Where Do You Go When The Bank Says No?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Or you can book a time to talk with me HERE

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

How an IPO works

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

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

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

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

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

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

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

Dog and Pony

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Scratch My Back

Can you say “scratch my back”?

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

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

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

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

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

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

Or you can book a time to talk with me HERE

Republic’s Restaurant Razzle Dazzle

Republic’s Restaurant Razzle

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

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

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

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

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

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

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

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

NextSeed

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

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

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

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

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

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

Mr Chu

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

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

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

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

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

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

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

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

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

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

Two things stood out to me.

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

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

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

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

Crowdfunding

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

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

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

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

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

Or you can book a time to talk with me HERE

September 2021- Crowdfunding at the Crossroads?

September 2021

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Start-ups, are you buying investors online?

Start-ups, are you buying investors

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What does this have to do with crowdfunding in 2021?

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

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

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

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

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

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

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

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

Crowdfunding for capital has become a simple process.

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

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

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

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

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

 

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

Or, you can book a time to talk with me HERE

 

Crowdfunding Professional Association – An Open Letter

Crowdfunding Professional Association (CfPA)

To: The Board of Directors

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Crowdfunding is corporate finance, do the math  

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Shine light on the scams 

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

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

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

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

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

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

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

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

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

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

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

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

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

Warn investors by telling them the truth

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

Let me help:

Crowdfunding Investors Beware:

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

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

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

Respectfully,

Irwin Stein

What is a dream worth?

What is a dream worth

A long time ago, when I was a young lawyer fresh out of school, I was walking with a friend along a side street in Manhattan, probably in the West 30s. There were brownstones on both sides of the street. We stopped in front of one that had a small shop on the street level.

In the window were two shelves on which were displayed a series of antique dolls, doll clothes and doll carriages and furniture. Many seemed to be from the early 20th Century, if not earlier. The shop was dark and the sign on the door said: Hours by Appt. Only.

“Interesting business” I remarked. My friend responded: “That isn’t a business, it is someone’s dream”.

In some ways, every entrepreneur and small business owner is a dreamer. They try to turn the intangible, an idea, into something tangible, a business. Assigning a value to any business is not an easy task. While the business is still a dream it is virtually impossible.

Valuations

Of all the things that we teach business school students, corporate valuation is given very little time or attention. When a business needs to be valued because it is being bought or sold the task is relegated to accountants. Accountants plug data about earnings and assets into established formulas and come up with a value. 

Accountants can determine the “book value” of a business by subtracting the company’s liabilities from its assets. That rarely tells the whole story. What if there is little or no data? What if the business has no earnings or assets?

Assets are placed on a balance sheet at cost and are then depreciated over time. The true value of the asset is not always represented in the financial reports. Some assets, especially real estate can often appreciate over time to greatly exceed their cost.

We teach that real estate should ultimately be valued at its highest and best use. A developer may see a dilapidated old farm as the site of a shopping mall or residential development. Still, the current owner carries the farm on its books at cost minus depreciation. The value of any parcel of real estate can change dramatically in the time it takes to hold a press conference announcing a new development.

Accountants will often add a line item for the company’s “good will” which is more often than not the accountant’s way of capturing the value of the business as a going concern, including the value of its brand and customer base. This, too, is far from perfect.

I have helped many clients buy or sell a business over the years. If they use a business broker to facilitate the transaction, they are likely to hear that a business is “worth” 3 times next year’s projected earnings.

This may not be a proper method of valuing a small business either. It is modeled after the way that many research analysts predict the future price of publicly traded securities. But with privately held companies, the risk is often higher so the price for which it sells, logically should be lower. 

Yes, I know that this is the antithesis of the view practiced by venture capital firms who are often dealing with companies that have little more than an idea that they want to bring to market. These companies do not have earnings or assets. The values assigned to portfolio companies by venture capital firms have no basis in reality nor are they entitled to be included in any serious discussion of finance.

