Where Do You Go When The Bank Says No?

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

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.

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

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

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

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?

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

KingsCrowd- selling ratings for fun and profit

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

Start-ups, are you buying investors online?

Start-ups, are you buying investors

I have been writing a lot about crowdfunding lately and speaking with other people in the crowdfunding industry.  From our conversations, it is obvious that most do not share my perspective on the entire business.  I see crowdfunding as continuing an evolution of the capital markets already in progress when I started on Wall Street in 1975.

In 1975 the stockbroker was king. People did not buy investments, I was told early on, stockbrokers sell investments.  Good stockbrokers, especially those on their way up, aggressively sold stocks. The sales pitch was often about one particular stock, frequently supported by a report prepared by research analysts.  Analysts were “ranked” every year and firms paid the “1st, 2nd and 3rd All-American teams”, handsomely.

While there were certainly stockbrokers who met their clients for lunch or at the club for golf who came back to the office with orders in hand, much of the “selling” was done over the telephone.  Young brokers were encouraged to stay into the evening and engage in a ritual known as cold calling.

During my training, I spent an evening with a single page from the NYC phone directory, script in hand, dialing for dollars. Most people had those old, heavy rotary phones.  I swear, I could hear the receiver sucking in air as it was being slammed down onto its cradle.

What cold calling teaches us is that some percentage of the calls you make will respond favorably, and buy what you are selling.  If you want to make more sales, you need to make more calls.

I mention this only as a backdrop.  This “sell-side” focus has shifted, significantly. Today, a great many retail stockbrokerage customers, make their own decisions about what to buy and what to sell in their stock or retirement accounts.  These customers are enticed by lower costs. They respond to advertising, and they will rely upon information delivered to them online.  Without these investors, crowdfunding could not exist. 

If I were teaching Law and Economics today, I would look back to 1975 and say that is where it all started.  Changes in the law, a new one enacted and an old one discarded, were the catalysts for enormous changes in the way the capital markets operate. The market responded to those changes by bringing in millions of new people who were affirmatively looking to invest and who brought trillions of new dollars with them.   

ERISA, enacted in 1974 created the tax-deferred Individual retirement account (IRA).  It was intended to incentivize millions of small savers to put their money into a bank or the stock market and to leave it there for the long term. 

In response to this new market of small investors who might start small and add a few thousand dollars every year, John Bogle opened the Vanguard Mutual Funds. Mutual funds provided a simple way for small investors to participate in the market.

Mutual funds had been around for a long time by then.  They were commissioned products sold by many stockbrokers.  And while an IRA account was the perfect vessel for mutual funds, what I would stress to my students would be the shift in the way mutual funds were advertised and sold directly to investors.

Vanguard and the other mutual funds actively advertised for investors seeking to make direct purchases.  Instead of dealing with a stockbroker who would call whenever they had, something that they wanted you to buy or sell, with a mutual fund, an investor could just put their money into a fund and the fund will do it all for you.  Somebody called it “passive investing”. Instead of touting the skill of their analysts to pick winners, these mutual funds sold convenience.

In 1975, both the State of New York and the City of New York were functionally bankrupt. The stock market had tanked and lending had ground to a halt.  The economy was in the midst of abnormal inflation.  People responded to the idea that they take some risk to grow their retirement funds in the stock market rather than save it in a bank so they could keep up with inflation.

Also in 1975, the New York Stock Exchange repealed its long-standing rule that had fixed the commissions that NYSE Members charged for each trade.  Mainframe computers were being installed up and down Wall Street. The costs of everything from executing trades to sending out confirmations and monthly statements were going down.

When commissions were fixed, the customer was charged a commission that reflected both the costs of execution and the “other” services that the brokerage firm provided, most notably, research that would tell the customers what to buy and when to sell. As commission costs became a source of competition, Charles Schwab and others were already talking about “unbundling” the cost of executing a trade from the research component that had always come with it. 

Schwab and its “discount” competitors demonstrated that a great many investors were happy to sit at home and make decisions on what to buy and what to sell, based only on what they read themselves. And while Schwab and other discount brokers now offer research reports, very few customers of discount firms are exposed to the type of research available to institutions. 

The stockbrokers’ response to this unbundling can be encapsulated in their advertising slogans of the time: “Thank you, Paine Webber”; “When EF Hutton talks, people listen” and my personal favorite: “Smith Barney makes its money the old-fashioned way, they earn it”.  The mainstream industry doubleddown; they were selling advice and they were proud of it. 

Without good advertising and a lot of it, the full-service stockbrokers, the discount firms like Schwab, and the entire mutual fund industry would not have grown into the behemoths that they are today.  The result of all of that advertising is a market full of millions of investors who are comfortable making their own investment decisions.  This includes a significant number of baby boomers who still represent a very large pool of capital that is available for investment. 

What does this have to do with crowdfunding in 2021?

If I have learned anything from watching the growth and evolution of this market since 1975, the one thing that stands out is that for companies that are selling investments, good advertising works. There is a cost, certainly, of acquiring investors for any given offering, but if you pay that cost, you will get enough investors to pony up the investment that you seek.

The best people in marketing who are working in crowdfunding understand that it is very much a “numbers game” just like “cold calling”, although now much less expensive and efficient. Modern data mining techniques enable each company that is seeking investors to present its offering to an audience that is more and more specifically targeted. 

I call it “buying investors online”. What do you call it?

I have sat in marketing meetings for various players in the financial services industry many times. Depending upon what these companies are selling and to whom, the marketing and sales strategies differ greatly.

The common denominator of these varied strategies is that they are all measured by the same standard, CAC, the cost of acquiring each customer or investor. The object of any marketing campaign is to attract the most customers (and their ‘orders’) from every dollar spent on any advertising directed at those customers. 

In crowdfunding, while statistics are few, it is obvious that the costs associated with acquiring investors varies greatly, offering to offering. Some offerings fail because investors do not find them attractive, most, I think, because they lacked marketing muscle.  

Personally, I find it painful to watch a company that has hired me to prepare the paperwork for their offering fail to acquire the investors they need.  Often, these company’s campaigns fails because they hire the marketing company that was the lowest bidder.  I try to steer my clients to a marketing company that may not be the least expensive, but gets the job done.   

The Regulation D, private placement market has found enormous success using crowdfunding for investors.  Even now, a sponsor can identify potential investors for the purchase of an office building who can afford to invest, who have an interest in real estate, and who live close enough to the property, to drive by if they want to look at it. And the data mining techniques that created these targeted mailing lists are still in their infancy.

Crowdfunding for capital has become a simple process.

Step one: create an investment that will be attractive to investors

Step two: create advertising copy that can be pre-tested and shown to be effective

Step three: put those ads in front of your pre-targeted lists of prospective investors.

Step four: Repeat step three until you raise the money you need.   

I have written elsewhere that I believe that crowdfunding has reached the point where it will now quickly grow to be a major source of capital for start-ups and small businesses.  A major reason will be that companies seeking funding can now approach crowdfunding with a high degree of certainty that they will get funded. With the proper perspective, those companies can appreciate that they are buying investors online. 

 

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

 

Crowdfunding Professional Association – An Open Letter

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