Issuers

BrightCOIN- The Legally Compliant ICO?

Capital Markets, Issuers, Law , , , ,

I recently read an article citing a study that concluded that as many as 81% of initial coin offerings (ICOs) are scams. Several people contested that number but it cannot be too far off. If you have more than a cursory interest in crypto currency and ICOs it is hard to miss all of the discussion about ICO scams and what to do about them.

There is a general consensus among many in the ICO community that the ICOs need to stop kidding themselves that they are not securities and begin to seriously comply with US securities laws.  In crypto industry parlance, there is an expectation that ICOs have begun to evolve into STOs (securities token offerings).

A company issuing a securities token will need to register the offering with the SEC or seek an exemption from registration such as Regulation D.  Most STOs will be sold under Reg. D,in part because the SEC has yet to approve a registered offering and does not seem to be in any hurry to do so. US securities laws require that investors be given full disclosure of the facts that they need to make an intelligent decision whether or not to invest.

Around the same time, I came across a discussion on LinkedIn about an ICO for a company called BrightCOIN. The company is raising between $1 and $40 million to expand its tech platform which enables companies to launch their ICO in a “legally compliant” manner.

I read the white paper which is anything but legally complaint and I said so on LinkedIn. This got some brush back by the company’s CEO who commented, among other things that the company had a great lawyer who had helped prepare the white paper.  The CEO claims to be a Y Combinator alumnus with several successful start-ups under his belt. So, of course, he should have an excellent lawyer.

I offered to explain why I thought that lawyer needed to go back to law school and the CEO scheduled two appointments with me so the lawyer could tell me that he was right and I was wrong. They cancelled both appointments at the last minute.

The ICO for BrightCOIN is intended to be a Reg. D offering. I would have thought that since it was selling a service and a platform where other companies can make “legally compliant” offerings, BrightCOIN would have taken pains to make its own offering “legally complaint”. They missed by a mile.

The BrightCOIN offering document is in what is now being called a “white paper format”.  If you look at a lot of ICOs, a great many use this format. I do not know where it originated, but it does not generally make the disclosures that are required for a Reg. D offering in the format that the SEC expects. Using this format is an invitation to the SEC, state regulators and class action lawyers to come after you.

A Reg.D offering is also called a private placement and the offering document is called a private placement memorandum (PPM). There is a reason that most PPMs look alike. Back in the 1980s and 1990s regulators in several states required hands on review of every offering. I personally spent hours on the phone with the staff at these various state agencies going over specific language in Reg. D offerings. They usually wanted additional disclaimers; more risk disclosures; the words “this is a speculative investment” in the cover page in bold.

Congress eventually took away the states’ ability to comment on these offerings; but a lot of lawyers, including me, appreciate that much of what they wanted amounted to good practice. Disclosures are made for the benefit of the company that is raising the money. They are a prophylactic against legal action claiming fraud and misrepresentation.

BrightCOIN calls itself the Kickstarter for ICOs.  It is essentially a crowdfunding platform for ICOs including those private placements offered under Reg. D and registered offerings filed under Reg. A+.  BrightCOIN charges no upfront fees and will provide everything that a company needs to prepare and launch an ICO including “audited documentation”.

Of course Kickstarter does not handle any securities offerings. They operate in the world of “rewards based crowdfunding”, not securities crowdfunding, so the comparison to Kickstarter that BrightCOIN makes in its ICO white paper is meaningless.

Elsewhere BrightCOIN claims that it will become the “next Goldman Sachs” and compares itself to Goldman, Merrill Lynch and JP Morgan.  The white paper included the logos for those companies, all of which I suspect are trademarked.

Did Merrill Lynch give permission for its trademark to be used in this offering? Does Goldman Sachs even know that BrightCOIN exists?  Is there any way to read this hyperbole and not consider it to be misleading?

BrightCOIN claims that its tech platform is valuable because an entrepreneur considering launching their own Reg. A+ or Reg. D offering in the form of a token might spend as much as $500,000 to have the tech built.  By “tech” it appears to be speaking about the crowdfunding platform that they are offering.

The last time I saw a bid to build a crowdfunding platform from scratch (November 2017) the cost was $50,000 and that had some unique CRM capabilities built in. I made a few calls and to add a token capability to that would cost no more than another $50,000 and probably a lot less. Where BrightCOIN gets that $500,000 number is anyone’s guess.

In any event there is no reason to create the crowdfunding technology from scratch. If you want to open your own crowdfunding platform there are several companies that offer white label products for a small upfront fee and even smaller monthly charge. At least one that I know of comes with AML/KYC capability attached.

For any offering of securities to be “compliant” it must present information in such a way that it is balanced to point that it is not misleading. The BrightCOIN white paper is full of interesting and unsubstantiated hyperbole.

Around the world, it appears that 10% of the funds that have been invested in ICOs have been hacked. BrightCOIN claims its platform is “100% hack proof”.  I have spoken with large, mainstream financial institutions that spend a lot of money making their platforms “hack-resistant” but I do not know a single attorney who would put the phrase “100% hack proof” in a securities offering document.  The truth is no one knows if a platform is hack proof until it happens.

The white paper discusses how BrightCOIN can be used to “tokenize” assets like real estate making those assets more accessible to small investors who will be able to trade those tokens on a global basis. The white paper notes (in bold type) that there are over $200 trillion worth of assets that can be tokenized.  In the context it is presented, that statement is akin to me saying that there are 1 million single women in California implying that I will always have a date on Saturday night.

BrightCOIN claims their platform is fully functional and that they are already in business. Do they disclose how many offerings they have done and how much money those offerings have raised? They do not. They also claim that they offer consulting services to help a company prepare and market its ICO. Do they identify the people who perform these services? No.

BrightCOIN estimates that it may be able to list and sell 20 ICOs per month and might be able to take in $6.5 million per month in “success fees” if it does. The lawyer who they claim prepared this offering and who was supposed to call me and explain it to me should have told them that unless the platform is a licensed broker/dealer “success fees” are forbidden.  No where does the white paper suggest that BrightCOIN intends to become a licensed broker/dealer.

People always ask me how is it that I can spot these scams when other people cannot.  In most cases, like here, they do not pass the simple “smell test”. The founder, in my opinion, should simply stop this offering until it is actually compliant. If not people at Y Combinator should pull him aside and ask that he stop using their name.

In my opinion, the attorney, if he actually wrote this offering, which I doubt, should go back to chasing ambulances.  When you prepare an offering of securities, it is expected that people will call up and ask some questions as part of their due diligence investigation. Any attorney, who agrees to field those questions, cancels two phone calls and makes no attempt to reschedule them, should refund the client’s money.

The entire ICO market has been one con after another. Telling investors the truth is not that difficult but it seems to be the one thing that the ICOs just cannot seem to do.

 

Crowdfunding Successfully

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Over the last 3 years’ equity crowdfunding has evolved into a fairly easy and inexpensive way to fund a business. More and more businesses, including start-ups, are attracting millions of dollars from investors without having to deal with Wall Street stockbrokers who charge hefty commissions or venture capitalists who want a hefty portion of their company.

I speak with companies every week that are considering crowdfunding as a way of finding investors.  The questions they asked a year ago centered on what crowdfunding is and how does it work. Today the questions are much more practical. They want to know how to get it done and how much it will cost.

One of the great mistakes that people make when they consider seeking outside investors is failing to consider the investment they are offering from an investor’s point of view. Investors expect that you are going to use their money to make more money.  Investors want a return on their investment and they expect some of the money that you make to find its way back into their pockets.

It is very important that you structure your offering to maximize the probability that investors will actually get the return you are promising. It is equally important that you clearly tell them what you are going to do to get there.

Structuring the offering correctly is a balancing act between an investment that will stand out from the pack and be attractive to investors and one that does not promise too much of the company’s profits that would stifle its growth or cause cash-flow difficulties. You can have a great little company with a great product and a huge upside but that does not mean you can attract investors if the offering itself and the return they will get is not attractive to them.

You can use crowdfunding to sell debt or equity in your company.  If you chose debt you get to set the terms and the interest rate. You get to decide whether the debt will be convertible to equity later on and if so when and on what terms. You can also sell common stock, preferred stock, convertible preferred or preferred stock that is callable. In many cases you can keep the financing off of your balance sheet by using a revenue sharing model or licensing your IP.

To structure an offering correctly you need to understand the company’s financial situation, cash flow and anticipated growth both of revenue and expenses.  You also need a good understanding of your competitors and how they approached their financing and the market if you are going to be competitive.

Serious investors look at your spread sheet first. They expect that you will be able to support the projections you are making with real facts and rational assumptions. If you are using investors’ funds to expand your business or introduce a new product into the market, you should have a good idea of what that market looks like, how you intend to reach it and what your competitors are doing.

