Republic’s Restaurant Razzle Dazzle

Republic’s Restaurant Razzle

A pizza restaurant in Houston filed for bankruptcy last week. While that might get a yawn from people who think that 90% of restaurants fail anyway, there is a story here that is a little different; one centered on its crowdfunding campaign.  

There is a world-renowned cooking school in San Francisco, the California Culinary Academy (CCA). It offers professional chefs a semester-long course in restaurant management. It includes how to price menu items, how to sell the menu items that produce a higher margin (typically appetizers and desserts), how and where to advertise, and items of “kitchen economics”. The latter includes how to select and deal with vendors and manage multiple chefs in a kitchen.   

There are established formulas regarding the ratio of food/beverage sales that guide restaurants to greater profitability. There are myriad case studies reviewing both successful restaurants and failures available for review.   

Pizza restaurants are used as a basic example of a simple and profitable restaurant operation. I offered the same breakdown of a pizza restaurant to my students when I was teaching Economics to business school students. It is a simple demonstration of superior efficiency and profitability. 

The owner of a pizza restaurant can stop by the market in the AM and pick up everything needed to make enough pizzas for one day’s business.  Your one-day inventory will be turned back to cash by the end of the day.

Very few businesses offer the opportunity to profit from that type of high-speed inventory turnover.  Too much Inventory in the freezer can impact a restaurant’s cash flow. 

Selling pizza and beer together is almost always a winning combination.  A $30 check for a large pizza and a pitcher of beer might cost the restaurant less than $5.00-$7.00 in ingredients, a very high mark-up, combined with the very high turnover. 

The Houston pizza restaurant that filed for bankruptcy was called Shoot the Moon. It opened in the middle of the pandemic which clearly increased the difficulty of filling the seats. But that is not what killed it.

NextSeed

The crowdfunding campaign for Shoot the Moon, and several other Houston-based restaurants, was hosted on a crowdfunding portal called NextSeed. NextSeed is now part of Republic, one of the largest crowdfunding portals.  

Shoot the Moon was trying to raise $535,000 to finish construction of its restaurant, purchase equipment and train its staff.  The offering was structured to give investors 10% of the revenue, that is, $1 for every $10 that rang through the cash register.

This type of revenue-sharing agreement is common in crowdfunding. NextSeed used it over and over to fund other restaurants. With proper marketing, Shoot the Moon’s offering might have sold out quickly.

Instead, the offering initially stalled at $140,000. According to the owner of Shoot the Moon, NextSeed suggested that he offer “perks” such as free beer to investors as an inducement to invest. NextSeed had used this same gimmick to help at least one other tap room in Houston raise capital.

The owner of Shoot the Moon apparently told NextSeed that he thought that he was not allowed to offer free beer because it was illegal. NextSeed advised him to offer free pizza instead.

Let me stop the narrative at this point. If one Houston restaurant that is selling food and beer can accept NextSeed’s advice and give away free beer and another selling food and beer thinks that it cannot, it should certainly raise a red flag that one or the other is incorrect.

Mr Chu

One of NextSeed’s founders, Mr. Abraham Chu, has an MBA from a very fine business school. I would think that something like this might have gotten his attention and the correct answer ascertained. 

Put aside for a moment the fact that no business school teaches that modern finance requires that you should give investors “perks” in order to raise capital. Business schools still teach that investors seek ROI more than anything else. The owner of Shoot the Moon says that supplying all the free perks that NextSeed advised him to offer negatively impacted his working capital.

The perks were enough to increase the total amount raised to $410,000. The owner of Shoot the Moon has said it paid a total of $80,000 to raise $410,000 which is more than a Wall Street firm would have charged to raise the same amount as a private placement. Wall Street firms don’t require issuers to give away free beer or pizza.

The raise netted Shoot the Moon closer to $330,000. The offering was clear that it was trying to raise $535,000, the amount it said it would need to get its business off the ground. That too should have been a pretty big red flag, which NextSeed ignored as it permitted the offering to close and took its fee. 

Shoot the Moon did open its doors and it made sales, 10% of which should have been paid to the investors. Its owner acknowledges that the payments were due from day one, but that he has not been able to make them.

NextSeed, for its part, interposed itself between the restaurant and the investors as the “collateral agent” for the transaction. I haven’t reviewed the exact paperwork, but it does raise some questions why the portal thought that it needed to do so. 

