capital markets

What the Women’s Movement can learn from Cesar Chavez

Capital Markets, Life ,
What the Women’s Movement can learn from Cesar Chavez

I got into an interesting discussion with a businesswoman who had posted on LinkedIn about the difficulties that women have in the workplace. Among other things, she commented that women are significantly under-represented in the executive suites and on the boards of directors of most large companies. I certainly agree.

Any intelligent person in the workforce today can see that women have more difficulty getting hired and promoted, are penalized for resume gaps when they take time off to have children, and overall, still get less pay for doing the same jobs as men. Women are too often exposed to toxic work environments, off-color jokes, inappropriate comments, and sexual overtures. That women face this type of discrimination in the workplace is a fact.

Some people approach the treatment of women in the workplace from the standpoint that this is a “gender’ issue. They assert that this conduct by men is our problem. Male business owners already know better than to discriminate against women. The simple truth is that men pay women less because they can get away with it.

I see this gender pay disparity as a labor issue. It is past the time for women to flex their economic muscles and actively purge this type of discrimination from large companies. If women were properly represented on the boards of directors of more companies, they would be in a far better position to rectify the actual problems of unequal pay and toxic work conditions at each company.

When I started law school my first-year class had 120 students including 12 women, exactly 10% based upon a pre-determined quota. Each of the women had been interviewed at the school before acceptance. None of the men had been required to sit for an interview. From the beginning, it was obvious to me that this small group of women was a little sharper than many of the men. That should have been expected as each of the women faced stiffer competition for each seat in the class.

Last week I saw the picture of a young woman wearing a tee-shirt that said: “I became the lawyer that my mother wanted me to marry.” To me, that one sentence encapsulates a generation of progress for women in the legal profession.

When I was in school it was commonly thought that women could only be trained to become nurses or teachers. Untrained, women might become waitresses, secretaries, or flight attendants. The uniforms of flight attendants were tailored to accentuate their figures and they were often fired as they got older and deemed to no longer be attractive to male passengers.

There is no question that women have broken through the glass ceilings put in their way in a great many industries. Women now work in construction and other traditionally male blue-collar jobs that would have been unthinkable not that long ago. Teachers, nurses, and flight attendants are now covered by union contracts that have raised their pay, improved their working conditions, and provided benefits and job security.

Women manage large numbers of employees within big corporations across all industries. As managers, they make decisions that define the company’s operations and impact its bottom line. Still, it is rare to find a woman as the CEO at a Fortune 500 company and virtually impossible to find a Board of Directors where women make up the majority of the directors.

Women represent one-half of the US population. The impact of women as consumers cannot be overstated. Even companies operating in niche industries deal with vendors, customers, and employees who operate in the much broader markets.

Shouldn’t seats on boards of directors be handed out equally to men and women so that the boards represent not just the perspective of the management, but the broader market that the companies serve and in which they operate?

Greater representation on corporate boards would seem to be an effective way for women to deal with issues regarding equal pay and toxic working conditions. Taking more control at the very top of the corporate governance pyramid would help women to rewrite the workplace rules at all levels.

Labor unions exist specifically to deal with issues like wages and working conditions. Unions representing workers with far worse conditions and far less power have been able to get what they want using a variety of tactics and strategies.

The last great strike, by the United Farm Workers (UFW), took place against the lettuce growers while I was in college and law school. The tactics employed by the union were quite different from those other unions had used in the past. The lettuce strike offers lessons that might help women successfully break into and take over corporate boardrooms.

Farm labor may be the world’s second-oldest profession. Growers have always had all the power and used that power to accumulate more power. Farm laborers had been excluded from the Fair Labor Standards Act and Social Security in the 1930s. Any attempt to organize farm workers was always met with a stacked deck.

In 1970, when the lettuce strike began, the working and living conditions of the lettuce workers were still medieval. Their pay was inadequate and provided only the barest necessities. The farm workers occupied the lowest rung on the ladder of American workers.

The lettuce strike organized by Cesar Chavez and the UFW was truly a David v. Goliath battle. Throughout, the growers used their considerable influence and deep pockets to thwart the workers.

Chavez succeeded because he did more than just throw up a picket line and negotiate as steel and automotive workers had done in the past. He used very different tactics to leverage support from larger groups to provide financial and logistical support.

Most importantly, the UFW successfully enlisted the lettuce consumers to alter their diets to support the strikers. The union effectively delivered a message that said 1) our working conditions are horrific and 2) don’t buy lettuce.

Traditionally unions and management negotiate contracts focused only on the numbers. Each side calculates how much each incremental boost in wages will cost the company. The union calculates the effect of lost wages on its members if there is a strike. Management calculates the effect of a strike on its bottom line.

By addressing lettuce consumers directly Chavez added the impact to the company’s reputation and customer base to the equation. The cost of winning back consumers after these boycotts would now need to be considered.

Chavez had tested out his new tactics during a 4-year strike against the grape growers. In that campaign Chavez, vowing to be non-violent, had tried out tactics adopted from the civil rights movement including long marches, prayer vigils, and a hunger strike. Local rallies in support of the union were scheduled. Media coverage of these events and the sometimes-violent protests by people opposed to the UFW kept the strikers in the public’s eye.

Chavez used the grape strike to garner support from church groups and other decent people who were horrified when exposed to the working conditions in the fields on television. By the time the strike against the lettuce growers began, Chavez already had all these tools in place. People who mattered, especially the media, had already been educated about the critical issues.

Opposition to the lettuce strike came primarily from the Teamsters Union which had negotiated sweet-heart contracts with some of the lettuce growers   The UFW strikers were physically attacked, and rallies and the union offices were firebombed. Chavez, the “pacifist” of the grape strike was much more aggressive. As the tempo and temperature of the strike increased Chavez was arrested for the first time.

Within a few days Ethel Kennedy, widow of Sen. Robert F. Kennedy visited Chavez in jail. As she was leaving a small riot broke out and Mrs. Kennedy needed to be rescued by the local police. It made for great television. Mrs. Kennedy’s appearance at the courthouse had been intended to be a carefully choreographed stop on the campaign trail. The violence ensured that every television station reported on it.

At this time, I was living in Brooklyn which was about as far from the California lettuce fields as one might get. After a while, it seemed that every telephone pole had a simple sign that said “BOYCOTT LETTUCE” stapled to it. That did not happen by accident.