Unless you have a finance professional on your staff or on your board of directors, you will need someone to help you structure and correctly set the terms of your offering. Very few of the crowdfunding platforms offer this type of advice, but that does not mean that you do not need it. The failure to understand finance is the root cause of the absurd valuations that are everywhere in crowdfunding and are a primary reason that serious investors will not look at your offering.

If you do not have a finance professional to help you, and the platform does not provide this type of advice, by default it is going to come down to the lawyer who is helping you prepare the offering paperwork. I have this discussion with clients almost every time I prepare an offering for crowdfunding.  If you are thinking about using a template to create the legal documents for your offering instead of a lawyer who can give you good advice you are likely to create an offering into which no one wants to invest.

Contrary to what any platform tells you very few platforms have a large audience of loyal investors ready willing and able to write you a check. I work with one platform that caters to institutional investors. Their investors are loyal because the platform is very picky about the companies that it will allow to list. Serious investors want this type of pre-vetting. Serious entrepreneurs want this type of investor.

Some of the worst advice you will get about raising money through crowdfunding is that you can use social media to build a community of potential investors or that crowdfunding for investors is a way to build your brand and solicit new customers at the same time. This actually makes no sense at all.

Customers and investors have divergent interests. Customers want you to sell them your product at the lowest price. They are consumers and think like consumers. Investors on the other hand want you to maximize your profits. They want you to sell your product for as much as the market will bear.

There are a significant number of people in the crowdfunding community who believe that the whole purpose of the JOBS Act is to allow small investors to invest in new companies. Both Regulation A+ and Regulation CF which were promulgated under the JOBS Act specifically allow for small investors.  Both are expensive and cumbersome. In my mind neither is worth the effort.

If you want to raise $1 million using Reg. A+ or Reg. CF you might expect an average investment of $250. That means you will need to reach 4000 investors. To obtain an investment from 4000 investors, your marketing campaign might need to reach 1,000,000 distinct prospects.

If you use Regulation D and make your offering to only accredited investors, you might set your minimum investment at $25,000. That way you need only 40 investors or less to raise the entire $1,000,000 and may need to reach out to only 10,000 prospects to do so.

I have worked with several of the marketing firms that specialize in equity crowdfunding. Some are more expensive than others. I always recommend spending your money on creating a good offering and a good presentation and not spending it on trying to reach 1,000,000 people or more

There are a lot of different crowdfunding platforms. Some specialize in funding real estate, some in solar projects and alternative energy projects. Sometimes a company can benefit by being on one of the larger, national platforms; often a local platform will work just as well.

There is technology available today that allows a company to set up its offering on its own website. You can set it up with what is essentially a drop box where the prospective investors can look at your offering and supporting documents. If an investor wants to invest, it will present the appropriate documents, accept his/her signature, verify the investor’s identity and qualifications and place the funds into an escrow account until the offering is completed.

You lose the advertising that a platform would do but you may gain from the fact that your offering is not competing with a dozen others all looking for investors. The fact that this technology is available has driven down the cost of listing on a platform.

Overall, if you want to raise between $1 and $5 million for your business using equity crowdfunding, legal and marketing costs and platform fees should run in the neighborhood of $50,000 more or less. Legal fees are usually the same but marketing costs increase with the number of investors you are trying to reach. Compared to the 10% fee that a stock brokerage firm would get, you can see why crowdfunding is becoming more and more popular.

 

Conning the Crowd

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Equity crowdfunding allows companies to sell their stock or debt offerings directly to investors by placing the offerings on a website platform. No stockbroker or stockbrokerage firm is needed.

An industry of crowdfunding platforms, experts and attorneys has emerged to help these companies raise the capital they seek.  Some do it better than others.  There are several that I would recommend without reservation.  But at the same time, some people do it so poorly that they make a mockery of the whole idea.

Some of those who do it poorly are now suggesting that that equity crowdfunding is a failure.  In reality, those people were never equipped to do it correctly in the first place and never really understood what selling stock to investors entails.

The one idea that these people and others in the crowdfunding industry never embraced was that “no one wins unless the investors win”.  There will never be a shortage of companies looking for capital.  Connecting those companies with people willing to invest takes more than the passive approach that many of the crowdfunding platforms have adopted. If a platform says “we list any company” I would recommend that you find another platform.

There are a small number of platforms that are licensed brokerage firms or run by people who have experience in the mainstream brokerage industry. They seem to appreciate what it takes to make equity crowdfunding work. These platforms offer demonstrably better investments.

The better platforms take the time to carefully consider each company that comes to them seeking capital.  They will not just allow any company to list their offering on their website.  Funding only companies that have a chance of success and providing investors with a return on their investment is the key to success for any crowdfunding platform.

One of the assumptions that people who lobbied for the JOBS Act put forward was the idea that a crowd of investors has the ability to review the offering materials being put out by a new company, evaluate that information and make intelligent decisions about which companies to invest in and which to pass on by.  The crowd never had that ability. Unless you have a working knowledge of accounting, analyzing the balance sheet and income statements of any investment will always be difficult.

When I first looked at crowdfunding I wrote two separate articles about Reg. A+ offerings that I thought were deficient in a number of ways. My primary argument in each case was that the numbers just did not add up. I thought that each company was promising more than it likely could deliver to the investors.  If I owned the platform where these two offerings were listed, I would not have allowed either to list because if they smell like they may be scamming investors, they probably are.

Both of those companies, Elio Motors and Med-X were subsequently the defendants in regulatory actions.  There have not been that many Reg. A+ offerings to date and the fact that there have been several other regulatory actions concerning Reg. A+ offerings should raise the eyebrows of any serious people in the crowdfunding industry.  I have looked at a few other offerings that were clearly suspect as well, but which the regulators have not yet publicly questioned. For the most part, many in the crowdfunding industry just do not care if investors get a fair shake.

A great many people who own and operate crowdfunding platforms simply do not know what they are doing.  If the platforms do not reject these scams, how will they ever build the long term trust of the investors that the industry cannot live without?

Finally there was an idea that websites would develop where the crowd could share its evaluations of various offerings and where the issuers could respond to comments and clarify what they were offering to investors. A true give and take of information so that investors might make informed decisions.

In most cases this has not really happened.  For all the talk about the wisdom of the crowd, there are people who are so foolish that they will not listen when someone makes a cogent analysis of an offering that would lead anyone with an ounce of common sense to invest in something else.

Case in point.

Both Elio Motors and Med-X were listed on a crowdfunding platform called StartEngine.  As I said, neither should have been allowed to come to market because it was pretty obvious that neither was giving investors the whole story.

StartEngine (SE) is currently offering its own shares to public investors under Reg. A+. I wrote an article about StartEngine’s offering as well. I questioned why it was not making a profit in an industry that should be enormously profitable.  As with all my articles, I asked some hard questions, but I always try to be polite. That cannot be said for everyone.

In the name of transparency, StartEngine posts the comments people make about its offering right on its webpage.  Several people sent me this comment which was posted on the StartEngine offering page which I re-publish here verbatim:

-StartEngine is paying its founders $400k apiece per year. This is INSANITY.
-StartEngine is paying all of its EXECUTIVES over $1,000,000 per year!! This is also insanity.
-Half of that pay was in cash bonuses. This needs to be addressed by their CEO especially as they have not made any profits and are taking investor capital.
-Investors are being offered Common Stock NOT Preferred Stock as they should be offered.
-What does that mean? That means that the founders have significant liquidation preferences over the investors.
-You are asking your investors to assign their voting rights to the CEO. This may not even be completely legal.
-The valuation of the company is unheard of,especially for a company that has continually lost money without any profit.
-There is no road map or path to reaching a revenue breakeven point where you can even sustain operations without SIGNIFICANT additional capital commitments.
-Investors will be HEAVILY diluted after this raise or worse there will VERY likely be a down round.
-The fund raise leaves the company with VERY little cash reserves. Guaranteeing the need for more cash.
-StartEngine has to be in the process of registering as a  full broker dealer for what it needs to accomplish the goals stated.
-The language of the offering circular makes it appear that SE is doing everything it can to shield investors from knowledge of its current and actual future plans as well as prevent them from having any ability to have a voice in the company.
-Over $5,446,367 has been spent to date in deficit without any profits.
-StartEngine does not include any listing or sufficient breakdown on its technology
-There is a significant lack of data and information that you would find in a standard pitch deck of a seed stage startup
-There is no timeframe for the ending of this campaign.
-There is no coverage of an exit strategy or potential for one.
-StartEngine does rolling closings and does not disclose when or how it will go about these, directly in conflict with the traditional “crowdfunding” model of get to your goal or get your  money back.
-StartEngine does not cover much on its competitors or the competing models or market.
                Please address these issues.