It seems that the only “collateral” supporting the offering from which investors might recoup their investment if the restaurant fails, would be the used restaurant equipment, some of which might be sold at $.10 on a dollar; the rest simply discarded. Calling it “collateral” is somewhat misleading.

It is clear that NextSeed was supposed to monitor the payments and notify the investors if there was a default. NextSeed was clearly aware of the default at Shoot the Moon and at other restaurants it had helped to fund but decided not to notify investors or declare a default. 

Mr. Chu has been quoted as saying that NextSeed’s policy regarding defaults was changed several times after offerings had closed.  Republic, which purchased NextSeed in 2020, apparently thought this was a good idea because it did not begin to send out notices of the defaults until April of this year.

In the real world, if you can negotiate the deferral of a payment that has come due, there is usually a penalty to be paid. I have seen nothing to indicate that NextSeed/Republic negotiated any additional payments to the investors to compensate them while waiting for their payments. Had there been a formal contract providing for a deferral of payment by each of the restaurants, they might not be in default today, and Shoot the Moon might not be in bankruptcy. 

Two things stood out to me.

First, If Shoot the Moon had an initial capital requirement of $535,000 but settled for $410,000 the first question should be: “what got cut from the budget?”  In all likelihood whatever got cut from the budget increased the risks of failure of the venture.

One item that was apparently absent from the budget was any cash reserve.  Even if Shoot the Moon sales were $10,000 in its first week of operation, it could not spare $1000 to pay investors.  Because the smaller raise probably added to the risk of failure, Shoot the Moon might have been better advised to up the ROI rather than provide free pizza to attract investors. 

Second, was the question of whether it was legal to give away free beer in support of the offerings.  Confronted with that assertion that it was not, NextSeed did not say that it was legal, or even, “let us check with our lawyers” but rather advised that the restaurant give away pizza instead, which was much more costly. 

NextSeed has clearly advised other restaurants that free beer was okay.  Did NextSeed’s failure to help Shoot the Moon understand that free beer was permissible to torpedo its opportunity to raise more money? Should NextSeed have told Shoot the Moon that there were less expensive ways to attract investors?

Crowdfunding

Let me repeat something that I have been saying for quite a while now: every well-run crowdfunding campaign should be able to raise 100% of the funds it seeks, 100% of the time.  The idea that a company should offer free beer, pizza, or other perks in order to have a successful campaign is simply false.

NextSeed apparently gave that very bad marketing advice to a number of companies. I wonder how many companies spent their money foolishly following the advice and who now wish that they had never engaged in these expensive, unnecessary promotions.

Republic has positioned itself between the restaurants and the investors. Does Republic intend to act as the investors’ champion or is this just damage control on Republic’s part?

If investors begin to question Republic’s financial responsibility for the very bad advice that NextSeed gave, again and again, they are likely to get stone-walled.  With reports that investors in NextSeed offerings may have already lost $2.4 million, I suspect that Republic will tell those investors to go cry in their beer. 

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

Or you can book a time to talk with me HERE

KingsCrowd – Again

kingscrowd-again

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why do I even care? 

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

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

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

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

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

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

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

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

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

Case in point:

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

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

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

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

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

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

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

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


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

 

KingsCrowd- selling ratings for fun and profit

kingscrowd

The thing about crowdfunding is that it attracts people who are paid to introduce investors to companies that have little to offer. The worst, of course, are those who know that the companies have little chance of success and hype the hell out of them anyway.

So I was particularly interested in a Reg. A+ offering filed by KingsCrowd, a publication that covers the Reg. CF marketplace and companies that are seeking funds.  KingsCrowd has a “patent-pending AI-driven startup rating algorithm” from which it intends to rate the various offerings on the Reg. CF funding portals.  

In its own words, KingsCrowd will “empower individual investors to make intelligent startup investment decisions on platforms like Republic, Wefunder, SeedInvest, Netcapital, etc., by providing institutional-grade research tools for assessing the thousands of investment opportunities available to investors at any one time.”

Given that 90% of start-ups will inevitably fail, any algorithm that can sort likely winners from likely losers would be welcome.  Even if unable to identify the 10% that will succeed, eliminating the bottom 10% or more that have no chance at success would benefit investors as well. 

KingsCrowd already tracks and rates “every Reg. CF investment opportunity in the United States.” It has a system to research and rate Reg. CF issuers. The only question is does their algorithm work?  How good is their research? What constitutes “institutional-grade” research anyway?

