Investors

Satoshi was a Copycat and Maybe a Criminal

Capital Markets, Investors, Technology ,
Satoshi was a Copycat

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Am I being too cynical?

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

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

It’s the romantic in me. 

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Lights. Camera. Bubkes.

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

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

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

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

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

Oh, well. That’s show biz.  

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

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

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

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

Where did Going Public go wrong?

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

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

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

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

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

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

What do investors get?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Seeking “reasonable” people in crowdfunding

Capital Markets, crowdfunding, equity crowdfunding, Investors

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

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

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

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

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

What do regulators expect from Reg. CF funding portals?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

When is a funding portal compliance director being reasonable?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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KingsCrowd – Again

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why do I even care? 

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

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

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

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

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

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

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

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

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

Case in point:

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

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

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

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

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

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

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

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

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

 

Start-ups, are you buying investors online?

Capital Markets, equity crowdfunding, Investors, Issuers , ,
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, equity crowdfunding, Investors, Issuers ,

Crowdfunding Professional Association (CfPA)

To: The Board of Directors

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Crowdfunding is corporate finance, do the math  

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Shine light on the scams 

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

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

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

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

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

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

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

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

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

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

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

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

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

Warn investors by telling them the truth

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

Let me help:

Crowdfunding Investors Beware:

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

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

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

Respectfully,

Irwin Stein

Investors: Be Careful Walking Down CrowdStreet

crowdfunding, equity crowdfunding, Investors ,
Investors: Be Careful

2016

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

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

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

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

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

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

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

$500M to $58M?

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

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

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

SEC

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

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

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

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

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

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

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

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

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

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

Multi-Million Dollar Scandal

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

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

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

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

Or you can book a time to talk with me HERE

Remembering the “customer’s man”

Capital Markets, Investors , ,

customer's man

The 1970’s

Several weeks back I had lunch with a colleague who, like me, had started in the brokerage business in the 1970s. At one point he referred to himself as a “customer’s man”. It was a term used to describe a registered representative that I had not heard in years. It evoked a way of doing business that has largely been lost.

At that time, commissions and costs were fixed across the industry. Today, we see these costs as an impediment to our ability to maximize investment returns. We have lost sight of the value that a good customer’s man brought to the process.

A good customer’s man got to know you.

The brokerage firms encouraged every customer’s man to get to know every one of his customers and to get to know them well. You would meet in person to share lunch, drinks, dinner or to play squash, tennis or golf. Over time and many conversations you would get to know quite a bit about each others’ lives and families. Your customer’s man would become one of your trusted advisers.

A good customer’s man was a good stock picker.

Customers’ men were always on the look-out for the next stock that was about to make a move. They were selling their ability to pick stocks and to buy them for you at the right price.

Your customer’s man would always tell you which stocks he was following and why he was following them. He would call to tell you when the price had dipped and to recommend that you give him an order to buy a few hundred shares for you. You would not hesitate.

A good customer’s man made money for you.

Customer’s men were judged by how much the stocks that they recommended went up. It was a simple metric that everyone understood. Very few built their book of customers by advertising or seminars. The best built their books by word of mouth. They asked existing customers for referrals. Customers who made money following their broker’s recommendations gave the best referrals.

From the 1970s forward if the firms wanted more customers, it meant having more brokers with bigger and bigger books of customer accounts. The big action was moving established producers around from firm to firm. Front-end bonuses for really big producers became really big. Just about every broker wanted to be a bigger producer.

That attitude was good for the firms and they encouraged it. Brokers became almost exclusively focused on bringing in more customers. No longer were they judged for the stocks that they picked or how much money their customers made. Producers were now judged on how many “assets under management” they have.

The actual management and investing of the customers’ funds was increasingly handled elsewhere. Enticing new customers meant selling the investing and management skills of others.