Certainly this list includes some issues that the company would do well to address. This commentator is no idiot and he is one person of whom it can be said that there are people who can read and assess a crowdfunded offering. He is exactly the type of investor that the crowdfunding industry needs if it is going to succeed.

So did the company respond with a point by point explanation?  It did not.  This is the company’s response which I also republish verbatim:

Thank you for your comment. We believe our offering describes our business effectively, and clearly shows our goals for the future. In fact, your critique of the offering is only possible because we chose to be so transparent.  If you have a specific question about StartEngine that will help you to decide whether or not to invest, please ask. We’d like to provide all the information we can.

Personally, I never would have let a client of mine publish that response.  It strikes me as arrogant and treats a potential investor who asked intelligent questions as someone who can be ignored. To me it smacks of the Wizard of OZ saying “don’t look behind the curtain.”  I would have counseled a carefully worded point by point response that demonstrated respect for the potential investor.

In truth I would never have suggested that StartEngine prepare a Reg A + offering or seek public investors.  As the anonymous commentator points out for any number of reasons investors are going to have a difficult time making a profit on this investment. This is not a charity. The executives are taking out a substantial amount of money ever year.  Because the company is not profitable, some of the money they are taking home is likely to be the investors’ money.

Despite this, the same web page notes that StartEngine has over 400 new shareholders as a result of this offering.  If an active crowdfunding platform can successfully make this offering despite its flaws, why would it care if any of the offerings that were listing on its platform had any value or could possibly offer a return to the people who are investing in them?

In my mind Elio and Med-X were strikes one and two against StartEngine and this offering is strike three. I would not advise a client to list on their platform and I certainly would not advise a client to invest in any company that does. In my opinion, investors deserve and should demand better.

As I said, this offering and the commentary was sent to me by an acquaintance who has toiled in the crowdfunding industry and the commentary was also mentioned to me by others.  They privately say tsk-tsk but do not want to publicly say what needs to be said.

I look at it this way, not every stockbroker is honest or competent. When they do bad things investors lose money. No one hates to see a stockbroker taken away from his office in handcuffs more than the honest stockbroker working across the street.  Bad actors and stupid people just demean the reputation of the whole industry and make it more difficult for honest people to make a living. That is true in crowdfunding as well.

In the past two years I have spoken with a lot of hard working people in the crowdfunding industry who are trying to help small companies find investors by giving investors a solid chance to make a return commensurate with the risk they are taking. You know who you are. Keep up the good work.

 

 

 

Equity Crowdfunding 2018

Capital Markets, Investors, Issuers , , , , ,

I received year end 2017 reports from quite a few equity crowdfunding platforms and consultants. All were glowing with their accomplishments.  Several reported the number of offerings that had successfully raised money. None spoke of the offerings that paid the listing fees and failed to get funding.

Overall the equity crowdfunding industry continues to grow and become more popular with both issuers and investors.  Still, no one wants to look at the significant problems that still plague this industry.

There is absolutely no reason why any company that lists on a crowdfunding platform should not raise the money that it seeks.  There is no reason that investors should be offered the opportunity to invest in scams or in businesses that are unlikely to succeed.  The amount of effort that the crowdfunding industry expends to protect investors from scams and losses is virtually nil. The crowdfunding industry cannot expect to succeed if it does not get its act together and begin to address these issues.

Equity crowdfunding allows a company to sell its shares, bonds or notes directly to investors through a website rather than through a licensed stockbroker. That can save a company a lot of money. It also allows start-ups and companies that are too small for most stockbrokers to handle efficiently to raise capital.

A stockbrokerage firm provides two specific and necessary tasks to any stock offering. First it provides investment banking services to the company to assist properly structuring the offering so that it will be accepted by investors.  Second, the brokerage firm provides the sales and marketing efforts that attract the investors, close the sales, and raise the money.  Both tasks are necessary. Offering a new issue of securities without either being done well is like changing a tire without a jack.

The platforms are remarkably passive as regards the structure and sales of any offering. They are content to accept listing fees from any company that wants to list. They do not care if the offering is successful. They do not care if the company is a good investment or if the investors will make a profit.  These are the crowdfunding industry’s biggest mistakes. For the crowdfunding industry to succeed it must reduce the risks to its investors.

The largest beneficiary from equity crowdfunding has certainly been the real estate industry. There are established real estate syndicators in this market offering investors participation in single properties and in public and private REITs.  Several have set up their own proprietary platforms to showcase their own offerings; others use public platforms where their offerings compete with other properties.

Many of these syndicators have always used private placements as a source of equity funding. Crowdfunding has enabled real estate syndicators to save the 10% -15% that stockbrokerage firms charge to fund their projects.  This lower cost usually provides more cash flow for investors.

Most of the platforms are using Regulation D private placements because there is no reason for an income producing property to be “public.”  Real estate is easy for investors to understand. Investors trust real estate not just as an asset class, but as an investment.

Start-ups have a more difficult time raising funds on crowdfunding platforms.  And before you say that is to be expected, when you compare most start-up offerings with real estate offerings it should become obvious that most of the deficiencies with start-ups are correctable.

If you are investing in the equity of a commercial real estate offering there is usually a bank that has done an appraisal of the property and a physical inspection.  With start-ups the valuations are often off the charts. Rarely has anyone actually tested the product to see if it is viable or conducted a patent search to determine if the product infringes on someone else’s patent.

With a commercial real estate offering there is usually a seasoned property manager to handle the day to day business affairs.  With many start-ups the management is often less experienced than it should be.  Asking for investors to fund your business if you have never run a business, or do not have good managers or advisors in place becomes an up-hill fight.

Real estate offerings are most often structured to provide income to investors. Simply stating that the property will be sold after 7-10 years is all the exit strategy most investors need.  Many start-ups would have a much easier time raising funds if they structured the offering as preferred shares or provided income through revenue sharing or royalty payments.

When I advise a start-up seeking to raise capital I always offer my sense of what they should do prior to the offering to strengthen the company. I advise them how they should structure their offering to increase the chance of success.  This is the advice that the crowdfunding platforms should offer to every start-up that is paying for the privilege of listing, but do not.

My hope for 2018 is that the crowdfunding platforms get on board and do the same.  The platforms handling start-ups just need to become more proactive. There is no reason that every offering that lists on a crowdfunding platform should not be funded.

When the JOBS Act was passed there was a lot of discussion about small investors being able to invest. Millennials, especially, were arguing that they were being denied the opportunity to invest in the next Facebook.   So at the end of 2015, the SEC promulgated changes in Regulation A allowing a slimmed down registration process for smaller offerings of up to $50 million.  By any standards Reg. A has been an abject failure.

It takes a lot more money and a lot more time to prepare and complete a Reg. A offering than a Reg. D offering. I will advise any company seeking funding to use the latter instead of the former.  A company that spends an additional 6 months and $200,000 to reach small investors is usually telegraphing that the more sophisticated accredited investors do not want to invest.

Reg. A has been used to raise a fair amount of money, but the issuers themselves have not prospered. Several of the most hyped offerings, such as Elio Motors, have crashed and burned taking the investors with them. The share price of most of the other companies that used Reg. A to raise capital have not been able to maintain the original offering price. And this is in the middle of an historic bull market.

The Reg.A platforms and advisors do not support the price, after the shares have been issued,the way a stockbrokerage firm would.  Again, my hope for 2018 is that they get their act together and provide all the services that a company issuing shares to the public needs, both before and after the offering.

Perhaps the most disappointing aspect of the crowdfunding market has been the lack of attention to the Reg. CF portals. These handle the smallest offerings of up to $1,000,000 that cater start-ups in need of seed capital.  They represent the very essence of what crowdfunding should be about; small investors helping small companies.

Unfortunately, only about 35 Reg. CF portals are operating.  Those that are operating also take a passive role. They fail to assist the companies with the structuring of the offering. They fail to assist with marketing.  The simple fact is that if you are going to raise $1,000,000 by taking one or two hundred dollars from a lot of small investors, then you need to reach out to tens of thousands of investors before you find enough who are willing to invest.  That takes both marketing money and muscle.

It is pretty clear that most start-ups will fail within 24 months and these investors will lose their money. It is these small start-ups that need the most help and these small investors who need the most protection from loss.  But again, the crowdfunding industry has just not provided that help in any meaningful way.

I hope to make a contribution to the crowdfunding industry in 2018.  I am working with a group that wants to provide a measure of protection to small investors that are investing in these small offerings.  They are discussing starting a new Reg. CF portal where small companies can raise $500,000-$1,000,000.

They intend to offer a program to buy back any shares of any offering that lists on their Reg. CF portal if the company fails within 24 months.  You know that they can only do this if they offer only companies that they think will survive and succeed.