CalPERS, the largest public employee’s pension fund manages a multi-billion dollar portfolio.  It employs several hundred research analysts to oversee that portfolio and to make specific buy/sell recommendations. Other funds and money managers around the globe use much the same data and much the same methods to analyze that data.  Generally accepted methods of securities analysis are taught in business schools and have been for decades.

If that is “institutional-grade” research and analysis then I needed no more proof that KingsCrowd does not provide it than the fact that it gave itself a “pre-money” valuation of $45 million.  There is no way that analysis that produced that valuation can be called “institutional-grade”. The numbers just do not add up.

KingsCrowd says that it collects “more than 150 data points on each issuer, including information relating to its team, its market, financial statements, traction with consumers, and competitors. Our investment research team collects data from multiple sources such as the issuers’ pitch decks, capital raise pages on all of the funding portals (including all Reg CF funding portals such as Wefunder, Republic, Netcapital, SeedInvest), news articles and announcements, social media, founder profiles and resumes, recruitment websites, the SEC filings, growth data provided by the companies and information derived from alternative data sources.” 

I do not think that I need tell you that data in “pitch decks” and “growth data provided by companies” is often exaggerated. Information on the funding portals is often unverified.  What I was hoping for was for KingsCrowd to bring some amount of real financial analysis to this marketplace.  To even begin the process it would be necessary for the data used on Reg. CF funding portals to be accurate.  It isn’t.

KingCrowds’ “algorithm uses a comparative modeling approach to rank and score all companies actively raising capital from the markets across the various key dimensions deemed notable in the rating algorithm and traditionally utilized by venture investors to make informed investment decisions.” 

Forget for a minute that the phrase that ties “venture investors” with “informed investment decisions” is itself an oxymoron.  I worked for VC funds and I have dealt with them as a representative of a company being funded, repeatedly, beginning in the 1970s. Funding has always been more about who you know than what you were selling. The days of an MBA as a requirement to be a “venture capitalist” are a receding memory.

I would think that if KingsCrowd’s algorithm really identified better investments, one of the VC funds would have scooped it up.  When you break down what they do, you can see that it is more smoke and mirrors than mathematics.

At the end of the day, KingsCrowd’s patent-pending AI-driven startup rating algorithm yields a rating that is a number between 1 (lowest score) and 5 (highest score) for every aspect of the issuer, including price, market, differentiation, performance, team, and risk, as well as an overall score for the issuer at a specific funding round.

Given that many of the start-ups being funded have neither income nor profits, the metrics of “performance” may be more subjective than one might expect. KingsCrowd seems to intimate that what they are identifying are companies that had a successful capital raise, not successful companies.  If that is true, they are on a fool’s errand. And, while I always help clients structure their offering to present an investment that will be attractive to investors, success in crowdfunding is often about how you market the offering and how much money you put into your marketing campaign.

Giving a numerical score to a “team” also seems quite subjective. KingsCrowd itself has only 3 employees and a “team” of outside advisors. Christopher Lustrino is a founder of the Company, Chief Executive Officer, President, Chief Financial Officer, Treasurer, and also a member of the Board of Directors. If these positions had been filled with qualified people would the “pre-revenue” valuation have been $60 million? More?

Some VCs and angel investors like a founder to have some skin in the game and invest their own money. Lustrino is selling $1 million worth of his stock in KingsCrowd as is one of the early investors. The fact Lustrino needed to sell his shares costs the company an equal amount.

KingsCrowd is also concurrently offering the same shares to investors in a private placement offering under Regulation D. They are raising a total of $15 million which, if the company had something to offer, would have been cheaper and easier to accomplish using only the private placement.

Under current law, however, Lustrino cannot sell his shares or those of the early investor, using Regulation D. To sell his shares, Lustrino needed to have the company prepare and file the offering using Regulation A+.

In the normal course, the shares being sold under Reg. A+ would be the subject of a commission, here 7%.  Shares sold on a crowdfunding platform using Reg. D do not pay a commission unless the platform is a licensed broker/dealer.

Lustrino arranged to have this offering placed with a broker/dealer affiliated with one of the Reg. CF funding portals, Republic. He has agreed to pay that broker/dealer 7% of the entire $15 million or more than $1 million. That is the fee the company will pay to liberate 2,000,000 shares being sold by Lustrino and his partner.     

The issue is more than the fact that KingsCrowd is spending money that it did not need to spend. The funds would certainly be better spent hiring a CFO to watch over the investors’ money.