The “BOYCOTT LETTUCE” signs had been stapled to those telephone poles as part of a well-thought-out and well-managed PR campaign. Originally, they appeared in about thirty cities and later in thirty more. Later signs went up urging consumers to boycott two supermarket chains, one east of the Mississippi and one to the west,which bought lettuce from growers not represented by the UFW. The PR campaign was targeted and periodically expanded to ensure that the number of supporters of the strike constantly increased.

Chavez won his strike and he won it not on the picket line. He kept the conditions of the farm workers in front of consumers, daily, for an extended period. Sympathetic consumers boycotted the product, and the growers took a far bigger hit to their bottom line than they would have if they had just paid the workers from the beginning.

It is fair to consider that similar tactics would get more women on the boards of directors of more companies. Women are the dominant consumers making the decisions whether to buy Tide or Cheer,Luvs or Huggies and whether to take the kids to Burger King or McDonald’s and many, many other products as well. Women can certainly utilize their economic power to have themselves appointed to the boards of directors of these companies.

Most consumers have no idea how many women are on the board of directors of the companies that make these products. Very few consumers know whether those companies are taking advantage of women by paying them less. But, as the UFW demonstrated, consumers can be educated, and they can be mobilized. And the UFW was working within the confines of 1970s technology and media.

I can certainly envision an organization seeking to fill many more directorships with women initiating a correspondence that said: “Dear Fortune 500 company: We have noticed that ten of the 11 people that you have nominated for your Board of Directors are male. Please replace five of the men with women. If you are having difficulty finding qualified women, we will be happy to send you the resumes of thousands of women who are more than capable of contributing to your board. If you have not replaced the five male directors with 5 females in 20 days,we will begin a national campaign advising women to boycott your flagship product.” 

I have no illusion that one tweet from Oprah or one of the Kardashians would be enough to sustain a national boycott of any product. I do believe that both could be included in a carefully planned, targeted, and executed campaign that includes a simple message spoken repeatedly by thousands of “influencers.”

I do not see a way for a large company can come out ahead from a public fight with its most important customers about board representation. There is no satisfactory answer to the question: “why can’t more women serve on your board of directors?” 

The success of the UFW and the tactics it employed will be a lesson to the unions when the next big strikes come along. Women have been fighting for equal pay and better working conditions since at least the 1970s. Despite all the progress they have made, I think they may need some new tactics and some “out of the box” thinking to finally get what they deserve.

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

Or you can book a time to talk with me HERE

KingsCrowd – Again

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why do I even care? 

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

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

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

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

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

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

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

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

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

Case in point:

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

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

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

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

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

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

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

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

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

 

Is Mom Still In The Market?

Capital Markets, Investors ,
Is mom still in the market

Millions of retirees are about to get screwed by taking the advice they are getting from their financial “professionals”.  Older investors and retirees are being told to stay invested in the market regardless of the current risks.  It is foolish advice that a lot of foolish retirees will follow.

A lot of people have done quite well in the stock market “buying and holding” during this long bull market. But the time to hold is likely behind us and the time to fold’em is right now. 

Many of these retirees have the same poorly diversified portfolios of stocks they have held for a long time.  It is improbable that the price many of those stocks will continue to appreciate. If anything, the risk that they will continue to go down is greater than the likelihood that they will continue to go up. If they are not going to go up in price, there is no reason to continue to hold them.

Concerned Mother

Last week, I got a call from a friend whose mother was concerned that her account had taken a 6 figure loss in value for the first quarter of this year. His mother is divorced and already retired. Her account is with a large, national brokerage firm. She is concerned that her account balance dropped so much and so fast.

Her broker is telling her not to panic which is always good advice. Investment decisions should be based upon mathematics. It is not very hard today to do the math and realize that holding on to the portfolio you had last year does not add up. 

Her portfolio today is worth less than it was 3 years ago and as I said, down over $100,000 in this last quarter alone.  Her broker told her to “stay the course” because “these corrections happen and the market always comes back”.  

is mom still in the market

As I have said before this current correction is my 7th or 8th and no two were exactly alike.  In the last two, 2001 and 2009 there were clear indications that the market averages were too high and likely unsustainable many months before the bottom. There was plenty of time to sell out and save some money but many brokers then, as now, told their customers to just hang on. 

The mainstream stock brokerage industry chose to ignore the same indicators that they used when they predicted that stock prices would go up. It is ignoring the indicators that this current market is still far from its bottom.

I wrote an article just two months ago when the pandemic was still tangential to everyday life.   I did not think that the government’s tepid response in January would be so consequential by April.  

I noted the various conflicts of interest behind the brokerage industry’s desire for investors to stay invested.  Recessions hit Wall Street hard.  Profits and bonuses disappear. A lot of people typically get laid-off.  The idea that people might sell their stocks and put the funds in a CD to sit things out gives Wall Street indigestion.  

Just Do The Math

Investing is governed by mathematics. Large institutions control most of the money that is invested in the stock market. Most use the same method of Fundamental Securities Analysis first described,in 1934, by Ben Graham in his book of the same name. That book is still used in virtually every major business school.  A large investor like CalPERS or an insurance company will have hundreds of analysts on staff.   

At its basic level, the analysts are using one primary metric; earnings both current and projected into the future.  A projection of higher earnings for next year would be an indication that the share price will be higher next year as well. Analysts are always looking at a company’s business to see if its revenues and profits are likely to increase 6 months or a year down the road.

What do these analysts see today?

Right now, it is pretty clear that a great many companies will continue to struggle at least until the end of this year. When these companies report their earnings for 2020 next spring, they will show that earnings, if any, will be down from earnings last year.  Lower earnings should indicate lower stock prices.

Every indication is that the stock market is likely to be lower next year. The risk that people who stay in the market for the next year will lose money is high. So why would any financial professional recommend that their clients should stay invested especially clients who are already retired? How much can retirees afford to lose in a bear market?

Regulators Agree

A lot of people who got the same advice to stay invested no matter what eventually watched their account values decline to the point that they finally realized that their broker was full of shit. They sold their portfolios and realized the losses that they had were a result of risks that they never wanted to take.

I handled many customer claims against their stockbrokers recovering losses from the last two corrections. The stockbrokers always make weak defenses when confronted with losses that their customers never expected and which they could ill afford.