This type of vetting is missing in the crowdfunding industry and I am pleased to be part of the team that is putting this together. Besides me the team includes people with years of investment and commercial banking experience and a young, dynamic marketing team.  The goal is to select only the best companies to offer to investors, help those companies get the funding they need and help them succeed thereafter.

Right now, the group is seeking a very small number of investors to help fund the platform itself.  It is using a revenue sharing model so these investors can expect their investment returned quickly with significant return thereafter. If you have an interest in participating with an investment, contact me and I will put you in touch with the CEO.

 

SEC v. Munchee – Will the crypto-currency community listen?

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 Just about 2 years ago I wrote a blog article about the first Securities and Exchange Commission (SEC) enforcement action involving equity crowdfunding, SEC. v. Ascenergy.  The SEC action against Ascenergy highlighted the need for the crowdfunding industry to step up and protect the investors from fraud.  That made good common sense because the crowdfunding industry needs investors to survive.

Notwithstanding, most of the crowdfunding industry ignored that enforcement action.  It still largely refuses to carefully vet the offerings that are put on the platforms for investors’ consideration or conduct meaningful due diligence to verify that what the companies are telling investors is true.

Recently the SEC brought what is considered its first action against an Initial Coin Offering (ICO), SEC. v. Munchee Inc.  An ICO is essentially a sub-set of crowdfunding and each offering should be governed by the JOBS Act and the anti-fraud provisions of the securities laws.

A lot of people in the ICO industry will disagree because they believe that they can construct an ICO offering that is not selling securities. The SEC has been clear that it has not seen an ICO that was not a securities offering. Most good securities lawyers agree with the SEC.

Accepting that simple truth would put many people in the ICO industry out of business.  I am referring to the many ICO consultants who charge a lot of money for bad advice. Some of the people who advised Munchee are well known in the crypto industry. Anyone want to bet that they will never mention their participation in the failed, non-compliant and illegal Munchee offering when someone asks about their track record?

On the same day as it announced the Munchee Cease and Desist Order, SEC Commissioner Jay Clayton issued a statement about how the Commission will likely view ICOs. Much of the commentary since has focused on the Commissioner’s statement and not on the enforcement action. That is a mistake.

The Commissioner’s statement covers more ground and speaks in somewhat general terms. It represents the view of the most important regulator in the ICO world, but it is still a statement about generalities that is open to some interpretation.

The enforcement action actually gives more of the “meat” of what the SEC deems illegal conduct. A cease and desist order may become the subject of litigation or appeal. The SEC staff tends to choose its words carefully. It sets forth the facts and the offending conduct, the jurisdictional basis for the action and the reasons why the conduct violates the law.  It is a road map of how not to conduct an ICO offering and everything in it should be scrutinized carefully.

So what, exactly, did Munchee do wrong?

Munchee claimed it was offering “utility” tokens and not securities. It claimed to have performed an analysis of the offering using the test denoted in SEC v. Howey case. I suspect that it did not.  The Munchee white paper lists a dozen officers and advisors not one of whom is an attorney. It provides links to a half dozen PR pieces about the offering but not the attorney’s analysis that these tokens were not securities. The failure to provide a copy of that evaluation was not lost on the SEC staff. They mention that fact specifically in the order.

If an attorney had done the analysis Munchee would set forth the attorney’s name or provided a copy of the evaluation. “Advice of counsel” can be a defense to an SEC action such as this one and Munchee declined to set forth that defense.

A lot of people claim to understand Howey and a lot of articles have been written by people who are not qualified securities lawyers and are claiming to explain it. An evaluation of the offering under the Howey test involves a lot more than just reviewing Howey.

The Order in Munchee refers to Howey and also the SEC’s July 2017 Dao Report.  That report reviews over 30 other cases that have applied the Howey test to various investment offerings. The Order specifically refers to several of those cases which are important to any discussion of this subject.

A lot of people seem to think that if you can use the token for some commercial purpose it is a “utility” token. The Order in Munchee should dispel that idea once and for all.

Purchasers of a Munchee token (MUN) would join a network of people writing reviews of various restaurants. Munchee would pay users in MUN for writing the reviews and would sell both advertising to restaurants and “in app” purchases to app users in exchange for MUN tokens.

Munchee also said it would work with restaurant owners so diners could buy food with MUN tokens and so that restaurant owners could reward app users–perhaps those who visited the restaurant or reviewed their meal in MUN tokens. As a result, MUN tokens would increase in value.

Howey defines a security as an investment premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. The argument here might have been that MUN owners might get a profit based upon their own efforts.

But Munchee intended to do much more. It intended to cut off the number of MUN at a fixed amount.  It intended to facilitate a secondary market where people could buy and sell MUN. Because you could buy MUN, not use them or do anything and later sell your MUN for an appreciated price, it should be abundantly clear that your expectation of profits had nothing to do with you and must therefore be derived from the efforts of others.

Let me offer a simple example: You can purchase a membership in COSTCO. The membership allows you to shop in their stores and buy goods in bulk at a discount. You also get free snacks and inexpensive hot dogs. The membership is recorded on the company’s records and you get an ID card with your picture that is checked every time you enter the store so it cannot be transferred to anyone else.  No one would think that a COSTCO membership is a security. But the SEC has declared some other memberships to be securities.

If COSTCO decided to cut off the number of memberships and allow them to be transferred, it might be fair to assume that the price would appreciate. That alone might make them into securities. Transferability, or the lack of it, is not itself the only indicator. A lot of unregistered securities cannot be freely transferred. But once your token can be transferred at a potentially appreciated price, you should certainly consider that you have crossed the line.

The other big issue raised by the SEC staff in the Munchee Order was the way in which the MUN were sold. Munchee posted information about the offering and the MUN White Paper through posts on the Munchee Website, and on a blog, Facebook, Twitter, and Bitcoin Talk.

This type of general solicitation is specifically permitted by the JOBS Act and is the type of marketing that is needed when a company is trying to raise $15 million without a brokerage firm selling the securities for them. If Munchee had accepted the fact that these were securities, this would not have mattered as long as they did not exaggerate the facts or the potential return.

At the same time, Munchee did not advertise the offering of MUN tokens in restaurant industry media to reach restaurant owners and promote how MUN tokens might let them advertise in the future which is what you might expect if the tokens were being sold for their “utility”. The SEC staff picked up on that fact.

Instead, Munchee and its agents promoted the MUN token offering in forums aimed at people interested in investing in Bitcoin and other digital assets. Munchee made public statements or endorsed other people’s public statements that touted the opportunity to profit, not necessarily the opportunity to use the MUN.

The Order states: “MUN tokens were to be available for purchase by individuals in the United States and worldwide.”  It notes that Munchee intended to use “10% of the offering proceeds ($1.5 million) to make sure Munchee is compliant in all countries.” While that sounds fairly innocuous, as I said, the SEC staff chooses the language it puts into these orders carefully.

There are countries where no crypto-currency or tokens can be sold, so saying it can be sold “worldwide” indicates that the offering is a scam. In a securities offering, it is common for the offering materials to set forth the countries where the offering is being made.  Most telling is the fact that you need to be certain that you are “compliant” before you make the offering, not after. The Howey test does not apply anywhere except the US.

The simple truth is that I would have been happy to help this company raise $15 million for a lot less than $1.5 million in full compliance with securities laws. I would have advised them to sell stock in the company and then memberships separately. They would have had a successful offering and money to market and sell memberships at a lower, more reasonable price where many more people might have joined.

The lesson here should be obvious. If you are claiming to offer a utility token, demonstrate its utility and sell it to people who may want to use it. If you are seeking investors, then stop telling yourself you are not selling a security. Hire lawyers and comply with the rules.

The time, effort and expense that the founders of Munchee expended developing their app and their business, went nowhere.  With the JOBS Act the opportunity for funding a small business has never been greater. If you want money from investors, stay between the white lines.

Remembering Bre-X- The First Big Internet Stock Scam

Issuers, Law , ,

It has been 20 years since the Bre-X stock scam.  It may not be completely accurate to call it the first internet stock manipulation, but it was certainly the largest for its time. The scam was based upon false information that the company originally circulated on the internet. After a while large companies and the mainstream media jumped on the bandwagon. Then large investors followed.

Bre-X was a Canadian penny stock company whose share price went from about $.30 per share in 1993 to over $250 in 1997. The stock was originally traded on the Alberta Stock Exchange and later the Toronto Exchange and then moved to NASDAQ.

At the end, it took only about one month or so for Bre-X to unravel completely.  When the stock collapsed, investors had lost somewhere in the neighborhood of $5-$6 billion.

Bre-X has a fairly simple story. The company claimed to have located a huge deposit of gold, perhaps the largest single deposit ever discovered, deep in the jungle on the island of Borneo which is part of Indonesia.

