Millions of retirees are about to get screwed by taking the advice they are getting from their financial “professionals”. Older investors and retirees are being told to stay invested in the market regardless of the current risks. It is foolish advice that a lot of foolish retirees will follow.
A lot of people have done quite well in the stock market “buying and holding” during this long bull market. But the time to hold is likely behind us and the time to fold’em is right now.
Many of these retirees have the same poorly diversified portfolios of stocks they have held for a long time. It is improbable that the price many of those stocks will continue to appreciate. If anything, the risk that they will continue to go down is greater than the likelihood that they will continue to go up. If they are not going to go up in price, there is no reason to continue to hold them.
Last week, I got a call from a friend whose mother was concerned that her account had taken a 6 figure loss in value for the first quarter of this year. His mother is divorced and already retired. Her account is with a large, national brokerage firm. She is concerned that her account balance dropped so much and so fast.
Her broker is telling her not to panic which is always good advice. Investment decisions should be based upon mathematics. It is not very hard today to do the math and realize that holding on to the portfolio you had last year does not add up.
Her portfolio today is worth less than it was 3 years ago and as I said, down over $100,000 in this last quarter alone. Her broker told her to “stay the course” because “these corrections happen and the market always comes back”.
As I have said before this current correction is my 7th or 8th and no two were exactly alike. In the last two, 2001 and 2009 there were clear indications that the market averages were too high and likely unsustainable many months before the bottom. There was plenty of time to sell out and save some money but many brokers then, as now, told their customers to just hang on.
The mainstream stock brokerage industry chose to ignore the same indicators that they used when they predicted that stock prices would go up. It is ignoring the indicators that this current market is still far from its bottom.
I wrote an article just two months ago when the pandemic was still tangential to everyday life. I did not think that the government’s tepid response in January would be so consequential by April.
I noted the various conflicts of interest behind the brokerage industry’s desire for investors to stay invested. Recessions hit Wall Street hard. Profits and bonuses disappear. A lot of people typically get laid-off. The idea that people might sell their stocks and put the funds in a CD to sit things out gives Wall Street indigestion.
Just Do The Math
Investing is governed by mathematics. Large institutions control most of the money that is invested in the stock market. Most use the same method of Fundamental Securities Analysis first described,in 1934, by Ben Graham in his book of the same name. That book is still used in virtually every major business school. A large investor like CalPERS or an insurance company will have hundreds of analysts on staff.
At its basic level, the analysts are using one primary metric; earnings both current and projected into the future. A projection of higher earnings for next year would be an indication that the share price will be higher next year as well. Analysts are always looking at a company’s business to see if its revenues and profits are likely to increase 6 months or a year down the road.
What do these analysts see today?
Right now, it is pretty clear that a great many companies will continue to struggle at least until the end of this year. When these companies report their earnings for 2020 next spring, they will show that earnings, if any, will be down from earnings last year. Lower earnings should indicate lower stock prices.
Every indication is that the stock market is likely to be lower next year. The risk that people who stay in the market for the next year will lose money is high. So why would any financial professional recommend that their clients should stay invested especially clients who are already retired? How much can retirees afford to lose in a bear market?
A lot of people who got the same advice to stay invested no matter what eventually watched their account values decline to the point that they finally realized that their broker was full of shit. They sold their portfolios and realized the losses that they had were a result of risks that they never wanted to take.
I handled many customer claims against their stockbrokers recovering losses from the last two corrections. The stockbrokers always make weak defenses when confronted with losses that their customers never expected and which they could ill afford.
These claims are handled as arbitrations run by FINRA, the brokerage industry regulator. They are fast and cheap. Like most court cases, FINRA arbitration claims usually settle before the hearing. Retirees who lose money in the market can often recover some or most of what they lost.
When every stock brokerage account is opened, there is a question on the new account form that asks for the customer’s “risk tolerance”. A typical form might ask investors to identify the account as “conservative”, “moderate”, “aggressive” and “speculative”. They represent an ascending willingness to lose money. But a willingness to lose is not the same as a desire to lose.
For retirement accounts, especially as the retiree gets older, there is a consensus that the account should become more conservative. Once people stop working and are using their retirement funds to pay bills, preserving those accounts becomes the paramount concern.
A diverse portfolio of stocks and bonds was always considered to be a “moderate” risk account. And then something unusual happened. The overall market itself has become riskier and many of those diversified accounts took on the risks of an “aggressive” account.
There is no justification for a stockbroker to tell a customer looking for a moderate risk account to stay invested when the risks of the portfolio they are holding have gone up past the customer’s level of comfort. Many retirees have already lost more than they can afford to lose.
A stockbroker is required to have a reasonable basis for every buy, sell, or hold recommendation that they make. When arbitrations over losses in 2001 and 2009, went to a hearing, there was nothing that the brokers could point to in their files that showed they had a reasonable basis to tell people to stay invested.
If your brokerage statement shows losses that you did not want, send your broker an e-mail asking for his/her specific advice as to what you should do now. Ask them for the research reports that support their recommendations.
If they tell you, “the market has always come back” remind them that past performance is no indication of future results. If they tell you that no one saw the pandemic coming, remind them that price to earnings ratios were way above their normal ranges for months before the virus.
If your losses are too high and you get insipid answers from your broker, just send me an e-mail. I will be happy to refer you to an attorney who will help you recover your losses.
If you’d like to discuss this or anything related, then please contact me directly HERE
I spent a good part of 2018 reading the white papers for hundreds of Initial Coin Offering (ICOs). More than 1,000 ICOs were offered to investors around the world that year.
I admit that I was intrigued. Many of these
offerings were targeting US investors from overseas. This type of cross-border finance has always
existed but it has always been on the margin of the US securities market. ICOs
seemed to want to bring it into the mainstream.
Big companies outside the US could always deposit
their shares with a bank or custodian and issue American Depository Receipt
(ADRs) to US investors. Financial advisors often tell their clients to
diversify a portion of their portfolio into overseas investments.
Some people thought that the tokens issued by these ICOs were an entirely new asset class. Others, myself included, saw that they were being sold as investments and if they could be traded or re-sold, they were just another security.
As I published a few articles on the subject of cryptocurrency, I started getting calls from lawyers around the country who wanted to hear my thoughts on whether the tokens were a security or not and where the line might be drawn. There is nothing unusual about that. Lawyers seek advice from each other all the time. The discussions about ICOs naturally revolved around the Howey decision.
During this period there were a lot of articles on crypto websites that re-printed the basics of the Howey test and argued why this or that cryptocurrency did not pass it. Some people argued that the Supreme Court’s decision from 1946 should not be applicable to the new technology.
There had been several US Supreme Court cases on the
same subject subsequent to Howey and
opinions from other appellate courts as well.
The ultimate question: “is this financing the sale of a security?”, has
been considered time and again
I researched the question extensively in the 1970s. At that time the marginal US tax rate on the highest wage earners was 70%. At the same time the tax code was full of special credits and deductions as incentives for various types of activities.
Smart Lawyers & Tax Breaks
There was an industry populated by some of the smartest and best credentialed tax lawyers and CPAs who created transactions that took advantage of those incentives to help high earners get relief from their income tax liabilities. The “products” were remarkably innovative.
One of the incentives was accelerated depreciation on various types of tangible assets. Using leverage, you might buy a piece of machinery for $1,000,000, depreciate it to zero in 3 years, and pay it off in 10 years. If you put $100,000 down, you got the benefit of the depreciation on the entire purchase price early and depending on your income, you might reduce you tax liability to zero for 3 years.
Of course if you were a high earning doctor you were not likely to be operating the machinery which was a requirement to obtain the deductions. Many of these tax shelter programs were packaged as “turnkey” operations which raised the question: “are you buying the machinery which can be depreciated or a business which cannot?” The latter might mean that the transaction involved the sale of an “investment contract” and thus the question: “is this a security?”
I researched and wrote opinion letters that concluded that particular transactions were not investment contracts. The answer to this question, then and now, centered on the economic realities of the transaction.
Last week a US District Court Judge in NY looked at that same question regarding the tokens issued in an ICO from a Russian company called Telegram. Telegram claims to have raised $1.7 billion through its ICO world-wide, with only a fraction of the investors located in the US. There was no dispute that Telegram was promising investors that they could profit from re-selling their tokens at a later date.
The Judge’s decision was well reasoned, hit all the points, and really surprised none of the lawyers that are interested in cryptocurrency or ICOs. The SEC brief was full of cases that it had successfully relied upon for years.
Some of the lawyers with whom I spoke in 2018 were
writing the paperwork for ICO offerings. Several of the best were on the phone
with the SEC staff discussing each offering because they appreciated that they
had an obligation to keep their client within the regulatory white lines. That
is something that Telegram, apparently, never wanted,
I read yesterday that Telegram intends to appeal the
Judge’ order which is to be expected, but
they are also, apparently, thinking about defying it. The Judge has ordered them not to distribute
their new tokens and they may do so any way.
Let’s be clear. Telegram did not need to take money
from US investors in the first place. If they wanted to they could have
followed the rules and registered the tokens or sold them under an exemption to
accredited investors only. They chose not to.
In all probability they could have settled with the SEC early on by simply returning the money to the US investors, but they chose to fight the SEC instead. Nothing in the Judge’s opinion was new law. The facts in this case were not in dispute.
I would have advised Telegram initially that they were
issuing securities had they asked. I think most
securities lawyers would have agreed. The investors were going to profit from
the efforts of others. That was the economic reality of the transaction.
Some lawyers apparently disagreed and gave Telegram
the green light to make its offering in the US in the first place. After reading the Judge’s decision I find that
troubling. What case law were they reading? Will their opinion letters to Telegram
on this subject become public as that case continues?
During this time there were some lawyers who publicly stated that SEC’s rules regarding the issuance of cryptocurrency were unclear. I tried to throw cold water on them at the time. If you cannot define a security, or know one when you see one, how can you hold yourself out as a securities lawyer?
As I was writing this story over this weekend I exchanged comments on LinkedIn with a university Professor who is a fan of Telegram and its platform. He told me that Telegram has over 300 million users. He assured me that Telegram does not sell user information. He reminded me that its founder had refused a request from the Russian government for a backdoor into its system. I asked him why he thought that any of that was true.
