crowdfunding

Crowdfunding Mailbag

Capital Markets, Investors, Law , , , ,

Without investors Crowdfunding will become a footnote in financial history.  The Crowdfunding industry continues to demonstrate that it just does not care about playing by the rules or giving investors a fair shake.

A few weeks ago, I wrote an article about Med-X, the first equity Crowdfunding campaign that the SEC stopped mid-offering. It was only the second time that the SEC’s Enforcement Division had gotten involved in a Crowdfunded offering and I thought it was worthy of an article.

Among other things, Med-X was raising money to research and sell products derived from cannabis. One of the larger cannabis websites re-printed the article and I got e-mails from a lot a people in the cannabis industry.

Several people suggested that the SEC’s action was part of a larger government effort to hold back the cannabis industry by denying it funding. They suggested that some Crowdfunding sites would not accept cannabis related offerings before the Med-X action. They thought that this enforcement action would have a chilling effect on their efforts to raise capital.

Frankly, I doubt this is the case. The SEC originally approved Med-X to sell its shares and there are a number of public companies in the cannabis industry. The SEC cares more about disclosure issues than it does about drug enforcement.

My article was also re-printed on a financial website. I got e-mails from several securities lawyers and people in the mainstream financial markets, many of whom, like myself, marvel  about the fact that the Crowdfunding industry offers securities to investors seemingly thinking that the body of law surrounding the sale of securities does not apply to it. The JOBS Act gives some relief from the registration provisions of the securities laws. The anti-fraud provisions of the securities laws still apply.

My real issue with the Med-X action was with the Crowdfunding portal that offered it, StartEngine. Med-X had failed to file financial information that it was required to file, meaning that investors were not getting information that they were required to get.  StartEngine is registered with FINRA as a Crowdfunding portal.  FINRA’s rules certainly impose a duty on its members to disclose all material information whenever they offer securities to the public.

I got an e-mail from the Compliance Director at StartEngine who told me that the SEC’s action against Med-X was about a missed filing date and the SEC did not mention the word “fraud” in its paperwork. Under the securities laws, fraud is defined as the omission of material facts. The failure to provide required financial information to investors fits that definition like a glove.

The Compliance Director told me that StartEngine was represented by competent counsel which I have no reason to doubt. Regulatory compliance in the securities industry is not something that they teach in law school. You are not likely to become well-versed in day to day compliance issues working for a law firm or regulator. You learn compliance the same way that a surgeon learns surgery; by doing it under the guidance of someone who knows what they are doing.

I was trained in compliance when I worked at two large brokerage firms. I offered to explain the problem that she apparently did not see to the Compliance Director or her counsel, without charge. I told her that I really hated to see someone step in it when this was such an easy problem to fix. She respectfully declined.

There are only about a dozen Crowdfunding portals that have registered with FINRA to conduct Regulation A+ offerings. I have corresponded or been on the telephone with the Compliance Directors of four of those portals. Three of the four had no experience with FINRA compliance.  The one who did have experience stood out like a rose in a garden of weeds.

One correspondent asked me why I brought up Elio Motors, another StartEngine offering in the article as well. Elio has become the poster child for the Regulation A+ offerings because it successfully raised about $17 million from investors. The marketing director from Elio recently spoke at one of the Crowdfunding conferences presumably to regale the attendees with Elio’s fundraising success.

I consider Elio Motors to be a nasty problem that will come back to bite the Crowdfunding industry on its butt. In my opinion Elio is a scam. I am not the only person who thinks so.

I base that opinion on the fact that Elio has been taking deposits and promising to deliver a vehicle to customers since at least 2014. Elio has no vehicles to deliver and is not actually building any. Taking deposits for and promising delivery of a product that you cannot hope to deliver is a deceptive business practice under state and federal laws.

In its Reg. A+ filing Elio disclosed that it was trying to get a loan from the Department of Energy to fund production. To qualify for the loan, Elio would have had to demonstrate that it had a strong balance sheet and that it could reasonably be expected to repay the loan.  Elio is insolvent.

Elio has taken deposits from approximately 65,000 people. I would not bet that these customers will receive delivery of their vehicle in 2017, if ever.

Rather, I would bet that a regulatory action (or a bankruptcy, or both) is going to occur in 2017.  Elio has raised a lot of money from the Reg. A+ offering and the deposits but does not seem have a lot of the cash on hand.  It still needs between $200-$500 million more to deliver on its promises.

Is it possible that a VC fund will make a substantial investment in Elio and bail them out? Yes, but I do not see it. Elio still has not demonstrated that even if developed its vehicle will be street legal.

To me Elio does not pass the smell test. I cannot imagine how a competent due diligence officer gave Elio’s offering a green light.

Another e-mail came from a person who suggested I should not be concerned with Med-X’ failure to make proper disclosures because “everybody” knows that most Crowdfunded businesses will fail and that investors treat Crowdfunding as if they were gambling in Las Vegas.  While I acknowledge that most Crowdfunded businesses will fail, the odds in Las Vegas are actually substantially better that the player will walk away with some of his money.

That person also told me that I do not appreciate that Crowdfunding is intended to “disrupt” the way in which capital is raised. I do appreciate that Crowdfunding is intended to allow companies that would not have access to that market to raise money from investors. I also appreciate that there is a correct, legal way accomplish this.

At the end of the day owning a Crowdfunding portal can be a lucrative business.  All I ever suggested was that every portal needs to play by the rules and offer good investments to investors.

In just one year the SEC has acted twice against issuers who broke those rules. In both cases the issuers were enabled by the Crowdfunding industry “professionals” who were not acting professionally.  If there is any take-away from this article it should be that I offered to set the Compliance Director at StartEngine on a straight path, without charge, and she declined.

There is a lot of promise in Crowdfunding that may be eclipsed by inappropriate behavior. Unless investors are willing to invest, and invest again because it worked for them, Crowdfunding will not fulfill this promise.

The SEC’s Enforcement Division is clearly looking for scam artists who are raising funds in the Crowdfunding market and for legitimate companies that fail to follow often complex rules.  It will keep finding them until the Crowdfunding industry gets serious about its business and makes an effort to protect the investors it cannot survive without.

 

 

 

 

The SEC Halts a Crowdfunded Cannabis Offering

Capital Markets, Issuers, Law , , , ,

In the year I have been blogging I have written several articles about the problem that the Crowdfunding industry does not want to address, fraud.  My thesis is simple: if the investors get screwed enough times they will take their money elsewhere.

As stories of Crowdfunding scams begin to proliferate, the industry’s reputation is likely to go down the toilet.  If the investors leave, people will be sitting around in bars saying: “I used to work for a Crowdfunding platform” the same way that people sat around in bars in 2009 saying “I used to be a mortgage broker”.

Back in February when Regulation A+ offerings were just getting underway, I wrote several articles raising some questions about specific offerings. The Crowdfunding industry was very gung-ho about Reg. A+ because these offerings could be sold to smaller investors. The bulk of Crowdfunded offerings are still private placements which can be sold to wealthier accredited investors only.

I wrote a blog article specifically about Med-X, Inc. which was attempting to raise $15 million under Reg. A+ to “research and develop, through state of the art compound identification and extraction techniques,  market and sell medically beneficial supplements made from the oils synthesized from the cannabis plant.”

I questioned the offering, in part, because cannabis is still illegal at the federal level.  But that was not the only reason.

Med-X had acquired an exclusive license from another related company, Pacific Shores Holdings to market NatureCide® herbicide and pesticide products to the cannabis industry in exchange for 10,000,000 shares of Med-X stock. As I noted at the time, an exclusive license can be valuable. In this case, because the products are readily available on Amazon.com the value of the “exclusive” license was questionable.  Both Med-X and Pacific Shore holdings were controlled by the same person, Mathew Mills.

To me, Pacific Shores Holdings looked like a classic penny stock. Mr. Mills had been sanctioned, twice, first in Pennsylvania in 2011 and later in California in 2013 for selling shares in Pacific Shores Holdings to investors to whom he had no business selling shares. The structure employed here, with one penny stock company acquiring a large block of stock in another pursuant to a licensing agreement is also a classic penny stock tactic.

Last week, September 16 to be exact, the SEC issued a temporary halt to Med-X Reg. A+ offering. The company was required to file an annual report on Form 1-K for the fiscal year 2015. Med-X operates on a fiscal year ending December 31. As such, Med-X was required to file its annual report by April 30, 2016. On September 16, Med-X had still not filed the annual report, so the SEC put a halt to the offering.