People have been scamming investors with claims of huge gold discoveries for a long time. And as they say “greed is a powerful motivator”.

As far as anyone knows the entire a scam was the product of no more than 3 people.  The primary players were David Walsh the founder and largest shareholder of Bre-X, John Felderhof the chief geologist and Michael de Guzman the on-site geologist in Borneo.

Walsh purchased the property located in the middle of a jungle in 1993 on the advice of Felderhof.  The on-site geologist, de Guzman, took samples which were assayed. He initially estimated that the deposit was equal to 2 million Troy ounces of gold. The estimate of the site’s size and worth increased over time. In 1995 the estimate was raised to 30 million ounces, in 1996 it was raised to 60 million and finally in 1997 the estimate was 70 million ounces.

There was actually no gold at the site. It was later revealed that de Guzman was “salting” the samples he was sending to be assayed, i.e. he was adding gold shavings to the samples.  There is nothing particularly new about this scam. People had salted gold and silver mines to gain investors before. What was new is that the fake information was disseminated over the internet.

The internet in 1994-1997 was very different than it is today. Computer screens still had no color. You could not upload or attach documents. There were no search engines.  E-mail was primitive and very few people had an e-mail address. There were 3 primary services that you could use for internet access; America On-Line, Prodigy and CompuServe.

I was an early CompuServe user. I say early because my account number had only six digits. I would usually access CompuServe in the evenings via my dial-up modem.  It was primarily a collection of forums and primitive chat rooms where users could swap information and discuss various subjects.  There was a section dedicated to stocks.

Bre-X was certainly one of the most often talked about stocks during this period. There might only be one or two dozen people who left comments but you knew that many more were silently lurking and reading them.  I was reading the comments late in the evening on the West Coast. There were certainly people who were writing comments and other people reading them on the East Coast the next morning.  There was a lot of information about Bre-X to post and discuss.

As new assays were supposedly being taken and the estimates about the size of the potential strike went up and up, larger players tried to put their hand into the cookie jar.

First there was a failed take-over attempt by Placer Dome which was a much larger mining company. Next, the government of Indonesia (then a corrupt dictatorship) tried to bring Barrick Gold on board. The government claimed to be concerned that a small company like Bre-X might not be able to handle a large mining operation,

Later, the government brokered a deal whereby Freeport-McMoran a third large mining company, would have a majority interest and run the mine.  Members of Indonesian President Suharto’s family and their cronies got a cut of that deal as well.

Once the shares were on the NASDAQ in 1996, Lehman Brothers and other big firms started to follow the stock. There were articles about it in the Wall Street Journal and the mainstream media.

Everyone seemed to think that the gold deposit that had been discovered in the middle of the jungle on Borneo might be larger than expected and that other sites in the jungle might be the next to be explored.  The “smart money” seemed to think that it was only a matter of time before more gold was discovered.

Freeport-McMoran began its due diligence by drilling samples in early February 1997. The internet chat rooms were on fire with the speculation that the results might show richer deposits than did previous samples.  But it was not to be.

The scam ended abruptly in mid-March when the geologist, de Guzman, supposedly fell (or was pushed) out of a helicopter over the jungle. The body that was recovered days later was badly disfigured and identified through dental records.  The body quickly disappeared from the local morgue. People have claimed to have sighted de Guzman in Canada and elsewhere in the years since.

Freeport McMoran reported the results from its test a few weeks later stating that there was little or no gold on the site.  There were a few subsequent tests which concluded that the gold in the original samples had come from elsewhere which is how we now know that the early samples were salted.

The stock, of course, collapsed.  Trading was suspended in Toronto and on NASDAQ and the company filed for bankruptcy. The bankruptcy revealed that three large Canadian public pension funds had been big investors and hence, big losers.

Walsh claimed innocence of the whole affair, moved to the Bahamas and died of natural causes. Felderhof was charged with insider trading (he had apparently sold millions of dollar’s worth of stock along the way) but was eventually acquitted.  Class actions brought on behalf of shareholders returned virtually nothing to them.

Just before the end, Bre-X had blamed the meltdown of the share price on the internet.  Walsh claimed that the rumors that the company had no gold had emanated from enemies of the Indonesian government and that the people in the internet chat rooms were short sellers who wanted to see the company fail.

It is certainly correct to argue that the stock would never have run-up if the “news” about the alleged gold discovery had not circulated in the chat rooms.  It is certainly fair to assume that the stock price would have gone higher if many more people had visited these chat rooms.  As the share price went up, more and more people became convinced that the people saying it will go higher must know what they are talking about.

It is appropriate to consider just how high the price of Bre-X might have gone if there had been as many internet users then as there are now.  In the 1990s the internet was just flexing its muscles. Today it can easily move the price of any investment up or down. People who know nothing can sound like geniuses if the the stock price goes up after they say that it should.

Bre-X is actually a model for a modern pump and dump schemes.  All you need to do is acquire a lot of shares in a penny stock, set up one or more investment newsletter websites and drive traffic to those sights by sending e-mails to lists of investors.  The SEC has closed down internet investment sites that have done just that.

If there is anything that any investor should learn from the Bre-X scam it is that you should only take investment advice from people that you know and trust.  A lot of what you hear on the internet is just not real.

 

Any Good Business Can Get Funded

Capital Markets, Issuers , , ,

I am always amazed when I get negative feedback to the premise that any good business can get funded. This is especially true when people tell me that businesses owned by women or minorities cannot get funded or that businesses locate outside of New York, Silicon Valley or some other money center have limited access to capital.

Frankly I think that a failure to get funding demonstrates ineptitude on the part of the entrepreneur. Inexperience is a greater impediment to attracting capital investment than gender, race or location.

When I was younger a business had two choices for funding, banks or Wall Street.  Wall Street would not take a company public until it was profitable. Companies often used an IPO to pay down debt and improve cash flow to pay dividends to the shareholders. If you wanted to get funded on Wall Street, it helped if you went to Princeton or Yale or your father did. It was very much a “who you know” network.

Banks provided the bulk of the capital that was available for small business. They still do. They do not care who you are as much as they want to know that you will pay them back.

When I graduated law school in the 1970s women could not get credit cards and minorities could not get even a loan application at any bank. So you cannot tell me that it is more difficult for women and minorities to get funded today.

The US Small Business Administration (SBA) has programs which will guarantee bank loans for about 20,000 small businesses every year.  I speak with entrepreneurs seeking capital all the time. I always ask if they have tried the SBA.  Most of the people I speak with never heard of the SBA or never considered it.  If you are looking for funding for your business, that is mistake number one.

Even if you do not qualify for a bank loan the cost of capital should be your primary concern. Shopping for a loan will give you an idea of how much money costs and how loan payments would impact your cash flow.  If, for example, you intend to borrow $1 million at 6% for 10 years, then the loan will cost you $600,000 and you will need to take $1.6 million out of cash flow to pay it back.

Many people think that venture capitalists will fund their business. That is simply not true. There are actually very few VC funds and they fund very few businesses every year. Some VCs specialize, i.e. they only fund biotech companies. That is great if you are a biotech company and know where to find those VCs with the expertise to evaluate your company. Randomly chasing after VC funds is a waste of time.

The serious money in venture capital is controlled by people who do a lot of analysis and extensive due diligence. Consequently, they like to invest in somewhat larger slices of $10 million or more. If they get 10% of your equity for that amount you are going to have to sell a lot of your product to bring the real value of your company up to the point where they will make a sizeable profit.  Consequently, not many companies will qualify.

The start-up world and especially Silicon Valley are full of stories about start-ups that become unicorns that exceed a $1 billion valuation but they are few and far between. If you are going to swing for the fences, fine. But for most companies this is not an option.

What makes the statement “any good business can get funded” true is the JOBS Act or what most people call equity crowdfunding.  It affords any company the opportunity to sell debt or equity securities directly to investors.

The JOBS Act opened the door for smaller companies to reach investors.  For most companies Reg. D is best because it is the least expensive and it has the largest developed market. Over $1.7 trillion is raised by businesses using Reg. D every year. If you want to raise money for your business, logic would tell you to go where the money is.

The best thing about equity crowdfunding is that the business owner controls the process. You hire an attorney to prepare the legal paperwork for you, prepare the marketing materials, list it on one of many crowdfunding websites and use your marketing program to attract investors.  You do not have to wait for the loan committee at a bank or for a broker/dealer to put you on their calendar. You can usually start raising money in 4-6 weeks from when you start the process.

Despite what you may have heard about crowdfunding campaigns that are not successful, it is really not that difficult if you hire people who know what they are doing.  Business owners call me about crowdfunding all the time. I always ask them the same four questions.