These claims are handled as arbitrations run by FINRA, the brokerage industry regulator. They are fast and cheap. Like most court cases, FINRA arbitration claims usually settle before the hearing. Retirees who lose money in the market can often recover some or most of what they lost.

 When every stock brokerage account is opened, there is a question on the new account form that asks for the customer’s “risk tolerance”.   A typical form might ask investors to identify the account as  “conservative”, “moderate”, “aggressive” and “speculative”.  They represent an ascending willingness to lose money. But a willingness to lose is not the same as a desire to lose.

For retirement accounts, especially as the retiree gets older, there is a consensus that the account should become more conservative.  Once people stop working and are using their retirement funds to pay bills, preserving those accounts becomes the paramount concern.

Diversify

A diverse portfolio of stocks and bonds was always considered to be a “moderate” risk account. And then something unusual happened.  The overall market itself has become riskier and many of those diversified accounts took on the risks of an “aggressive” account. 

There is no justification for a stockbroker to tell a customer looking for a moderate risk account to stay invested when the risks of the portfolio they are holding have gone up past the customer’s level of comfort.  Many retirees have already lost more than they can afford to lose.

A stockbroker is required to have a reasonable basis for every buy, sell, or hold recommendation that they make. When arbitrations over losses in 2001 and 2009, went to a hearing, there was nothing that the brokers could point to in their files that showed they had a reasonable basis to tell people to stay invested.

If your brokerage statement shows losses that you did not want, send your broker an e-mail asking for his/her specific advice as to what you should do now.  Ask them for the research reports that support their recommendations.

If they tell you, “the market has always come back” remind them that past performance is no indication of future results. If they tell you that no one saw the pandemic coming, remind them that price to earnings ratios were way above their normal ranges for months before the virus.

If your losses are too high and you get insipid answers from your broker, just send me an e-mail. I will be happy to refer you to an attorney who will help you recover your losses.

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

Or you can book a time to talk with me HERE

The Troubling Tale of Tether

Capital Markets, Investors , ,
the troubling tale of tether

I had intended to stop writing about crypto currency.  Despite the massive buzz in 2016 and 2017, crypto has largely shown itself to be irrelevant to any serious discussion about finance or economics.  

The same people who were screaming back then that bitcoins would be trading at $100,000 each are still “certain” that it will happen “soon”.  The promised institutional investors never materialized and probably never will.  The bitcoin ATMs promised for every street corner must still be on order. 

The “un-hackable” online wallets and accounts still get hacked.  People who invested good old fiat currency in more than 1000 “alt-coins” saw those coins disappear into thin air. 

There were and still are people who favor crypto currency because they hate banks. Many have moved on to other battles against the establishment.  Some, having fattened their own wallets as crypto currency consultants, now have very high limit American Express cards. 

There are still people who defend crypto currency despite the fact that there have been so many scams and losses. A common argument is that the losses in crypto are not significant compared to consumer losses caused by banks.  That follows the same logic as the sentence “Ted Bundy killed more than 30 people and I only killed one”.

Perhaps the most disappointed people in the crypto world will be the many who favor crypto currency because of what they see as a lack of transparency and over-concentration in the traditional banking system.  I cannot imagine how they must feel when they realize that the future of crypto currency may be in the hands of Facebook. 

Lawyers no longer have to lecture on the Howey test or lament that they cannot do what they do without more guidance from the government. The best lawyers work with the regulators to “tokenize” this project or that, even when those projects could likely raise money without tokens.

Whatever becomes of the crypto or token market it is a lot cleaner than it was because regulators became more and more active, not because crypto investors have gotten any smarter.  But there is still a lot of crypto-trash to clean up.

The enforcement action of the month involves an action by the New York State Attorney General (NYAG) against iFinex Inc. which operates of the Bitfinex trading platform and Tether Limited, issuer of “Tether” a self–styled crypto currency.  Both, apparently, are controlled by the same people.

Tether bills itself as a “stable coin”.  Its original white paper claimed that “each issued into circulation will be backed in a one to one ratio with the equivalent amount of corresponding fiat currency held in reserves by Hong Kong based Tether Limited.”

On its website the company still claims “Every Tether is always 100% backed by our reserves, which include traditional currency and cash equivalents” and “Every Tether is also 1-to-1 pegged to the dollar, so 1 USD₮ is always valued by Tether Ltd. at 1 USD.”

IFinex Inc. says it issued more than $1 billion worth of Tether.  The New York State Attorney General believes that the reserves may be short by $700 or $800 million or more and wants to see the books. 

People have actually been questioning the accuracy of the reserve figure for some time.  The company promised and then refused to provide any kind of audited financial information.  

The original white paper notes that Tether, Ltd. “as the custodian of the backing asset we are acting as a trusted third party responsible for that asset. This risk is mitigated by a simple implementation that collectively reduces the complexity of conducting both fiat and crypto audits while increasing the security, provability, and transparency of these audits.”

It should be cheap and easy to prepare a certified audit because the company should be able to easily demonstrate how many coins it issued. The reserves are all held at banks and should be easy to prove.  Instead of an audit the company offers a letter from their law firm that says that it looked at some account statements and it seems that there are adequate reserves.  The letter did not satisfy the New York Attorney General.

The idea behind stable coins was intended to fix a problem created by other crypto currency like bitcoins which were susceptible to volatile shifts in their exchange rate with US dollars.  Given that bitcoins were a intended to be “currency”, merchants take on a substantial risk every time transactions were denominated in bitcoins, instead of dollars.  It is a problem best solved by eliminating the bitcoins rather than adding the Tether to the transactions.

Actually the only thing new about stable coins is the name. The financial markets already have a class of securities that are pegged one-to-one to the US dollar and backed by cash or cash equivalents. We call them money market funds. 

Money market funds are registered with the SEC under the Investment Company Act and subject to specific disclosure and custody rules like other mutual funds. Issuing a stable coin on a blockchain is remarkably similar to buying a money market fund from a mutual fund company using a book entry system. Mutual funds are required to provide timely, accurate information to the public.  The management at Tether does not believe that they should be required to do the same.  

Bitfinex and Tether have had problems in the past. In early 2017, Bitfinex accounts were thrown out of Wells Fargo Bank.  At the time, many people in crypto saw this as “retaliation” by a legacy bank against the brave new world of crypto currency. The bank no doubt looked at it as a refusal to assist or participate in an obvious scam. 

In late 2017, Bitfinex announced that hackers had stolen $31 million worth of Tether from its own wallet.  No investigation was ever reported. Management did not even raise a fuss.