The clear message here is that information that investors were entitled to receive, as a matter of law, was not provided to them between May 1 and September 16. Failing to provide material information to investors is the textbook definition of securities fraud.

Med-X did file its Form 1-K within days of the SEC order halting its offering. What that filing discloses about what Med-X is doing with the money it has raised so far validates my earlier suspicions.

Back in February, Med-X reported that it had received $3.6 million in reservations from over 1100 prospective investors for their Reg. A+ campaign on StartEngine, a Crowdfunding portal.  Those reservations were apparently meaningless.

As of June 17, 2016 the Company had sold 1,124,038 common shares. The Company received net proceeds of $430,430 from this offering. Med-X has committed to spend $150,000 of that money with a company based in London to develop a mobile platform for its marijuana media site among other things.  How it will pay for the research it promised is anyone’s guess.

Next month the SEC will conduct a hearing to determine whether or not it will allow Med-X to resume its offering.  Since the Form 1-K has now been filed, they may let it proceed. If the SEC has other concerns about the company, it may keep the halt in place while it investigates further.

The SEC has a long history of leveraging its budget for enforcement actions by going after small companies like Med-X where the facts are clear-cut, where it is not likely to find a high-powered law firm defending and where it can make big headlines. With this action, it is likely to make bigger headlines in the cannabis industry than with the Crowdfunders.

An enforcement action against Med-X would send a message to the cannabis industry which should want to seek Crowdfunded financing as banks are generally closed to them as a source of capital.  Despite what you may think about cannabis as a legal industry, the federal government’s policy is to wipe it out.

I have spoken with several people involved with the cannabis industry who report that the Crowdfunding industry, at least in the US, is already skittish.  Given the publicity surrounding cannabis and its thirst for capital, you would expect to see many cannabis related businesses raising funds on Crowdfunding sites but you don’t.

The SEC specifically cautioned brokers, dealers, shareholders and prospective purchasers that they should carefully consider Med-X’s failure to file its annual report on a timely basis along with all other currently available information and any information subsequently issued by the company. Let me translate.

This is the second enforcement action that SEC has brought against a Crowdfunded offering. The first action, SEC v. Ascenergy, was based on the fact that the company was raising money to drill for oil on land where it did not have the rights to drill.  The SEC called out the four Crowdfunding platforms on which offerings took place by name but did not sanction them in any way.

I wrote a blog article about SEC v. Ascenergy which was reprinted on several Crowdfunding media sites. What I wrote was that this was the SEC’s way of telling the Crowdfunding industry to get its ducks in order. I believed and I still believe that sooner or later the SEC will sanction a Crowdfunding platform or portal that lists a fraudulent offering. For the most part the industry looked at the Ascenergy case with a yawn and declared it to be an isolated instance of fraud.

StartEngine has gone to the trouble to become registered with FINRA specifically to be able to offer Reg. A+ offerings to mom and pop investors. They are required to follow FINRA’s rules when listing offerings and that includes the requirement for a significant amount of due diligence. In my mind the Med-X offering raised a number of red flags, not the least of which was the NatureCide® licensing agreement.

More directly, FINRA and the SEC have every reason to expect StartEngine or any other registered Crowdfunding portal to have known that regulations required Med-X to have filed its annual report by April 30 and that it was late. The SEC may justifiably ask StartEngine why it did not close the Med-X offering down instead of forcing the SEC to use taxpayer funds to do it.

It is not always possible to determine what a government agency will do next. In the SEC’s mind the matter may simply be over or they may take action only against Med-X and Mr. Mills. He has, after all, already been sanctioned by two state regulators and has apparently not learned his lesson.

The SEC may give StartEngine a pass or it may not. It may leave the matter to FINRA which also has a history of going after smaller firms while its largest members often get away with fraudulent offerings that impact thousands of people for large amounts of money.

One thing is clear; the standard for the SEC would be to plead that StartEngine “knew, should have known or was reckless in not knowing” that Med-X did not file its annual report in a timely manner.  I do not see that StartEngine has a cognizable defense.

StartEngine did list another offering, Elio Motors which I also questioned in another blog post. My issue with Elio was that it was taking deposits from and promising delivery to consumers for a product that did not exist and which it could not hope to deliver with the funds it had on hand or which it was likely to raise. I am pretty certain that taking deposits and promising delivery of a product that does not exist and is not very likely to exist violates some regulation under the Federal Trade Commission Act or a similar statute.

The Crowdfunding industry has hailed Elio as a success because it raised $17 million from investors.  The people who helped raise the funds speak at various industry conferences to an audience of Crowdfunding participants who want to know how it is done.  (Spoiler alert: In Elio’s case it was done by making promises that they were not likely to keep but that is not what you will hear at the conferences.)

No one invites me to speak at any of the ever present Crowdfunding conferences because the Crowdfunding industry does not want to hear what I have to say.  If I were thin skinned, I would be concerned that the Crowdfunding industry really does not like me.  I’m not.

In all fairness to the Crowdfunding industry, I was solicited a few weeks back by one of the larger platforms. They wanted me to write a series of articles and an occasional white paper for them. When I spoke with the Director of Marketing, the firm’s Compliance Director was on the call. He knew that he would have final approval of anything that I wrote.  I was not surprised to learn that he had learned compliance at a mainstream brokerage firm.  It is not that difficult to stay complaint with the rules if you know what you are doing.

If the SEC or FINRA come calling to any Crowdfunding portal or platform, including P2P lenders, the first thing they will ask for is the firm’s written procedure manual.  There should be written standards and procedures for listing companies. There should be standards and procedures for reviewing the videos and marketing materials that accompany many of the offerings. Far too many of those videos are not compliant with the rules for anyone to think that the industry is serious about the business in which it is engaged; selling securities.

What is likely to happen at the hands of regulators is the industry’s own doing. They are too busy telling themselves that they are being “disruptive” to actually take notice that investors are being ripped-off.  Fraudulent offerings are not going to stop until the industry takes steps to make them stop. The SEC is not going to wait forever.

Blogging for Fun and Profit

Capital Markets ,

Why blog?  For many people the answer would seem to be that they blog to bring attention to themselves and their business; they blog with the idea that it will help them to make money.

I started blogging just about a year ago. It began at the suggestion of the editor of my book.  She advised me to start a blog to help get my name out there and sell the book. Blogging is free, she told me, and I had no budget to promote the book.  I receive nothing from the proceeds of the book, all of which go to cancer research.

She also advised me to publish the blog on Linked-in, rather than Facebook where she thought more “serious” people would see it. At the time, I knew very little about either writing or publishing and I willingly took her advice. If I am doing something that I have never done before, I always hire someone who knows what they are doing or seems to know.

The blog follows the basic theme of the book. Its avowed purpose is to call out “foolishness” in the mainstream capital markets. There is certainly enough foolishness to go around. Much of what I write is a reaction to what I see or read elsewhere.  Many of the articles were inspired by conversations that I have with friends or strangers.

Because I write about foolishness in the financial markets, several articles have gravitated to two subjects, Robo-advisors and Crowdfunding.  Both are championed by fools who put a lot of bad information into the marketplace.  I try to counter that bad information with reason.

Robo-investing is foolish because it cannot work.  If you invest with a Robo program you are guaranteed to lose money when the market turns down.  Automated trading programs have been around in the commodity markets for a long time and are universally rejected by regulators and people who understand that a computer program cannot predict the markets.  If you are not investing to make money and are happy to lose, then in my mind, you are foolish.

Robos-advisory programs have become big because they eliminate the most expensive part of the investment transaction, the human advisor, which leaves much more profit for the firm that is offering the program.  A theme of the book, which carries over to Robos is that if the financial industry offers a product it is more likely than not designed to make money for the industry not the investor.

I get a little pushback from the Robo industry when I write negative articles about it. A number of people who contacted me after one article in particular, told me that whatever I thought about Robos, human advisors were terrible. In my experience not all investment advisors are terrible. I responded by inviting people to contact me for the name of my advisor who is very intelligent, competent and hard working and who gets good results for his advisory clients because of it. A few people took me up on my offer and seem to be happy to be working with him.