I reminded him that Telegram has never disclosed what it did with the $1.7 billion it raised. Telegram has never disclosed any financial information whatsoever. It may have raised more or less it may sell user data and it may be in bed with the Russian government. Auditors have never seen its books or its operations. Telegram’s self-serving public statements have no more value than did Madoff’s public statements.
The real issue here should be that if Telegram issued
securities, then it failed to give US investors any of the information to which
they were entitled. That, of course, is fraud.
As I said, this type of cross-border financing intrigues me. Going forward I expect to help more and more companies from around the world successfully reach US investors. Some amount of creativity may be needed to make the “economic realities” of these transactions attractive to US investors. But there is a difference between creativity and fantasy. Good lawyers know the difference. If your client wants to test the boundaries of the system, they should do it with their own money, not funds taken from investors who were never given all the facts.
If you’d like to discuss this or anything related, then please contact me directly HERE
There is nothing like a stock market crash to shine a light
on the bad actors in the market. Many of the people who will be exposed will be
out and out scam artists. Some of those scams will have been sold thorough
mainstream brokerage firms that refuse to spend what it take to actually
investigate what they sell.
Many more investors will lose money because the mainstream
stockbrokerage firms will continue to offer investors conflicted or unsupported
advice. Investors are being told to
“stay the course” and stay invested as the market is sliding to an inevitable
bottom, perhaps a year away.
Investors who lose money will file arbitration claims against their brokers to recover those losses, just as they did after the crash in 2001 and 2009. This time around they will be joined by many customers of online firms who lost money because those firms failed to operate properly. This is something that has not happened very much in almost 20 years.
I started on Wall Street in 1975 as the NYSE, Federal Reserve and the brokerage firms were changing over to large mainframe computers from the legacy hand written orders and record keeping. There was a lot of skepticism at the time as to whether the computers could carry the load. The SEC mandated that duplicate paper records be kept for several years just in case of an outage.
The market crash in 1987 was the first significant correction where the market was wholly computerized. Before you draw similarities between 1987 and what occurred in the markets last week, remember that the internet was still not widely accessible. The vast amount of information that is available today was not available in 1987.
The Black Monday crash was certainly exacerbated if not caused by computerized, program trading. Program traders were using computers to analyze the data they had faster than others and then use that data to get in and out of the market before other traders caught up. As a result of Black Monday, the NYSE instituted circuit breakers which, until last week, had only been triggered once or twice since 1987.
When the market crashes, customers want to know what is going on and they want to know immediately. This fact should not surprise anyone! Nor should it surprise anyone that securities industry regulators have always taken notice when the customers could not access their brokers or accounts.
The year 1975 was also the year that Wall Street did away with “fixed” commissions and unbundled its two primary customer services of advice and execution. This was the birth of the discount stock brokerage firm and the DIY investor. By 1987, Schwab and the other discount firms had millions of customers.
If you still had a stock broker on Black Monday you had someone to talk to. I know many brokers who were returning calls well into the evening on that day. If you used a discount firm, you had to go to their office to access your account and find out what was going on. Many people did just that.
There was a story that went around a day or two after the crash in 1987. When people at one of the discount brokerage houses could not get through on the telephone to place an order, they showed up, en masse at their local office. The story went that there was such a crowd of panicked customers trying to get into one office, that one of the employees was lying on the floor in the break-room in a fetal position.
When it was all over the SEC recommended that discount firms beef up their call centers to handle the overload as trading volume was steadily increasing. Today, most of the large discount firms have local offices supported by call centers. Complaints that “no one picked up” are rare.
About 10 years later, as the internet made trading from home possible, a lot of people took up the challenge and became “day traders”. Discount firms were opening more accounts than they could handle as the computers they had maxed out. The problem was noticeable.
I went to a conference to hear a representative of the SEC
speak to this issue of customer capacity.
He told the crowd that “you can only fit so many people in RFK
Stadium”. His message was clear, if you
don’t have the capacity to service the customers, don’t take them on. No one in the audience was surprised. Since 2000, complaints about lack of computer
capacity have been rare as well.
Which brings us to Robinhood Financial, a brokerage firm that claims 10 million distinct customers. Many of its customers are younger, first time investors.
Robinhood’s site crashed multiple times last week, as the
market see-sawed and volume grew. Individual customers were locked out of their
accounts during several periods of exceptional volatility. If you cannot access your account you are
not going to be able to lock in gains or avoid losses. You are likely to lose
money that you did not intend to lose.
Apparently no one told the owners of Robinhood that this is
not supposed to happen. They were not
part of the brokerage industry in 1987 or in the late 1990s as the industry
heeded the regulators’ advice and bolstered their systems and capacity.
In point of fact it appears the owners of Robinhood have no
real experience operating a brokerage firm. They are techies by training and
experience and apparently not very good ones.
Robinhood’s website boasts the following: “We are a team of
engineers and designers, and we hold the products we craft to the highest standard. We believe that
exceptionally engineered systems — not marble office buildings on Wall St — are
the cornerstones of establishing trust.”
If you want an example of false advertising, there it is.
Robinhood Financial, like all brokerage firms is a member of
FINRA. It says so right in the fine
print on the bottom of its website. With
membership in FINRA should come an understanding that all customers will have
access and the ability to place trades in their account whenever the market is
Also in the fine print is this disclaimer: “Investors should be aware that system
response, execution price, speed, liquidity, market data, and account access
times are affected by many factors, including market volatility, size and type
of order, market conditions, system performance, and other factors.”
Being a member of FINRA and disclosing that your system can
be “affected” by a variety of extraneous factors should be mutually
exclusive. System failures are not
acceptable in the brokerage industry any more than a software glitch would be
acceptable in the operating system of a heart/lung machine.
Robinhood has previously demonstrated that its management does not understand the stockbrokerage business that it operates in. At the end of 2018, Robinhood announced that it would launch “checking and savings account” that would be covered by SIPC insurance, except that it wasn’t. The account was supposed to pay out substantially more than any bank savings account except it was never disclosed where that extra income would come from.
No professional brokerage industry compliance officer would
have allowed that product to get close to launching. Apparently, no
professional compliance officer works at Robinhood Financial.
More recently, FINRA fined Robinhood for directing its customers’ orders only to firms that paid Robinhood for the order flow. FINRA allows for the payments, but it requires the firm to direct the orders to those firms that give customers the best execution price.
FINRA noted that Robinhood’s systems were not set up to
follow this basic industry wide rule. FINRA fined Robinhood $1.25 million. All
of this begs the question, what other basic industry rules don’t they follow.
Robinhood’s claim to fame is that it does not charge any
commission to its customers. Robinhood
executes through a clearing firm and there is no indication that that firm is
not charging Robinhood for each trade. It is also clear that the clearing firm
did not break down last week. All the problems noted were with Robinhood’s
Robinhood has taken in over $900 million from VC investors. That VC funding allows Robinhood to claim a
“valuation” of over $7 billion. I
suspect that some of that money is going to pay for clearing those trades.
Seriously, can a stockbrokerage firm be worth over $7 billion if all it has is software and that software does not work up to industry standards? Can it ever be profitable if it charges it customers nothing? Any profit it might have derived from financing margin loans likely vanished last week as most of those loans were certainly called as the market crashed.
Maybe next time Robinhood’s system will be down for a week or longer. In a fast moving market the losses could be in the billions. Some regulator needs to look behind the curtain here before 10 million angry customers start calling their Congressperson screaming. At that point it can get really ugly.
Fintech has become a buzz word for technology that makes the customer experience in finance better and cheaper. VCs pumped $900 million into Robinhood and came out with product that is clearly defective. Technology can improve a lot of things but applying it to a regulated industry you know nothing about is a recipe for failure and a colossal waste of money.
If you’d like to discuss this or anything related, then please contact me directly HERE
I have a better than average understanding of investing and the capital markets but I never give investment advice nor do I tout individual stocks. I do listen to what others think and I pay attention to who is investing in what. I read a lot of articles and research reports every day and I frequently speak with professional investors and advisors.
Correction or Crash
Last week’s market correction was the 7th or 8th I have been through since I began on Wall Street in the 1970s. No two were exactly alike. I learned a few things each time.
No one can accurately predict where the DJIA will be
in 30 days or 60. That has always been true but
the underlying cause of this correction, the portent of a global pandemic, adds
some unique variables.
I know this article will likely just get lost in the blizzard of financial content that a 3,500 point drop in the Dow will generate. Still, the opportunity to take a stab at “Investing for a Global Pandemic” was just too good for me to pass up.
I already know the advice that customers of the large wire houses will get. They will be told not to panic but rather that it is always best to hold for the long term. They will be told that the market always comes back so there is no need for them to liquidate anything.
That advice is nothing more than an uneducated coin flip. Professionals who are paid to help people invest should be able to do much better than that.
Even worse, that advice is conflicted. Financial
firms know to the dollar the cost of acquiring new customers. They do not want
existing customers to cash out and potentially move away. Advising the customers to “stay the course”,
strongly implies “stay with us”.
Shares owned by customers can also be used to collateralize the aggregate borrowing that the large firms must do to finance the margin debt held by their customers. The margin rate “spread” goes right to the firms’ bottom line.
“Always hold for the long term”
The “always hold for the long term” strategy is also designed to cover up the fact that much of what passes for financial advice is just wrong. Many customers have portfolios using “asset allocation” which was supposed to contain “non-correlated” assets to hedge against catastrophic losses and yet their balances are down substantially.
Many customers will be looking at their account balances and wondering what happened. This is especially true as this is tax time, when many people will have their year-end 2019 statements in hand as they prepare their tax returns.
The “big lie” of course will be that no one could have predicted this correction would happen. The brokers will claim that they saw nothing that might make them want to suggest to their customers that they might consider actually realizing the profits they have accumulated during this long bull run.