Jordan Belfort, the infamous Wolf of Wall Street called Tether a massive scam.  His comment got some press at the time. Most people in crypto just refused to see anything related to crypto as a scam in 2017.  That is largely still true and unfortunate.

IFinex and the other defendants argued that the Judge should refuse to let the NYAG look at their books because they never did any business in the State of New York.  The NYAG has presented the court with evidence that they did. Sooner or later the Judge will question everything the defendants tell her.  

In the meantime, Bitfinex claims to have raised another $1 billion by selling a new crypto currency token called the LEO.  As I said the best securities lawyers are now working with the regulators when they want to issue anything that purports to be a crypto currency.  It does not seem that any regulator, anywhere, reviewed the LEO paperwork.  The NYAG told the court that LEO offering “has every indicia of a securities issuance subject to the Martin Act, and there is reason to believe that the issuance is related to the matters under investigation.”

Sooner or later the Judge will want to see the records that prove that the reserves are indeed in the bank. No one, and I mean no one, should seriously expect that the reserves will be there unless the proceeds from the sale of the LEOs are meant to replenish them.  That will not solve the problem because the people who bought the LEOs were not told the reserves were missing or that their funds would replenish them.

Over the years I have read thousands of prospectuses and other documents that are given to investors when they purchase any new security. Among other things, the documents disclose specific risks that may adversely affect the investors’ returns.  I have seen those “risk factors” go on for pages and pages.

Still there is one “risk factor” disclosed in the original Tether white paper that I cannot recall ever having seen before.  Management at Tether Ltd. deemed it necessary to disclose to the initial buyers of Tether stable coins that: “We could abscond with the reserve assets.” Perhaps they were already thinking about it.

I have written about investment scams before, and as I said, I really do not think crypto is worth writing about. What makes Tether interesting is the potential magnitude of the loss. 

The NYAG says that as much as $850 million may be missing from the reserve account.  After that money was allegedly already gone, the company may have raised another $1 billion with the LEOs.  It is more than possible that a year from now the crypto industry will be staring at a $2 billion loss because the management of Tether just absconded with all of it. 

I actually wonder if the crypto zealots will consider that to be a “significant” loss.  

Want to discuss further? You can contact me directly on Linkedin or right here

 The Troubling Tale of Tether

Bitcoins, BS and Banking

Capital Markets , ,

I do not believe in Bitcoins because the whole idea behind them smacks of alchemy. For centuries, going back to classical Greece, people believed they could turn lead into gold. A great many, otherwise intelligent people spent a lot of time in this pursuit from the Middle Ages into the 20th Century.

In the latter half of the 19th Century people believed that the new Industrial Age would come up with a mechanical contraption to solve every problem. There were people peddling mechanical contraptions which claimed that you could put a lead bar in one end and a gold bar would come out the other. The process or internal workings of the machine were not disclosed and they became known generically as “black boxes”.

Today, thanks to new technology, you can buy a machine, plug it in and every so often it will send a few lines of computer code to an electronic wallet. You can then exchange that code for a lot of cold hard cash.  That is exactly what a Bitcoin is, just computer code that can be replicated by a machine. They may have value today; but sooner or later those lines of computer code are more likely than not, to become worthless.

For these lines of code to retain value people must be willing to buy them after they are manufactured. As the price increases, more and more people will likely start manufacturing them especially if the next generation of machines are more efficient or cost less.  Sooner or later there will be more code in the market than the market wants and the price will drop. That of course is just basic economics.

Basic economics is something that is often absent from any discussion about crypto-currency. It seems that many people who support crypto-currency, who are passionate about it and who are absolutely certain that it will prevail and disrupt the world are people who have technical backgrounds.  Some of those who are most adamant in the defense of crypto-currency have backgrounds in totally unrelated fields. They gained their insight into finance by having a credit card or reading economic theory in magazine or blog articles.

Most economists, including a Nobel Prize winner or two and most people who have worked in finance or banking dismiss crypto-currency as a fad.  On more than one occasion, a negative pronouncement by someone with stature in economics or finance has led to the crypto-enthusiasts mocking economics, economists and anyone who has worked in finance.  More than one has suggested that I and others are just too old to understand the new Blockchain technology that forms the underlying platform for crypto-currency.

Blockchain is essentially a decentralized ledger. It is a method of bookkeeping where each participant to a transaction creates a record of the transaction which is matched and verified with the other participants to the transaction.

When I wanted to learn about Blockchain I spoke with people who are working in Blockchain at large companies and universities in the US and around the world.  What they told me is that we may see Blockchain coming into various industries in the next few years. Initially they expect that it will be used in supply chain and logistics applications.

What I do not hear from these same people is a lot of enthusiasm for Blockchain in the financial sector.  FINRA assembled a panel of Blockchain experts in 2016 that looked at various functions in the financial markets that might be made more efficient by Blockchain. The overall conclusion was that Blockchain development still had a way to go.

There will certainly be decentralized ledgers within various financial companies and for some financial tasks. The entire world of finance is based upon checks and balances, supervision of employees, and repeated audits. Some of that has been automated since the 1970s.

The financial markets need to keep the bad actors out. Decentralization does not do that. If anything it is the opposite.  Blockchain verifies the transactions but not the people behind them.

A decentralized system prides itself on anonymity and anonymity invites bad actors.  If you read what the regulators of the banking and financial markets around the world have published, they continually share two main concerns about crypto-currency; money-laundering and tax avoidance.

Crypto-defenders will argue that far more money is laundered through banks. Banks spend a lot of money trying to curtail money laundering. The crypto-industry spends virtually nothing. The fact that there are other ways to launder money is no excuse for the creation of a new system that makes money laundering easier.

In the past few months banks, bankers, stockbrokers and serious investors have all given the thumbs down to crypto-currency. Recently the large credit card companies announced that their credit cards can no longer be used to purchase crypto-currencies. The largest stock brokerage firms will not purchase crypto-currency as an investment for their customers. Most professional investment advisors realize that they cannot purchase crypto-currency for their clients and satisfy their obligations as fiduciaries.

Part of the reason is that the crypto-currency industry itself cannot decide if crypto-currency is a security, commodity, currency or a whole new asset class. There is so much divergent opinion within the crypto-community that anyone who reads a few dozen articles on the subject is likely to be confused rather than enlightened.