I get a lot more pushback when I write negative articles about Crowdfunding. I personally think that Crowdfunding has a lot to offer for the companies in need of funding. Unfortunately the Crowdfunding industry is populated by many people with zero experience raising money for small companies. Much of the activity in Crowdfunding is people giving seminars to other people teaching useless information and patting each other on the back.

Pointing out that fact makes those people very angry but it does not change the fact the Crowdfunding industry is remarkably unsuccessful at raising money. It takes money to raise money. The Crowdfunding industry is busy telling people just the opposite; that an inexpensive  social media campaign is all a company needs to successfully attract investors.

Many companies who try Crowdfunding do not get the funds they want. That is a shame because it really is not that difficult for a good investment to attract investors.

There is a very small group of Crowdfunding platforms that close every offering that they list. The people who run those platforms don’t give seminars because they are too busy being successful.  Several are run by people who came out of the mainstream financial industry and understand what works and what doesn’t.

One of the reasons Crowdfunding is failing is because not every company that wants to be funded is a good investment.  Early on I offered to read any company’s pitch deck and make comments for free. That has brought me into contact with a fair number of entrepreneurs, most of who I have found to be quite interesting and appreciative.

I also write about the markets themselves, especially regulations of the markets, FINRA and FINRA arbitration.  If I write fewer articles about these subjects it is because there are a great many lawyers and others who put out good information. The mainstream securities industry is usually careful to stay within the regulatory white lines.

So has blogging been good for my business?  Yes, but in unexpected ways.

Blogging has certainly gotten my name “out there”.  When I started the blog I had about 200 Linked-in connections, mostly friends, colleagues and former clients.  I add new connections with every article and the number has increased 8 fold and continues to increase weekly with each new article.

My articles on the investment industry got me the opportunity to write articles for a mainstream digital publication serving the investment advisor market. Some of those articles reach thousands of readers. I am still very much at the Jimmie Olsen, cub reporter stage but the editors there have been very patient and supportive.

The articles on Crowdfunding, especially the negative ones, put me in touch with a several groups that want to do Crowdfunding correctly, with due consideration to what investors want and deserve.  I have been helping these Crowdfunding platforms move from the planning to the implementation stage. Each shares a goal of funding every company that it lists. I expect that other groups seeking to start Crowdfunding platforms or make existing platforms more successful will seek me out as well.

The articles on arbitration and market regulation have resulted in a few expert witness gigs in FINRA arbitrations and a consulting assignment for one of the larger Wall Street investment banks. I suspect that more will come.

The best part of blogging has been that it has put me in touch with a large number of people with whom I would not otherwise have been in contact.  I speak to 2 or 3 people every week. Some of those conversations go on for an hour or more.

During most of the conversations I find myself laughing over a good joke or comment.  For me it is these personal connections that are the best thing that comes from blogging.  A good laugh in the middle of the business day seems harder and harder to find.

 

 

 

Regulatory Compliance in Crowdfunding

Capital Markets, Issuers, Law , , , ,

The more that I blog or comment about the foolishness in the Crowdfunding industry the more people seem to want to shoot the messenger. Of late, several prominent people in the industry have taken umbrage at my comments; a few have gotten personal. Obviously, I have hit a nerve.

I have never been a particular fan of regulation.  I do, however, appreciate that regulations keep the food supply safe, make the air and water cleaner and force people to buckle up their children into their cars that saves many young lives every year.

I also appreciate that the US capital markets are heavily regulated which keeps many of the scoundrels out. It also helps keep investor confidence in the market high and facilitates the formation and intermediation of capital upon which the entire economy relies. Many people see Wall Street as a den of thieves and want more regulation.  The Crowdfunding industry wants less.

The Crowdfunding industry seems to universally hate regulation. A loud cheer went up from the industry when a federal appellate court recently shot down an attempt by state securities regulators to review Crowdfunded offerings.  I doubt a single one of the cheering throng ever had a private placement reviewed by a state regulator. If they had, they might think differently.

Back in the 1980’s many states required private offerings to be reviewed. You would file the offering, pay the fee and usually get back a letter with comments. It was pretty clear from the comments that some knowledgeable attorney working for the state had actually read the document. You could just make the suggested corrections or get that attorney on the phone to discuss them. I never found the process to be adversarial.

To the contrary, I always took some comfort knowing that a seasoned professional had reviewed the document and passed on it. If one of the offerings had later been questioned by an unhappy investor, I would have taken comfort in being able to tell a judge that I had reviewed the offering with regulators in half a dozen states.

At this writing, only ten firms have registered with FINRA to become Crowdfunding portals under Title III of the Jobs Act. A portal will be able to offer Crowdfunded securities to non-accredited investors. It is something that a great many people in the Crowdfunding industry wanted. More firms will certainly take the plunge and register with FINRA to become portals as time goes on.

The Crowdfunding industry sees a need to offer these speculative investments to mom and pop investors. Everyone understands that most Crowdfunded startups will fail. Notwithstanding, the industry continues to stress the “opportunity” for mom and pop to invest in the next Amazon or Facebook.

To be fair, most of the people in the Crowdfunding industry are content to offer investments only to accredited investors on platforms that comply with Title II of the Jobs Act. Many appreciate that hundreds of billions of dollars worth of private placements are successfully sold by the mainstream financial industry every year and follow the well trodden path to success.

Let’s be clear about the fact that owning a Crowdfunding platform or portal can be a lucrative business. Issuers in the mainstream Reg. D private placement market often pay a 10% commission, most of which goes to the individual stock broker who makes the sale. Many Crowdfunding platforms charge a similar listing fee for each offering, all of which goes to the house.

There are a number of people in the Crowdfunding industry who are convinced that regulatory burdens are keeping Crowdfunding from reaching its full potential. They want Congress or the SEC to ease the regulatory scheme for Crowdfunded offerings. The primary concern is that compliance costs too much. The obvious retort is that non-compliance is likely to cost more.

The securities laws, both state and federal, deal primarily with the issuance and trading of securities. They are designed to provide transparency and stability to the capital formation process that is central to our entire economy. If you were to boil all of the laws and regulations down to a single word, that word would be “disclosure”.

FINRA has its own rules which govern the day to day operations of its member firms. A Crowdfunding portal will have no need to concern itself with most of FINRA’s rules. The portal is not trading securities, issuing research reports or handling transactions in options.

Three specific FINRA rules will get the most attention; the rule regarding investor suitability; the rule regarding communications with the public; and the rules regarding the offering and sale of private placements.

FINRA’s suitability rule restricts investment recommendations to those within the customer’s risk tolerance. Every customer who purchases a security on a Crowdfunding portal is buying a speculative investment. Every customer agrees that they understand they can lose every dollar they are investing and that they can afford to sustain the loss. Under the Crowdfunding rules the amount of money that a non-accredited investors can invest is limited. Compliance with the suitability rule is cheap and easy.

FINRA likewise has a fairly comprehensive set of guidelines regarding advertising materials and other communications with the public.  In most cases a portal will use a “tombstone” advertisement which is also cheap and easy.

Other marketing materials for each offering of securities will need to provide accurate information and a balanced presentation of what the investment provides and does not provide.  This applies to the videos with which the Crowdfunding industry seems enamored. If a video is used in conjunction with any offering the video must be accurate, balanced and otherwise comply with the advertising rules.  Again, compliance with these rules is cheap and relatively easy.

The most expensive rules with which a portal or platform will need to comply deals with the sale of private placements. The rules mandate a “reasonable” investigation of private placement offerings. FINRA issued specific guidelines for the offering and sale of private placements in 2010.

Those guidelines (FINRA Notice to Members 10-22) provide: “While BDs are not expected to have the same knowledge as an issuer or its management, firms are required to exercise a “high degree of care” in investigating and “independently” verifying an issuer’s representations and claims. Indeed, when an issuer seeks to finance a new speculative venture, BDs “must be particularly careful in verifying the issuer’s obviously self-serving statements.” The Notice goes on to make suggestions for how due diligence investigations are to be conducted in various circumstances and for various types of offerings.  It highlights the need to identify “red flags” and to resolve them.

The Notice also references several securities anti-fraud statutes, judicial opinions and enforcement actions. There is really nothing new here. I got my training in due diligence in the 1970s and attended my first conference on due diligence in the early 1980s. Not that much has changed.

The small segment of the FINRA brokerage firms that sell private placements to retail investors has a history of conducting due diligence very poorly.  In most cases, it is because they do not want to spend what it costs to do it right even though they may receive a 1% fee, from the sponsor, to do their own and independent due diligence.

