September 2021- Crowdfunding at the Crossroads?

September 22, 2021September 22, 2021 crowdfunding, equity crowdfunding, Issuers crowdfunding platforms, JOBS Act, Securities and Exchange Commission

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Start-ups Don’t Have to Fail

August 20, 2020November 6, 2020 Capital Markets, equity crowdfunding, Issuers crowdfunding, JOBS Act, start-ups

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

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

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

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

Economics

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

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

Start-ups Don't Have to Fail

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

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

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

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

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

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

Start-ups Don't Have to Fail

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Or you can book a time to talk with me HERE

Investment Crowdfunding Can Offer Better Investments Than Stockbrokers

June 17, 2019June 30, 2020 Capital Markets, Investors, Issuers crowdfunding, crowdfunding platforms, JOBS Act, Reg. CF, Reg. D

Investment Crowdfunding

Someone in the crowdfunding industry should put that sentence on a coffee mug and send me one.

I have been writing about and working in investment crowdfunding for more than 3 years. I find it interesting to watch this fledgling industry mature. It is certainly attracting more and more new money every year and is past the point where it can be ignored by any company in search of investors.

I have looked at a great many offerings on a great many crowdfunding platforms. I read a lot to keep abreast of new offerings and industry developments. I take the time for conversations with platform owners and their lawyers and several of the better investment crowdfunding marketing executives.

I also speak with a lot of companies who are considering investment crowdfunding to raise capital. Any company that would raise capital in this new DIY crowdfunding marketplace wants to know if it spends the money to list its offering on a crowdfunding platform will enough investors show up and invest? From the company’s perspective, little else really matters.

The JOBS Act was intended to be a different approach for corporate finance using the internet instead of a stockbroker to reach potential investors. The internet allows companies to reach a lot of prospective investors, very cheaply. Success or failure in investment crowdfunding is more about what you have to say to those potential investors than anything else.

Selling securities issued by your company to investors is not the same as selling your product or service to potential customers. Investors will have different expectations and will respond to different things.

People who sell securities for a living will tell you that any new issue of a stock or bond needs two things: good numbers and a good story. Investors want a return on their investment.

So the best stories are always about how much money the investors will make and what the company will do to provide that return.

There are two distinct branches of investment crowdfunding. First, there are the private placements sold under Reg. D to institutions and other larger, accredited investors. This marketplace is healthy and growing rapidly. Professional money-raisers have caught on that they can use investment crowdfunding, to substantially reduce the cost of capital and use that savings to enhance investor returns.

Reg. D offerings have been sold through stockbrokerage firms since the 1980s. Most are sold to institutional investors. Some are sold to individual, accredited investors. Minimum investments of $50-$100K or more per retail investor are common.

Many of the retail Reg. D offerings will fund some type of real estate (construction or purchase), energy (oil, gas and alternative energy) or entertainment (films, music, and games) project. There are professional sponsors; people who package and syndicate these projects, often being paid to manage the business on behalf of the investors after the funding.

The costs of selling a Reg. D offering through a stockbrokerage firm, including commissions, run 12%-15% of the funds raised. That would be up to $1.5 million for each $10 million raised.. Most Reg. D offerings sold through brokerage firms just raise an additional $1.5 million and dilute the investors’ return. Using investment crowdfunding a company can raise that same $10 million and not spend more than $100,000 in legal and marketing costs and frequently a lot less.

The Reg. D crowdfunding platforms compete with stock brokerage firms for projects to fund and for investors to fund them. The same institutions and accredited investors who have been purchasing Reg. D offerings from their stockbrokerage firm for years are catching on to the fact that they can get good offerings and better yields without the need to pay the very high commission.

The other branch of investment crowdfunding is the Reg. CF or regulation crowdfunding. This allows offerings which can help a company raise up to $1 million from smaller, less experienced investors. Reg. CF allows smaller businesses to sell small amounts of debt or equity to small investors.

The Reg. CF market was the SEC’s gift to Main Street American small businesses. There are always a great many small companies that could benefit from a capital infusion of a lot less than $1 million, the Reg. CF upper limit.

To put down a layer of investor protection the SEC required that these portals that are dealing with small investors become members of FINRA. FINRA dutifully set up a crowdfunding portal registration system and has audit and enforcement mechanisms in place.

As a reward for joining FINRA, the SEC allows Reg. CF portals to be compensated by taking a percentage of the amount the company raises which the Reg. D platforms cannot. Several of the portals also take a “carried interest” in every company in case the company is eventually re-financed or sold.