Much of that divergent opinion is caused by the fact that these are legal definitions being interpreted by non-lawyers. I will not apologize for thinking an opinion written by a non-lawyer with a technical background living in Europe, Asia or Australia about how something should be defined under US law should carry little weight.

That does not stop the crypto-community from hanging on the word of every hack with a keyboard who holds himself out as a crypto-expert.  For an industry barely 2 years old, there are enough people holding themselves out as “crypto-experts” to fill Yankee Stadium at least once, perhaps more.

If all was well in crypto-land I would never have heard about Tether. Tether is a crypto-currency that is exchangeable into US currency at a fixed rate.  It claims to have a cash reserve of $2 billion to back up each and every Tether coin that has been issued.  People have questioned whether the owners of Tether really have secured $2 billion and the owners have repeatedly refused to respond with simple proof that the $2 billion is there. In any legitimate industry this question would never have to be asked more than once.

Theft and fraud are rampant in the crypto-currency world.  Electronic wallets are routinely hacked. Estimates run as high as 10% of the money sent to ICOs may have been hacked from the ICO’s wallet and hundreds of millions of dollars have been stolen from the various secondary market exchanges where the crypto-currency is traded.

Fund raising using crypto-currency (ICOs) has reached a fever pitch and has attracted a significant amount of scoundrels. Very few ICOs fund projects that are worthwhile ventures and most cannot be considered worthwhile investments by any stretch of the imagination. Telling the whole truth about the venture being financed is becoming the exception rather than the rule. Following existing laws regarding investment offerings is an anathema to the crypto-industry.

On more than one occasion an ICO has listed someone as an advisor who has never heard of the company or never agreed to be an advisor. I know this to be true because a few months back someone alerted me that my picture had been included in an ICO offering even though I had not given permission for the company to include it. This actually happens way too often.

There was actually one ICO that was so brazen that the people behind it raised a few million dollars and then took down their website leaving only the picture of a phallic symbol. The people who invested in this ICO got the shaft in more ways than one.

What I find most ridiculous about crypto-currency advocates is their overwhelming dislike for banks and their absolute but incorrect belief that crypto-currency and Blockchain will replace banks and send them to the rubbish heap of history.

Some of these people are European based Socialists who have always hated banks, which is their prerogative. But they have unsuccessfully been trying to supplant banks since the French Revolution. Blockchain is not going to help them.

Other people hate banks because they assert, incorrectly, that banks were the cause of the stock market crash in 2008.  I do not know of a single instance of a bank putting a gun to someone’s head and making them take out a loan that they could not afford to repay. The real estate bubble that preceded the crash might better be laid at the feet of the thousands of real estate brokers who encouraged people to buy homes with the foolish notion that real estate always goes up in value.

The most vocal group of bank haters seems to be millennials who have very little experience dealing with banks, but who constantly tell me that they do not trust them. They tell me that banks charge too much and that the world needs better platforms to make payments.

A payment platform like PayPal works quite well and is a big step up from the way banking worked 20 years ago. All it actually does is move money from my bank to a vendor’s bank quickly. Blockchain may make these payments systems better and faster.

I think these advocates will be disappointed to find that banks will ultimately take the best Blockchain has to offer and utilize it in such a way as to fire significant numbers of employees and make more money. Blockchain may actually strengthen the banking industry rather than displace it.

The problem with the idea that crypto-currencies will replace banks is that banks do a lot more than just facilitate payments. The primary function of banks is to aggregate and intermediate capital.  Banks take deposits from a lot of people and use the funds to make loans to small businesses and to make mortgage loans to homeowners.  The consumer side of these transactions can be done with a peer-to-peer approach and an app. You can apply for a small loan or a mortgage from your smart phone, but you are still borrowing from a pool of money held at a bank.

Banks also make large loans. On any given day General Motors or Dow Chemical may float a bond issue to borrow a few hundred million dollars. On the same day the State of New York may float a bond issue to fund a highway or bridge project or new university dormitory. There may be a hundred or more of these large loans and bond financings taking place around the world every day.

It is not likely that these large complicated financings will ever be done with an app on a smart phone.  These bonds are sold to syndicates of commercial banks. This requires that capital be pooled and that large entities have control over those pools of capital. Bank depositors do not decide how the bank invests the money they deposit.

This is the antithesis of the decentralized world envisioned by crypto-enthusiasts. In their world, the crypto-currency is held in electronic wallets over which only the owner has control.  No banks or centralized entity has access to those crypto-funds. There are no banks or similar entities to pool those funds and make the large loans upon which the global economy depends.

Crypto-enthusiasts have no answer to how these large loans might be made in a decentralized financial world. They do not care that banks evolved to where they are because of the need for large loans to fund large companies and large projects.

The US capital market is not a stodgy outdated system screaming for reform. It is a large, dynamic system that handles trillions of dollars of transactions every day. Virtually every transaction settles with every party happy.

It is way past time for the Blockchain industry to leave crypto-currency and the bank-haters behind and to focus on the applications for Blockchain in existing financial institutions and other industries.

 

 

 

 

Fake Business News

Capital Markets , ,

I think I first heard that we were entering the “Information Age” in the 1990s. The internet was just coming on-line. It promised that every book ever written would be available without a trip to the library. It promised that I could view every painting in every museum in the world without ever getting on an airplane.

In just two decades we have become inundated with information that is simply false. I am not talking about political “fake news” or “fake facts” spewed by politicians. No one in their right mind expects politicians to be truthful.

The internet has become a prime source of financial information and anyone can add to the growing library, even if they have no idea what they are talking about.  The world is full of information about finance that is pure fantasy.

For a great many years I got my business news daily from the Wall Street Journal. When I moved to San Francisco in the1980’s I started reading the San Jose Mercury News because it had the best tech reporters around.

I admit that I am somewhat of an information junkie especially as it regards business, the economy and the financial markets.  I currently watch the national news on PBS or CNN. I have been known to watch Bloomberg TV especially the shows focused on European and Asian markets. I read scientific and tech journals and law review articles. I am an old dog trying to learn new tricks. I want to keep up with what is going on in finance, law and technology.

That is one of the reasons that I like LinkedIn.  I have connected with people all over the world and through them I get articles about many things that are going on in the global marketplace that I would not otherwise read.  But not every one of those articles has any value at all.