Approximately 90 small FINRA firms sold interests in various real estate offerings made by a company called DBSI. DBSI was operated as a classic Ponzi scheme with previous investors being paid from new investment not operations or profits. When the court appointed receiver sued those firms for a return of the commissions that they had illegally obtained, 50 of the firms went out of business.

The Commonwealth of Massachusetts sued Securities America, one of the larger FINRA firms selling private placements over another Ponzi scheme called Medical Capital. Securities America apparently had a due diligence report that raised a number of questions and red flags about Medical Capital and chose to ignore the report. Securities America apparently sold $967 million worth of securities in this Ponzi scheme to retail customers. Medical Capital sold $2.2 billion worth overall. Adequate due diligence would have stopped Medical Capital in its tracks.

Over the years, I have met a number of due diligence professionals who are serious about their job and who do it well. The best bring some judgment and a healthy amount of skepticism to their work. They understand what a “red flag” looks like.

I have also personally cross-examined due diligence officers and industry experts who worked at FINRA firms and outside companies many times.  If they are on the witness stand, it is because I have alleged in the complaint that the loss suffered by the investor could have been avoided. I would argue that if the firm had adequately investigated the offering, they would not have sold it.

Within the first 10 questions I usually ask about their training in due diligence.  Most of the people who do not conduct due diligence investigations correctly were never trained to do so. That fact seems to be true in the Crowdfunding industry as well.

It is also true that due diligence investigations for many offerings are not cheap. That is the primary reason that Crowdfunders do not like to be reminded that they are required to do it. If a company approaches a platform on Monday and the due diligence report is ready on Wednesday, the odds are that the investigation was inadequate.

I wrote a blog article last fall when the SEC brought its first enforcement action against a Crowdfunded company, Ascenergy. The article was reprinted in several Crowdfunding publications. I do not believe that the Crowdfunding industry wants to offer the public fraudulent offerings. I think that most people in the industry unfortunately do not know how to spot one.

I also wrote a blog article about Elio Motors.  I chronicled a number of red flags that I saw when the shares were being offered. Those included the fact that the firm had no patentable product and was raising less money than it needed to deliver one by a factor of 20.  Elio had apparently been taking orders and promising delivery before it made its offering and continues to take orders and deposits even though it has no way to deliver the product.  Notwithstanding, many people in the Crowdfunding industry herald Elio Motors as a success because it was one of the first to raise funds under the new Reg. A+.

The very first call I received about the article was from a class action attorney who saw what I saw.  I suspect that the attorney had someone buy some shares in Elio so that he will be first in line to file a class action when Elio goes under. You can bet that the officers, directors, lawyers and Crowdfunding platforms that participated in the offering will all get sued when the time comes.

Some people in the industry seem to think that if they do not register with FINRA these rules do not apply to them.  Actually, the rules are what is known as a “codification of reasonable conduct” which was a phrase the SEC used to use for rules that were proposed but not finalized. If you sell private offerings on your platform that turn out to be fraudulent, you can explain to the judge why you ignored these simple rules that would have avoided the fraud and protected the investors.

Some people in the Crowdfunding industry despise regulation because they believe that the inherent unfairness of the capital markets that keeps otherwise worthy entrepreneurs from becoming billionaires.  I could glibly remind you that life isn’t fair but the truth is there is no data to support this particular unfairness.

There have always been ways for entrepreneurs and small businesses to get funded.  Before Crowdfunding, entrepreneurs worked two jobs or hustled family and friends for startup cash. The SBA has pumped billions of dollars directly to this market for decades. We managed to get the light bulb, radio and the personal computer into the marketplace before Crowdfunding.  There is far more venture capital money around today than ever before.

There are certainly many professionals in this industry who are doing it right. But there are also many who write blogs, give interviews and put on conferences that do not.  This is the group that keeps chanting, “Regulation is killing Crowdfunding”.  Respectfully, foolish amateurs are killing Crowdfunding with a desire to change the rules rather than play by them. There is much too much hype and much too little substance in this industry.

The fulcrum in the Crowdfunding industry is the desire to fund new businesses. There is an amazing lack of concern for the investors, without whom the industry will wither and die.

As a matter of full disclosure, I am currently counseling people actively involved in the Crowdfunding business. I have been advising a group of realistic executives who want to remove the risk from investors in this market. It is not that difficult. They have spoken to a number of existing platforms about this but have gotten no takers. There does not seem to be a serious interest in protecting the investors at any level of the Crowdfunding industry.

I am also counseling established real estate and business brokers who want to add Crowdfunding to their arsenal of capital raising tools. These are two groups that appreciate the value of raising money efficiently and who are beginning to understand how they can leverage Crowdfunding to make money. To no one’s surprise, most are professionals who have been around the block once or twice. They understand that regulations need to be complied with rather than complained about.

I do not go out of my way to seek out negative aspects of the Crowdfunding industry about which to blog or comment. Many of my negative articles were the result of articles by other bloggers. One lawyer in particular who blogs regularly about Crowdfunding made favorable comments about both Elio Motors and Med-X which in my opinion are scams.

The same blogger spoke highly about two vendors to the Crowdfunding industry who offer a lot for very little but who did not impress me as people who could deliver anything of value when I interviewed them. I would be happy to send my clients to a good vendor if the vendor can supply what the clients need. In both of these particular cases, the vendors were too inexpensive to be able to provide what was actually required. Crowdfunders hate to spend their own money to obtain investors’ money.

I fully intend to continue to call out foolishness in the marketplace whenever and wherever I see it.  I think that is especially fair if I see someone who does not want to play by the rules and who wants your money anyway.

 

 

 

Raining on Crowdfundings’ Parade

Capital Markets, Issuers , ,

If you follow my blog, you know that I am very much in favor of the crowdfunding market place developing and succeeding. However, I need to throw a bucket of cold water over the exuberance that the industry exhibits. I want to inject some much needed reality and perspective into the discussion.  I want to ask some of the hard questions that people do not seem willing to ask. I want to de-bunk some of the major claims that form the foundation of the crowdfunding industry and to set the record straight.

There has been an enormous amount of hype around equity crowdfunding. In mid-May, the last of the JOBS Act sections will take full effect allowing a registration process for equity offering up to $50 million. This section allows mom and pop investors to invest in start-ups and smaller companies, albeit for only a limited amount of money.

Up until now equity crowdfunding (buying shares of stock in small companies and start-ups on crowdfunding websites) has been limited primarily to wealthier, accredited investors.  The equity investments that are being offered on crowdfunding platforms are among the most risky investments available.  Should small investors actually be encouraged to take these risks with their hard-earned money?

The crowdfunding industry expects that these small investors will fund a multitude of new companies and that this new source of capital will greatly boost the industry’s income. It is the income that the industry will earn, not the profits that investors will make that drives the hype.

It is not difficult for a crowdfunding platform to generate a seven-figure annual income for its owners.  Crowdfunding platforms can actually net more profit per dollar raised than a traditional investment bank because they perform a fraction of the work and provide few of the valuable services that a company needs to make a successful offering.

The crowdfunding industry is remarkably cavalier about investors’ money. Nothing about equity crowdfunding respects investors or cares whether investors get a fair shake, let alone a legitimate opportunity to make a profit for the substantial risk that they are taking.  The crowdfunding industry is focused on itself and upon companies that want to raise money. The investors are an afterthought.

What, exactly, does a crowdfunding platform do to help a company seeking funds to succeed? Before the offering not much; after the offering, even less.

Every investor in every market has the same goal; they invest their money to make money. In crowdfunding that has not happened and there is nothing on the horizon that suggests that it will happen.  This is not just about the lack of liquidity for crowdfunded offerings; it is about the fact that most crowdfunded businesses fail.

So let me start with the simple declarative sentence that should counterbalance much of the hype: if you invest in shares of a start-up on a crowdfunding website, it is very, very doubtful that you will ever see your money again.

According to the SEC, the common refrain is that 9 out of 10 start-ups fail, but an equally interesting statistic from one post-mortem analysis is that 70 percent of failed start-ups die within 20 months after their last financing and have raised an average of $11 million.  In other words, not only are these investments highly risky, they also fail quickly.