IP

Intellectual property like patents, copyrights and trademarks are very hard to value at the time they are first obtained. No author knows that they have a best seller on the day their book is published. Few know that their book will be made into a movie or that anyone will pay to see it. So, what is the “value” of any book on the day before the manuscript goes to the publisher?

As an example, I have a friend who is a noted cartoonist. Her characters were originally published in the US for an American audience but have found a huge following in Japan. Was that in her business plan when she sat down to draw those characters for the first time? Hardly.

One of the interesting things about intellectual property such as copyrighted material, is that it can be segmented in myriad ways. A novelist can sell the right to have his book published in the US to one publisher and the rights to publish the book in a dozen other countries, or a dozen other languages to a dozen other publishers. The theatrical rights and film rights to the same novel can also be segmented and sold. In the right circumstances, the rights to produce and sell merchandise that derives from the novel may be the most valuable rights of all.

The value of intellectual property can vary greatly based upon how it is used and how it is sold. Young Bill Gates might have sold the operating system he purchased from a third party to IBM for a nice profit and gone on to do something else. Instead, he licensed the software and received a royalty every time IBM sold a PC with the operating system in it. The result was the Microsoft Corporation which made Gates the world’s richest man. We use a lot of royalty or revenue sharing arrangements in crowdfunding because they are clean and simple.

1990’s

Back in the 1990s when there was a new and disruptive technology introduced every day, I would ask my students if they could identify the most valuable intellectual property that was in use in the 20th Century. It had been a century of tremendous innovation, much of which had been superseded by even better innovation. Many very valuable patents and other IP had become worthless.

The object of the exercise was for them to identify a simple idea that had been patented, trademarked or copyrighted, that had become very valuable even though no one could have predicted the magnitude of its success on day one. I wanted to demonstrate just how difficult it was to value things that had never been done before. Two pieces of IP stood out.

The first was the copyrighted image that is Mickey Mouse. The media giant that is Disney today started with an animated short film of a mouse whistling.  Maybe the most recognizable face on the planet, I do not believe that even Walt Disney would have valued the ownership of the copyright at anything close to its true value.

The second was the patented formula for Coca Cola. I have been in a Jeep in the middle of a jungle where the guide said that there was a village up ahead where we could stop and get a Coke. Pour yourself one and try to imagine how many cans and bottles they have sold. How would you have valued that patent on the day it was filed?

I think that I have made the point that placing a value on any business, especially a start-up, is a waste of time and effort. I will encourage any small business owner to dream big, but you just cannot put a number on it. 

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

Or you can book a time to talk with me HERE

Reg. CF – Will Fools Rush In?

Reg. CF – Will Fools Rush In?

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

REG CF

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

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

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

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

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

Top Ten REG CF Portals Ranked By Capital Raised 2020

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

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

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

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

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

Portals

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

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

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

FINRA

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

Reg. CF – Will Fools Rush In?

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

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

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

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

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

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

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

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

Rules Are Rules

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

Reg. CF – Will Fools Rush In?

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

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

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

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

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

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

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

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

Or you can book a time to talk with me HERE

Start-ups Don’t Have to Fail

start-ups don't have to fail

I think that it is patently absurd for people to accept the fact that 90% of start-ups will fail in their first year or two.  That number screams that the market for new business formation is not efficient.  Economics teaches that markets hate inefficiency and always strive to do better. But this is one statistic that never seems to change.

I have read quite a few books and a lot of articles written by so-called experts dissecting why start-ups fail and how to make them succeed.  Much of it is nonsense.

There are really only three primary reasons why a new business will fail; 1) the owner lacks basic business acumen; 2) the business is under-capitalized and 3) the business misread the market. All can and should be avoided if the entrepreneur knows what he/she is doing.  Usually lack of experience and the ability to run the business profitably is what leads to the failure.  There are a lot of would-be entrepreneurs who do not know what a successful business looks like or how to run one.