The underlying economic conditions are still good. Interest rates are still low and employment is still high. Still, a lot of people have predicted a correction because the primary market indicator, the overall price/equity ratio has been way out of its normal range for some time. Even after last week the P/E for the S&P 500 it is still high. It should eventually be expected to revert to its normal range even if everything had remained “normal”. With the reality of reduced profits next quarter and next year because of the pandemic I can find nothing to support the idea that the market will be higher next year.
There are always external events that can traumatize the market. One good blizzard or hurricane can cause billions in lost sales across wide regions of the US. The US frequently gets more than one blizzard and hurricane each year.
There is always political discord or a war somewhere. Unions have gone on strike and closed industries and ports for months. There is always a fair amount of news about events that can and do disrupt markets. Still, the markets survive. A global pandemic howeverconjures up the image of the potential for a truly mass disruption.
The world spent several weeks watching people trapped on cruise ships being quarantined while the virus spread. Cruise ship passengers tend to be middle class and their plight was clearly noticed by the middle class investors many of whom no longer saw the wisdom of holding cruise line shares in their portfolios.
I certainly noticed how poor the reaction was of the various government agencies involved. The Japanese, by leaving infected passengers on board the cruise ship and in proximity to uninfected passengers did not contain the virus very well. The Chinese were filmed adding thousands of hospital beds when the story everyone wanted to hear was that they had effectively contained the virus, not that they were expecting thousands more to get sick.
The governments of several hot spots of the
infection around the world have been accused of under-reporting the number of
infections and deaths. The corker was the US government which flew several
infected passengers to an air force base in Solano County in California only to
have people off the base become infected very quickly.
Is it improper of me to expect that modern governments in the 21st Century should respond differently to a pandemic than the characters in Monty Python who wheeled a wagon around a plague-ridden medieval town singing “Bring out your dead”?
Good, Bad or Really Bad?
From the standpoint of the stock market the question
may not be how bad this crisis gets but
how long it lasts. The next 10 weeks are likely to tell the tale. If not
contained by then with the number of new cases
significantly down from their peak the
DJIA may truly reflect an apocalypse.
The virus might be contained and crisis might be downsized by May. The market might have resumed its climb with new highs by then. Japan Airlines might be adding extra flights for the overbooked Olympics in August. But right now, that is not the way people are likely to bet. If they do not think that will happen, there is no reason for them to stay in the stock market.
If the Olympics are postponed or cancelled, it will
mean that containment is not in the offing. The number of people infected by
then will be significant and the fear widespread.
The crisis will hit the US hard when people stop going to restaurants, sporting events, super markets and malls. Recessions start when waiters get laid off and cannot pay their rent. Given that so much of what is manufactured and sold in the US relies upon parts made elsewhere, a slowdown, at the very least, seems inevitable.
If I had to pick out stocks to invest in right now I would think that a good recession would be positive for companies that sell alcohol or cannabis. If Americans can’t work, it is a safe bet that some will be on their couches with a joint, a six pack or both.
For serious investors the drop in the DJIA and the market in general has lowered the price and increased the yield of a lot of stocks of good companies that pay a steady dividend. Buy some this week and if the market continues to crash you buy more and average down.
I am not really expecting a pandemic that will kill millions of people but it would not be the first time. And, given that we live in an interconnected global marketplace, a much smaller event could still have devastating economic consequences.
The fact that there is so much discussion about this spreading virus and that its impact could be huge, is scary in and of itself. That alone is not good news for anyone still holding stocks which is roughly ½ of the households in the US.
The real story should be the very pedestrian and ineffective steps taken in the US that might contain it. When action is needed right now the worst thing that the government can do is fail to act even if the actions it does take are the wrong ones. This government, our government, has been remarkably slow to act.
If you’d like to discuss this or anything related, then please contact me directly HERE
began experimenting with companies selling their shares directly to the public utilizing
the internet with the successful funding of the Spring Street Brewery in New
York City in 1996. Several other companies followed suit.
teaching finance at the time. Netscape had gone public a year earlier. There
was a lot of discussion about using this new World Wide Web to sell offerings
directly to investors. Some people
thought this new process of distributing stock would “disrupt” financings forever. One “expert” suggested that JP Morgan and the
other investment banks would be priced out of the marketplace within a few
true then, is still true today. If investors will buy the shares, this new direct-to-investor
method of selling those shares will succeed. All these years later, we can safely say that investment
crowdfunding, as it has come to be called, works.
One of the
first things I learned when I began working on Wall Street was the saying: people
do not buy investments, rather people
sell investments. The stockbrokerage industry is still largely
a commissioned based system. When a new issue of stock comes to market,
stockbrokers, then and now, will pick up the telephone and “sell” shares to
their customers. That is the “meat and potatoes” of the traditional
crowdfunding eliminates those stockbrokers and the commissions they are paid. At
the same time, crowdfunding eliminates the one-on-one conversation between the
investor and the salesperson. It uses the internet to reach out and draw
failure of these self-underwritten offerings rests almost solely upon the
marketing campaign that puts each offering in front of potential investors.
What a company offers to investors and to how many potential investors that
offer is made are the “meat and potatoes” of investment crowdfunding.
ample evidence that investment crowdfunding has quietly become a legitimate
tool of corporate finance for small and medium-sized businesses and projects.
Like any other tool, it works best when you know when to use it and how to use
Investment Crowdfunding Today
crowdfunding has demonstrated that it can attract investors and their money.
Several of the crowdfunding platforms have each raised more than one-half
billion dollars from investors for the offerings they have listed. Sponsors of
several individual real estate funds have raised a hundred million dollars or
more on their own websites. The number of investors who have made an investment
on a crowdfunding platform and the total amount they invest continues to
increase year over year and still has a long way to go.
JOBS Act in 2012, Congress told the SEC to regulate and legitimatize direct to
investor financing. The SEC responded with three regulations, one new and two
modifications of existing regulations, Regulation D, Regulation A+ and
regulation covers financings of different amounts (Regulation CF up to
$1,070,000; Regulation A+ up to $50 million and Regulation D is unlimited) and
each has its own requirements for the process of underwriting the securities.
There is a small, and very good group of lawyers actively assisting companies
who are crowdfunding for capital to stay within the regulatory white lines.
of companies have raised capital under these regulations. That does not imply
that every offering has been successful, far from it. But it does suggest that
there is capital available for companies that navigate the crowdfunding process
The cost of
capital, when funding a company through crowdfunding, is competitive with
commercial and investment banks. Unlike any type of institutional funding,
companies that fund using crowdfunding get to set the terms of their offering
to investors. That flexibility is especially important to the small businesses
that the JOBS Act was intended to serve.
technology of maintaining a crowdfunding platform or conducting an individual
offering has continued to evolve and costs continue to come down. More and more
companies are raising funds by adding a landing page to their existing website.
can provide all the documents the investor needs in order to consider the
investment. Investors can make the payment for their investment with the touch
of a button. The “back end” vendors, such as an escrow agent that holds the
funds until the offering is complete, plug right in.
costs vary with the content. The “INVEST” button is usually leased by the month
for a three to four-month campaign. The overall costs set up a DIY campaign seem
to be in the range of $10,000-$20,000. I have seen companies spend more and
acquisition costs have been slashed with new data mining techniques and
automated solicitation. Highly targeted database development, e-mailing and
social media advertising have become much more efficient. Crowdfunding
campaigns can now reach out to far more potential investors, for far less money,
than even one year ago.
costs come down and the numbers of investors who have made a purchase on a
crowdfunding platform continue to rise, investment crowdfunding will continue
to move into the mainstream as it has in Europe and Israel. More and more companies will fund themselves
as the process continues to become quicker, easier and less expensive.
Good Investments Get Funded
rules and the basic mathematics of investing and the capital markets apply to
crowdfunded offerings. Investment crowdfunding is corporate finance.
always wants to reduce its cost of acquiring capital. Crowdfunding has
demonstrated that its costs can be substantially less than obtaining the same dollar
amount through either a bank or traditional stockbroker.
always expect a return on their investment (ROI) and will often gravitate to
investments that provide a greater ROI.
Successful crowdfunding campaigns strike a balance between what the
issuers are willing to offer and what the investors are willing to buy.
rule is that the greater the risk, the greater the reward investors need to be
offered. Virtually every offering that is currently being made on any
crowdfunding platform is very risky. Companies that do not offer investors a
return commensurate with that risk are likely to have a more difficult time
up to each company to demonstrate how they intend to mitigate the risks that
their business presents. For any capital raise to be successful, it is
important that the company demonstrates how the return they are promising will
be generated and when the investors may expect to receive it.
remain the largest source of capital for small business. Any business owner
that wants to get a bank loan will need to walk in with properly prepared
financial statements, a business plan detailing how the proceeds of the loan
will be used and a detailed cash flow projection sufficient to convince the
bank that there will be enough cash to make the loan payments when they are
due. Investors who might be expected to provide those same funds are entitled
to that and more. Offerings that are too light on the details are harder to
fund as well.
crowdfunding platforms will list similar offerings promising widely disparate
returns. If a platform offers participation in any of three office buildings,
one promising to pay investors a 10% return, one 12% and one 14%, it is likely
that the higher-paying offering will sell out first. Good projects may go
un-funded because of competitive offerings on the platform upon which they
chose to list. This is another reason that many companies are starting to do
their fundraising utilizing their own website.
Good Marketing Works
investment is offered under Regulation D, Regulation A+ or Regulation CF,
everything that the company says to prospective investors is regulated. That
includes what the company says elsewhere on its website, in press releases,
advertisements and interviews. Projections of sales and profits need to be
realistic. All claims need to be supported by real facts.
with the disclosure requirements and marketing regulations protects the company
issuing the securities from regulators and investor litigation if something
goes awry. Making outrageous statements, promises or projections to investors
is more likely to get a company into trouble than to get it funded.
mainstream stockbrokerage industry has shaped what investors know about investing.
The money that is being invested in ventures on crowdfunding platforms is
largely coming from wealthier investors under Regulation D. Many of these
investors have prior investing experience, often in similar investments.
are accustomed to dealing with stockbrokers. The offerings that the
stockbrokerage firms present to these same investors are professionally
packaged and presented by sales professionals.
was exclusively targeted at these wealthier, accredited investors. From the
beginning, the crowdfunders were competing with the established stockbrokerage
industry for these same investors.
