firm that was funding Silicon Valley start-ups.

In the early days of crowdfunding, there was some discussion that the “crowd” of investors could collaborate together and ask the questions on a public platform that investors should ask. That was never true and never really developed. If you want to conduct due diligence on any offering it is always best to hire someone who knows what they are doing.

One of the very early crowdfunding platforms was a company called CrowdStreet which raised $800,000 in seed capital and opened for business in Portland, OR in 2013. It was a Title II platform offering real estate investments to accredited investors. CrowdStreet was one of the few platforms I looked at when I first became interested in crowdfunding. 

Over time, CrowdStreet seemed to quietly grow and succeed. Syndicating real estate is not rocket science and there is no shortage of accredited investors with money to invest.

In 2018, CrowdStreet “partnered” (their word) with a real estate firm in New York City called MG Capital. MG Capital claimed to be “the largest owner-manager of debt-free luxury residential properties in Manhattan”. At that time, MG Capital was offering investors the opportunity to invest in two real estate funds, MG Capital Management Residential Funds III and IV. The principal of MG Capital was a gentleman named Eric Malley.

$500M to $58M?

The private placement memos for these funds touted the success of MG’s two prior funds (Fund I and Fund II) as would have been appropriate. It claimed that MG had raised over $1 billion for the two earlier funds. Based upon their successful raises for Funds I and II, MG projected a successful raise for Fund III of over $500 million. According to the SEC, they actually raised about $58 million, based upon the strength of their prior success with Funds I and II.

Unfortunately, neither Fund I nor Fund II actually existed. On its website, CrowdStreet makes the following claim: “We evaluate the sponsor’s track record, including a review of their quarterly reporting, to confirm they have successfully executed on past deals and can demonstrate stewardship of investor capital. We specifically look for successes in the asset type they are trying to bring to the Marketplace. We want to work with sponsors that value direct relationships with investors and have the infrastructure to support those investors for the duration of the project.”

Forgive me for asking the obvious question but how do you “evaluate” a track record that does not exist?

SEC

According to the SEC, Malley and MG Capital made numerous other misrepresentations in their marketing materials and offering documents, including claiming that investors’ capital was “100% protected from loss” and secured by a non-existent $250 million balance sheet. MG also  claimed that they had partnerships with hundreds of prospective tenants with pre-signed, multi-year lease agreements.

Just the statement “100% protected from loss” is a red flag for any capable due diligence officer. Any private placement is a speculative investment and investors are always advised that they may lose all or part of their investment.

If a company like MG Capital presented a balance sheet claiming $250 million, a good due diligence officer would have asked for an audit. Crowdstreet’s due diligence files should have had a sampling of those leases sufficient to satisfy that MG’s representations were true.

Also according to the SEC, Malley and MG Capital misappropriated more than $7 million in investor assets while using falsified financial reports to conceal huge losses that ultimately forced the two funds into wind-down. At least one early investor sued MG as early as May 2019.

In truth, I don’t follow CrowdStreet, nor did I have any reason to doubt the honesty of its management. I was prepared to give them the benefit of the doubt and assume that they had just been bamboozled by the bad actors at MG Capital.

What actually got my attention was the fact that CrowdStreet is looking for a new President and Chief Compliance Officer. LinkedIn dropped a notice of that job offering into my feed because their algorithm thought it matched my skill set. After 40 plus years syndicating real estate even I thought it was a good match.

I sent in an application last week, in part because the Golden State Warriors were losing (badly), in part because the job was being offered as “remote” which was interesting to me, and in part because if the problem with MG Capital was a one-off, I could probably help them to compartmentalize their exposure.

It took them one day to tell me that my skill set was not what they desired.

Upon further investigation it appears that lawyers who represent investors are lining up to sue CrowdStreet for offerings it hosted that had nothing to do with MG Capital. And let’s be clear, in order for an investor to sue, the investor needs to show that they lost money. In this bull market for real estate, that is hard to do. If CrowdStreet hosted a number of offers where investors were defrauded, in my experience and opinion, the problem at CrowdStreet is a systemic failure.

In addition to a new slate of managers, CrowdStreet is moving from Portland to Austin, Texas. If I had to guess, I suspect that this is the beginning of its winding down process and an attempt to distance the current management from the stench they created.

Multi-Million Dollar Scandal

CrowdStreet may turn out to be a huge, multi-year, multi-million dollar scandal that will turn investors off to the idea of buying shares in a real estate project from a website. That would be a huge black eye for the crowdfunding industry as a whole. 

Notwithstanding, the crowdfunding industry “experts” will, at best, lament this as an aberration. The idea of teaching every platform or portal operator how to conduct a legitimate due diligence investigation is a non-starter. Believe me, I have offered to teach at least one platform that consistently hosts offerings that are BS for free and got turned down.

As I have said before, the crowdfunding industry needs to re-focus on investor protection or the investors the industry cannot live without will continue to stay away.