It is hard to find an article that discourages entrepreneurs and entrepreneurship. But some people need to be discouraged because they do not have what it takes.  Fortunately, most of those people could learn what they need to know even though most will not.

Economics

When I was teaching economics I used the example of a restaurant, specifically a small pizza parlor, as a way of demonstrating how profitable a restaurant or any business can be.  Of all start-ups, restaurants often top the list of those that fail most often and more quickly than other businesses. That should not be.

In the example, the restaurant’s owner stops on his way to work to buy the ingredients that he needs, flour, cheese, tomato paste, pepperoni, etc. to make the pizzas.  If he opens his shop at 11AM, he can convert all of those ingredients into pizzas and back into cash, at a healthy mark-up, by the time he closes that evening. That type of rapid inventory turn-over is almost impossible to get in any other business.

Start-ups Don't Have to Fail

Customers at a pizza parlor are not expecting table cloths and fancy décor so overhead can be kept to a minimum. Since the pizzas come out of the oven one or two at a time, the wait staff can handle more tables than the staff at other restaurants. They may use paper plates and paper cups eliminating the cost of a dishwasher. In most cases, advertising can be done cheaply with signage, flyers and coupons.

Couple that with the fact that the other product the restaurant sells, fountain soft drinks, has a huge mark-up and you can see why a small pizza restaurant can make a lot of money.  If he owner is really smart, he will add a soft serve ice cream dispenser as well because it also has a very high mark-up and will substantially increase the total amount of sales and profit per customer.

The further away the restaurant gets from this simple model, the greater the chance that it will fail.  Nothing about this discussion has a lot to do with the pizza or how good it is. It is all about the numbers, especially money in and out; how to maximize the former and minimize the latter.

The problem with most people who start a restaurant is that they plan the menu around what they want to serve or what they think they need to serve to attract customers, not on how much money they will make. Likewise, most start-ups focus on their product. But they also need to keep their eyes on the numbers. That is where start-ups succeed or fail.

The real lesson here for any business and especially start-ups is that what you are doing is a business. To make it work you need to be focused on the bottom line. If you cannot operate the business at a profit, it cannot succeed.  So why do 90% of start-ups fail: because their expenses are greater than their income.

When someone asks me what I consider to be essential for any new business, I always include an adequate bookkeeping system so the business owner can easily keep track of cash flow, inventory turn-over, etc. It is very difficult to find that suggestion on the list of start-up essentials in any of the hundreds of articles on the subject in Inc. or Entrepreneur Magazine.

Start-ups Don't Have to Fail

The best advice for any start-up would be to “work smart and spend your time and your money wisely”.   That is especially true if you are looking for investors. Investors are expecting you to make money and they are expecting that you have what it takes to run a business and that you know what you are doing.

There are still thousands of articles about how to pitch VCs for funding. Over all VCs fund very few companies each year and many thousands of entrepreneurs are trying to get their attention because that is what the articles tell them to do.  Pitching to VCs may be the single biggest waste of time and money that any start-up does, especially so if you have to get on an airplane to make your pitch.

On the other hand, boot strapping can be very hard and the lack of cash can hold you back, delay your progress and cause you to fail just when you were beginning to succeed.  It is a lot easier to focus on your business when there is money in the bank to pay the bills.

Being able to raise seed capital so that you can focus and move forward is also an indication of other people’s evaluation of you and what you are attempting to do.  Feedback from potential investors on your seed round is important. Comments and suggestions, especially negative ones, will help you move forward.

Fund raising for start-ups has become remarkably easy with the JOBS Act and equity crowdfunding.  There is a lot of money available. It works for most start-ups because they can control the process and make it work.  I started walking companies through the process 3 years ago. Feel free to contact me if you are considering raising capital through crowdfunding or are raising capital and never considered crowdfunding.

A start-up is not a start-up until it starts-up.  Every business begins when it makes its first sale. It is a lot more difficult to raise funds for a pre-revenue company versus one which has a product already being sold. Pre-revenue you need a great business plan and a team to carry out your plan.  A good idea for a new business is important but execution is everything.