The 1987 Crash

This was logical as so many of the customers’ men had not seen the 1987 crash coming. If they had, logic suggested that they would have pulled their customers out before it happened.

customer's man

It was time to let the experts manage your investments. Customers were sold many different kinds of managed funds, annuities and other “packaged” financial products. All of these products were expensive from the customers’ standpoint. The firms had built in significant underwriting costs and management fees.

Many of these fund managers drank from the Kool-aid that said that price/earnings ratios of 50 or more were sustainable and likely to go higher. Individual brokers who questioned the wisdom of the high paid fund managers and research analysts were brought into line or shown the door.

When the tech market inevitably crashed, many in the industry argued that “no one had seen it coming.” They said the same when the market crashed again in 2008. It was a phrase that was repeated so often that people started to believe it.

It re-enforced the idea that the average financial adviser can do no better than average. Everyone just started buying the index, certain that no human being who actually works in the markets every day could actually have awareness of what was going on or to help customers profit from it.

The index was much cheaper than a human adviser in any event. Lower costs were more efficient and would increase returns, provided, of course, the market goes up.

A good customer’s man always put the interests of his customers first. It was an era when almost every business adhered to the idea that “the customer was always right.” When is the last time that you heard that phrase or saw it posted in a business or an office?

Today, the industry staunchly opposes any regulation that would require individual brokers to put their customers’ interests first. That should tell you everything that you need to know about the financial services industry today.

The individual registered representative, the back-bone and the public face of the brokerage industry will likely not survive another generation. Their jobs are already foolishly being replaced by computer driven robo-advisers.

The industry will survive and prosper without the customer’s men. It is already oblivious to what it has lost.

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

Fidelity’s Folly: Bitcoins for All?

Capital Markets, Investors, Law , ,
Fidelity

Fidelity Investments

People keep asking me what I think about Fidelity Investment’s announcement that it will act as a custodian for bitcoins and other cryptocurrencies. As anyone who follows me knows, I don’t think very much of it at all. 

Fidelity has made it clear that it is “all in” on cryptocurrency. Its website notes that: Fidelity Investments “operates a brokerage firm, manages a large family of mutual funds, provides fund distribution and investment advice, retirement services, Index funds, wealth management, cryptocurrency, securities execution and clearance, and life insurance.” 

Fidelity would certainly wish to expand each of those profit centers. With bitcoins and cryptocurrency there is the potential for enormous growth if Fidelity can turn them into just another “investment”. It can’t, even though it is trying very hard. 

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

Please do not be impressed with that gooblygook. There is no real data about bitcoins for the Director of Research to research. You cannot analyze bitcoins in any traditional way. They are merely a few lines of computer code. This report is reminiscent of the type of justification that analysts gave in the dotcom era for supporting stocks, with no income, trading above $100 per share. 

The report further suggests that bitcoin’s current market capitalization “is a drop in the bucket compared with markets bitcoin could disrupt.” That certainly sounds like a “buy” recommendation to me.

The primary markets that bitcoins might disrupt are banks. In truth, bitcoins, when used as payment in commercial transactions, disrupt nothing. Banks and banking are not going away.   

If you consider how many payroll and Social Security payments are already deposited directly to recipients’ accounts and how many of those recipients pay their electric power or insurance company “on-line” it is fairly easy to see that converting the deposit to bitcoins before you make the payments is an extra step not likely to find favor.  

The one thing that will cause the current price of bitcoins to appreciate is a lot more investors willing to buy them and hold on. That is the strategy being pushed by Fidelity with the blessings of “pseudo” market professionals. 

Last month, Fidelity stated that it had polled a number of the “professional” fund managers and investment advisors who are currently its customers.  Apparently enough advisors would consider bitcoins for their advisory clients to warrant Fidelity acting as a bitcoin custodian. 

Some number of advisors who already use a Fidelity platform will certainly purchase some amount of crypto currency for their clients’ accounts.  That “professionals” are buying bitcoins is likely to be used by Fidelity as a reason to advertise them to average, small investors as “what the Pros” are buying. 