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

Making the New Capitalism Efficient

Capital Markets, crowdfunding, equity crowdfunding
Making the New Capitalism Efficient

Economic theory teaches us that in a perfect world capital would always be allocated to its best use. The best use is always viewed from the perspective of the person or entity that is deploying the capital. Consequently we normally calculate the best use as the highest rate of return that the capital can reasonably achieve. The object is always to use money to make money.

To further this goal, capital has always been deployed to companies that have had the best chance of success. A due diligence process is employed to separate the best companies from those that the market deems less worthy. While far from perfect, this system has historically worked well enough to create our modern society with few truly innovative ideas left by the wayside, meaning unfunded.

In the last 20 years, some people with capital have been content to deploy it for other, more altruistic reasons. Specifically, they want to make capital available to people who have no access to the mainstream capital markets and others who for a variety of reasons could not get funded.

This new capitalism has taken two innovative forms, micro-lending and crowdfunding. Each has the potential to put capital into the hands of people who otherwise would never have access to it. Both have the potential to be transformative at the lowest tier of the global economic system. Neither is focused on highest rate of return as its primary goal.

In its purest form a micro-loan is very small and will often help a subsistence level individual transform into a capitalist. Micro-loans are frequently used to purchase one sewing machine to create a manufacturer; one shipment of goods at wholesale to create a merchant. Some micro-loans are used by a rural community to purchase one used truck or tractor. The benefits of these loans are obvious.

As originally envisioned, micro-loans were often interest free or loaned at an interest rate low enough to cover only the lender’s overhead and the costs of defaults. Even though no one who gets a micro-loan has a FICO score, statistics show the rate of default worldwide to be very low. As much as 97% of the loans are repaid. As conceived, micro-lending is a model of market efficiency.

Unfortunately, as this industry has developed and matured, there are some places where micro-loan programs are managed by bloated bureaucracies. There are stories of interest rates that would make loan sharks blush, corruption and exploitation in the lending process and misappropriation of funds intended for borrowers.

Crowdfunding

Crowdfunding is a remarkable tool for capital formation. Its successful utilization still eludes too many small businesses who might benefit most from an infusion of capital.

The crowdfunding industry still suffers from “experts’ who have no idea how to raise capital. Fraud remains a problem because no one really vets the companies that seek funding. The process itself can be expensive and is often hit or miss even though it does not need to be.

Investors who buy into the equity of a small company on a crowdfunding platform must understand they may take a total loss. Even if the company is initially successful, there is no liquidity for the equity that investors purchase.

There is, I would think, a way to combine the micro-loans with crowdfunding in a way that would remove much of the inefficiency. I think it would be welcomed in the developing world.

In most developing countries there are universities whose students are themselves often making the transition to the middle class. They should appreciate that strengthening the underclass will provide a greater market for the products and services that they themselves will eventually make and/or sell.

What I would propose is that each university in developing countries create a crowdfunding program to enable students to fund micro-loan programs in their own communities.

Most peer-to peer lending platforms allow companies in need of loans to borrow from multiple individuals, essentially syndicating each loan. I envision the university students creating a single fund from which to make micro-loans to many borrowers.

I would ask the students to fund the program by purchasing shares in the fund with a small yearly tithe for the 4 years that they are students and for a few years after they graduate. Call it a 10 year voluntary commitment to purchase shares.

Additional funds would come from sale of shares to faculty, alumni, local banks, businesses and importantly, each country’s expatriate community. University students in western countries could partner with university students in developing countries. All anyone need do to participate is buy one share.

I have intentionally left out any local government involvement or participation. Direct government participation rarely adds efficiency to anything.

Business students and volunteer faculty at each university would administer the fund. This would remove much of the costs and corruption. It would give these students valuable experience evaluating business proposals and detailed knowledge about the local economy that will not be found in their textbooks.

Borrowers would pay a fixed interest rate. A rate of 6% might be sufficient to cover the risk of defaults and provide some amount of internal growth. Real growth for the fund will come from new students who will join the program each year as they enter college.

At some point each fund would reach a predetermined principal amount and be closed. In the US and elsewhere a closed-end mutual fund can become registered and be listed and traded in the regulated securities markets. This would provide liquidity to these crowdfunded investments where none exists.

Even after it is closed, a fund can continue to collect payments on existing loans and make new loans year after year. There would be no reason or requirement for it to liquidate.

As the fund grows after it is closed the per-share value will continue to appreciate. Providing for growth and a liquid market would mean that shareholders could expect to make a profit from their investment.

The closing of one fund will be followed by the opening of a new fund to replicate the process. Over time, multiple funds will exist in every country that wants them, sponsored and funded by university students and others who will see both the benefits of the program and the potential for their own modest profit.

Replicated university to university and country to country a program like this would have a demonstrable effect within a decade. On a continuing basis it has the ability to transform communities and economies in the developing world from the bottom up.

It is an opportunity to demonstrate that altruism and capitalism are not mutually exclusive.

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