That statistic is for the larger start-ups funded by institutions and professional venture capital funds.  Smaller start-ups funded on crowdfunding sites cannot expect to do better and most likely will do worse. These are companies that frequently cannot attract venture capital, which is why they come to ordinary investors on crowdfunding websites in the first place.

Unless something is done about this enormous failure rate, equity crowdfunding is not a sustainable model. While this is just my opinion, it is supported by basic math and economics.

If Wall Street brings an IPO to market raising $50 million, the company issuing its shares gets the money that it can use to create new products and new jobs.  Almost immediately, the investors can sell the stock for more or less and re-invest the same money into another IPO.

The same $50 million might fund a handful of smaller businesses on crowdfunding platforms but the great bulk of those funds cannot be recycled into new businesses because the investment are illiquid and most initial businesses will fail.  It is not even fair to say that the crowdfunded offerings create new jobs when the companies and the jobs are usually gone within 2 years.

Assuming that equity crowdfunding grows to where it can raise $500 billion in a given year, the bulk of that money will be lost so another $500 billion in new money will need to enter the market the next year for new companies to get funded.  For how many years is that likely to occur?

This model is unsustainable if for no other reason than investors will not keep going into their pockets again and again if they only lose.  Long term, equity crowdfunding can only be successful if the businesses that it is funding succeed. Right now very few people in the crowdfunding industry are focused on that fact.

The vast majority of the key players and “experts” in the crowdfunding arena have little or no experience in the mainstream financial markets.  Most have no history of dealing with investors even though investors supply the capital upon which the entire crowdfunding market depends.

One of the common excuses that the crowdfunding industry makes is that the current problems are the result of “growing pains” because the industry is still in its infancy. Many people in the crowdfunding industry believe that crowdfunding began with the JOBS Act (2012) and is governed solely by it. Actually, equity crowdfunding has been around for more than 20 years, more than enough time to get its act together.

The first direct to the public stock offering (DPO) done via the internet is generally credited to the Spring Street Brewing Company which successfully raised about $1.5 million in 1995. It was ground breaking at the time, because no underwriter (Wall Street firm and those pesky salespeople) was involved in selling the stock.  No video accompanied the offering as I do not believe that the internet supported video in those days.

The offering was done under the watchful eye of a forward thinking SEC.  Many of the crowdfunding “experts” that you might hire today are not aware of this offering or the serious discussions about DPOs that were engaged in by many regulators and market professionals at the time.  Tell an expert that offerings can be done without a video and they will look at you as if you said the Chicago Cubs just won the World Series.

By 2000, the SEC had already brought a hand full of enforcement actions against other firms that had sold stock via the internet because investors were being defrauded. Wall Street was not interested in DPOs then or now. Scam artists jumped right in. Those scams are the likely reason that the anti-fraud provisions of the federal securities laws are specifically incorporated into every JOBS Act offering.

When an “expert” tells you that the paperwork for a JOBS Act offering is less cumbersome than a regular public offering; they should also tell you that companies still need to disclose all of the material facts to potential investors, no matter what the forms suggest or how cumbersome the disclosures might be.  They should also tell you that the video that accompanies the offering must be in compliance as well.

Every equity offering made on a crowdfunding platform should have the disclosure THIS IS A SPECULATIVE INVESTMENT. INVESTORS CAN EXPECT TO LOSE ALL OF THE MONEY THAT THEY INVEST, in bold, on the first page.  It is the same type of disclosure that is routinely made to accredited investors in the REG. D, private placement market.

The SEC has already brought its first enforcement action against a company funded under the JOBS Act, Ascenergy.  The SEC went out of its way to spell out that the company’s website was a part of the offering. That certainly would apply to any video that accompanied any equity offering.  Most of the people selling videos to the crowdfunding industry are unaware of the Ascenergy case and do not appreciate that the videos they create to support a crowdfunded equity offering need to comply with the law.  That applies to social media campaigns and “tweets” as well.

Many people seem to believe that investors (the crowd) are expected to investigate the offerings themselves. It was never realistic to believe that investors could evaluate a new issue. That is what many people wanted but it is not what the JOBS Act and the SEC regulations delivered.

The JOBS Act places a great deal of the fraud avoidance responsibilities on the crowdfunding platforms. The Ascenergy case called out 4 crowdfunding platforms by name. You would certainly think that these firms have a target on their backs not to repeat their deficient performance.

There is a remarkable absence of trained compliance personnel at the crowdfunding platforms. I spoke with 2 lawyers at one of the larger Crowdfunding platforms a few weeks ago. They were certainly bright attorneys. They had previously worked at law firms and at regulators and had no specific training in investment banking.  There is a big difference between understanding federal securities law and evaluating specific transactions, marketing materials and accompanying social media campaigns for compliance.

I have a particular issue with securities attorneys who are spreading the crowdfunding hype.  Some actually recommend specific platforms and specific offerings. Putting your law firms’ reputation behind a securities offering was always considered a problem.  If you do not believe me, you might want to check with your professional liability carrier.

There are several securities attorneys who are selling technology-based services to the crowdfunding industry.  I started out as a young lawyer with a secretary who took my dictation in shorthand, so nobody has to sell me on the idea that technology can help reduce the costs of practicing law.

The cost of preparing a securities offering or running a crowdfunding platform is important, but should never be the driving issue. Qualified and experienced securities lawyers are still essential to the process of selling equity. Offering securities to public investors incorrectly can be very, very expensive to all concerned.

A few of the crowdfunding platforms carefully vet each offering before they list them.  These platforms reject more offerings than they accept which has to cost them a lot of money.  It is against these platforms that the rest of the industry will be ultimately judged by investors, regulators and class action juries.

Small businesses were funded before crowdfunding. Many entrepreneurs saved up or worked two jobs to get their nest egg to open the business of their dreams.  Others tapped family and friends for seed capital. The Small Business Administration has funded millions of businesses and continues to do so.  Angel investor funds are often made up of groups of smaller investors and are more prolific than ever before.

A good business could often find capital if the entrepreneur tried hard enough and surrounded himself with the right advisors. Better mousetraps get funded and will continue to get funded with or without crowdfunding.  There is nothing “essential” about this new industry.

I spend a lot of my time reviewing pitch books and speaking with founders of companies who are seeking investors. A great many start-ups are not worthy of funding. A great business idea is not the same as a great business.  A great many people with good ideas do not understand what it takes to run a successful business.

Most small equity crowdfunding campaigns fail to raise the minimum amount of capital that they seek.  This inefficiency also suggests that equity crowdfunding is not a sustainable model. In part it is because the owners read a book or two or listen to crowdfunding experts who have no actual expertise. It is also because many entrepreneurs do not want to spend what it takes to do it right.

Traditional underwriters raise the amount of money that they set out to raise virtually every time.  That is the Holy Grail of equity crowdfunding which the industry does not come close to achieving. It is usually because the company raising the money is not willing to spend what it takes to sell their offering to investors.  They fantasize that if they just put the offering onto a platform and send out a few e-mails or tweets, investors will come running with checks.

While no one can guarantee success of a crowdfunded offering that is raising equity for a start-up or small business, there is one group that I have watched that clearly understands how to bring a significant amount of investors’ to each offering that they present.  I suspect that they charge a little more because they obviously do a better job.

I have already had this discussion with several people who are preeminent in the crowdfunding industry and whose best response has been, sadly, that the crowdfunding industry will eventually work things out.  In the meantime, the industry is working things out using money from many thousands of small investors.  The industry is tooting its own horn over its success in being able to separate those investors from their money knowing that the vast majority of those investors will get nothing in return.

The simple truth is that if you have a few hundred extra dollars in your pocket and would like to help a small business succeed, you can go to a local restaurant, order a meal and a bottle of wine and know that the owner will be very happy to have your patronage.  The odds are that the owner stands on his/her feet for many hours a day for 6 and maybe even 7 days a week.

If you are not hungry and have a few extra dollars you know that there is a food bank not far from you no matter where in the US you are that will appreciate your money as much any crowdfunding entrepreneur, probably more so.  I would argue that a food bank donation gives an excellent return on your money in the form of inner satisfaction.

I expect some blow-back from this article, especially that last paragraph.  If anyone would like to debate me on this subject, publicly, I would be happy to appear at any conference. I would expect the topic of the discussion to be “what is the financial benefit of crowdfunding for the crowdfunding investors?”  I know that it is a buzz kill but that is the point.