In 2 years, Fidelity may have many billions of dollars’ worth of bitcoins held in accounts on its platform. That will not make it the right thing to do.

Law and Economics, which I taught back in the 1990s, studies how our interwoven markets interact with the laws that regulate them. Judges interpret those regulations, often influenced by what they perceive the regulators intended to accomplish.

The regulations that govern our financial markets (equity, debt, currencies and insurance) have evolved over the centuries with the markets that they regulate. The introduction of something as novel as crypto currencies into the financial markets should be expected to suffer some adverse legal consequences. 

As a matter of law, every Registered Investment Advisor (RIA) and anyone investing other people’s money is held to a fiduciary’s standard of care.  Fiduciaries are usually required by law to: 1) act in the best interests of their clients, 2) preserve and protect the assets entrusted to them and, 3) when investing to act as a “prudent” investor would act.

A fiduciary’s duty to its client or beneficiary is a much higher standard of care than in any ordinary commercial transaction. To satisfy that standard often means taking “extra” care to mitigate obvious risks.

Fiduciaries become fiduciaries when people trust them to hold their property or to act on their behalf.  People most often trust fiduciaries because they have specific expertise in the matter at hand. Both fund managers and RIAs fit that description. Both are held to a fiduciary’s standard of care and their conduct is most often judged against that of other experts in their field. Most investment professionals will never purchase any crypto currency for their clients.

Fidelity, the fund managers and RIAs who do purchase bitcoins and store them at Fidelity obviously believe that the price of bitcoins (currently in the range of $10,000 a piece) will appreciate and perhaps double or more.  It is certainly possible this could happen.  Two years from now the price of a bitcoin might have risen to $20,000 each and possibly higher. Many of the bitcoins held at Fidelity will have been purchased at close to that amount.   

Let’s assume that for some reason or another, in a 90-day period, the price drops back to $10,000 each.  That could result in several billion dollars in actualized losses as some will “hold” all the way down in hope of a rebound.  Does Fidelity shoulder any liability for these actualized losses?

The Fund Managers and RIAs certainly do. Unlike most litigation, where the burden of proof is on the plaintiff, in many states, fiduciaries are required to demonstrate the reasons that they made the offending investments.  Much of the case will be dependent upon what the advisors can show were their reasons for buying bitcoins in general and also specifically on the day and at the price that they did. They will also have to demonstrate why they held on as the price deteriorated.

Given that there are no fundamental reasons for purchasing bitcoins I suspect that most will try to defend themselves arguing that bitcoins are a hedge against adverse results in the rest of the portfolio. That argument is likely to fail. 

Bitcoins are, after all, a commodity, and putting aside the fact that most RIAs are not trained or licensed to sell commodities, gold would be a more accepted hedge if that is what the RIA wanted to do. If nothing else gold is unlikely to lose 1/2 its value in a short period of time, which bitcoins have already demonstrated they can do. 

Litigation

Fidelity’s role as a platform or clearing firm might save it in Court but these customer claims are more likely to be heard by arbitrators appointed by FINRA, especially if Fidelity is named as a respondent. I have been an arbitrator and argued many cases in front of others. They are more likely to be older and their view of bitcoins will probably be closer to Beanie Babies, than as a new form of currency that trades in a very opaque market. 

Fidelity

Two recent cases brought by the SEC will not help Fidelity’s defense either. The first is SEC v. ICO Box, where the SEC alleged that the platform “facilitated” the sales of more than 30 different crypto currencies. “Facilitated” is a word that will make defense lawyers crazy. 

By the time that these claims get to a hearing I suspect that complaining customers will be able to present a banker’s box or two of “reports” written by Fidelity that suggest that RIAs purchase bitcoins for their customers. That should certainly be viewed as a “facilitation”.