Some of the articles are written by people who call themselves strategists, influencers, gurus, visionaries, evangelists and futurists.  Many seem to be self-appointed experts without credentials or experience.  Some just regurgitate stupidity because they cannot discern good information from bad information or ask intelligent questions about what they are reading.

Is it unfair to expect that someone who holds themselves out as an expert in finance have an MBA or have worked in finance?  Is it unfair to expect someone commenting on a fairly complex legal issue to have graduated from law school?

This seems to have carried over to the mainstream financial press. There are “experts” contributing columns to Forbes and Fortune who could not find their way out of a paper bag. They lack context, perspective and expertise.  So much is the need for content that quality has gone out the window.  The desire for “views” and “likes” is more important than the quality of thought that goes into the writing.

This has also migrated over to the conference circuit. When I go to a conference, I want to learn something valuable from people who know what they are talking about. I want to hear speakers who have been in the trenches; those who have walked the walk.

Many conferences refuse to pay for the best speakers opting instead for those who will speak for free and pay their own way in exchange for “exposure”.  Some conferences charge speakers to appear. This eliminates many of the best academics and usually people from big companies who do not need the exposure and certainly are not going to pay for it.

There has always been some amount of fake news about some businesses. Tobacco companies said that smoking did not cause cancer; coal and oil companies deny global warming.  You would expect a salesperson or CEO to say that their company’s product is the best or their service the fastest and that is not troubling. But there were always rules.

For any company with investors the dissemination of financial information is regulated. Every press release and often every advertisement is usually vetted by  the company’s lawyers to assure accuracy and compliance.

When a public company published financial information it was presumed that the information was accurate. There would be auditors looking over managements’ shoulders in any event.  There are quarterly phone calls with analysts who ask questions. If management gets a reputation for being too optimistic on a recurring basis, people know about it and begin to discount what they are saying.

If you worked for any large company, when you made a statement in public you always represented that company. You were expected to maintain a professional demeanor, to go out of your way not be controversial or say something that might make the company look bad.  You were always expected not say something that was stupid or inaccurate. That is still true in many cases but it is far from universal and it seems to be less and less true as time goes on.

This becomes a serious problem when a small company is trying to obtain funding from investors.  Investors are entitled to a full and fair disclosure of the actual facts.  Most of the Wall Street firms take care to verify the facts that they are passing on to investors but this has become a significant problem on the fringes of finance like Crowdfunding and investors are getting ripped off every day.

I speak with people every week who want to raise funds for their business. I appreciate that many of the people who contact me have done some research first. But just because you heard something at a Ted Talk or read an article in Inc. does not make it real.

One of the core premises in the Crowdfunding market is that the investors can fend for themselves or that the crowd will be able to separate good investments from bad ones. That is simply not true, has never been true and is unlikely to become true.  The vast majority of investors have no idea what questions to ask and if they do, they have no ability to verify whether the answers they get from the company are true.

This “fake” news often shows up in the company’s sales projections. Projections in an offering are always rosy but the projections need to have some basis in fact. I have asked people who are Crowdfunding their offering how they arrived at their sales projections and many have no idea if their product is priced correctly or what their competition is offering.

I try to be pretty careful about what I write on this blog. I limit my articles to areas which I know fairly well, finance, law, investments and economics. I do a fair amount of research for any article. When I write articles for this blog, all of which are read over by a colleague before I publish them, I always ask myself “would I be willing to say that to a judge?”

I have been taught to be a critical thinker. I think that the best lawyers are. I was taught to question facts and assumptions. As a lawyer I try to understand the underlying transaction and the expectations of the parties whether I am writing the paperwork or litigating over someone else’s.  It carries over to this blog and other articles that I write.

When I started this blog I said that I was constantly amazed by the vast amount of patently foolish investment advice in the marketplace and promised to call out financial foolishness whenever I see it.  I never expected that so much of that false information would present itself or that so many people would accept that information without question.

So far I used the blog to point out the obvious facts that 1) robo-investment advisors, in part because they are looking backwards not forwards, are virtually useless; 2) investing in a cannabis related company has the extra risk of investing in a business that is patently illegal; 3) the Crowdfunding industry needs to act like responsible intermediaries because the offerings are either bad investments or fraudulent and 4) crypto-currency has limited utility as a method of finance in part because it is a very expensive way to raise money.

You should certainly be aware that there are a great many articles out there that see the world very differently on each of these subjects. The more time I spend reading what is out there, the more I know that I have my work cut out for me.  The simple truth is that markets need accurate information in order to operate efficiently.

 

Elio Motors- A Crowdfunding Clunker?

Capital Markets, Investors, Issuers , , , ,

A colleague asked me to look into the securities offering of Elio Motors in Phoenix, Arizona. The company is one of the first to register shares to be sold under the new Regulation A.

Reg. A allows smaller companies to raise up to $50 million without the use of an underwriter. Elio is selling its shares directly to investors through a Crowdfunding platform called StartEngine.

Elio is attempting to raise $25 million making it one of the largest direct to investor financings to date. Many people in and around the Crowdfunding industry are anticipating the offering’s success.

Elio claims to be a designer, developer and manufacturer of highly efficient, low cost automobiles. The company intends to offer a 3 wheeled, gas powered vehicle that will get 84 MPG and cost roughly $6800.

It certainly sounds good and from the pictures that accompany the offering the vehicles look pretty good as well. The company says that it hopes to be delivering its vehicles to consumers by the end of this year.

Unfortunately, that seems highly unlikely. The company currently has only a few drive-able early prototypes of its vehicles. It does not have a full production prototype, a final design, a built-out manufacturing facility or manufacturing processes. Even with this financing, the company will still need another quarter of a billion dollars to get its manufacturing facility into production.

I reviewed the prospectus and made a note of a number of “red flags” – items that seemed a little off base to me. A number of things caught my eye.

First, the company is insolvent and will continue to be insolvent even after investors put in $25 million. Investors will pay $12 per share and each share will have a negative book value and no liquidity for a long time to come.

Roughly $10 million is owed and due to an affiliate of a large shareholder within the next 6 months. That loan is already over due and subject to a forbearance agreement. If the agreement is not renewed roughly 1/2 of the proceeds of this offering will revert to the lender.

The company hopes to obtain a $165 million loan under a federal government program intended to help existing auto manufacturers expand their businesses. If unsuccessful in obtaining this loan Elio will need to find that much and more, elsewhere.