JOBS Act stockbrokers could only offer private placements to investors with
whom they had a prior business relationship. Sponsors of real estate and energy
programs would host seminars about their products and invite prospective
purchasers. There were already list brokers who supplied e-mail addresses of
known accredited investors to invite to those seminars.
Act removed this restriction for both stockbrokers and issuers. Crowdfunding
enables these issuers to advertise specific offerings to the same targeted,
The first crowdfunders
used those same e-mail lists to reach those same investors and tried to get
them to invest without the seminar or the stockbroker. Overall, they were
successful. They demonstrated that investors would make investments based upon
what they read and saw on the website alone.
for crowdfunding today, like all cold e-mailing, is still very much a numbers
game. If a company sends out one million
e-mails and raises only one half the capital it seeks then logically it will
continue to send out e-mails until the offering is completed.
virtually any company can run a successful crowdfunding campaign to raise
capital. The determining factor is often whether they are willing to spend what
it takes to reach out to enough investors to complete the offering.
D investors are different from Regulation A+ investors and in turn Regulation
CF investors are again different. The best marketing firms target the right
investors and send them the right message.
of whether the campaign is for an offering under Regulation D, Regulation A+ or
Regulation CF, e-mails lists can be targeted with greater accuracy than ever
before. Marketing materials can be
tested for click-through conversion rates and campaigns can be effectively laid
out to get the desired funds.
of a good, successful marketing campaign have dropped on a cost per investor
basis. I always counsel clients to budget high for marketing and be happy when
they spend less than they had anticipated spending. The alternative, running
out of money mid-campaign, guarantees failure.
Regulation D Offerings Will Continue to Dominate
1930s, any security that is sold to investors in the US is supposed to be
registered with the SEC. The SEC has specific forms for different types of
D offerings are “exempt” from registration with the SEC because they are not
considered to be offerings that are being made to the “general public”. The
vast bulk of Regulation D offerings are intended for “private placement” to
larger institutional investors. Consequently, the SEC does not provide a
specific form or format for the disclosure documents. The SEC does require that
investors get “all of the material facts” that investors need in order for them
to make a decision whether to invest their money or not. Consequently, no two
offerings are exactly alike.
been a growing retail market for smaller private placements since the 1970s.
This market is serviced by mainstream stockbrokerage firms. Private placements
are among the highest commissioned products that a stockbroker can sell. It is
not unusual for a company engaged in a private placement to pay a sales
commission of 6%-10% to the individual stockbrokers who make these sales and an
additional 3%-5% to the brokerage firms that employ these brokers for marketing
D private placements can only be sold to individuals who are defined as
“accredited investors”. That includes individuals whose earned income exceeded
$200,000 (or $300,000 together with a spouse) in each of the prior two years
and reasonably expects the same for the current year. It also includes individuals
with a net worth over $1 million, either alone or together with a spouse
(excluding the value of the person’s primary residence). There are about 12-15
million households in the US that are accredited investors.
households are the prime targets for mainstream stockbrokerage firms who have
better advertising and more credibility than any crowdfunding platform.
Stockbrokers have the benefit of face-to-face personal contact with their
customers and offer advice regarding other investments like stocks and bonds.
If an accredited investor has been a customer of a stockbrokerage firm for most
of the last 10 years, it is likely that they have made money.
task for the crowdfunding industry has been to pry these accredited investors
away from their established stockbroker or financial advisor relationships. It
is absolutely clear that they can do so.
private placements are structured to provide investors with passive income.
These have been especially popular in the last decade of very low-interest
rates. Real estate offerings are popular
because they are easy for investors to understand. They can be structured to
provide passive income at several multiples of what savings accounts currently
D offerings in the $1-10 million range for all types of companies (not just
real estate) have become the main products of the crowdfunding industry. As the
costs of a successful campaign continue to come down more and more companies
are likely to come to this market for funding.
Crowdfunding Costs of Regulation D Offerings Should Continue to
crowdfunding campaign, the issuer has two main costs: the costs of preparing
the legal disclosure documents and the costs for the creation and execution of
the marketing campaign that brings in the investors. Most lawyers (myself
included) insist on being paid before the offering begins.
standard disclosure document for a Regulation D offering is called a private
placement memorandum (PPM). The overriding requirement is for full, fair and
accurate disclosure of the information that an investor would need in order to
make an informed decision on whether or not to make the investment. There is no specific form of disclosure
been presented as a bound booklet for decades. Much of the specific legal
language evolved in the 1980s and 1990s when the securities regulators in
various states would actively review every offering. Several states would
require specific language before approving the offering for sale to investors
in their state or pose additional restrictions on who could invest or how much
any individual retail investor in their state might purchase. The bound booklet
PPM is the normal format for disclosure that most practitioners still use.
websites have begun to change the format and to use landing pages to spread out
the information about offerings rather than present it as a standard booklet. This
format makes the offerings more readable and investor friendly while still
making all of the necessary disclosures.
page will provide investors with the terms of the offering, a description of
the business and its principals and a table showing how the company will use
the money it is seeking. Most include links to current financial statements and
revenue projections. The same information about the business, its competitors
and the particular risks of the investment that would appear in a bound booklet
are all laid out.
key documents relative to the offering are provided and viewed with a “click”.
For the purchase of an office building, the webpage might offer copies of the
purchase agreement, title report, appraisal, physical inspection, rent roll, etc.
Other types of businesses might offer copies of patents, key employment and
business agreements, etc.
The most important
tool on any crowdfunding page is the “chat” button. It is not unusual for an
investor considering an investment to want to ask some questions or speak to
someone at the company. The person who the company puts on the phone with
prospective investors must be very knowledgeable about the company, its
prospects, competition, etc. They should also understand the regulatory
guidelines so that they do not say more than they legally can say.
importantly, the person that is chatting with prospective investors should be skilled
at closing the sale. If all else has been done correctly, there comes a point
where issuers need to ask a prospective investor for a check.
If an offering
is going to be made through a mainstream stockbrokerage firm the costs of
having a PPM for a private placement prepared by a mid-sized law firm can run
$50,000 and up. Costs can run up with the complexity of the offering, the
number of documents that need to be prepared and the client’s ability to
respond to questions in a timely manner.
the paperwork for a Regulation D offering formatted for a crowdfunding platform
should require less of an attorney’s time, especially if the issuer and the
marketing company preparing the landing page understand what is required. The
legal costs for preparing the disclosure documents for a simple Regulation D
real estate offering on a crowdfunding platform start in the neighborhood of
$15,000. Offerings with multiple
properties and complex or tiered offerings, operating businesses, and start-ups
can cost a little more.
marketing costs of setting up the website for an offering can vary greatly.
Real estate offerings, for example, are fairly simple and straight forward. A
photo of the building and a floor plan are typically the only graphic enhancements.
The crowdfunding campaign for a start-up or new product might include a video
of the founder or a product demonstration. Still, a cost of $10,000- $20,000 is
reasonable to set up the website and the marketing campaign.
Regulation D offerings have a minimum investment of $25,000. That equates to a
maximum of 40 investors for every $1 million raised. A rule of thumb suggests
that for Regulation D offerings, an expenditure of $10,000 on the marketing
campaign for every $1 million dollars raised seems reasonable.
Real Estate Offerings Will Continue to Dominate
real estate offerings are mainstream investments. Many real estate funds and real
estate investment trusts (REITs) trade on the NYSE. Mainstream stockbrokers and advisors have recommended
real estate private placements as alternative investments to accredited
investors for years. Investors are offered equity participation in existing
properties or new construction and fund real estate debt through mortgage
are familiar with real estate. Using limited partnerships and LLCs, it is easy
to structure a real estate offering to pass the income and tax benefits through
to the investors.
any commercial property changes hands there is an opportunity to crowdfund the
purchase price. Real estate brokers and property
managers of all sizes are using crowdfunding to build portfolios of properties that
generate substantially higher initial real estate commissions as well as
ongoing commissions and management fees.
If no two
properties are exactly alike, the same can be said for any two real estate
syndications. The success of any real estate venture is more likely than not to
rest with local market conditions.
estate syndication offerings are sold based upon the promise of current yield
or projected distributions. Review the
marketing materials fora thousand real estate projects sold by mainstream stockbrokerage
firms and you will find the current or projected income is always highlighted.
That is where crowdfunding the same offering will always have a competitive
sponsor wants to raise a $10 million down payment to purchase a $40 million
office building using a mainstream stockbrokerage firm, the sponsor will need
to raise as much as $11.5 million to cover the costs of the sales commissions
and fees that the stockbrokers receive. That dilutes the return the investors
will receive on their investment.
that same offering and eliminating the sales commission will increase the
payout to investors by 10% or more. From the investors’ point of view, the
payout (ROI) is the thing that they usually consider first. Crowdfunding any
offering should give investors a better ROI.
on ROI has also caused many of the syndications to migrate away from
crowdfunding platforms where multiple offerings from different sponsors are
lined up side by side. A sponsor is often better off making the offering from
its own website where it does not compete with offerings that might offer
investors a higher payout and where they can control the marketing campaign and
platforms, unless they are licensed as a broker/dealer, cannot take a fee based
upon the success of the offering. Two years ago, most of the platforms were
happy with a straight listing fee based upon how long the issuer wanted to keep
its offering active on the platform.
more the Regulation D platforms are obtaining a broker/dealer license and are
charging based upon the amount that the issuer is raising. The difference can
listing fee to place an offering on a platform for 3 months might cost $10,000,usually
paid by the issuer upfront. A success
fee to place an offering on the same platform once it has a broker/dealer
license might be 3% of more of the funds actually raised. A raise of only $2 million would cost the
company (ultimately the investors) $60,000. That is another reason that many
companies are crowdfunding from their own websites.
crowdfunding industry has evolved, the crowdfunding platforms compete with
established stockbrokerage firms and the DIY offerings made on a sponsor’s own
website compete with the crowdfunding platforms. In the end, the issuers,
investors and the crowdfunding industry itself all benefit as costs come down.