Questions 1 and 2. How much money do you want to raise and what do you intend to do with that money?  If your answer to the second question is that you intend to “disrupt” this industry or that industry, you better be able to demonstrate that you know a lot about that industry and especially about your competitors.

What investors really want to know is that you have a good business plan and that you are raising enough money to execute it.  It is always better to stick with what you know and hire people who know what you do not.  You should be able to show that you are not just building a better mousetrap but that you are building a good, profitable business.

Question 3. What is in it for the investor?  Investors are often disrespected in the crowdfunding universe. This is partially because the crowdfunding platforms compete for issuers and partly because many crowdfunding platforms are operated by people who do not understand what investors want.  In truth all investors want the same thing; they want to end up with more money than they originally invested.

People who are willing to invest in a start-up understand that most start-ups will fail.  It is important to distinguish yourself and convince investors that your company has a better chance to succeed because you have mitigated some of the risk.

Over the years, I have used a variety of financing tools including preferred shares and revenue sharing models to help start-ups manage their cash flow and still make the investment attractive to investors.  No two companies are the same. If you are thinking that you can just download a template for your offering without some real advice about how to structure it, you are not likely to be successful.

Question 4. What is your fundraising budget?  This is what really separates successful fundraising programs from unsuccessful ones.  You should always be prepared to spend a little more than you think you may need.

What is an adequate budget?  Enough to prepare the legal paperwork, marketing materials and to drive enough potential investors to your offering to get it funded. For a Reg. D offering, few companies spend as much a $50,000 unless they are raising $10 million or more.

One of the common mistakes people make is selecting the wrong crowdfunding platform.  Several advertise that they have had 10,000 investors or more but most crowdfunding investors are not loyal to a particular platform. Only a very few platforms are right for any particular offering. You need to make a decision about which platform to use based upon a number of factors including the size of your offering, the industry that you are in and how your offering is structured.

Under the JOBS Act you can make a Reg. D offering on your own website if you wish.  Given the fact that you will be paying for the marketing costs, it may make sense to be on your own platform where there will be no competition from other offerings.

I speak with about a dozen companies every month and I only take on one or two because I do not want to work full time. If I take you on I will walk you through the process and usually get you funded. That goes for companies owned by women and minorities and those located in Toledo or Tallahassee.

Using the JOBS Act any good business can get funded. If you are going to run a business, then you have to get things done and not make excuses. That goes for financing your business as well.

If you cannot fund your business with equity crowdfunding then it is on you not the market. It is actually a lot easier, faster and more certain than chasing venture capital.

Behind the Crowdfunding Curtain- StartEngine Goes Public

Capital Markets, Investors, Issuers , , ,

StartEngine, one of the first and most active crowdfunding platforms has filed the paperwork to offer stock under Regulation A. They are raising $5 million, offering 1,000,000 shares to the public at $5 per share.

If you follow my blog, you know that I have written about several other Reg. A offerings; Elio Motors, Med-X, Ziyen, etc. which I thought were essentially scams run by people with questionable intentions.  I have my issues with StartEngine, but I never thought the owners were dishonest or trying to scam investors. Nothing of that sort should be inferred here.

The fact is that crowdfunding platforms, like most businesses, are not public. This offering is the first I have come across where a company that is actually active in this marketplace has published audited financial statements and made disclosures about its business and the risks inherent in that business. For someone like me, who is working in crowdfunding with some of StartEngine’s competitors, looking through this information was irresistible.

First and foremost, StartEngine itself is a start-up and is losing money funding other start-ups.The company lost $1 million in 2015, almost $3 million in 2016 and another $1 million during the first 6 months of 2017. The company had initially raised a little over $5 million in venture capital and has essentially burned through it. It now wants another $5 million to continue.

StartEngine’s business is basically a website and has 13 full time employees. It has no cost for goods sold and the bulk of its expenses are for administrative purposes and marketing.

The core premise of equity crowdfunding is that it facilitates the sale of new issue securities without the commissioned salespeople who perform this function at traditional stock brokerage firms. The commission savings are passed on to the companies who list their offerings on the platforms and ultimately to the investors. It is certainly fair to expect that because the offerings do not have a commission expense more of the funds that are raised will go to the company that is funding its business.

The JOBS Act permits three types of offerings to be funded on a website. StartEngine offers all three; Regulation A, Regulation Crowdfunding (CF) and Regulation D offerings.  At the end of August StartEngine announced that it also intends to offer crypto-currency offerings(ICOs) on its platform. With a full menu, StartEngine can offer more flexibility to a company seeking funds and a larger selection of investments for potential investors.

Under Reg. D a company can raise an unlimited amount of money from wealthier, accredited investors, under Reg. A up to $50 million and under Reg. CF up about $1 million. Reg. A and Reg. CF offerings can be sold to any investor albeit in limited amounts.

StartEngine was one of the first movers in the Reg. A market. The offering document notes that they have hosted the Reg.A offerings of ten companies.  StartEngine’s first offering, Elio Motors, eventually raised $16,917,576 from 6,345 investors.

Regulation CF went into effect on May 16, 2016. StartEngine has acted as intermediary for offerings by 58 companies; raising $7,383,960. According to Crowdfund Capital Advisors, of the 26 platforms registered with FINRA, StartEngine was second in terms of the number of Reg. CF offerings. Overall, in two years of operations, the StartEngine platform has raised about $40 million for issuers from over 17,000 investors.

For a little perspective I write the legal paperwork for crowdfunded offerings being made under Reg. D that are listed on various competing platforms.  I am on target to write the paperwork for $50 million worth of offerings during calendar 2017 and probably more next year. I work part time, out of my home on a 5-year old laptop.

My advertising budget is zero dollars. I get all my business through referrals or because someone reads one of my blog articles and thinks that I have some common sense. I take the time to speak with a lot of people who are starting new businesses and are seeking capital. I have referred a few to appropriate crowdfunding platforms, even if someone else writes the paperwork.

With a six figure per year advertising budget StartEngine should easily be able to host and sell $100 million worth of offerings per year or more.  If they did, the company would be profitable.  So what is the problem?

There are three parties to every transaction, the company seeking investment, the investors and the platform that introduces the other two. The intent should be that all three will ultimately make money from each offering. If the investors make money they will be happy, come back again to make additional investments and recommend the platform to friends.

Roughly 1/3 of StartEngine’s entire customer base invested in Elio Motors. I questioned Elio at the time that StartEngine put Elio’s offering on its platform.  It was obvious to me that Elio was not likely to ever put out its vehicle or turn a profit and I wrote just that.  If that was obvious to me, it should have been obvious to StartEngine as well.

StartEngine’s offering document mentions that it may be liable if a company that lists on its platform gets sued for securities fraud.  It states that even if StartEngine is a party to the suit and prevails, being a party to these suits might cause “reputational harm that would negatively impact our business” in addition to the costs of its defense.

Regulators have just begun to catch up with Elio. Elio was recently fined roughly $550,000 by the State of Louisiana for taking deposits for its non-existent vehicle without a proper license to do so. The lack of a proper license should have come up in the pre-offering due diligence investigation conducted by StartEngine.

Even if Elio is never alleged to have committed securities fraud, the company is insolvent and is unlikely to ever produce a vehicle or operate profitably.  Investors will lose the money that they invested.

Reputational damage for a company like StartEngine also comes from listing any piece of crap that comes along. Why should investors be expected to come back to StartEngine a second time, or a third, if the companies that StartEngine lists on its platform are not likely to succeed?

StartEngine defines its mission as: “To help entrepreneurs fuel the American Dream.” Its long term objective for 2025 is to “facilitate funding for the startup and growth of 5,000 companies every year.”

Assuming that each of those companies raises only $500,000 StartEngine is projecting that it can bring in $2.5 billion in new money every year.  Given that most or all of that money will be lost, I think that is a fantasy. StartEngine is likely to become known as a place where investors flush their money down the toilet long before 2025.

Had I been asked to write this mission statement I would have said something like “the company’s objective is to match investors with worthy companies that offer new technology and new products.”  The key word is “worthy”.

There is no way to sugar-coat the fact that 90% of start-ups fail and that many fail very quickly, usually within the first two years.  No one who I have met in crowdfunding denies that fact and most just accept it as a fact of life, even if they really do not want to talk about it.

An intermediary like StartEngine should be able to discern which companies are more likely to be part of the 90% that will fail and which have a chance of being part of the 10% that will succeed. That is what broker/dealers and investment bankers do every day and have done for decades.

The mainstream stockbrokerage industry has no difficulty identifying or funding new technologies. Stock brokers raised money for Apple and Microsoft when very few people owned personal computers. They raised money for Genentech at a time when no investor had ever heard the words “genetically engineered pharmaceuticals” before.