The SEC looks at Reg. CF as a tool of corporate finance for small business. It provides a mechanism where a great many small businesses should have access to a pool of capital every year, potentially a very large pool. It provides for a market structure for these small offerings and incentivizes the portals help raise that capital. All in all, not too bad for a a government regulation.

Sadly, the Reg. CF industry is still foundering. There are still fewer than 40 registered portals operating and several have closed up shop. So why are these portals not successful? Because the people who operate them are not listing better investments than stockbrokerage firms.

When I first looked at investment crowdfunding there were a lot of people proclaiming that it would “democratize” capital raising. They believed that the crowd of investors could discern good investments from bad ones and that the crowd would educate each other as to the pros and cons of each. That was never true.

The Reg. CF portal websites are full of bad information and consequently, bad investments. “Comments” about any offering that lists on a portal, if any, are always overwhelmingly positive. Investors will not do any due diligence or other investigation of the company because they do not know how.

The Reg. CF portals compete with banks, which are the primary source of funding for small business. Here too, a Reg. CF portal can have a competitive edge. When you borrow from a bank you do so on the bank’s terms. On a Reg. CF platform you can set the terms of your financing. Done correctly, you can get the capital infusion you want for your company without giving up too much equity or pledging your first-born child to the lender.

What the portals should be offering investors are bank-like products that stress the ROI that investors reasonably might expect to receive. The portals should be telling investors how each company mitigated the risks that the investors might face. Instead, too many portals and too many people in the Reg. CF marketplace are still selling fairy tales and lies.

The big lie, of course, is that by buying equity in any of these companies an investor might hit the proverbial home run. Suggesting that investors can or should think of themselves as VCs is patently absurd for any company that I have seen on a Reg.CF portal. I always tell people who ask that if even one valuation on a Reg. CF portal seems very outlandish, then they likely cannot trust that the portal operator knows what they are doing. I would question anything told to investors by any company that lists on that portal.

If a company wants to raise $1 million on a Reg. CF portal, it might end up with 2000 distinct investors each investing an average of $500. To secure subscriptions from 2000 people, the company might need to put on a marketing campaign that will put its offering in front of hundreds of thousands of investors if not more. Success or failure of your fundraising campaign will depend on what you say to these people.

The cost of the marketing campaign is the major upfront cost of the offering. The good news is that marketing seems to be more data- driven and more efficient as time has gone by reducing the cost of the marketing.

Sooner or later these Reg. CF portals will wise up to the idea that they cannot succeed unless the investors can make money. They, too, could offer better investments than stockbrokers, but do not seem to have bought int the idea.

Until that happens, I expect more portals to fail and close up shop and the SEC’s “gift” to small business to remain largely unwrapped.

DreamFunded – Crowdfunding the Dream – Poorly

October 22, 2018 Capital Markets, Investors, Issuers crowdfunding, crowdfunding platforms, due diligence, FINRA, JOBS Act, start-ups

One of my pet peeves about the crowdfunding industry is that the so-called professionals take Pollyanna views of bad acts and bad actors. They ignore felons and felonies. When someone screws over investors, they make excuses or worse, simply ignore it.

When the SEC brought its very first action against a crowdfunded offering, Ascenergy, I wrote an article about it. I called out how the lack of due diligence would be a problem for the industry. That was in 2015. A lot of people told me then that the crowdfunding industry would get its act together.

In 2016 when FINRA brought its first action closing down crowdfunding portal UFunding, I wrote an article pointing out the need for better compliance for crowdfunding portals. The crowdfunding industry gave a concerted yawn.

I have written several articles about companies that were raising money on crowdfunding platforms that looked and smelled like scams. No one else seems willing to do so. The idea of protecting investors from scams and scam artists seems to be an anathema to the crowdfunding industry.

So I really was not that surprised when someone sent me a disciplinary complaint that FINRA had lodged against one of the better known Reg. CF crowdfunding portals last April. Even though the industry publications had published every press release and puff piece about this portal while it was operating, I could not find even a mention of the FINRA complaint in the crowdfunding media, let alone a serious discussion about what this platform had done wrong. Perhaps I missed it.

It is not like FINRA’s complaint was not noteworthy. The portal, DreamFunded, was owned by Manny Fernandez a serial angel investor, CNBC celebrity, White House invitee and noted author who has appeared on many TV shows and podcasts and in article after article about crowdfunding. If you are going to run any business having a celebrity out front is usually an asset. But that does not mean that a celebrity can run the business.

