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Why crowdfunding is madness, but maybe not with an RIA at the helm

With its holier-than-thou pitches and self-dealing syndication fees, crowdfunding is really only good if you're the crowdseeker

Tuesday, April 26, 2016 – 5:38 PM by Columnist Irwin Stein
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Mary Jo White: Nine of 10 startups fail but an equally interesting statistic from one post-mortem analysis is that 70% of failed startups die within 20 months after their last financing and have raised an average of $11 million

Brooke’s Note: Irwin Stein and I had a few intense conversations as he wrote this article. I knew he had a solid column in him about the perils of crowdfunding and why investors are almost certain to experience a terrible return. But if he was writing to RIAs, Stein was, he said, determined to introduce a giant nuance — that RIAs really ought to consider being the point force in crowdfunding. In short, Stein believes that crowdfunding unto itself is not evil and in fact is a rather phenomenal way of cheaply and effectively assembling capital in niche circumstances. But it requires somebody with a fiduciary mindset and the ability to vet a deal, he contends. So when you read this column, beware not only of crowdfunding but of our attempt to reconcile such a bifurcation.

If there is a group du jour shouting louder for RIAs’ attention than the sellers of smart beta, liquid alts and robo advice for private labeling, it is equity crowdfunding.

Yet though the promoters of this so-called democratization of venture capital seed money raises oftentimes fairly drip with righteousness, see it for what it is — cover for flagrant hucksterism. See: The SEC democratizes crowdfunding but RIAs need to guard against clients getting seated at an expanded kids’ table.

Crowdfunding is easy pickings for the ones assembling crowds to raise funds. Crowdfunders often take a 10% cut right off the top. It can also be good for the companies that get funded because no other financial fix works. Often the reason small firms seek crowdfunders is that banks and venture capitalists seek to avoid them.

But this de facto email-for-dollars system of crowdfunding — so elegant in its bare bones execution — too often makes victims of the investors who predictably get hosed almost every time that they invest.

Though most RIAs have thus far avoided a soaking by dint of sheer common sense, the crowdfunding industry is just getting going in improving the illusion of legitimacy and casting of a wider net. See: Credible reasons Facebook and Google won’t become robo-RIAs and other things I learned at Hearsay Social-Pershing event in San Francisco.

Easy first $50 million

In mid-May the last of the JOBS Act sections, Reg A+, will take full effect, allowing a simplified SEC registration process for equity offerings up to $50 million. The SEC has been registering offerings of up to $20 million under Reg A+ since last November.

Reg. A+ allows penurious investors to invest in startups and smaller companies, albeit for only a limited amount of money.

The crowdfunding industry is licking its chops because it can play a bigger numbers game. It expects that these small investors — with greater aggregate assets and less aggregate investing sophistication — will spur industry revenues to new stratospheres.

But the laws of startup physics are immutable.

SEC Chairwoman Mary Jo White, who was appointed in 2013 and charged with implementation of the JOBS Act, is keenly aware of the problem. See: After starring in New Yorker article, Mary Jo White holds SIFMA event spellbound and 'no-admit, no-deny’ is still in play.

At a speech at Stanford University last month, she noted amid a discussion of crowdfunding that these amateur syndications start with long odds and short survival prospects. “Nine of 10 startups fail,” White stated. “But an equally interesting statistic from one post-mortem analysis is that 70% of failed startups die within 20 months after their last financing and have raised an average of $11 million. In other words, not only are these investments highly risky, they also fail quickly.”

Desperadoes of finance

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

Companies seeking funds list their offerings on the website as they would if they were selling their homes on a multiple listing service website. Potential investors view a video that pitches the deal and all of the appropriate disclosure documents.

If investors like what they see and want to invest, they click a button which takes them to a page where they type in their personal information and are directed how to pay their money. Funds are collected in an escrow account until the offering reaches its minimum. If the offering does not close within the allotted time, the funds are returned.

The crowdfunding industry wants to focus on mass market investors. In order to be able to sell to these investors, a website must register with FINRA and the SEC to become a crowdfunding portal, a new type of registration category.

Many people see crowdfunding as disruptive of the traditional investment banks. Clayton Christensen, the noted Harvard Business School professor who coined the phrase “disruptive innovation” in 1995, was an early investor in one of the larger crowdfunding websites.

Christensen was quoted in Fortune as saying that one of the areas where crowdfunding has the most opportunity to disrupt “is by taking root in these under served areas that traditional financiers have traditionally found unattractive. This is a classic entry point for disruption — expand participation in the market by lowering cost at the low end of the market, where incumbents don’t see profit opportunities.”