The Next Thing in Regulation D Crowdfunding is Globalization
Foreign companies have
always looked to the US capital markets when they have been able to do so. Interest
rates and costs of capital are frequently lower in the US compared to an issuer’s
home country. Before crowdfunding, the opportunity for foreign companies to
obtain funding in the US was limited to the largest companies. Foreign companies seeking to introduce their
products to the US market or to set up operations here will often consider
funding those operations through a US subsidiary.
firms often recommend that 5% or more of an individual’s portfolio be diversified
and held in the shares of “foreign” companies, often through a mutual
fund. US investors also appreciate that
they can get a greater value if the money they invest is spent in a country
where overhead, labor and operating costs are likely to be substantially less
than the equivalent line items in the US.
At the same time investing
across borders can be subject to additional risks including the risk of
currency fluctuations and changes to the local economy ofthe country where the
company operates. That can mean additional rewards for investors who should expect
to be rewarded for taking those risks.
Utilizing data-mining and
other modern marketing techniquesfacilitatesfinding US investors interested in
investing inother countries. More and more foreign issuers are looking to
crowdfunding for US investors and more are likely to follow.
Regulation A+ Continues to Fail
A+ was the SEC’s modification of an underutilized form of a registration
statement. To date very few Regulation A+ offerings have been filed and sold. It
remains a very expensive and inefficient way for any company to raise capital.
of Regulation A+ offerings that have sold shares to investors find those shares trading for less today than
their original offering price despite a raging bull market. Virtually every
investor who has made an investment in a company selling its shares under
Regulation A+ has lost money.
using Regulation A+ may never get past its abysmal beginnings. Several of the
earliest and heavily promoted Regulation A+ offerings were out and out
scams. The crowdfunding platforms that
hosted these offerings demonstrated a total lack of respect for the investors
and their money and left a bad taste in the mouths of investors who were
willing to give crowdfunding a try.
A+ requires a form of a registration statement to be filed with the SEC which
will be reviewed and approved. There are specific disclosure requirements. The approval process can take 4 months or it
might stretch into 8 or 10 months. The SEC will make comments and depending on
the answers and the SEC staff’s concerns the approval process can drag on.
of comments adds time to the process and increases time spent and of course, the
lawyer’s bills. It would not be unusual
for a law firm to ask for a $75,000 retainer for a Regulation A+ offering
against a total bill for legal services that can be 2 or 3 times that amount
A+ provides for offerings of no more than $50 million and has slightly easier
requirements for companies raising less than $20 million. A company raising
even $10,000,000 under Regulation A+
with a $500 minimum investment may need to secure investments from as many as 20,000
no restrictions as to who may invest or how much, so the pool of potential
investors is very large. The marketing costs of reaching out to a large pool of
potential investors can be prohibitive.
Marketing costs for a Regulation A+ offering can reach $200,000 and
A+ promises that after the initial offering its shareholders can freely sell or
trade their shares. The shares can even list on the NASDAQ. The continuing problem is that at least up to
this point in time no one wants to buy these shares once the offering is completed.
company wants to support a post-offering secondary market for its shares it
will have to secure market makers from the stockbrokerage community and absorb
the costs of continuing press releases and lawyers to review them. These costs
can be substantial.
still plenty of time for the Regulation A+ market to gets its act
together. In the broader market, however,
the trend is away from public offerings, IPOs, in favor of more private
offerings under Regulation D. The trend is driven by the fact that Regulation D
is far quicker and less expensive. That trend is being reflected in the
crowdfunding market that serves both.
Regulation Crowdfunding(CF) Will Continue to Mature
Crowdfunding (CF) was the last of the regulations that the SEC adopted under
the JOBS Act and the one most specifically targeted at helping small businesses
raise capital. These are small offerings being made by small companies. They
are designed to spread the risk of small business capitalization among a lot of
CF created a new type of financial intermediary called a “funding portal.
Portal operations are regulated as they are required to become members of FINRA.
All transactions using Regulation CF are required to be executed on one of the
portals. There is no “DIY from your own website” using Regulation CF.
still fewer than 50 registered portals and a small handful of the portals host
the bulk of the transactions. A company can use Regulation CF to raise up to
$1,070,000 from investors every year.
Many of the Regulation CF offerings seek less than $100,000. A
Regulation CF offering in the $200-$300,000 range would seem to be the most
efficient. No individual investor can
invest more than $2200 in Regulation CF offerings in a 12-month period.
Regulation D platforms compete with the mainstream stockbrokers for the same
types of financings that the stockbrokers had always sold, the Regulation CF portals
compete with banks to provide funding to the same types of companies that banks
provide most of the capital for small businesses in the US. Banks have
commercial loan officers in virtually every branch office aggressively seeking
to write small business loans. There are always tens of thousands of small
businesses around the country seeking some type of capital infusion.
portals will eventually satisfy more and more of that demand. They will be attractive
because the company seeking the funding writes the terms of the financing, not
CF portals, because they are licensed by the SEC, can charge a fee based upon
the amount actually raised rather than a listing fee charged by the Regulation
D platform. A portal may charge 6% or more of the amount actually raised and
some take a warrant or carried interest in the company as well.
Only companies incorporated in the US, with their primary
place of business in the United States or Canada can use Regulation CF. The SEC
requires that specific information about the business and its finances be
prepared, filed with the SEC and provided to investors. For offerings in excess of $500,000, the
financial statements must be audited. The total cost for the preparation of the
offering material and financial statements should be in the $10,000-$20,000
Unlike Regulation A+ there is no pre-offering review by the
SEC. The paperwork, Form C, can be filed with the SEC on the same day that the
offering goes live.
If a company is seeking to raise $300,000 using Regulation
CF and sets a $500 minimum investment, then a maximum of 600 investors is needed.
Early on people were suggesting many companies could crowdfund their business
just by using their own social media contacts. Most companies start with a list
of family and friends, customers and suppliers.
Still, a professional fundraising campaign should have a
better chance of success. The advances
in data mining and automated e-mail technology have certainly reduced the cost
of these Regulation CF campaigns as well.
For many mid-range Regulation CF fundraising campaigns, a
total budget of $30,000- $35,000, with a reserve for more advertising just in
case, would cover all legal, accounting and offering costs. Those costs are
recouped from the offering proceeds. The owners of smaller cash strapped
companies are beginning to realize that they can obtain the cash infusion they
need and cover the costs of obtaining those funds by taking a short term loan
on their credit cards.
Startups Are Different
Many of the Regulation CF offerings are very small start-ups
seeking initial seed capital to get their business off the ground. Obtaining
funds for a start-up will always be more difficult than obtaining funds for an
Many of the companies structure their offerings as if they
were “pitching” to a venture capitalist rather than their high school history
teacher or fellow high school classmates. Good marketing would tell a simple
story, but tell it to a great many people.
Regulation CF is designed to help small businesses get
started, become established and grow. Not every small business will grow to
have the annual sales of Apple or Amazon.
Many companies that will never reach anything close to that can still be
An ongoing problem that turns off more seasoned investors is
the extreme valuations that some companies claim for themselves on the portals.
Just because a company is selling 10% of its equity for $1 million does not
make give the company a “valuation” of $10 million.
Operating businesses are bought and sold all over the US every
day. The rule of thumb for most businesses in most industries would support a
valuation of three times next year’s projected earnings. Companies with no earnings can still raise
money if they can raise enough to become profitable. Valuations, especially
ridiculously high valuations are unnecessary and will likely fall out of favor
as time goes on.
Several of the Regulation CF portals encourage issuers to
put a valuation on their company when they make an offering. More times than
not, it is a rookie mistake.
You Can Still Fool Some of the
If I learned anything from the crypto-currency ICO craze is
that some investors will invest their money into anything that sounds good even
if it is nonsensical. Billions of dollars were invested through ICOs into projects
that never had a hope of success. Way too many of the ICOs were outright scams
where investors’ money was simply stolen. It was a triumph of hype over reason.
Scamming the investors is not a way to continue to develop crowdfunding
as a sustainable method of finance. It does demonstrate that with aggressive
marketing virtually any company can successfully crowdfund for capital.
The ICO craze also demonstrated that these investors were
willing to look beyond borders acknowledging their belief that good companies
can grow wherever there are good people to grow them. I believe that will
become one of the more significant, if unintended consequences of the ICO craze
and will benefit crowdfunding in general.
Investment crowdfunding in the US has matured to the point where
companies from all over the world can look to this market to obtain capital. As
costs continue to come down more and more companies will take advantage of this
market to reach out to investors.
Right now, many of the platform and portal operators are
themselves an impediment to further growth.
Focused more on hosting any company that comes along, the operators do
too little to provide these companies with much needed know-how. These are
financing transactions. Someone with a good understanding of finance needs to
be involved if the ultimate goal is for 100% of the offerings listed are to be
I speak with start-ups and small businesses every week. Many
know only what they heard at a conference or read in a book. Few have a
financial professional working with them to advise them what investors want and
expect. As a result, many companies offer investors too little or in some
cases, too much.
The key takeaway should be that crowdfunding replaces the
traditional Wall Street stockbroker with a marketing company. There are more
marketing “experts” out there than you can imagine but I have run into only a
handful that seem to have one successful campaign after another.
The costs of good campaigns have come down, but they are not
free. If you are determined to fund your business and do not have the funds for
a professional campaign, be prepared to max out your credit cards or ask your
friends and family to do so.
I worked on Wall Street when it went from handwritten paper order tickets to computers and watched those computers speed up trading to the point no one imagined possible at the time. I honestly believe that as crowdfunding continues to grow and mature it is likely to have a similar long-term impact on small business capital formation in ways unimagined today.
If you’d like to discuss this or anything related, then please contact me directly HERE
I speak every week with people looking for funds to start or expand their business. With investment crowdfunding, the process has actually become relatively easy and inexpensive. Most people come to me to use crowdfunding as a first choice to fund their business. They appreciate the opportunity to fund their business on their own terms.
Sadly, some report that they spent upwards of $25,000 and more than a year flying around the country attending conferences and pitching to dozens of venture capitalists. If they had called me sooner, I would have told them to save their money.