Mr. Fernandez was able to assemble a large group of well credentialed advisors for his portal, some of whom were angels and VCs, but all of whom apparently lacked experience in the business that the portal was set up to do, sell securities to investors. No competent securities attorney was involved even though selling securities is a highly regulated business.

The crowdfunding industry is supposed to follow those regulations but quite often does not. FINRA’s complaint against DreamFunded and Mr. Fernandez lays out a road map exactly on how not to run a crowdfunding portal. And, again, the industry has ignored it.

At the heart of the complaint is the fact that companies that were selling securities on the platform were lying to investors or making unsupported claims about their business. That is securities fraud, plain and simple. Every crowdfunding platform or portal is supposed to take steps to see that it does not happen. DreamFunded listed fraudulent offerings on its portal even when the fraud was obvious. And worse, Fernandez affirmatively told lies to investors himself to help at least one of those companies scam investors.

DreamFunded operated as a funding portal beginning in July 2016, shortly after Reg. CF became effective, until November 2017 when FINRA apparently began to ask questions about its operation. During that time, it managed to list only 15 companies. How many of those offerings actually raised the funds they were seeking is not disclosed. FINRA takes specific issue with three of the offerings.

The first was a social networking company that had no assets, revenue, or operating history. Notwithstanding, it claimed a $1 million valuation without providing any support or basis for that valuation. Valuation of pre-revenue start-ups is a significant problem in crowdfunding but you will not find a discussion about it at any of the industry conferences.

The company also claimed that it was in a “$9B market,” that it could achieve a “$900MM+ market cap” and that it projected 100 million active users by its fifth year of operation. The company claimed that its exit strategy was to be acquired at a sales target of $500 million, which would provide a significant return to investors. The company then listed numerous well-established internet and technology companies as potential “strategic acquisition partners” with no basis or support for doing so.

The company closed its offering early without notifying investors as it was required to do. “DreamFunded, through Fernandez, transferred the investor funds raised through DreamFunded’s portal to the personal checking account of the company’s CEO. Communications from the CEO available to DreamFunded and Fernandez at that time indicated that the relevant checking account had a negative account balance and was being charged overdraft fees.” No competent securities lawyer would have allowed that to happen but apparently consulting with an attorney who understood this business was not in Mr. Fernandez’ playbook.

The second of those offerings involved a health and wellness company, which claimed assets of less than $5,000 and prior-year (2016) revenue of $12,250. Elsewhere it also claimed assets of $2.3 million, which it attributed almost entirely to an online content library, though it provided no support or basis for this valuation.

Moreover, the company’s “business plan” projected 2017 revenue of $500,000 and 2018 revenue of $2 million but provided no basis or support for these projections. According to FINRA, the company made unrealistic comparisons between itself and established companies and falsely implied that it was endorsed by a leading entertainment and lifestyle celebrity.

DreamFunded stated on its website that it followed the Angel Capital Association’s “strict due diligence guidelines,” the purpose of which was to “mitigate investment risk by gaining an understanding of a company and its market.” DreamFunded also claimed that the firm’s “due diligence and deal flow screening team screened each company that applied to be featured on the DreamFunded platform.”

DreamFunded and Fernandez did not follow the Angel Capital Association’s due diligence guidelines. Likewise, DreamFunded did not have a due diligence and deal flow screening team. Its claims of due diligence and deal flow screening were false and unwarranted and were designed to mislead investors into a false sense of security regarding the level of due diligence conducted with respect to the offerings featured on the DreamFunded portal.

There is a horrible lack of real due diligence in the crowdfunding industry but that is really not the problem here. In plain English, the problem here, in my opinion, is Mr. Fernandez’ lack of honesty and integrity. The problem is that Mr. Fernandez apparently has a problem telling investors the truth.

Fernandez was a guest on a cable television network program that purported to match inventors with investors. On the program, Fernandez claimed to have invested $1 million for 30 percent ownership in a third company which subsequently conducted an offering through DreamFunded’s funding portal. Fernandez had not, in fact, made any investment in the company. His statement that he had made an investment was a lie and it seems that it was intended to help that company successfully complete its offering on the platform.

Despite the fact that he lied to investors, I am confident that Fernandez could have settled this complaint with FINRA and would have been permitted to continue to operate DreamFunded provided he cleaned up his act. There are larger FINRA member firms which have done far worse that FINRA has fined but whose memberships they have not revoked. But Mr. Fernandez’ duplicity did not end with lying to investors, it looks like he lied to FINRA as well.