I have been criticized, repeatedly, because of my negativity toward crowdfunding.  I am not negative about crowdfunding. I just get angry and frustrated by the experts who think they know what they are doing but don’t.  If you do not want me to call out your foolish behavior, stop acting like fools.

Several dozen crowdfunding portals have lined-up to become FINRA members and offer equity offerings to ordinary investors. I am not particularly looking for a job, but I would be happy to sit down with any crowdfunding platform that is actually interested in only offering good investments to investors. I would think that it is the least that they should want to do.

In the next few years a lot of people will be lured into crowdfunding by the hype and will lose their money. It does not usually happen with offerings made by Wall Street firms. It does not need to happen on crowdfunding platforms either.

Making the new capitalism efficient

Capital Markets, Economics , ,

Economic theory teaches us that capital in a perfect world would always be allocated to its best use. The best use is always viewed from the perspective of the person or entity that is deploying the capital. Consequently we normally calculate the best use as the highest rate of return that the capital can reasonably achieve. The object is always to use money to make money.

To further this goal, capital has always been deployed to companies that have had the best chance of success. A due diligence process is employed to separate the best companies from those that the market deems less worthy. While far from perfect, this system has historically worked well enough to create our modern society with few truly innovative ideas left by the wayside, meaning unfunded.

In the last 20 years, some people with capital have been content to deploy it for other, more altruistic reasons. Specifically, they want to make capital available to people who have no access to the mainstream capital markets and others who for a variety of reasons could not get funded.

This new capitalism has taken two innovative forms, micro-lending and crowdfunding. Each has the potential to put capital into the hands of people who otherwise would never have access to it. Both have the potential to be transformative at the lowest tier of the global economic system. Neither is focused on highest rate of return as its primary goal.

In its purest form a micro-loan is very small and will often help a subsistence level individual transform into a capitalist. Micro-loans are frequently used to purchase one sewing machine to create a manufacturer; one shipment of goods at wholesale to create a merchant. Some micro-loans are used by a rural community to purchase one used truck or tractor. The benefits of these loans are obvious.

As originally envisioned, micro-loans were often interest free or loaned at an interest rate low enough to cover only the lender’s overhead and the costs of defaults. Even though no one who gets a micro-loan has a FICO score, statistics show the rate of default worldwide to be very low. As much as 97% of the loans are repaid. As conceived, micro-lending is a model of market efficiency.

Unfortunately, as this industry has developed and matured, there are some places where micro-loan programs are managed by bloated bureaucracies. There are stories of interest rates that would make loan sharks blush, corruption and exploitation in the lending process and misappropriation of funds intended for borrowers.

Crowdfunding, which is still in its infancy, is still remarkably inefficient. Fraud is prevalent because no one really vets the companies that seek funding. Far too many companies sell products that they can never deliver. The process itself can be expensive and is often hit or miss. Only about 30% of the rewards based crowdfunding campaigns successfully raise the funds that they seek.

Investors who buy into the equity of a small company on a crowdfunding platform must understand they may take a total loss. Even if the company is initially successful, there is no liquidity for the equity that investors purchase. Despite all of the enthusiasm for crowdfunding, this much risk and inefficiency cannot be sustainable.

There is, I would think, a way to combine the micro-loans with crowdfunding in a way that would remove much of the inefficiency, at least in the developing world.

In most developing countries there are universities whose students are  themselves often making the transition to the middle class. They should appreciate that strengthening the underclass will provide a greater market for the products and services that they themselves will eventually make and/or sell.

What I would propose is that each university creates a crowdfunding platform to enable students to fund micro-loan programs in their own communities.

Most peer-to peer lending platforms allow companies in need of loans to borrow from multiple individuals, essentially syndicating each loan. I envision the university students creating a single fund from which to make micro-loans to many borrowers.

I would ask the students to fund the program by purchasing shares in the fund with a small yearly tithe for the 4 years that they are students and for a few years after they graduate. Call it a 10 year voluntary commitment to purchase shares.

Additional funds would come from sale of shares to faculty, alumni, local banks, businesses and importantly, each country’s expatriate community. University students in western countries could partner with university students in developing countries. All anyone need do to participate is buy one share.

I have intentionally left out any local government involvement or participation. Direct government participation rarely adds efficiency to anything.

Business students and volunteer faculty at each university would administer the fund. This would remove much of the costs and corruption. It would give these students valuable experience evaluating business proposals and detailed knowledge about the local economy that will not be found in their textbooks.

Borrowers would pay a fixed interest rate. A rate of 6% might be sufficient to cover the risk of defaults and provide some amount of internal growth. Real growth will come from new students who will join the program each year as they enter college.

At some point each fund would reach a predetermined principal amount and be closed. In the US and elsewhere a closed-end mutual fund can become registered and be listed and traded in the regulated securities markets. This would provide liquidity to these crowdfunded investments where none exists.

Even after it is closed, a fund can continue to collect payments on existing loans and make new loans year after year. There would be no reason or requirement for it to liquidate. As the fund grows after it is closed the per-share value will continue to appreciate. Providing for growth and a liquid market would mean that shareholders could expect to make a profit from their investment.

The closing of one fund will be followed by the opening of a new fund to replicate the process. Over time, multiple funds will exist in every country that wants them, sponsored and funded by university students and others who will see both the benefits of the program and the potential for their own modest profit.

Replicated university to university and country to country a program like this would have a demonstrable effect within a decade. On a continuing basis it has the ability to transform communities and economies in the developing world from the bottom up.

It is an opportunity to demonstrate that altruism and capitalism are not mutually exclusive.

Med-X – Crowdfunding, cannabis and chicanery

Investors, Issuers, Law , , ,

As a college student during the 1960s, I was exposed to marijuana and had friends who were out and out stoners. As a young lawyer I represented a wholesale head shop company that Time Magazine referred to as “the Dunhill of the industry”. Through them I met many entrepreneurs who had profited in the wholesale and retail paraphernalia industry.

Being a cancer patient I am familiar with medical marijuana. I have read the literature and discussed it with my doctors. I know many people who have used marijuana as part of their recovery from cancer and other illness.

This article is not about the pros and cons of legalizing pot. It is about Crowdfunding, the cannabis industry and a questionable investment.

Sales of marijuana in states where it is legal are expected to top $5 billion this year. Still, I cannot see the loan committee of a major bank or any Wall Street firm step up to finance the cannabis industry in any major way. Even though its use is legal in an increasing number of states, the cultivation, distribution or sale of marijuana is still a federal crime and banks and brokerage firms are regulated by federal agencies.

It is not surprising then, that the cannabis industry has found Crowdfunding to be a source of new capital to fund its growth. Rewards based Crowdfunding campaigns for new vaporizers and similar products are easy to find.

What surprised me was that the Securities and Exchange Commission (SEC) has recently approved a $15 million offering for a cannabis related company under the new Reg A +. The offering for a Southern California based company, Med-X, became effective in early February.

The company has no sales or current business to speak of. The company states that it will use the money from investors to: “research and develop, through state of the art compound identification and extraction techniques, and market and sell medically beneficial supplements made from the oils synthesized from the cannabis plant.”

The Company’s planned compound identification and extraction research and development operation will be conducted primarily at the Company’s existing 600 square foot indoor cultivation center in Chatsworth, California, where controlled quantities of high quality cannabis are being grown, harvested and stored for research and medical use to the extent permitted by California law.

The company has several physicians on its Board of Directors. However, none has disclosed any published research paper on cannabis and none, apparently, works fulltime at the company’s 20’x30’ cultivation center to direct that research. Cannabis is apparently being grown, although the equipment needed to conduct the promised research will not be purchased until the offering is funded. In any event, the research is for future products.

In the meantime the company will use some of the investors’ money “to acquire, create and publish high quality cannabis industry media content through the Company’s media platform, (a website) to generate revenue from advertisers as well as through the sale of industry related products.”

If this were styled as a media company I would not question it. But the website is only a few months old, has no revenue and again the company lacks personnel with a media background to run it.

The company’s other revenue generator will be sales of a product called NatureCide® to cannabis cultivators throughout the world. NatureCide® is an insecticide and pest repellant. This product is owned, manufactured and distributed by a company called Pacific Shore Holdings, Inc. an affiliated company that is controlled by the same person who controls Med-X, Mathew Mills.

Med-X acquired an exclusive license from Pacific Shores Holdings to market NatureCide® products to the cannabis industry in exchange for 10,000,000 shares of Med-X stock. An exclusive license can be valuable, however, in this case the products are readily available on Amazon.com making the value of the exclusive license questionable.