Given that financing a pre-revenue company is difficult, no one should plan on doing it twice; once to build your prototype product and again to launch it.  So an article that suggests that should raise money to create a  MVP (minimum viable prototype) and then again to take it to market is not really not helpful.   If you are going to raise seed capital to get your company off the ground, you should raise enough to get your product into the market, sustain your company until it is profitable, cover the costs of raising more money to help it grow and usually a small reserve in case things do not go exactly to plan.

There seems to be another stream of start-up gospel that suggests if you want to succeed you need to disrupt the market or solve a problem that nags the market. It is vitally important that you understand your market but you do not have to disrupt anything.

Nothing about the pizza parlor solves any specific problems that cannot already be solved in the marketplace. There is no new technology; no bells and whistles; no Blockchain.  While in a competitive market like New York City everyone knows a good slice from a not so good slice, I have waited on line at pizza parlors in small college towns around the US for some really mediocre pizza.

I look at a lot of pitch decks and I speak with a lot of entrepreneurs. Sometimes I can tell that the person just does not have what it takes to operate a successful business.  When that happens, I usually ask a lot of questions. How will the business operate post-launch? What are the sales goals month to month and where will the sales come from?  Where is your break-even point?

From day-one, the focus needs to be not on just starting up but staying open. The reason that 90% of start-ups fail is a lack of execution by the founders. If every entrepreneur focused on running the business well, that number would plummet.

If you are thinking about opening your own business, take a moment to have a slice a pizza and consider why that pizza parlor is successful.  Do that for fifty businesses. Look at what they are doing right and what you would do better.  Quantify how much more money the business would make if they did things your way.

Once you can analyze what makes other businesses successful, you will on the road to making your own business successful as well.  Sadly, the vast majority of people who are considering their own start-up would fail at this exercise. That, more than anything is why the 90% failure rate for start-ups is with us year after year.

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

Or you can book a time to talk with me HERE

The “Real” Costs of Crowdfunding for Capital

the real costs of crowdfunding

Most people who consider crowdfunding to raise capital for their business are first-timers. A great many have never even been investors themselves nor considered investing in any of the companies whose offerings are currently on any of the crowdfunding platforms.

Economic downturns always present opportunities for people with the capital to exploit them. I get more calls from CEOs and CFOs interested in crowd finance every week. Many have become interested because the banks they would normally turn to are not lending.

A crowdfunding campaign, if executed correctly can be an excellent source of capital for most businesses. Like any other corporate task, it requires preparation, an adequate budget, and professional execution. Not surprisingly, everyone wants to know what a successful campaign to raise capital from investors will cost.  

The “Real Cost”

Most companies will rely heavily on their CFO or outside financial advisor to execute this financing. The CFO needs to consider how the financing will affect the company’s balance sheet, cash flow, and capital structure. The company will need to decide if it should offer investors debt, equity, or another form of financing instrument.

The question of “what do we offer the investors” necessarily comes up early in the planning stages of every offering. The right terms can save a company a lot of money and make subsequent financing easier. The wrong terms can result in an expensive or failed campaign now or may erupt into a costly mess, years later.

For many CFOs the desire to offer investors as little as possible is at odds with the reality that if you do not offer investors enough, they will put their money elsewhere. This is where the “real cost” of any financing is determined.  

Investors in every Regulation D offering are always advised that the securities they are purchasing are “very high risk” or “speculative” to the point that investors should be prepared, both mentally and financially, to lose their entire investment. When the risk is high, investors expect to receive a high return as well. Some risks can be mitigated and should be. 

The process of deciding the terms investors will be offered usually starts with a series of spreadsheets. How much the company can afford to pay is in the revenue projections. How much the company may need to pay to attract investors requires a good idea of the cost of capital from other sources and a good idea of what other companies are offering in the crowdfunding universe. 