The government program was intended to help Ford and GM when they were having financial difficulty back in 2008/2009.The program is specifically designed to have low upfront borrowing costs. Elio is paying a lobbyist $1 million to help them to get funding under the program in addition to the lobbyist presently on staff. Perhaps the company does not believe that it could obtain the loan if the government agency judged the company solely on its merits.

There does not appear to be a single dollar of professional venture capital in this company. The company says this is because the venture capital industry moved away from investing in new vehicle startups. Personally, I believe it was because the venture capital industry spotted Elio as a loser or worse, a scam.

There are no patents. Despite years and millions of dollars worth of designs and modifications Elio does not have anything that it deems to be worth patenting. That always begs the question of whether or not their designs infringe on anyone else’s patents.

Perhaps the most disconcerting issue is that the company currently funds itself by taking vehicle deposits from consumers. The company has taken in more than $20 million in deposits from in excess of 45,000 people promising to deliver vehicles for which it does not yet have a final design and still needs up to a quarter of a billion dollars to produce.

The sales projections seem very rich. In order to get its retail price to $6,800 the company is projecting 250,000 units sold annually, meaning sales would be about $1.7 billion. With competition from other larger automotive manufacturers this number even if attainable would seem difficult to sustain.

No one apparently conducted a real due diligence review. StartEngine is not a FINRA firm and cannot be expected to conduct a due diligence review that is up to FINRA standards. The name of the law firm that prepared the offering is not disclosed. Experience suggests that this prospectus is not the product of one of the large Wall Street law firms.

Interestingly, Elio will pay a FINRA firm, FundAmerica Securities, to conduct due diligence on the investors to make certain that they comply with the SEC’s rules regarding how much they can purchase. FundAmerica Securities will receive up to about $950,000 for this service. (For the record, I would have cheerfully performed this administrative task for about ½ the cost).

No similar fee is being paid to anyone to verify the statements in the prospectus and to make certain that all appropriate disclosures have been made. Due diligence can be expensive and the amount spent, if material, would likely be disclosed.

If fully subscribed, this offering will cost Elio about $2.4 million which is about what it would have cost if the offering had been done in the traditional way by a FINRA firm using salespeople. The offering would have been subjected to real due diligence and if it passed more likely than not would have sold out before the end of last year.

I suspect that the “crowd” will buy up all of the shares that Elio is selling, not because the crowd knows what it is doing, but because most people would not know an investment scam if it bit them on the butt.

As I said, a lot of people in the Crowdfunding industry are waiting for Elio to sell its shares as an indication of how the Crowdfunding industry has progressed. The industry would be better served if got behind companies that offered investors a better chance of success.

The lesson of Long Term Capital Management

Capital Markets, Economics, Investors , , ,

Over the years I have marveled at the fact that some of the most intelligent people in the financial markets repeatedly get blindsided by market action. Frequently it is because in the real world the markets do not act in accordance with their view of how the markets should act.

A great many intelligent people lost money when the markets crashed in 2000 and 2008 because in each instance they did not see the crash coming. Many fall back on “nobody” can predict the market when what they mean is that “they” failed to predict the market.

A great deal of the advice given by the Wall Street firms is conflicted. Even simple tools like asset allocation are grossly misapplied. Finding a better than average financial adviser can be hit or miss.

Many people agree that investing requires time, information, analysis and discipline. There is logic that suggests using computers and mathematics to make investment decisions has merit. Computers will certainly analyze more information in less time and can trade any account subject to a rigid discipline.

Success should be dependent upon analyzing the right information in the right way. Hiring really smart and accomplished people to decide which information to collect and how to analyze it would seem to enhance the chance of success. Except that it does not always work.

The most outrageous example may be the case of Long Term Capital Management (LTCM), a Connecticut based hedge fund that lost about $4.5 billion of investors’ money in 1998 and almost brought the markets down with it. The investors were some of Wall Street’s biggest banks and many of the individual executives who managed them.

LTCM was started in 1993 by Lee Meriwether, a very accomplished trader who had made substantial profits for Salomon Brothers. Showcased members of the team were Myron Scholes and Robert Merton, two economists who had devised a mathematical model for pricing options. Merton and Scholes won the Nobel Prize in Economics for that model in 1997 just before the downturn that wiped out LTCM.

LTCM performed arbitrage with its investors’ money. They looked for small discrepancies in the price of the same or similar instruments in different markets. They assumed that the markets would always efficiently close those gaps.

LTCM created sophisticated mathematical tools to identify those discrepancies and to evaluate the greater markets so they could estimate how those gaps would close. No one has suggested that LTCM’s math was wrong; it is just that the events that occurred were not in the database that they were analyzing.

In 1997 the government in Thailand devalued its currency. The ensuing defaults roiled the markets in Asia and caused a serious decline in the equity markets. Credit markets in Japan, a major US trading partner and the most important capital markets in Asia tightened significantly. It did not help that Russia defaulted on its own sovereign debt shortly thereafter.

Importantly, LTCM did not lose money when the devaluation occurred in 1997 but a year later. The LTCM fund was very profitable into 1998. Losses started to mount up when its mathematical models could not account for the shifting market conditions caused by the devaluation. They were useless to predict the effects of the often conflicting ways in which other Asian governments and central banks would deal with it.

The lesson to learn from LTCM is quite simple. Even the best mathematical models created by the smartest people should not be relied upon to tell us what the markets may do. No computer program can accurately predict the price of securities one month or one year from today.

Despite this fact, there are currently a multitude of “quant” firms that are developing and using ever more sophisticated mathematics to do just that. Most are focused upon making predictions of what will happen in the markets today not next month. I wish them luck but I would not give them any of my money to invest.

The markets will continue to evolve, globalize and expand. Developing mathematical models based upon how the markets have acted up until today will be less and less accurate and have less and less utility going forward.

Millennials think otherwise and are expected to invest trillions of dollars with robo-advisers who use mathematics in the same way. A substantial percentage of those funds will be lost the next time the market turns down.

Then the market”professionals” and pundits who currently sell and endorse robo-adviser programs will remind the millennials that “nobody can predict the market” because some things about the markets never change.

Sex and crowdfunding

Economics , , ,

Crowdfunding is very much an exercise in self-funding. The companies that are raising funds on the crowdfunding platforms are often expected to solicit their own customers, suppliers, friends and family to become investors in the business as part of the crowdfunding process.