From the FINRA complaint:

“On January 5 and January 19, 2018, DreamFunded and Fernandez provided limited document productions in response to only a subset of the requests contained in the Rule 8210 request. For example, they did not produce financial records, bank account statements and investor agreements responsive to the request. Without such documents, FINRA staff was unable to fully investigate whether Fernandez and/or DreamFunded violated additional rules in connection with their fundraising efforts conducted ostensibly on behalf of DreamFunded.

The January 19 production was accompanied by a doctor’s note representing that Fernandez was ill and unable to work between January 17 and January 20, 2018. In light of the doctor’s note, FINRA staff granted DreamFunded and Fernandez yet another extension of time, until January 29, 2018, to provide a complete response to the Rule 8210 request.

On January 25, 2018, new counsel informed FINRA staff that he too would no longer be representing DreamFunded or Fernandez. The following day, Fernandez sent FINRA staff a second doctor’s note, this one dated January 23, 2018, which stated that Fernandez would be unable to resume a normal workload until February 5, 2018. The note did not identify any illness that Fernandez was suffering from or otherwise specify the reason for his alleged inability to work. Moreover, during the time period when Fernandez claimed he was incapacitated, his social media posts indicate that he traveled out of town to enjoy, among other things, a film festival in Salt Lake City and a concert in Las Vegas.”

In truth, Mr. Fernandez did not want to maintain his membership in FINRA. At the first whiff of the investigation he filed the paperwork to withdraw his membership and just walked away.

What he left behind were perhaps thousands of investors who were defrauded and a number of start-ups and small companies that may be sued by those investors. These are investors who gave crowdfunding a try and who are unlikely to give it a try again. As I said, the crowdfunding industry has refused to condemn this fraud and in my opinion is shooting itself in the foot by ignoring it.

Operating a crowdfunding platform can be a very lucrative business. There is no shortage of small companies looking for funding. Several of the Reg. CF portals charge 7% of the money that a company raises and take a carried interest in the companies which can be very valuable if one actually takes off. I can tell you from experience that a good portal should be able to raise $2-$3 million a month or more. Paired with a Reg. D platform side by side, a good team could demonstrate that the JOBS Act can deliver everything it promised.

I have actually worked in the securities industry; this is my home turf. If I had a backer, I would open a crowdfunding portal tomorrow because a well run portal can make a lot of money. (This is a serious request. I am actually looking for a backer who wants to make more than reasonable ROI. Send me an e-mail if you want to fund a crowdfunding portal run by a serious team of professionals.)

As for Mr. Fernandez, like a lot of people who failed at crowdfunding he has apparently moved on to greener pastures. He currently speaks at crypto currency conferences and undoubtedly holding himself out as a financial “professional”.

The crowdfunding industry is busy lobbying Congress asking it to change the rules to make it easier for more small investors to participate in this marketplace. Perish the thought that they should spend any time or effort cleaning their own house first. Lobbying for more investors without real compliance with the existing rules and protecting the investors they already have is really a waste of time.

Crowdfunding Successfully

August 21, 2018 Capital Markets, Investors, Issuers crowdfunding, crowdfunding platforms, JOBS Act, Reg. A+, Reg. D, start-ups

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Conning the Crowd

February 20, 2018 Capital Markets, Investors, Issuers crowdfunding, crowdfunding platforms, JOBS Act, Reg. A+

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

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

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

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

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

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

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

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

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

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

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

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

Case in point.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Equity Crowdfunding 2018

January 4, 2018 Capital Markets, Investors, Issuers crowdfunding, crowdfunding platforms, JOBS Act, private placements, Reg. A+, start-ups

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

December 20, 2017 Capital Markets, Issuers, Law Bitcoins, crowdfunding, Crypto-currency, JOBS Act, Securities and Exchange Commission

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

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

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

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

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

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

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

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

So what, exactly, did Munchee do wrong?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Any Good Business Can Get Funded

October 10, 2017 Capital Markets, Issuers crowdfunding, JOBS Act, Reg. D, start-ups

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Behind the Crowdfunding Curtain- StartEngine Goes Public

September 25, 2017 Capital Markets, Investors, Issuers crowdfunding, crowdfunding platforms, JOBS Act, Reg. A+

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Law and Economics in Capital Markets

Thoughts and essays by Mr Irwin Stein

JOBS Act