KingsCrowd is essentially giving $1 million to a company whose offerings it will rate. This kind of conflict of interest would, in my opinion, negate any rating KingsCrowd issues on a company listed on Republic and likely its competitors as well. As importantly, by selling his shares, Lustrino gives the impression that he has one foot out the door, ready to ditch the algorithm with little utility and ready to fund his next company.

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

Start-ups, are you buying investors online?

Start-ups, are you buying investors

I have been writing a lot about crowdfunding lately and speaking with other people in the crowdfunding industry.  From our conversations, it is obvious that most do not share my perspective on the entire business.  I see crowdfunding as continuing an evolution of the capital markets already in progress when I started on Wall Street in 1975.

In 1975 the stockbroker was king. People did not buy investments, I was told early on, stockbrokers sell investments.  Good stockbrokers, especially those on their way up, aggressively sold stocks. The sales pitch was often about one particular stock, frequently supported by a report prepared by research analysts.  Analysts were “ranked” every year and firms paid the “1st, 2nd and 3rd All-American teams”, handsomely.

While there were certainly stockbrokers who met their clients for lunch or at the club for golf who came back to the office with orders in hand, much of the “selling” was done over the telephone.  Young brokers were encouraged to stay into the evening and engage in a ritual known as cold calling.

During my training, I spent an evening with a single page from the NYC phone directory, script in hand, dialing for dollars. Most people had those old, heavy rotary phones.  I swear, I could hear the receiver sucking in air as it was being slammed down onto its cradle.

What cold calling teaches us is that some percentage of the calls you make will respond favorably, and buy what you are selling.  If you want to make more sales, you need to make more calls.

I mention this only as a backdrop.  This “sell-side” focus has shifted, significantly. Today, a great many retail stockbrokerage customers, make their own decisions about what to buy and what to sell in their stock or retirement accounts.  These customers are enticed by lower costs. They respond to advertising, and they will rely upon information delivered to them online.  Without these investors, crowdfunding could not exist. 

If I were teaching Law and Economics today, I would look back to 1975 and say that is where it all started.  Changes in the law, a new one enacted and an old one discarded, were the catalysts for enormous changes in the way the capital markets operate. The market responded to those changes by bringing in millions of new people who were affirmatively looking to invest and who brought trillions of new dollars with them.   

ERISA, enacted in 1974 created the tax-deferred Individual retirement account (IRA).  It was intended to incentivize millions of small savers to put their money into a bank or the stock market and to leave it there for the long term. 

In response to this new market of small investors who might start small and add a few thousand dollars every year, John Bogle opened the Vanguard Mutual Funds. Mutual funds provided a simple way for small investors to participate in the market.

Mutual funds had been around for a long time by then.  They were commissioned products sold by many stockbrokers.  And while an IRA account was the perfect vessel for mutual funds, what I would stress to my students would be the shift in the way mutual funds were advertised and sold directly to investors.

Vanguard and the other mutual funds actively advertised for investors seeking to make direct purchases.  Instead of dealing with a stockbroker who would call whenever they had, something that they wanted you to buy or sell, with a mutual fund, an investor could just put their money into a fund and the fund will do it all for you.  Somebody called it “passive investing”. Instead of touting the skill of their analysts to pick winners, these mutual funds sold convenience.

In 1975, both the State of New York and the City of New York were functionally bankrupt. The stock market had tanked and lending had ground to a halt.  The economy was in the midst of abnormal inflation.  People responded to the idea that they take some risk to grow their retirement funds in the stock market rather than save it in a bank so they could keep up with inflation.

Also in 1975, the New York Stock Exchange repealed its long-standing rule that had fixed the commissions that NYSE Members charged for each trade.  Mainframe computers were being installed up and down Wall Street. The costs of everything from executing trades to sending out confirmations and monthly statements were going down.

When commissions were fixed, the customer was charged a commission that reflected both the costs of execution and the “other” services that the brokerage firm provided, most notably, research that would tell the customers what to buy and when to sell. As commission costs became a source of competition, Charles Schwab and others were already talking about “unbundling” the cost of executing a trade from the research component that had always come with it. 

Schwab and its “discount” competitors demonstrated that a great many investors were happy to sit at home and make decisions on what to buy and what to sell, based only on what they read themselves. And while Schwab and other discount brokers now offer research reports, very few customers of discount firms are exposed to the type of research available to institutions. 

The stockbrokers’ response to this unbundling can be encapsulated in their advertising slogans of the time: “Thank you, Paine Webber”; “When EF Hutton talks, people listen” and my personal favorite: “Smith Barney makes its money the old-fashioned way, they earn it”.  The mainstream industry doubleddown; they were selling advice and they were proud of it. 