There is a burgeoning industry of consultants who will help companies that want to raise money on these platforms. These consultants exist because there is still far too little capital available in this market. These consultants specifically help companies compete for that capital, but the crowdfunding process is still largely hit or miss.

It seems to be common knowledge that a good social media campaign should accompany any equity offering on a crowdfunding platform. Like all advertising, a social media campaign is a “numbers” game. Its goal is to bring enough eyeballs to your offering so that all of the shares you are offering will get sold.

If eyeballs are what you need to successfully crowdfund a company, it would seem logical then that the easiest company to crowdfund might be one selling a line of lingerie. No crowdfunding consultant worth his/her fee would likely tell the company not to include its product catalog in its presentation to investors if that catalog had pictures of models wearing lingerie.

Titillation aside, lingerie companies sell products that may be easily and inexpensively sourced and which can often be sold at substantial mark-ups. But that is not what the conversation is likely to be about.

In a perfect economic world, investors would travel to the “efficient frontier” (a great name for a crowdfunding platform, in my opinion) and select investments suited to their taste for a blend of risk and reward. Illiquid shares received by crowdfunding investors will always be speculative, so reducing the risk or increasing the potential reward seems to be the obvious way for the platforms to gain the most customers.

When a crowdfunded business finally monetizes the investors’ “bet” there should be every expectation that the investors will be well compensated. Greed, not sex, should be the emotional basis for any crowdfunding investment.

The crowfunding platforms are filled with companies seeking funding for real estate projects, technology projects, electronics, toys, bio-tech, consumables, films and office applications. A prospective investor visiting a few of the larger platforms would likely find a few hundred very different offerings to consider. As the offerings attempt to distinguish themselves one against the other, there seems to be more showmanship than substance.

The classic business model for offering new securities to the market would have them underwritten by an investment bank or brokerage firm. This model works for the companies that are being funded because they get funded. It is also exceedingly profitable for the investment banks.

Investors in an underwritten offering can expect to get a reasonably investigated, intelligently structured investment into which someone at the investment bank, independent of the company, has given some time, thought and analysis. The value added to a funding transaction by an investment bank is the judgment that they bring to the transaction. Investors who may know nothing about the company seeking funds will invest if they have relied upon the bank’s judgment in the past and made money.

I was only able to find one crowdfunding platform that even attempted to offer this type of assistance to companies that were listing on it. Only one platform that seems to see what everyone else is missing.

I should not have to tell you that many of the companies that are currently seeking funding on the crowdfunding platforms are very weak. Even companies which have a “cool” new product created by a great team of engineers will often employ no one with the experience to effectively get the product to market.

There are many start-ups on these platforms that are not yet in business. Someone independent of the company issuing its shares still needs to ask the question: “can you get this to market, on time, sell it and make a profit?” In the crowdfunding marketplace, at least up until now, no one really asks this question because no one considers it their job to do so.

Sooner or later, the platforms will likely realize that they are in the business of selling equity shares to investors and step up. Goldman Sacks is also in that same business and makes a lot of money doing it. As billions of dollars find their way to these platforms in the next few years, there will be a lot of money to be made as the crowdfunding industry matures.

The crowdfunding industry will have matured, in my opinion, when the social media messages change direction. Eventually, the current outgoing “please buy my offering” messages will be replaced by the incoming ”I wonder what the ‘Efficient Frontier’ crowdfunding platform is offering this week?”

Looking back ten years from now, will any of the crowdfunding platforms now operating be able to boast that “97% of the companies funded on our platform in the last 10 years are still operating” or anything close? Certainly the platforms should realize that this type of track record would draw a lot of new investors to their offerings and encourage loyalty from the investors that they already have.

Crowdfunding success or failure should never really be determined by sexy catalogs or the size of your social media campaign. The cream should always rise to the top. The crowdfunding market is new and growing rapidly. All that it needs to succeed is an infusion of a little judgment and some common sense.

Reg. A+ Assessing the True Costs

Capital Markets, Issuers , , , , , , , ,

From the laptop of Irwin G. Stein, Esq.Many small and mid-sized companies seem to be assessing their option to raise equity capital using the SEC’s new Regulation A+, which was promulgated under the JOBS Act. The regulation allows companies to register up to $50 million worth of their shares with the SEC and then offer them for sale to members of the general public.

Until now, companies seeking equity capital at this low end of the market could only seek funds from wealthy, accredited investors using a different regulation; Reg. D, the private placement rule.

The upfront costs of preparing a private placement offering will always be less than the costs of a Reg. A+ offering. In both cases competent securities attorneys will prepare the prospectus. Reg. A+ requires that the company’s books be audited as well. This is an added expense. The true costs however, will be determined by who sells the offering and how it is sold.

It is not unusual for a private placement being sold under Reg. D to have an upfront load of 15% of the total amount of the offering or more. The issuing company only receives 85% or less of the funds that are raised by the underwriter.

One percent of the load might repay the company’s costs of preparing the offering. Another one percent might cover the underwriter’s marketing and due diligence costs. The rest is the sales commission and other fees that the underwriter is charging for selling the private placement.

Many accredited investors are currently purchasing Reg. D offerings and paying the 15% or more front-end load. There is no incentive for the brokerage industry to charge Reg. A+ issuers any less.

When you purchase shares in a private placement you generally cannot re-sell them. Even if the company does well at first, if it fails in later years, you still lose your money.

With Reg. A+ the shares are supposed to be freely trade-able, except that they are not. The market in which they are supposed to trade is not yet fully developed. It may not develop for quite some time.

How much will the underwriters charge for a fully underwritten Reg. A+ offering? The rule of thumb has always been that commissions go up as the risks go up. Shares issued under both Reg. D and Reg. A+ are speculative investments.

Since both regulations will yield securities that are speculative investments that cannot be re-sold, it is reasonable that underwriters will charge the same for both types of offerings.

Some companies will attempt to sell their shares under Reg. A+ directly to the public without an underwriter. Investors who purchase these shares will get more equity for their investment. That does not necessarily mean that they will get greater value. If many issuers can self-fund without an underwriter it might cause downward pressure on loads and commissions that underwriters can charge.

If commissions on Reg. A+ offerings turn out to be substantially less, many accredited investors may shift to the Reg. A+ market. More likely, some brokerage firms will sell both Reg. D and Reg. A+ offerings side by side. If they do, the commission structure and total load on each should be similar.