Pacific Shores Holdings is a classic penny stock. Mr. Mills was sanctioned, twice, first in Pennsylvania in 2011 and later in California in 2013 for selling shares in Pacific Shores Holdings to investors he had no business selling shares to. The structure employed here, with one penny stock company acquiring a large block of stock in another pursuant to a licensing agreement is also a classic penny stock tactic.

Like any Crowdfunded offering, shares of Med-X are being sold by the company directly to the public. In theory investors should be able to make an informed evaluation of the company before they invest their money. But most investors cannot.

I expect that many people will line up to send their money to invest in this company’s shares. It certainly will not be because this company represents a good investment.

More likely, if you will forgive the pun, the buzz about this offering will be about its asserted link to the cannabis industry. The minimum investment is $420. (No kidding).

Stop to consider that its main product, NatureCide®, was pre-existing. Its only connection to the cannabis industry is the statement that it can be used by cannabis growers in the same way that people growing virtually anything else can use it.

Mr. Mills was apparently content to sell shares of Pacific Shores Holdings without adequate advice from a securities lawyer. He now proposes to conduct cannabis research without a cannabis researcher on staff and publish a website without an experienced website publisher.

Remember, I want the Crowdfunding industry to succeed. To do so it will need to offer investors the opportunity to invest in companies that at least have a likelihood of success. I do not believe that investors will find that here.

Instead, Med-X is poised to give both the evolving Crowdfunding and cannabis industries a black eye and to leave many investors holding the bag. The cannabis industry will survive.

If Med-X turns out to be a $15 million scam, (and there are others) investors may begin to realize that there are better places to invest their money than a Crowdfunding portal.

Equity Crowdfunding – What the Crowd Expects

Investors, Issuers

As the crowdfunding industry moves from rewards programs to equity offerings companies that are seeking funding will need to step up their game. Investors will not receive your product at a discount. They will have very different expectations.

When you make a debt or equity offering for your company on a crowdfunding portal you are asking investors to help you to fulfill your dreams with their money. That is perfectly fine and in many ways is a process that is at the very core of the capital markets.

What do investors expect in return? If you have not asked that question and if you are not prepared to answer it, raising debt or equity capital in the crowdfunding market may be more difficult than you think.

Investors invest their money to make money. It may sound obvious until you realize that for crowdfunding investors it is very unlikely that it will happen. Most crowdfunding investors will lose their money.

Even if you are successful and profitable for many years crowdfunding investors will not be able to cash out of their investment in your company until you sell the company. That is one reason that many investors will select investments that pay dividends (preferred shares) or interest (debt offerings).

Your investors will be prepared to lose the money that they are giving to you. They know that all crowdfunded investments are speculative. They know that the best deals are likely to be scooped up by angel investors or venture capitalists. They know that despite your best intentions and best efforts most new businesses fail.

For smaller companies that want to use a crowdfunding portal for financing I cannot over emphasize the importance of being able to demonstrate to investors that your company can succeed. At the very least, you should be able to show investors that you have put the pieces into place to give your company a fighting chance.

Equity crowdfunding can be expensive and cutting corners can lead to problems and a campaign that does not get you the funds that you need. You are going to need an experienced securities attorney to prepare your disclosure documents and to guide you through the regulations. You are going to pay a portal for the privilege of listing your offering and you are going to need to fund the marketing effort to reach out to potential investors. If you are going to spend this money to reach investors, your offering needs to be strong.

Remarkably, many of the experts in the crowdfunding arena have never raised any significant amount of money from investors. Many cannot, themselves, tell a good deal from a bad deal. They certainly cannot gauge whether your offering will be well received by investors.

I have reviewed business plans and pitch decks from dozens of companies that want to raise funds through crowdfunding. From an investor’s point of view, many of these offerings are weak. Many people do not seem to appreciate that having a great idea or product is not the same as having a great business.

Equity crowdfunding will necessarily tap into a pool of investors who have had experience in the mainstream financial markets. If you expect them to invest in your business, you should be prepared to demonstrate at least the following:

1) That you understand your business, not just your product. Investors appreciate that you want to tell them that your product will sell millions of units, cure disease or become a ubiquitous part of everyday life. What they really want to know is about your business. Show them not only that people will want to buy your product but that you can produce it profitably, deliver it efficiently and sustain both.

2) That you will follow the rules. The most common abuse in the private securities market is that the marketing materials accompanying the offering are not complete or balanced. The sales pitch frequently exaggerates the positives to the exclusion of the negatives. If the video that accompanies your offering shows people saying things about your business that are very different from the disclosures in your official prospectus, you have a problem.

3) That you can tell investors what you really intend to do with their money. Vague statements in your prospectus that allocate funds for “research and development” or for “general corporate purposes” do not encourage investment. Specific details help investors to better gauge your business.

4) That you will spend investors’ money wisely. Hewlett and Packard, Jobs and Wozniak started out in garages. Why do you need an expensive  loft with a cappuccino machine and foosball? Make money first, buy toys later.

5) That you will allocate some money for reserves. The last thing that either you or your investors want is for you to run out of money just before you get to the finish line. You should plan for problems, delays and contingencies because they will happen.

6) That you have a full management team. Investors know that 4 techies and a CFO do not make a company. It starts with people with experience in the industry in which you will be operating. Investors like to see a marketing director with real experience selling similar products and a lawyer to help with contracts, problems and problem avoidance. If you are not yet ready for a full time marketing director or general counsel, at least have someone with marketing or legal experience on your board of directors.

7) That you have good, experienced and active advisers and directors. Frequently companies seeking investment dress up their board of directors with people with good resumes. Investors want to see a board with the experience to give you the advice that you will need. The same is true for your corporate attorney and accountants. However, if these people are not available to actually help you, then they do not belong on your board.

8) That you have a supply chain in place. It is fine if all you have is a prototype at this point, but if you expect to sell 100,000 units in the first year, please be ready to tell investors that you know where you will get those units and what they will cost.

9) That you know your competition. A formal market research report is preferable but if you plan to market a new toy, you should at least be able to say that you have been going to the New York toy show for a few years to see what other people are offering and that you have spent hours at Toys-R- Us or similar toy stores looking at other products.

10) That you are making realistic projections. Do not tell investors that 100 million consumers might buy your product. Tell them how many units you might reasonably procure and sell. Investors like to know that you know what it will take for your company to break even. Talk about astronomical profits after that.

11) That you have taken steps to protect investors and the company. If your product or design is patent-able, apply for a patent. If you are raising money from the public without Directors & Officers’ insurance you are just plain foolish.

12) That you have some skin in the game. Before crowdfunding the only option for people seeking to fund their small business was the Small Business Administration (SBA). The SBA requires collateral for the loans that they make. Usually the company owners or their family pledge the family home to get the funds. Sweat equity is fine, but if you, your family and friends do not have enough faith in your success to have put their hands into their pockets to get you started, why should investors?

This list is by no means inclusive. If you really want to raise capital from investors, your offering needs to be strong and you need to give investors what they want and expect.

If you would like to know how investors are likely to view your offering my partner and I will be happy to review the offering before you put it out on a portal. We will give you the benefit of our combined 85 years of experience raising money and dealing with investors.

We will charge you a ridiculously small amount for a detailed point by point written report, telling you how to make your offering stronger and how to make it stand out from other companies seeking the same funds from investors. We offer feedback, perspective and some constructive criticism that you will not find elsewhere. Call us when you decide to make an equity offering on a crowdfunding portal. We will save you time, money and disappointment.

What The Crowdfunders Forgot ….The Crowd

Capital Markets, Investors, Issuers , ,

My own interest in Crowdfunding goes back only about one year but there are few old timers like me in this now exploding corner of the capital markets. By now I have now read hundreds of articles and studies, spoken and corresponded with people who were instrumental in getting the JOBS Act passed and people who work in the Crowdfunding market every day.

I admit that I am fascinated by Crowdfunding. I see it as especially beneficial to smaller companies who can now raise capital in a regulated environment. Much of the literature focuses on the benefits of that capital to those companies and the benefits of those small companies to the general economy.

Very little seems to have been written on how this market will attract investors. If anything, there seems to be an attitude that suggests that ”if we build it, investors will come”.