The other case is called SEC v. Lorenzo.  Lorenzo was charged with copy and pasting an e-mail written by someone else and sending it to prospective investors. The SEC alleged that Lorenzo “disseminated” misleading information in order to make the sale. Given the outrageous claims made by many in the bitcoin world, some Fidelity employee is more likely than not to resend a report or article that Fidelity cannot defend.

The mutual fund industry, Fidelity’s core business, is under great stress to lower the fees it charges investors.  For all the BS that you may hear about how Fidelity’s actions in embracing crypto is “cutting edge” or “visionary”, it makes more sense that Fidelity is touting crypto to make up for revenue lost elsewhere.

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

Reg. CF – Will Fools Rush In?

Capital Markets, equity crowdfunding, Investors, Issuers , ,
Reg. CF – Will Fools Rush In?

I have written a lot of articles about crowdfunding in general and specifically about crowdfunding to accredited investors under Regulation D.  I have largely ignored the much smaller financings that are accomplished under Regulation Crowdfunding (Reg. CF) that accept investments from all comers. The time has come to fill that void.

REG CF

Reg. CF was the last of the regulations issued by the SEC under the JOBS Act.  It embodied much of what proponents of the Act had wanted….a sanctioned method for community funding for start-ups and small businesses. 

The first Reg. CF offerings began in May 2016. Despite a few success stories, the Reg. CF marketplace has yet to mature.  I do not see that coming at any time soon, despite the out-sized need for small business capital.

Reg. CF created a new class of financial intermediary called “portals” which are essentially websites where companies seeking investors are displayed.  But the portals are more than just websites.

The SEC wanted this market to be regulated, in part to protect investors from fraudulent offerings and in part to provide the companies seeking capital with a way to interact with investors in a regulated environment. The SEC required the portals to register with FINRA, the stock brokerage industry’s regulator, and to adhere to FINRA’s regulations.     

Until recently only about 50 portals had been registered with FINRA, a number that had been fairly static for a while. A small handful of the portals handle the bulk of the transactions.  Some of the earlier portals have quietly gone out of business. The rest quietly grind out only a few offerings at a time. 

Top Ten REG CF Portals Ranked By Capital Raised 2020

Reg. CF required that investors be given specified disclosures about each company.  It set baselines for the presentation of financial information and set limits on how much any small investor could invest every year in these very risky ventures.  A required filing gives the SEC specific information about each offering. 

Reg. CF allows companies to raise no more than $1,070,000 in a single year. For reference, the average loan guaranteed by the SBA is closer to $600,000. The SBA guarantees about 40,000 loans per year and rejects a similar amount. There are many thousands of small companies that do not come up to SBA standards.

A great many companies would have their capital needs satisfied with much less than $1,000,000.  These companies should be looking to Reg. CF portals but are not. The portals have not demonstrated that every listing will get funded which is what any company should want.   

A very large percentage of the offerings that list on Reg. CF portals raise very little money.  Still, a great many start-ups and small businesses ask for very little.  Many of the offerings seek less than $100,000. 

Many of those small offerings do not employ a specialized marketing company or even an organized crowdfunding advertising campaign.  Too many of the campaigns rely solely upon the company’s existing social media contacts which are rarely enough to get the company funded. 

Portals

Very, very few of the portals are wildly profitable, if at all, even though the compensation structure is patterned after the wildly profitable mainstream stock brokerage industry.  Most portals charge close to 7% of the funds every company raises. The very best portals raise a total of less than $1 million every week.  This against a backdrop of so many companies in need of capital.

Five new portals were registered this month and the scuttlebutt around the industry is that another dozen portals more or less are in various stages of the registration process. Many anticipate that the SEC will raise the limit to $5 million. That may or may not happen and it will have little import since most of the portals have no idea how to raise even $100,000.

Just in the last few months, I have spoken with several people planning new Reg. CF portals. With one exception, none of these new portal owners knew anything about selling securities which is the business of any portal. None seemed particularly interested or focused on helping the listing companies raise the funds that they seek, even though the portals get paid a percentage of the funds that are raised.