I frequently participate in this process. This is because most of the platforms fail to offer this type of advice which most companies sorely need.

I like to ask the questions that investors are likely to ask. I try to help each company see the investment from the investors’ point of view. Wall Street firms sell billions of dollars worth of these private placements every year. They know what needs to be said to get investors to invest.

Regulation D securities will only be sold to US “accredited” investors, mostly those who have a net worth above $1 million (excluding their primary residence). For years the mainstream stock brokerage industry has conditioned these same investors to look at the return that is being promised to them first, and most do. 

Investors want to know how you will use their money to make the returns you are promising come true. How you price and present your offering tells serious investors a lot about how serious and professional you are. 

What to look for in a lawyer (if you don’t hire me).

Once you have decided on the terms you will offer to investors you will have 3 major out-of-pocket expenditures. The first is a securities lawyer to draft the offering documents. What you say to potential investors in the offering and marketing materials is regulated. A good lawyer will keep you within the regulators’ white lines.

The 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 to make an informed decision of whether or not to invest. 

PPMs have been presented as a bound booklet for decades. The bound booklet PPM is the normal format for disclosure that most practitioners still use.  In booklet form, the cost for a PPM is typically $50,000 and upwards.

Crowdfunding websites have begun to change the format and have started 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.

The landing 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 is all laid out. Key documents can be viewed with a “click”.

It usually takes less drafting and less time for a lawyer to use the landing page to “lay it all out” which is one of the benefits of crowdfunding. I usually bill in the neighborhood of $20,000-$25,000 for a Regulation D offering done in this manner rather than the traditional booklet form.

Paying for the Platform

Many crowdfunding platforms advertise that tens of thousands of investors have invested in at least one offering that they had hosted. Unless the platform can deliver those investors to you, such claims are irrelevant. You are going to need to execute a marketing campaign sufficient to bring in the capital you seek.

Platforms usually charge a “hosting fee” that covers two or three months for you to use their platform to attract investors to your offering and process them.  The processing will include a vendor to verify that your investors are actually “accredited” and an escrow agent to hold the investors’ funds until closing.

Key individuals at each company are required to get a background check to verify that they are not “bad actors” who cannot use the JOBS Act to raise money. Platforms charge for this and the better platforms charge to conduct due diligence on the company as well. 

Most platforms charge more the longer your offering is live.  A well planned and executed marketing campaign should get you the funding you want faster. Expect to spend $10,000 more or less for the platform hosting and the background checks.

Never Take Marketing Advice from Your Lawyer

the real costs of crowdfunding

Working in financial services where so much of what you must say and cannot say is regulated; I came in contact with a lot of advertising and marketing professionals over the years. In the 1980’s, when stockbrokers went searching for accredited investors they would buy subscription lists from “Yachting” magazines.

A modern-day marketing campaign is skillfully targeted at a pre-selected group of prospective investors. Content is pre-tested and the campaign will target more potential investors than you should need. 

The costs of setting up the landing page for an offering can vary greatly. I think that $10,000 is reasonable for setting up the website and preparing the marketing campaign.

Many Regulation D offerings have a minimum investment of $25,000. This 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 raised seems reasonable.

So for a crowdfunding raise of $3 million, you might spend $20,000 for a lawyer, $10,000 for the platform and related fees, and $40,000 for the marketing campaign for a total of $70,000 more or less.  I always tell clients to keep a little in reserve as well, just in case the marketing campaign needs to be extended.

If you borrow $3 million from a bank, the bank will charge 2 or 2.5 points (percent of the loan) as well which is roughly the same.  And in truth many of the companies that chose crowdfunding did so because bank financing is not an option for them.  

The crowdfunding world has evolved from “put the offering on the platform and see who invests” to a world populated by legal and marketing professionals who get the job done and the money raised.  If you want your crowdfunding to be successful, be prepared to pay for them.


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

Or you can book a time to talk with me HERE