The offering suggests that StartEngine intends to harness the power and wisdom of “the Crowd”. To be blunt, no one has ever suggested that the crowd has any wisdom sufficient to discern which companies are worthy of investment and which are not. If they did, I doubt anyone would invest in StartEngine.

The lawyers who prepared the StartEngine offering included this statement as a risk factor: “none of our officers or our chairman has previous experience in securities markets or regulations or has passed any related examinations or holds any accreditations.” That, in one sentence, is StartEngine’s entire problem.

StartEngine’s customers are the investors, not the companies raising money. StartEngine has no idea how to give investors what investors want, a fighting chance at making money from the investments that they make.

Some of the other crowdfunding platforms understand this. MicroVentures has a reputation for turning away potential issuers that do not meet its standards.  I have worked with WealthForge which crowdfunds offerings to institutional investors. They would not consider offering those institutions any company that lacked the substance to succeed. Both were founded by or employ people with backgrounds in mainstream brokerage or investment banking.

Running a crowdfunding platform and funding companies without someone trained in investment banking is like running an animal shelter without a veterinarian on staff.  You can round up the animals, but you may not really be able to help them.  People who adopt the animals will never know if the animal is sick or healthy and that is something that they want to know.

Investing in start-ups is risky. You can run your platform like  newspaper want ads taking any ad that comes along or you can use some judgment and refuse ads for bottled water that claims to cure cancer because you know that your readers will not be happy. It is incumbent upon any crowdfunding platform to mitigate the risk for the investors that look at the offerings it lists.

I have personally resisted the idea of working for one of the crowdfunding platforms although I have advised a few. If you seriously want to invest in a crowdfunding platform, I could assemble a team and improve upon what StartEngine has to offer, without the baggage of offerings like Elio Motors, for a lot less than $5 million, probably around $500,000 (maybe even less if I do not replace my laptop).  I could operate the platform profitably and offer a return on your investment probably within a year. Interested? You know where to find me.

 

Cannabis and Crypto-Currency-The Blind Leading the Blind

Capital Markets, Investors, Issuers , , ,

A few weeks back I wrote a blog article where I stated that I was not interested in preparing the legal paperwork for any company that was raising funds for a cannabis related company. In the same article I said that I would also decline the opportunity to prepare the paperwork for an initial coin offering (ICO).  Either would be lucrative for me but in both cases I saw significant problems for the investors.

I might have predicted that people would start sending me the paperwork for ICOs that were looking to fund cannabis businesses seeking my thoughts and comments. Two stick out as examples of how not to raise money for your cannabis business.

In July, the US Securities and Exchange Commission (SEC) issued a report on ICOs. Crypto-currency is all the rage this year with some offerings raising millions of dollars in a matter of minutes and coins when issued quickly appreciating in price. Bitcoins for example have been appreciated significantly this year and some people think that Bitcoins are a legitimate investment, an assertion that is questionable at best.

The SEC correctly concluded that most crypto-currency offerings would fall within the definition of a security and thus its jurisdiction.  There was really no surprise as the SEC initiated about a dozen enforcement actions against crypto-currency issuers before it wrote its report.

Because an ICO is the offering of securities it is required by law to either 1) register with the SEC or 2) be exempt from registration assuming that an exemption is available. In either case, the issuer of the coins is required to give potential investors all the facts that would be material to making an investment decision.

If investors who purchased the coins got a discount on an ounce or two of marijuana the coins might not be securities. These two cannabis ICO offerings are clearly offering securities.  In both of these cases, investors profit if the underlying business profits which is more than enough for these to be securities and the SEC to have jurisdiction.

There are some facts which the SEC and any securities lawyer would consider to be material. This would include who is running the company; how much money is being raised and what will it be used for; the basic structure of the company’s ownership; how investors get paid and how much they might expect; an idea of the size of the market in which the company intends to compete and the names of the companies that are its major competitors.

Nothing really earth shattering,but the SEC has been reviewing offerings and ruling on how these facts are disclosed for decades. Making the disclosures correctly requires a fairly good idea of what the SEC expects and an equally good idea of the operation of the business offering the securities which is why securities lawyers who prepare offerings really have to know what we are doing.

The first cannabis ICO I looked at was for a company called Growers International.  Like all ICOs it uses a “White Paper” (which it prefers to call a “Green Paper”) instead of a traditional prospectus.  I doubt that it was prepared by a securities attorney. (I would suggest that you might add the words “Like, cool” or Yeah, man” between the sentences and it would read like the script of an old Cheech and Chong movie but I do not want to insult Cheech or Chong.)

From the Green Paper: “Q: Why should I trust the team? How do I know this isn’t a Pump & Dump situation?  A: We ask that all investors do their research on the people behind Growers International. Our lead developer has found success in both the cryptocurrency arena as well as in the cannabis industry. If there is any question regarding the legitimacy of the project, we encourage investors to reach out to Ryan (Lead Dev) personally on slack.”

It is always a good idea to research the people who are running any company into which you are making an investment.  In this case the “Green Paper” discloses the management to be: “Lead Developer: Ryan Wright (34, California / Taipei); Blockchain Programmer: Eddie E. (48, New Zealand); Web / API Developer: Michael J. (32, Maidenhead, England); Social Media Director: Devvie @Devnullius (40, Sweden); Community Coordinator: Jeremy Toman @MadHatt (37, Canada) who prefers the name ‘Tyler Dirden’ or ‘MadHatt’;Graphic Designer & Cryptocurrency Consultant: Chris S. @Elypse (26, Detroit); Community Manager: @DayVidd and Bitcointalk Manager & Financial Consultant: Dr. Charles @drcharles (26, USA).”

I suspect that if you contact Mr.Wright as suggested he will vouch for them all if he bothered to ask their last names. Do not bother to ask about Members of the Board of Directors as they have apparently not yet been appointed, so one Director might turn out to be Pablo@Escobar.

The other cannabis related ICO I reviewed is prepared more professionally but still, in my opinion, misses the mark by a good country mile. The company is called Paragon Coin, Inc. It is in the process of raising $100 million through the ICO. Just to be clear Paragon supports the cannabis industry, it does not appear that it intends to grow or distribute cannabis itself.

Paragon intends to bring block chain to the cannabis industry.  It intends to use a distributed ledger to bring order to this fragmented industry. According to the White Paper the company intends to “offer payment for industry related services and supplies through ParagonCoin; establish niche co-working spaces via ParagonSpace; organize and unite global legalization efforts through ParagonOnline; bring standardization of licensing, lab testing, transactions, supply chain and ID verification through apps built in ParagonAccelerator.”

All that is fair enough and the names and pictures of the operating personnel are included. Their education and work histories going back 10 years which I would have expected to see are not present.

The White Paper clearly notes that cannabis is not legal at the federal level and asserts that it will only operate in states where it is legal. This is the prime oxymoron of the cannabis industry.  Illegal at the federal level is illegal everywhere. Marijuana is a Schedule I drug and possession or sale is a felony in all 50 states. That is a fact about which that the cannabis industry does not want to think and largely ignores.

The Paragon White Paper describes one of the Risks of investing in its coin offering as follows:

CERTAIN ACTIVITIES INVOLVING MARIJUANA REMAIN ILLEGAL UNDER US FEDERAL

LAWS. SUCH ACTIVITIES INCLUDE BUT ARE NOT LIMITED TO: (A) DISTRIBUTION OF MARIJUANA TO MINORS, (B) TRANSPORTING MARIJUANA FROM STATES WHERE IT IS LEGAL TO OTHER STATES, (C) DRUGGED DRIVING AND OTHER ADVERSE PUBLIC HEALTH CONSEQUENCES, (D) GROWING MARIJUANA ON PUBLIC LANDS, (E) MARIJUANA POSSESSION OR USE ON FEDERAL PROPERTY, AND

(F) OTHER CRIMINAL ACTIVITY OR VIOLENCE ASSOCIATED WITH THE SALE OF MARIJUANA. TO THE EXTENT THE COMPANY AND/OR PARAGON COIN, INC. MAY NOT PREVENT CERTAIN OF ITS USERS FROM USING PRG TOKENS IN VIOLATION OF US FEDERAL LAW, IT MAY SUBJECT THE COMPANY AND/OR PARAGON COIN, INC. TO CIVIL AND/OR CRIMINAL LIABILITY AND THE UTILITY, LIQUIDITY, AND/OR TRADING PRICE OF PRG TOKENS WILL BE ADVERSELY AFFECTED OR PRG TOKENS MAY CEASE TO BE TRADED.

This derives verbatim from the Cole Memorandum which was written in 2013 as a direction from the US Department of Justice to Federal prosecutors as to how they should allocate their resources when they decide who to prosecute and for what. It never made cannabis legal anywhere.