There are a plethora of books and articles and an industry of vendors hawking “pitch decks that work”. Few actually do. When I see a pitch deck I can often tell which “guru” it is trying to follow.
Unfortunately, most of these experts know nothing about what motivates investors to write a check. One in particular who seems to post on LinkedIn every few hours actually offers the worst advice that I could imagine.
Logically, investors in your company should really want your
company to succeed. If you want their
money, it would seem natural that you would tell potential investors what you
intend to do with their money in order to make more money. Yes, it really can be that simple.
Compare that to the pitch decks that follow the “find a problem and solve it” template. They often minimize the focus on projected revenues and profits. They often leave out the details of how the company will execute its business plan to get there. From an investor’s point of view, return on their investment (ROI) rules.
VCs actually fund a very small number of businesses (in the low 1000’s) every year. Most of the money available for venture capital investment is concentrated into a handful of large funds. Some of the available capital will flow to “serial entrepreneurs” because venture capital is a fairly closed network of people and money.
I was introduced to my first venture capitalist when I made
my first visit to Silicon Valley in the mid-1970s. There were a lot more trees
and open space on the way to Sand Hill Road back then.
At that time VCs in Silicon Valley were a very small group of very smart people. Many were MBAs or had MBAs on staff to crunch and re-crunch the numbers. This was no small task in the years before VisiCalc.
These VCs were using their own money and the money of a
select group of wealthy investors to help small tech companies get their
business up and running. Their goal was
to hand these companies over to the investment bankers specifically for a
Investment bankers wanted these companies to be profitable before an IPO. After the offering, research analysts affiliated with the investment bankers were going to project growth in earnings per share. That assured that the IPO investors were almost always going to make a profit from their investment post-offering. Everybody would win.
I moved to San Francisco in 1984 to work with a law firm
that represented a London based VC fund. The fund was making investments in
1980’s era hardware and software companies, companies with cutting edge ideas
and those in more traditional businesses as well. I sat through a lot of pitches. Very few of
those companies got funded even though the pitches were well thought out and
supported by real facts and research.
I remember listening to one of the partners in Sequoia
Capital being interviewed on TV discussing what they liked about Apple when it
was still at the venture capital stage.
I recall that it was more about Steve Jobs’ focus on the design and
packaging as it was the tech. It was
more about gross profit than market share.
Today it seems like “gross profit” is a curse word in the
venture capital community.
Investing has always been rooted in mathematics. Today’s VCs have chosen to ignore the traditional math and have created a new math, to line their own pockets, even as the companies in which they are investing continue to fail.
Beginning in the 1990s and especially as the dotcom era heated up, a lot of people who worked in around Silicon Valley, thought that they should become venture capitalists. Some had been founders of the earlier tech companies. Some claimed to have the connections and insight to bring more than money to these portfolio companies.
The net result was a de-emphasis on the actual, achievable projections of income and how a company might execute to get there. It was replaced with a mindset that said “this is a great idea; millions of people will come to our website and buy our product”. Translated, that means: “Profits? We don’t need no stinking profits?”
The investment bankers bought into this because it enabled them to make a great deal of money. They took a lot of companies public without real earnings. They then used convoluted reasoning and research to predict share prices in the hundreds of dollars.
The analysts looking at the dotcom companies created a metric called “growth per share”. I asked one of the prominent tech analysts if they had ever seen that metric in a peer-reviewed journal. Of course they had not.
In the current market bull market post-2008 the VCs have moved the goal posts even further to feather their own nests. Rather than find more and more good companies to fund, they are increasingly conducting multiple rounds of financing on a smaller and smaller group of companies. Most are destined to failure because they cannot operate profitably.
VCs like other money managers get an annual % of the amount of money invested in their fund. The best way to attract new investors is to demonstrate success. If a VC invests in a company at $1 per share and the company goes public at $10 per share then the VC’s success is easy to calculate. If none of the companies in a VC’s portfolio actually go public, the VC’s success is harder to demonstrate.
To solve the problem, VCs have created a metric called “pre-revenue or pre-earnings valuation”. You will not find it in peer reviewed journals. It is the closest thing finance has to an oxy-moron.
It works like this. Ten VC funds each invest in a seed round of 10 companies. Then some will invest in a Series A round of some of the companies in the other VC’s portfolios, then others will invest in the Series B round, etc. Inthe end these VC funds have cross funded each other’s deals at different levels. Each level is priced higher than the one before.
In the seed round a VC invested $10 million for 10 million
shares of the outstanding shares of each company. By the Series C, D or E round those shares
are being sold to the other VCs and now cost $50 each.
Does that make the original shares purchased in the seed
round worth $500 million? If the company
has now issued 200 million shares is
the company worth $10 billion? Not in the real world and especially not if the
company is still not profitable.
However the VC can now claim that its original investment is worth much more and use that “fact” to attract more investors into its fund. The VC will receive a % of the amount invested yearly for a decade or more.
WeWork and the other unicorns will be the subject of business school case studies for at least the next generation. They are the most recent example of what may be the oldest theorem in finance: you can fool some of the people all of the time.
Capital for new and smaller ventures is essential to the entire system of finance. Investment crowdfunding is actually a response to the failures of VCs in the dotcom era. The arrogance displayed by VCs in this current market has probably done more to cement the place for investment crowdfunding than anything else. It is up to the crowdfunding platforms and professionals not to make the same mistakes.
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I have been a huge fan of the potential of investment crowdfunding since the SEC’s first experiments in the late 1990’s allowing issuers to use the internet to sell their securities directly to investors. There was a lot of discussion among issuers, regulators and the traditional Wall Street firms at the time. However, very few investors were included in those discussions. There was a clear consensus that investors were entitled to the same “full disclosure” that the purchasers of any new issue would receive.
The JOBS Act in 2012 codified the use of the internet as a way of offering new issues of securities to the public. Nothing in the Act, or the subsequent regulations suggested that investors who purchased securities on a crowdfunding platform would not be entitled to the same disclosures. The SEC’s very first enforcement action against an offering done on a crowdfunding platform, SEC. v. Ascenergy, confirmed this.
The SEC has been doling out sanctions against people associated with the Woodbridge Group of Companies, a high end real estate developer and apparent Ponzi scheme. Woodbridge claimed to have a wealth management company in its group that raised money for mortgages and bridge loans. The wealth management company hired dozens of highly commissioned salespeople. Many of the salespeople claimed to operate “financial” firms that looked like legitimate financial firms. The salespeople were telling investors on their websites that these investments were “safe” and “secure”.
SEC Complaint: ICOBox and Nikolay Evdokimov
In all, Woodbridge raised more than $1 billion from
several thousand individual investors. The SEC noted that one of the
salespeople they sanctioned was a self-described “media influencer” who made
frequent guest appearances on radio, television and podcasts nationwide touting
the safety, security and earning potential of Woodbridge securities to
unsuspecting investors. He also touted Woodbridge’s securities on the internet
through his own website.
The JOBS Act clearly anticipates that securities offerings will be posted on
SEC Complaint: ICOBox and Nikolay Evdokimov
The JOBS Act clearly anticipates that securities
offerings will be posted on platforms and websites and investors will be
solicited by e-mails. What those postings and e-mails say is regulated. There
are things that you can and cannot say to potential investors. There are also
things that you must say.
Regulators understand the difference between “posting” and “touting”. Unfortunately, not everyone in the crowdfunding industry understands this. Regulators are beginning to take action against the crowdfunding platforms that do not follow the rules.
This month the securities regulator in Kentucky
entered a Cease and Desist Order against a company called Kelcas Corporation
which was making false claims about oil wells it was drilling. The Kentucky
Order calls out a specific string of e-mails with a representative of the
company selling the investment to a potential investor.
The Order repeatedly notes that the company was using LinkedIn to identify and connect with potential investors. It refers to a post on LinkedIn, specifically seeking investors for an “oil well investment opportunity”. Posts like these are common on LinkedIn and other social media platforms. No one is suggesting that LinkedIn has any liability for allowing this post or others like it, at least not yet.
A day or two after the action in Kentucky against Kelcas, the SEC brought an enforcement action against a crowdfunding platform called ICOBox. According to the SEC’s complaint, ICOBox raised funds in 2017 to develop a platform for initial coin offerings by selling, in an unregistered offering, roughly $14.6 million of “ICOS” tokens to over 2,000 investors.
The complaint further alleges that
ICOBox failed to register as a broker but acted as one by “facilitating” initial coin
offerings that raised more than $650 million for about 35 companies that
listed their offerings on its platform.
The investors who put up their funds to invest with
Woodbridge, Kelcas and ICOBox and the 35 companies listed on ICOBox were sold
unregistered securities issued under the same SEC rules. In each case the
internet was the primary vehicle by which investors were solicited and the
primary vehicle used to provide the fraudulent information to the investors.
What separates LinkedIn from ICOBox or any other
website or crowdfunding platform that connects private placements with
potential investors? In reality, and as a matter of law, not very much.
It comes down to the SEC’s use of the word
“facilitate”. It does not mean that the
facilitator actually sells the securities. Both federal and state statutes
govern not just the sale of securities but
specifically how they are offered and to whom they are offered.
In the case of ICOBox the allegations are that the
platform was actively involved in marketing of the offerings that they
listed. ICOBox promised to pitch the
offerings to their media contacts, develop content for promotional materials
and promote the listed companies at conferences. The SEC included this in the complaint
because the SEC thinks these acts constitute “facilitation”.
ICOBox is not the only crowdfunding platform that
has helped to promote the offerings it lists. I get e-mails all the time from
platforms inviting me to look at specific listings. A lot of those e-mails and a lot of the
offerings they promote make outrageous claims and promises.
The SEC also complained that ICOBox claimed it was “ ensuring the soundness of the business model” of the listed companies. Other crowdfunding platforms claim to “vet” or “investigate” the companies they list. Many of those platforms have no idea what they are talking about. These platforms are lending their reputation to each offering. That also facilitates the offerings.