FINRA

FINRA has always been a fairly lax regulator.  Notwithstanding, like many regulators, FINRA can get their teeth into you. They especially like to tangle with smaller firms that would rather settle than fight. 

Reg. CF – Will Fools Rush In?

I expect FINRA to get more involved as it is aware that the investors themselves have little recourse. If an investor invests in a Reg. CF offering that is a total scam no lawyer is going to file a suit against the portal if the loss is only $500.  Even a $1 million Reg. CF offering is likely too small for a class action.

FINRA has its own set of portal rules and an established set of standards and practices.  FINRA views the portals as being in the business of selling securities to public customers and should be expected to act accordingly.

Several people in the crowdfunding industry have suggested to me that crowdfunding platforms and portals have no real liability if an offering they host uses fraudulent or deceptive means to attract investors.  At least with portals, that is categorically not true.

FINRA’s Rules for Portals specifically forbids the portals from engaging in fraudulent conduct with the same language it prohibits the mainstream stock brokers. As the portals do not have trading desks, the only place the portals might engage in fraudulent conduct is regarding the offerings they host.

FINRA expects each of its Members to have some system in place to verify the information that the listing companies provide to the public investors.  FINRA has warned its members to not accept the self-serving statements of the founders of these companies at face value.  In many ways, this is the antithesis of the approach that many portals take, especially with start-ups. 

I have said before: when a portal lists an offering for a pre-revenue company, with negative or minimal book value, and allows the company to claim a “valuation” of tens of millions of dollars it is a fraud.  What some VC might think or say about the company is not regulated in the same way as a firm registered with FINRA.  The lawyers who allow the portals they represent to make a misrepresentation as to the “value” of a company are not doing anyone any favors. 

There are very few lawyers who work with Reg. CF portals. Every one of the lawyers that I have met or spoken with was a very competent professional.  But not all of them could really see Reg. CF offerings from the investor’s point of view which FINRA is likely to adopt as its own.

I recently spoke with an attorney who represents one Reg. CF portal and who is in the process of helping a client set up another.  His new client writes a blog with a lot of followers. The blog features articles about specific start-ups.  His client frequently appears on podcasts that get a significant amount of viewers. The client hopes to leverage his notoriety to help the companies that list their offerings on his new portal.

Rules Are Rules

FINRA expects portal owners to follow its rules regarding communications with the public.  When you are selling securities much of what you can and cannot say is regulated.  There is also a list of things that you must say when talking about an offering where you expect to collect a fee if the offering is successful.

Reg. CF – Will Fools Rush In?

FINRA has already expelled one portal owner for what he said about an offering in an interview away from his portal. There will be others.

I asked the attorney if the portal he was working on had an in-house compliance officer with experience to check all the scripts and the advertising copy for compliance before it is released.  He told me that his client had not even thought about it.

That is the nub of the problem.  Only one of the new portal owners with whom I spoke had a clear idea of how they would find companies to fund or how to make certain that there were always more investors available than securities to sell.  And that is really crucial to the success of this business.

Adding 20 new portals to a market where most of the portals are not profitable is likely to result in a race to the bottom rather than the top.  Adding more portals whose operators lack essential experience and trained compliance officers is not going to get more small businesses funded correctly.

Ideally, there would already be 50 portals each supplying $1 million per week or more for start-ups and small businesses.  Another 20 would be welcome, especially now when the need for small business capital is great.

With Reg. CF the SEC offered a truly new and relatively simple method of corporate finance for small business.  FINRA offers a roadmap to compliance and respectability. The road to success will come when the portal owners start acting like they are in the business of selling securities and focus on doing exactly that. Sadly, I do not see that happening any time soon.

If there are any portal owners out there who are ready to give up because they cannot run their portal profitably, I have some clients who would be interested in acquiring your registration to help you to salvage something from your efforts.  Serious inquiries only.

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