More importantly, the Cole Memo it is not an Act of Congress or Federal regulation and not binding on the current administration in any way. Any suggestion that it will continue to be followed under the current administration is wishful thinking given the Attorney General has repeatedly stated that it will not.

Medical marijuana has been legal in California for more than a decade. That did not stop the federal government from raiding and closing down a large medical dispensary in Oakland, CA in 2012. Parenthetically, Paragon’s initial co-working space is slated to open in Oakland, California.

Perhaps the most troubling aspect of this offering is that it intends to fund the use of block chain, a relatively unsecure distributed ledger to link the many growers and suppliers in the cannabis industry. If successful it may well deal a serious blow to the cannabis industry it is trying to support.

One of the leading ICO platforms, Coinbase, has been engaged in a two year battle with the Internal Revenue Service which wants a list of all the people who use its platform to trade Bitcoins. The IRS alleges that people are trading the coins profitably and not reporting the gains and paying the taxes. The US government has also alleged that drug cartels and other bad actors use crypto-currency to launder money.

If you are in the cannabis industry you have certainly heard stories of how the DEA would obtain the customer lists of hardware stores that sold supplies for hydroponic growing. Everyone who was a customer did not use these supplies to grow cannabis but the government used those lists to identify and prosecute people who did.

If you have a “decentralized” list of a large group of people who are on the list only because they are affirmatively in the cannabis business as Paragon wants to create, how long do you think it will take for the US Government to obtain it? Think that will be difficult because Paragon never touches any marijuana or sells it?

The CEO of Paragon, Jessica VerSteeg, is also CEO of AuBox which the White Paper describes as “an upscale marijuana delivery service in the SF Bay area”. That is more than enough “probable cause”for the DOJ to get its hands on Paragon’s distributed ledger and the names of every company that uses it. The icing on the cake will be when they tell the judge that the cannabis industry is full of drug cartels and money launders which, of course, it is.

When you write the risk factors for a securities offering, it is important to disclose all of the things that might reasonably occur.  Assuming that this ICO raises the $100 million that it seeks, it is certainly within the realm of possibility that the Attorney General might just seize that money under the federal asset forfeiture provisions. The people behind this offering somehow refuse to accept that there was an election last November and that there is a new sheriff in town.

What I took away from these two offerings was a sense that they were prepared by amateurs who were attempting to do something that was way over their head. In this current administration, raising money for a cannabis company waves a red flag in front of the US government. Compounding that fact by raising money through an ICO just increases the size of that red flag, exponentially.

I personally do not think that there is any hope for Green International but Paragon did not demonstrate that it needed $100 million and could have certainly raised a lesser, more reasonable amount in a more traditional fashion which is what I would have advised them to do if they had asked me.

 

 

The Start-up Funding Wars-Another Dispatch from the Front Lines

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I speak with start-ups and business owners who are trying to raise capital for their businesses several times a week.  Some are my age or close to it; others are very much younger.  Most know their own business well, but few understand the ins and outs of raising capital which is why they call me in the first place.

If I take on the task of helping a start-up raise funds I can usually get them the funds they need.  That is not an idle boast. I will not even attempt to help a company solicit investors if I do not think that the company is a good investment.

That is unfortunately the case with the vast majority of the companies with which I speak.  I will review any pitch deck and offer comments and suggestions for free.  I will spend an hour of my time on the phone with any entrepreneur, no charge. Most simply do not measure up.

What I want to hear is that you have a business.  I want you to tell me that you have a product; that you know what it will cost to source your product and that you have actual customers who have bought or at least used the product and have reacted favorably to it.  If you are not yet at that stage, at the very least I want to know that you are close.

The difference between raising funds for a product that has been developed and raising funds to develop a product is huge. The number of investors who will take a chance on the latter is much smaller. It can still be done but it might take a little more time and money to reach them.

The two things that I do not want to hear is that your product will “disrupt” the market or that your company is destined to have a billion dollar plus valuation.  Neither is likely to come true.  I would rather hear that you have a good marketing and sales plan in place and have hired good, experienced people to execute it.

Please do not ask me to sign a non-disclosure agreement (NDA) before we speak.  In the first place, I am an attorney at law, so everything that you say to me is confidential if you want it to be.  In the second place, if your product or process is so novel, valuable and proprietary then get it patented.

Please do not send me a pitch deck that has no resemblance to a business plan. If your pitch is all flash and no substance it is not going to work. Investors want to see what you are going to do with their money and how and when your company will become profitable.

Please do not tell me that you have read all the books about funding a start-up and have attended several conferences featuring the best start-up “gurus”.  If you had read all the books that actually count, you would probably have an MBA in Finance.

Sometimes I can help a small company up its game by suggesting that it add some additional directors, patent its product, refine its business plan or change the terms or structure of its offering.  But more often than not, I find myself turning away business.

What I really want to hear most in that first phone call with any entrepreneur is that he/she can close the sale. If you are going to deal with investors, you are going to have to do more than tell them about the great company that you are building. You are going to have to ask them for a check. To get it, you need to tell investors how they are likely to profit from the investment in your company and why you can make it happen.

I am not a philanthropist. I charge for my services albeit less than I used to charge when I was paying rent for an office in a financial district high rise.  I will not work for stock in your business and you cannot pay me later after we raise money for you.

It takes money to raise money.  If you raised seed capital from friends and family to develop your product and did not raise enough to take you to the next level of fundraising at the same time, let me say this judiciously, you blew it.

I generally tell people to budget between $35-$50,000 if you need to raise between $5-$15,000,000.  So far none of my clients have gone over budget and most have spent less, but running out of money would be aggravating to all concerned.

A lot of people ask me to introduce them to VCs. I know a few VCs on both coasts and a few in between.  Most are serious investors meaning that they want to invest in companies that will succeed and produce a good return on their investment.  This is true of all investors, not just VCs.

For most start-ups seeking venture capital is a waste of time.  VCs actually fund very few businesses every year and each has its own funding requirements. The process is time consuming (even companies that get funded can be at it a year or more) and often political (like a lot of things in life it is often who you know that is important).

For most start-ups and small companies, equity crowdfunding would be the preferred way to raise funds.  It can be quick (90-120 days) and inexpensive ($35-$50,000).  I work with several equity crowdfunding platforms and several different marketing companies.  If you start with the idea that you are just going to slap an offering together as inexpensively as possible, put it up on a crowdfunding platform that has dozens of competing offerings and send out an e-mail or two to prospective investors, you are more likely than not going to fail.

I know a lot of people in the crowdfunding industry and I think that I know the best of the best.  I can usually direct a client to an appropriate crowdfunding platform and a marketing firm that will get the job done. I use different firms for different offerings of companies in different industries and at different stages of their corporate development.

Funding is always a team effort. That is why I like to pick the team.  I try to use the best people for each job.  Some charge more than others but like everything else in life, you get what you pay for.

To save time here are three types of offerings that I do not do.

1) Anything to do with cannabis. It is not that I am a wimp on the subject of marijuana. I was in college in the 1960s.  It is just that I can read the handwriting on the wall. Cannabis is illegal in all 50 states, no matter what the state legislature may have enacted.  The current US Attorney General, Jeff Sessions, seems to be getting ready to start enforcing federal law and closing down the retail stores and medical dispensaries.  He recently loosened the rules on asset forfeiture, meaning that nice warehouse where some company is growing cannabis might be seized and sold without a trial.  If I was an investor who helped to fund the purchase of that building I would sue the principals for using my money to participate in an illegal enterprise.

2) Any Reg. A+ offering. Reg. A+ requires the registration of shares with the SEC so that they can be sold to smaller investors. There is more than enough money in the Reg. D private placement market to fund your business. A Reg. A+ offering will likely cost you $150,000 or more to raise the same amount of money. That does not scream “look how smart I am” to any investor.

3) Any ICO. Recently I have been asked by more than one company to do an Initial Coin Offering (ICO).  These are offerings denominated in crypto-currencies. Several have raised significant amounts of money.  The SEC has declared that depending on how these offerings are structured they may be securities. Most of the lawyers with whom I spoke would err on the side of caution if they were asked to prepare an ICO. I got quotes in the range of $150,000- $250,000 just for legal fees. Again why spend that much more than you need to spend to fund your business.  And if you need a gimmick like an ICO to fund raise funds, what does that say about your business?

By refusing to fund businesses selling cannabis, any Reg. A+ or any ICO, I am leaving a lot of money on the table because these offerings, especially the latter two, pay well.  I have the expertise but I also have a reputation. I will not advise a client to use Reg. A+ or an ICO when a Reg. D offering will work just as well and cost them much less.

Good businesses get funded. While 90% of start-ups fail,  the key is to convince investors that you are among the 10% that will not.  If you are unsure, you are welcome to try to convince me first.