Without good advertising and a lot of it, the full-service stockbrokers, the discount firms like Schwab, and the entire mutual fund industry would not have grown into the behemoths that they are today.  The result of all of that advertising is a market full of millions of investors who are comfortable making their own investment decisions.  This includes a significant number of baby boomers who still represent a very large pool of capital that is available for investment. 

What does this have to do with crowdfunding in 2021?

If I have learned anything from watching the growth and evolution of this market since 1975, the one thing that stands out is that for companies that are selling investments, good advertising works. There is a cost, certainly, of acquiring investors for any given offering, but if you pay that cost, you will get enough investors to pony up the investment that you seek.

The best people in marketing who are working in crowdfunding understand that it is very much a “numbers game” just like “cold calling”, although now much less expensive and efficient. Modern data mining techniques enable each company that is seeking investors to present its offering to an audience that is more and more specifically targeted. 

I call it “buying investors online”. What do you call it?

I have sat in marketing meetings for various players in the financial services industry many times. Depending upon what these companies are selling and to whom, the marketing and sales strategies differ greatly.

The common denominator of these varied strategies is that they are all measured by the same standard, CAC, the cost of acquiring each customer or investor. The object of any marketing campaign is to attract the most customers (and their ‘orders’) from every dollar spent on any advertising directed at those customers. 

In crowdfunding, while statistics are few, it is obvious that the costs associated with acquiring investors varies greatly, offering to offering. Some offerings fail because investors do not find them attractive, most, I think, because they lacked marketing muscle.  

Personally, I find it painful to watch a company that has hired me to prepare the paperwork for their offering fail to acquire the investors they need.  Often, these company’s campaigns fails because they hire the marketing company that was the lowest bidder.  I try to steer my clients to a marketing company that may not be the least expensive, but gets the job done.   

The Regulation D, private placement market has found enormous success using crowdfunding for investors.  Even now, a sponsor can identify potential investors for the purchase of an office building who can afford to invest, who have an interest in real estate, and who live close enough to the property, to drive by if they want to look at it. And the data mining techniques that created these targeted mailing lists are still in their infancy.

Crowdfunding for capital has become a simple process.

Step one: create an investment that will be attractive to investors

Step two: create advertising copy that can be pre-tested and shown to be effective

Step three: put those ads in front of your pre-targeted lists of prospective investors.

Step four: Repeat step three until you raise the money you need.   

I have written elsewhere that I believe that crowdfunding has reached the point where it will now quickly grow to be a major source of capital for start-ups and small businesses.  A major reason will be that companies seeking funding can now approach crowdfunding with a high degree of certainty that they will get funded. With the proper perspective, those companies can appreciate that they are buying investors online. 

 

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

 

Start-ups Don’t Have to Fail

start-ups don't have to fail

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

DreamFunded – Crowdfunding the Dream – Poorly

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.

Chasing the Unicorn

About a year ago I got a fairly unusual phone call.  The caller told me he had been an early employee of a company that had started up about 8 years earlier.  He loved the work and the camaraderie of the core group.  He was upset that the company had been sold for several hundred million dollars because the team had always told themselves that the company would become a unicorn; a start-up valued at over $1 billion.  He told me his share of the sale was “only” about $25 million and he wanted to start up a new company so that he could reach that unicorn status.

I have a very different value system than this gentleman. In my mind, if I get to the point where I have $25 million in one place, my first thought would be about walking into the local food bank with a large check.  Values and valuations are what make people chase unicorns.

Unicorns, in case you need to be told, are not real.  When someone says that a business has a “value” of $1 billion or more, it is not real either. It is an accounting trick that is used by Venture Capital (VC) firms to pat themselves on the back.

VC’s are the key to your valuation becoming a unicorn.  You will need multiple financing rounds at ever increasing valuations to get there.

The idea is that if you sell 20% of your company to a VC in Round A for $5 million, then your company’s Unicorn value is $25 million (5x $ 5 million). Of course, assuming it had no other assets, for accounting purposes its book value is closer to the $5 million that you just raised.

If you burn through that $5 million and then sell another 10% of the company for $20 million you have a book value of that $20 million and a Unicorn value of $200 million (10x $20 million). By the “C” round it is usual for the VCs to push the Unicorn value up into the hundreds of millions or higher even if all the company has is the cash it just raised.