Up until now, Crowdfunded offerings could only be purchased by “accredited investors”, wealthier people who are supposedly sophisticated enough to evaluate a private offering themselves and who are presumed to be wealthy enough to accept a loss if the investment tanked.

Before Crowdfunding accredited investors were sought out for private placements offered under Regulation D. Reg. D offerings are generally made through regulated brokerage firms where professional salespeople sell them to investors and are sometimes motivated by high commissions.

Crowdfunding is attempting to compete with these live salespeople using mostly passive portals and social media. It is not the same. Social media is just a tool. What Crowdfunding needs to embrace is a message that these investors want to hear.

A significant number of Reg. D offerings are real estate or oil and gas production syndications. In a great many of these offerings investors are promised a share of the rents or royalties or some other monthly or quarterly income stream. Some of these offerings offer tax benefits that are attractive to wealthy investors.

There are many established sponsors in the Reg. D market. These companies fund project after project through private placements. The larger sponsors can often point to a track record of success. By success I mean that prior investors were able to cash out for more than they invested.

Crowdfunding is too young for any company to post a similar track record. Crowdfunding counts its successes by how many companies get funded. As Crowdfunding matures it needs to judge its success by how many investors make money.

Only a small portion of the people who qualify as accredited investors actually invest in private placements. What exactly is the Crowdfunding industry doing to lure these private placement investors to Crowdfunding websites? The short answer is: not nearly enough.

The Securities and Exchange Commission (SEC) has recently opened Crowdfunding to all investors. Many smaller investors will be restricted to investing no more than $2000 on Crowdfunding portals each year. The SEC understands that with any Crowdfunded offering there is a high risk that the investors will could lose their entire investment.

Since we are speaking of only $2000 of non-essential income, it would seem more logical that people might opt to take that amount money to Las Vegas and put one dollar at a time into a slot machine. Statistically, slot machines pay out about 97% of the money that people put into them. Whether you ultimately win or lose has a lot do with when you stop. If you play a slot machine for long enough the casino is likely to buy you a beverage.

Investing that same $2000 in a small business through a Crowdfunding portal would have a significantly higher risk of loss and demonstrably less entertainment value. I see a lot of ads for Crowdfunded offerings and to date none has included a drink coupon.

The allure of Crowdfunding to any investor is the chance to cash out big. For the vast majority of Crowdfunded businesses that is very unlikely to happen even if the funded company is successful.

To date, there is no meaningful secondary market for Crowdfunded offerings. An investor who invests in a company that does well may still not get their money back to spend or invest in other offerings.

What will the Crowdfunding portals offer to entice any investor to bring money?

There is a lot in the Crowdfunding literature regarding the use of social media campaigns to sell offerings. This reliance upon social media actually highlights a weakness in the Crowdfunding system.

Investors who are solicited by a single company because they are suppliers or customers of that company or friends of the management have no reason to evaluate any other offering on the same portal or other portals. The portals should not expect these investors to become repeat customers.

If an investor does not get interest or a regular share of the profits, cannot cash out and has worse odds of success than at a slot machine, it is easy to see that the Crowdfunding industry still has will have some work to do. Once the “newness” of Crowdfunding wears off investors will need better deals and better incentives for investors.

 

SEC v. Ascenergy; Crowdfunding’s First Black Eye

Capital Markets, Investors, Uncategorized , , , , , ,

The Securities and Exchange Commission (SEC) has brought its first fraud enforcement action that occurred on a Crowdfunding portal  http://Ascenergy LLC et al. (Release No. LR-23394; October 28, 2015).  The Commission alleges that a Texas oil company called Ascenergy raised $5 million from 90 investors on at least four Crowdfunding portals including crowdfunding.com, equitynet.com, fundable.com and angel.com.

Ascenergy claimed to be raising funds to drill oil wells on leases that it had evaluated and secured. The investors were defrauded because Ascenergy had not secured any leases. The person whom the company claimed had evaluated the leases had not done so, did not work for the company and had not agreed to allow his name or resume to be used by Ascenergy to raise money.

Ascenergy used false and misleading facts and omissions to create a false legitimacy which the portals and the public readily accepted. The Commission noted that Ascenergy’s website contained false claims of partnerships or associations with several legitimate companies whose logos appeared on Ascenergy’s website, also without permission.

Investors were told that investing in Ascenergy was “low risk” and that its shares were “liquid” when they were neither. The vast bulk of the money raised was spent on what the SEC calls ”personal expenses” of the person who thought up this scam and who might have gotten away with it.

Scams like this are common in the mainstream Regulation D private placement market. It is more likely that the due diligence process at a Financial Industry Regulatory Authority (FINRA) member firm would not have passed Ascenergy along to investors. No FINRA firm would likely have allowed Ascenergy to call its offering “low risk” or “liquid”.

The SEC’s complaint charges Ascenergy with fraud under the same sections of the federal securities laws that the SEC has been citing for decades. The SEC has made it clear that it expects Crowdfunding portals to actively seek to keep scams off their websites. The SEC has been just as clear that the anti-fraud provisions of the securities laws absolutely apply to Crowdfunding transactions.

The final Crowdfunding rules encourage and almost mandate portals to become members of FINRA. FINRA has established guidelines for due diligence investigations for private placement offerings. The FINRA due diligence standards seem reasonable to adequately keep scam artists away from public investors.

As scams go Ascenergy was not particularly novel or complex. FINRA firms have conducted thousands of due diligence investigations of oil drilling programs over the years. No due diligence investigation properly done by a FINRA member firm would have let Ascenergy claim to have secured leases without verification.

The portals generally do not conduct anything close to this type of due diligence investigation. The investigations can be costly and most portals elect not to spend the money. Very few of the Crowdfunding portals even attempt to conduct a substantive investigation sufficient to catch the “bad actors” let alone the “bad” deals. But do the portals assume the risk?

If you were one of the 90 investors who purchased Ascenergy on one of the four portals listed above, send the portal an e-mail and ask for your money back. Tell them that you have been defrauded because the portal failed to do its homework. Please copy me on the correspondence. I am curious to see how much denial the Crowdfunding industry is in.

Let me predict the future. The next SEC enforcement action will not mention the Crowdfunding portals in passing. The next SEC enforcement action (or the one after that) will find the portals being named as defendants and subjected to significant fines. The SEC has no real budget for Crowdfunding enforcement. In my opinion the SEC’s Enforcement Division is more likely than not to make an example out of an offending portal to send a clear message to the Crowdfunding industry that they must actively attempt to keep fraudulent offerings off their websites. That is, if the industry did not get the message the Enforcement Division delivered in its complaint against Ascenergy.

If any of the portals or their advisers disagrees I would like to hear from them as well. The literature surrounding Crowdfunding is rife with experts who have little or no experience actually preparing securities offerings or raising money from investors. I have seen many articles by “good” lawyers suggesting that a due diligence investigation is an unnecessary cost or that a superficial investigation is sufficient for a small Crowdfunded offering.

The problems that the SEC found with the Ascenergy offerings should not have occurred. Investors should not have had their $5 million stolen. The four portals that facilitated Ascenergy’s fraud owe at least an apology to the investors who got scammed.

Some people in the Crowdfunding industry have already suggested that Ascenergy is an isolated case. As I have written elsewhere, there are a great many portals that are currently offering securities for companies that are obviously not telling investors the whole story. Perhaps it is a little easier for me to spot an investment scam because I have seen so many, but that is exactly the expertise that the portals need and lack.

The Crowdfunding industry projects $40 billion in Crowdfunded offerings next year. The bulk of these offerings will be executed by buyers, sellers and portals that are mostly novices in an uncharted and unregulated market. If you wanted to commit securities fraud, what better opportunity could you find?

The Crowdfunding industry is justifiably jubilant about its prospects for success. Small companies have good reason to cheer this large infusion of new capital. But are the investors jubilant? Certainly not the 90 people who put up $5 million for the securities sold by Ascenergy.

I would advise crowdfunding.com, equitynet.com, fundable.com and angel.com to carefully consider their position should any defrauded customer correspond or a member of the financial press come knocking. A public pronouncement that due diligence is unnecessary or that a cursory investigation is sufficient will likely be used against you in a court of law.

The crowdfunding industry has very few investors who are loyal to one portal over another. It should be obvious to the industry that exposing investors to scams like this will not build loyalty, but will send investors back to their stockbrokers at mainstream brokerage firms.