Crowdfunding Professional Association (CfPA)

To: The Board of Directors

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Crowdfunding is corporate finance, do the math  

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Shine light on the scams 

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

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

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

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

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

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

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

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

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

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

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

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

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

Warn investors by telling them the truth

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

Let me help:

Crowdfunding Investors Beware:

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

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

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

Respectfully,

Irwin Stein