What may surprise you is that VCs often have an understanding between themselves: you invest in the “C” round of a firm I am already invested in and I will invest in the “C “round of one of the companies that you have already invested in. That way, the valuation of the early rounds that each is holding will show a paper profit, making the VCs’ investors very happy.

There is another value that accountants assign to companies that may help to illustrate the problem; replacement value.  It is the cost of starting a competing company from scratch.

The best example might be Uber which has a Unicorn value of $65 billion. The company is essentially an app and a lot of independent drivers. I am confident that anyone could develop a competing app for less than $10 million. If they pay their drivers a little more per ride Uber’s drivers will jump ship.  If you start slowly and run the company lean, you could actually make a profit which is something Uber cannot seem to do.  But you will never be a Unicorn.

Remember that the Unicorn value has nothing to do with running your business profitably.  It is all about VCs and their perception of you. What they care about most is that you tell a great story that will make them look good.

If you are interested here are 12 steps to help you achieve Unicorn status:

1)  Never approach a VC directly. Always find someone who can introduce you to a VC.  The founder of another company that the VC has funded is best.  In a pinch the VC’s frat brother will do.

2) Learn to pitch the VC correctly. Never use words like bottom line or profitable. Focus on growth and market share.  Tell the VC why every human being on earth will buy what you are selling every day.

3) Never, ever wear a necktie to pitch to a VC.  It is a sign of disrespect. Always wear a wrinkled tee-shirt or a hoodie. It is fine if there is dog hair on it, but never cat hair. Your company’s logo on the shirt is best. If it is a tech company a picture of Alan Turing will work. Use a picture of Michael Palin if it is a consumer goods company.  In a pinch you can have your college logo on the tee shirt as long as it is Stamford, MIT or NYU.  If you went to a state university, default to Michael Palin.

4)  Never discuss competitors with a VC even if your main competitor is a Fortune 500 company. Remind the VC that you have no competition because you are light-years ahead of everyone else and that if you had competition you would crush it.  If the VC is really concerned about this; tell them that in the worst case, if some competitor comes out of the woodwork that you can’t crush, the VC can always give you enough money to buy it.  After funding, always respond that you are closer to market with your product which is demonstrably better than the competitors, even if your product is way behind schedule and will cost more and do less.

5) Once you are funded, focus on selling your product even if it is not ready for market or for that matter does not exist. Sign “strategic partnerships” with other start-ups or with existing companies in need of a shot in the arm from new tech.  Remember, promising a product roll-out or a delivery date is just a promise.  It is like telling your kids that you will start spending more time at home.

6) Good “PR” is everything. Start talking about your IPO very early on.  Appear at conferences on panels with other start-up superstars. Do a Ted Talk.Tweet a lot. Support popular causes like saving trees or creating a gluten free America with a big check and a big press release. Remember that it is the VC’s money that you are giving away, so be generous.

7) Create a corporate culture that fits your personality even if you are a schmuck. Do not be afraid to yell and scream or call employees at 3AM with questions you could ask the next morning or just to brainstorm on something you know is not important. Employees will not love or respect you, so fear is everything.

8) Treat the company insiders, the bros you need, to stock options with long vesting schedules, just in case they decide to jump ship.  Make them sign ironclad NDAs. Do not be afraid to stab them in the back. They would do the same to you in a heartbeat.

9) Treat everyone else at the company like they do not matter, which they don’t. Make them work long hours for minimal pay. Remember that a cappuccino machine in the employee lounge is cheaper than good healthcare insurance. Promise them bonuses when the company goes public. Always remind them that the company is a team effort and you could not do it without them. If they complain tell them that they do not share your vision for the company and should move on. If they will not move on, replace them. Nobody likes complainers.

10) Remember that rules and regulations do not apply to you. That includes rules about wages and hours, discrimination in hiring and conduct in the workplace. You do not need to apply for a permit if you want to modify your office space or any other type of permit to operate your business. Rules and permits are for legacy companies. Do not test your products for safety or your data storage for hackability. That is what insurance is for.

11)  If you get called before Congress to testify make sure that you look at them with disgust.  Tell them that they are old and do not understand new technology or your business model. You can admit that you made mistakes and promise to do better in the future. It does not matter.  By “do better in the future” they will understand that you will make a fat campaign contribution the next time they run for office.

12) Change your LinkedIn profile to “Visionary”.

And remember that unicorns are for children. If you are still chasing them it means that you have yet to grow up.

 

Crowdfunding Successfully

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.

 

Equity Crowdfunding 2018

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.

 

Any Good Business Can Get Funded

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.