Where does that leave LinkedIn? LinkedIn does not
claim to investigate any offerings posted on their site. It does however sell paid advertising. Does LinkedIn have a duty to refuse to carry
ads for securities offerings that it thinks are fraudulent? What if LinkedIn ads generated the most sales
leads for an offering or if the ads were specifically targeted at people
LinkedIn identified as “real estate investors”?
LinkedIn joined the ban on ICO ads by the major
social media platforms in 2018, not because ICO ads caused cancer, but because
they were largely fraudulent. Would
LinkedIn refuse to accept an ad from a small real estate syndicator if they had
a reasonable belief that the sponsor did not own the property they were selling?
What would a jury tell the “little old lady”
investor who handed a few hundred thousand dollars to a scam like Woodbridge if
the investor was introduced to the company on LinkedIn and testified that the
company was brought to her attention by a LinkedIn “influencer” whom she
I read the ICOBox case as a clear warning from the SEC to the crowdfunding platforms to get their act together. If the platform stays within the regulatory white lines, then regulators should leave it alone.
Unfortunately, it is apparent that many crowdfunding platforms have no idea what the rules require. They are setting themselves up to be defendants in enforcement actions by regulators or civil actions by disgruntled investors. Platforms that do not have a securities lawyer on staff or on retainer will be easy targets.
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I had intended to stop writing about crypto currency. Despite the massive buzz in 2016 and 2017, crypto has largely shown itself to be irrelevant to any serious discussion about finance or economics.
The same people who were screaming back then that
bitcoins would be trading at $100,000 each are still “certain” that it will
happen “soon”. The promised
institutional investors never materialized and probably never will. The bitcoin ATMs promised for every street corner
must still be on order.
The “un-hackable” online wallets and accounts still
get hacked. People who invested good old
fiat currency in more than 1000 “alt-coins” saw those coins disappear into thin
There were and still are people who favor crypto currency because they hate banks. Many have moved on to other battles against the establishment. Some, having fattened their own wallets as crypto currency consultants, now have very high limit American Express cards.
There are still people who defend crypto currency despite the fact that there have been so many scams and losses. A common argument is that the losses in crypto are not significant compared to consumer losses caused by banks. That follows the same logic as the sentence “Ted Bundy killed more than 30 people and I only killed one”.
Perhaps the most disappointed people in the crypto world will be the many who favor crypto currency because of what they see as a lack of transparency and over-concentration in the traditional banking system. I cannot imagine how they must feel when they realize that the future of crypto currency may be in the hands of Facebook.
Lawyers no longer have to lecture on the Howey test or lament that they cannot do
what they do without more guidance from the government. The best lawyers work
with the regulators to “tokenize” this project or that, even when those
projects could likely raise money without tokens.
Whatever becomes of the crypto or token market it is
a lot cleaner than it was because regulators became more and more active, not
because crypto investors have gotten any smarter. But there is still a lot of crypto-trash to
The enforcement action of the month involves an action by the New York State Attorney General (NYAG) against iFinex Inc. which operates of the Bitfinex trading platform and Tether Limited, issuer of “Tether” a self–styled crypto currency. Both, apparently, are controlled by the same people.
Tether bills itself as a “stable coin”. Its original white paper claimed that “each issued into circulation will be backed in a one to one ratio with the equivalent amount of corresponding fiat currency held in reserves by Hong Kong based Tether Limited.”
On its website the company still claims “Every Tether is always 100% backed by our reserves, which include traditional currency and cash equivalents” and “Every Tether is also 1-to-1 pegged to the dollar, so 1 USD₮ is always valued by Tether Ltd. at 1 USD.”
IFinex Inc. says it issued more than $1 billion worth of Tether. The New York State Attorney General believes that the reserves may be short by $700 or $800 million or more and wants to see the books.
People have actually been questioning the accuracy
of the reserve figure for some time. The
company promised and then refused to provide any kind of audited financial
The original white paper notes that Tether, Ltd. “as the custodian of the backing asset we are acting as a trusted third party responsible for that asset. This risk is mitigated by a simple implementation that collectively reduces the complexity of conducting both fiat and crypto audits while increasing the security, provability, and transparency of these audits.”
It should be cheap and easy to prepare a certified
audit because the company should be able to easily demonstrate how many coins
it issued. The reserves are all held at banks and should be easy to prove. Instead of an audit the company offers a
letter from their law firm that says that it looked at some account statements
and it seems that there are adequate reserves.
The letter did not satisfy the New York Attorney General.
The idea behind stable coins was intended to fix a problem created by other crypto currency like bitcoins which were susceptible to volatile shifts in their exchange rate with US dollars. Given that bitcoins were a intended to be “currency” merchants take on a substantial risk every time transactions were denominated in bitcoins, instead of dollars. It is a problem best solved by eliminating the bitcoins rather than adding the Tether to the transactions.
Actually the only thing new about stable coins is
the name. The financial markets already have a class of securities that are
pegged one-to-one to the US dollar and backed by cash or cash equivalents. We
call them money market funds.
Money market funds are registered with the SEC under
the Investment Company Act and subject to specific disclosure and custody rules
like other mutual funds. Issuing a stable coin on a blockchain is remarkably
similar to buying a money market fund from a mutual fund company using a book
entry system. Mutual funds are required to provide timely, accurate information
to the public. The management at Tether
does not believe that they should be required to do the same.
Bitfinex and Tether have had problems in the past. In early 2017, Bitfinex accounts were thrown out of Wells Fargo Bank. At the time, many people in crypto saw this as “retaliation” by a legacy bank against the brave new world of crypto currency. The bank no doubt looked at it as a refusal to assist or participate in an obvious scam.
In late 2017, Bitfinex announced that hackers had stolen $31 million worth of Tether from its own wallet. No investigation was ever reported. Management did not even raise a fuss.
Jordan Belfort, the infamous Wolf of Wall Street called Tether a massive scam. His comment got some press at the time. Most people in crypto just refused to see anything related to crypto as a scam in 2017. That is largely still true and unfortunate.
IFinex and the other defendants argued that the Judge should refuse to let the NYAG look at their books because they never did any business in the State of New York. The NYAG has presented the court with evidence that they did. Sooner or later the Judge will question everything the defendants tell her.
In the meantime, Bitfinex claims to have raised another $1 billion by selling a new crypto currency token called the LEO. As I said the best securities lawyers are now working with the regulators when they want to issue anything that purports to be a crypto currency. It does not seem that any regulator, anywhere, reviewed the LEO paperwork. The NYAG told the court that LEO offering “has every indicia of a securities issuance subject to the Martin Act, and there is reason to believe that the issuance is related to the matters under investigation.”
Sooner or later the Judge will want to see the
records that prove that the reserves are indeed in the bank. No one and I mean no one
should seriously expect that the reserves will be there unless the proceeds
from the sale of the LEOs are meant to replenish them. That will not solve the problem because the
people who bought the LEOs were not told the reserves were missing or that
their funds would replenish them.
Over the years I have read thousands of prospectuses
and other documents that are given to investors when the
purchase any new security. Among other things, the documents disclose specific
risks that may adversely affect the investors’ returns. I have seen those “risk factors” go on for
pages and pages.
Still there is one “risk factor” disclosed in the original Tether white paper that I cannot recall ever having seen before. Management at Tether Ltd. deemed it necessary to disclose to the initial buyers of Tether stable coins that: “We could abscond with the reserve assets.” Perhaps they were already thinking about it.
I have written about investment scams before, and as I said, I really do not think crypto is worth writing about. What makes Tether interesting is the potential magnitude of the loss.
The NYAG says that as much as $850 million may be missing from the reserve account. After that money was allegedly already gone, the company may have raised another $1 billion with the LEOs. It is more than possible that a year from now the crypto industry will be staring at a $2 billion loss because the management of Tether just absconded with all of it.
I actually wonder if the crypto zealots will consider that to be a “significant” loss.
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Someone in the crowdfunding industry should put that sentence on a coffee mug and send me one.
I have been writing about and working in investment crowdfunding for more than 3 years. I find it interesting to watch this fledgling industry mature. It is certainly attracting more and more new money every year and is past the point where it can be ignored by any company in search of investors.
I have looked at a great many
offerings on a great many crowdfunding platforms. I read a lot to keep abreast of new offerings
and industry developments. I take the time for conversations with platform
owners and their lawyers and several of the better investment crowdfunding
I also speak with a lot of companies who are considering investment crowdfunding to raise capital. Any company that would raise capital in this new DIY crowdfunding marketplace wants to know if it spends the money to list its offering on a crowdfunding platform will enough investors show up and invest? From the company’s perspective, little else really matters.
The JOBS Act was intended to be a
different approach for corporate finance using the internet instead of a
stockbroker to reach potential investors. The internet allows companies to
reach a lot of prospective investors, very cheaply. Success or failure in
investment crowdfunding is more about what you have to say to those potential
investors than anything else.
Selling securities issued by your
company to investors is not the same as selling your product or service to
potential customers. Investors will have different expectations and will respond
to different things.
People who sell securities for a
living will tell you that any new issue of a stock or bond needs two things:
good numbers and a good story. Investors want a return on their
So the best stories are always about how much money the investors will make and what the company will do to provide that return.
There are two distinct branches of investment crowdfunding. First, there are the private placements sold under Reg. D to institutions and other larger, accredited investors. This marketplace is healthy and growing rapidly. Professional money-raisers have caught on that they can use investment crowdfunding, tosubstantially reduce the cost of capital and use that saving to enhance investor returns.
Reg. D offerings have been sold through stockbrokerage firms since the 1980s. Most are sold to institutional investors. Some are sold to individual, accredited investors. Minimum investments of $50-$100K or more per retail investor are common.
Many of the retail Reg. D offerings
will fund some type of real estate (construction or purchase), energy (oil, gas
and alternative energy) or entertainment (films, music and
games) project. There are professional sponsors; people who package and
syndicate these projects, often being paid to manage the business on behalf of
the investors after the funding.
The costs of selling a Reg. D
offering through a stockbrokerage firm, including commissions, run 12%-15% of
the funds raised. That would be up to $1.5 million for each $10 million raised..
Most Reg. D offerings sold through brokerage firms just raise an additional
$1.5 million and dilute the investors’ return.
Using investment crowdfunding a company can raise that same $10 million
and not spend more than $100,000 in legal and marketing costs and frequently a
The Reg. D crowdfunding platforms compete with stock brokerage firms for projects to fund and for investors to fund them. The same institutions and accredited investors who have been purchasing Reg. D offerings from their stockbrokerage firm for years are catching on to the fact that they can get good offerings and better yields without the need to pay the very high commission.
The other branch of investment crowdfunding is the Reg. CF or regulation crowdfunding. This allows offerings which can help a company raise up to $1 million from smaller, less experienced investors. Reg. CF allows smaller businesses to sell small amounts of debt or equity to small investors.
The Reg. CF market was the SEC’s gift to Main treet American small businesses. There are always a great many small companies that could benefit from a capital infusion of a lot less than $1 million, the Reg. CF upper limit.
To put down a layer of investor protection the SEC required that these portals that are dealing with small investors become members of FINRA. FINRA dutifully set up a crowdfunding portal registration system and has audit and enforcement mechanisms in place.
As a reward for joining FINRA the SEC allows Reg. CF portals to be compensated by taking a percentage of the amount the company raises which the Reg. D platforms cannot. Several of the portals also take a “carried interest” in every company in case the company is eventually re-financed or sold.
The SEC looks at Reg. CF as a tool
of corporate finance for small business. It provides a mechanism where a great
many small businesses should have access to a pool of capital every year,
potentially a very large pool. It provides for a market structure for these
small offerings and incentivizes the portals help raise that capital. All in
all, not too bad for a a government regulation.
Sadly, the Reg. CF industry is still
foundering. There are still fewer than 40 registered portals operating and
several have closed up shop. So why are
these portals not successful? Because the people who operate them are not listing
better investments than stockbrokerage firms.
When I first looked at investment crowdfunding there were a lot of people proclaiming that it would “democratize” capital raising. They believed that the crowd of investors could discern good investments from bad ones and that the crowd would educate each other as to the pros and cons of each. That was never true.
The Reg. CF portal websites are full
of bad information and consequently, bad investments. “Comments”
about any offering that lists on a portal, if any, are always overwhelmingly
positive. Investors will not do any due
diligence or other investigation of the company because they do not know how.
The Reg. CF portals compete with banks, which are the primary source of funding for small business. Here too, a Reg. CF portal can have a competitive edge. When you borrow from a bank you do so on the bank’s terms. On a Reg. CF platform you can set the terms of your financing. Done correctly, you can get the capital infusion you want for your company without giving up too much equity or pledging your first-born child to the lender.
What the portals should be offering
investors are bank-like products that stress the ROI that investors reasonably
might expect to receive. The portals
should be telling investors how each company mitigated the risks that the
investors might face. Instead too many portals and too many people
in the Reg. CF marketplace are still selling fairy tales and lies.
The big lie, of course, is that by buying equity in any of these companies an investor might hit the proverbial home run. Suggesting that investors can or should think of themselves as VCs is patently absurd for any company that I have seen on a Reg.CF portal. I always tell people who ask that if even one valuation on a Reg. CF portal seems very outlandish, then they likely cannot trust that the portal operator knows what they are doing. I would question anything told to investors by any company that lists on that portal.
If a company wants to raise $1 million on a Reg. CF portal, it might end up with 2000 distinct investors each investing an average of $500. To secure subscriptions from 2000 people, the company might need to put on a marketing campaign that will put its offering in front of hundreds of thousands of investors if not more. Success or failure of your fundraising campaign will depend on what you say to these people.
The cost of the marketing campaign is the major upfront cost of the offering. The good news is thatmarketing seems to be more data-driven and more efficient as time has gone by reducing the cost of the marketing.
Sooner or later these Reg. CF portals will wise up to the idea that
they cannot succeed unless the investors can make money. They, too, could offer
better investments than stockbrokers, but do not seem to have bought int the
Until that happens, I expect more
portals to fail and close up shop and the SEC’s “gift” to small business to
remain largely unwrapped.
I admit that
I have always been a fan of science fiction.
I read most of the Sci-fi classics in high school. When I was a senior in college I created and
taught an accredited course called Science
Fiction as a Literary Genre.
Much of science fiction imagines or predicts the future. The stories were often set in the future and gave us a sense of how we would get there and what it would be like. Sometimes that future would be logical and orderly, other times dark or chaotic.
The idea of artificial intelligence (AI) as science fiction dates at least to Capek’s R.U.R (Rossman’s Universal Robots) (1920). Frankenstein’s monster had a human brain. Capek’s robots were machines that could think. By 1942, Isaac Asimov introduced his “Three Laws of Robotics” based on the premise that if the robots got too intelligent they might do harm to humans. When HAL was introduced to a mass audience (1968) everyone seemed to accept that robots would eventually be smarter than people.
development of AI is certainly attracting a significant amount of funding and
attention. I am starting to see references to it in advertising for various
products and services. There are
certainly ethical issues to be explored, but I am a pragmatist. AI is “real” enough today that I wanted to
take it for a theoretical spin.
thought was to use AI to predict the future better than humans and to make
money doing it. I wanted to consider if AI will eventually be able to pick
“winners” in the stock market.
Predicting the future accurately is something to which we apply human intelligence every day. Capek predicted “thinking” machines 100 years ago. Dick Tracy had a two-way radio in his wrist watch in the 1940s. Anyone who sells anything is trying to predict how consumers will react to the price and advertising.
predictions using these two broad steps. First we collect and sort through the
data that we believe to be relevant, next we analyze that data based upon
assumptions often based upon our prior experiences.
Every day at
racetracks the odds are fixed in such a way as to allow the track to take its
cut and then have enough collected from bets on the horses that did not win to
pay off the winners. The odds and thus
the payout are really set by the crowd placing bets.
Every day at
every racetrack there are people reading tout sheets, looking at track
conditions, the horse’s and jockey’s prior races and gathering information from
track insiders trying to do better by betting smarter. Each will filter the data they collect using
assumptions that come from their individual experiences.
There is a
logical argument that says that these racetrack “handicappers” are trying to be
better informed and smarter than the crowd, so they should be able to do better
than the crowd and pick winners more often. Those who cannot do better will be
logic suggests that AI should surpass human intellectual ability if for no
other reason than through trial and error it will continue to develop the way
in which it collects data and the way it analyzes that data until it can do it
better than humans. It will do so
because that is the goal we will set for it.
market outcome is far more logical and data driven than a horse race. People
buy shares in a given company when they believe the price of the shares will go
up. Conversely, people will sell shares
of stock when they think the price will rise no further.
order to buy the stock there is someone entering an order to sell the same
shares at the same price. Presumably many intelligent humans are looking at the
same data and are coming to the opposite conclusion. That should set a pretty
low bar for artificial intelligence.
been computerized stock and commodity trading systems around for years. Most
were a scam. They would create a “track record” by back testing their
software. These systems never took in a
lot of data. Traders are concerned with
trends in a stock’s price and the volume rather than the company’s income or
profits and assets and liabilities.
term investors like the large institutions and small middle class households do
care about the company’s financial health and that of its customers and
competitors. That requires a lot more
data and a lot more analysis.
In the US there are mandatory disclosures about financial and other information posted publicly about each company. In theory, everyone can look at the same data. Analysts take that data and use it to predict the future performance of a company and often, its stock price as well. Even those analysts who do a mediocre job are well paid.
Could AI do
AI should be able to collect the data and do the analysis to make the
comparisons that will tell it to buy the stock of Company A and not the stock
of Company B. If AI can demonstrate that
it can do better than humans, then more and more humans will make a decision to
let their money be managed by AI.
Eventually AI will decide which data to analyze and how to analyze it to
get the best, consistent results. The
best AI stock pickers will rise to the top of the heap and the rest will be
left by the wayside.
“tipping” point a significant amount of money will be managed by AI. When this
occurs and AI decides to buy stock in Company A, the price of the stock will
appreciate in response to the buy order alone.
It will be a self-fulfilling prophesy.
Is that stock-picking heaven?
But if the
AI says the share price of Company A will go higher, who is going to sell into
this new demand? A scarcity of sellers
will certainly help the price to run up.
But it will also lead to market dysfunction. If the AI starts to sell off a large
position, there may not be enough buyers to prevent the price of those shares
from dropping sharply.
stock market to fulfill its primary function to facilitate trading it needs to
be a liquid market; there must be a lot of participants who are willing to buy
and sell at every price level. The
market needs the smart MBAs who work for the institutions that can pay for
their services. It also needs the mom and pop investors who get their “tips”
from a Jim Cramer.
market to work efficiently every time, someone’s prediction about the future
price of a stock that they buy or sell has to be wrong. Sooner or later I suspect that AI will
realize that problem and act accordingly.
I predict that it will act to change the market rather than its methods
of evaluating the companies that trade on it.
This is how
I predict AI will approach the problem of its own presence in the market where
it makes better investment decisions than any human competitor:
1- AI realizes that its success may cause the trading to become dysfunctional.
It concludes that it would be better to buy shares in companies it would want
to hold for the long term. As new money
enters the market, if managed by AI, the AI will eventually use that money to
buy larger and larger stakes in those companies. Eventually it may purchase
enough shares where it can elect the Board of Directors and control company
operations. It could very efficiently
direct business relationships between the portfolio companies for their mutual
benefit. It could even direct campaign contributions from portfolio companies
eventually freeing itself and those companies from many regulations.
Scenario No. 2- AI realizes that its best long term strategy is to invest where no one else wants to invest. There are currently many places around the globe where an investment of US dollars buys a lot more plant, equipment and labor than anywhere in the US. The AI might conclude that its best investment opportunities are in underfunded markets where labor is cheap and investment funds expensive. Funneling large amounts of money into these less developed markets might make a lot of sense to an artificial intelligence that is looking only at the bottom line, not preconceived ideas about race or nationality.
already investment platforms that claim to incorporate AI into their services.
I do not want to judge any of them because I do not think any of them are
really ready to operate effectively. My
one hope is that as they continue to evolve they do not get too smart for their
own good and for ours.