No sales, no commissions … no Wall Street interest

Crowdfunded offerings have no salespeople and pay no commissions. The websites cannot offer investment advice or recommendations; solicit purchases, sales or offers to buy the securities displayed on its platform; compensate employees, agents; or other persons for soliciting sales or hold, manage, possess or handle investor funds or securities. The websites collect a 10% listing fee from each offering but are essentially passive.

The established brokerage industry has shown no interest in these commission-less transactions but there may be opportunities for entrepreneurial minded RIAs to profit from some of the changes that the JOBS Act has introduced.

Many RIAs already consider various types of alternative investments, including private placements, for appropriate customers. Using a crowdfunding website and a do-it-yourself approach, an RIA can create smaller, proprietary private placements which fund local companies and local projects.

Most crowdfunding websites are trying to list as many offerings as they can. Their business plan is focused on the number of offerings that they can list. The companies bring investors to the site, close their funding and the site takes 10%.

But that does not have to be everyone’s business plan.

Industrywide, only about 30% of listed offerings raise the minimum amount that they seek and close. The quality of the offerings is rarely addressed — which is what makes most offerings a sucker’s bet from the investor’s standpoint.

But there is no requirement that a site list only likely-to-fail startups. A crowdfunding website owned by an RIA with some experience, knowledge of finance and an understanding of what makes a good deal a good deal could present offerings that would raise money only for qualified businesses. See: Online RIAs will mostly fail — and here are 10 reasons why.

Why it might all work with RIAs

At the same time, an RIA with a business plan focused on providing a valuable service to the local business community can use crowdfunding to bring in new, wealthier clients, provide good deals for its existing clients and make money in the process.

Private placements have always been sold under Regulation D. The JOBS Act has changed the game for Reg D offerings, which could historically only be sold to investors with whom a broker had a prior business relationship. That generally meant existing customers only. The SEC has now removed that restriction, allowing for the general solicitation of Reg D offerings to accredited investors.

A Reg D offering can now be listed on a crowdfunding website. If sales are limited to wealthier, accredited investors, those with a $1 million net worth or $200,000 annual income, the website does not need to separately register with the SEC or FINRA.

Marketing for these offerings is typically done by the company, not the website. Companies selling Reg D offerings are already using advertising, direct email and PR firms to drum up interest in their campaigns. This brings new investors to the website. Since all of the people who sign up to invest will be wealthier accredited investors, RIAs that own a website will certainly be able to offer other services such as financial planning and portfolio management to these people as well.

Local investors may be interested in the syndication of a local office building or the expansion of a local company. Using proprietary Reg D offerings as an advertising lead will certainly differentiate RIAs, especially in smaller markets. See: Advertising practices that can raise the hackles of regulators.

At the same time, a local company seeking to raise $5 million or $10 million in equity on a local platform might understand that you would be happy to help them and even reduce the listing fee if they allowed you to manage the company pension plan or the retirement accounts of the company executives.

Fish bait and syndicate

Many websites specialize. An RIA could join with a real estate broker to offer shares in commercial properties, one after the other. There is no restriction against syndicating preferred shares, debt issues or other securities that provide investors with steady income; not what you would expect from a startup.

Many people seem to think that crowdfunding began with the JOBS Act. Actually, the first direct-to-the-public stock offering done via the internet is generally credited to the Spring Street Brewing Co., which successfully raised about $1.5 million in 1995. It was groundbreaking at the time, because no underwriter (Wall Street firm and those pesky salespeople) was involved in selling the stock. The offering was done under the watchful eye of a forward-thinking SEC.

Certainly the JOBS Act has rekindled interest in direct-to-the-public securities offerings. Just as certainly, the technology, both website development and the use of social media, have reduced the costs of setting up a crowdfunding platform and advertising offerings to ridiculously low levels.

Several companies sell turnkey crowdfunding websites that are all-inclusive. You get the site with blank pages to list offerings and forms to take investors’ information. There are hook-ups available to escrow companies, companies that will verify that the investors are in fact accredited and companies that will perform due diligence on the offerings before you list them. Everything that you need can be outsourced. Add your own graphics and a hosting site, and you can be open for business for less than $10,000.

Lawyer on speed dial

It is probably a good idea to keep a good securities lawyer handy, if not on staff. Liability insurance is a good idea as well. You are selling new issues and fraud or non-disclosure by the issuers can always be a problem. The SEC does not even require offerings smaller than $500,000 to be audited, and the information that is passed through the website to investors must be accurate. But it’s worth knowing that the SEC has already brought a fraud action on a crowdfunded offering just to let everyone know that it is paying attention.

RIAs are uniquely positioned to use their knowledge, skills and experience to structure and offer better deals to prospective investors. Just because it is a market populated by hucksters, it does not mean that you have to be one of them. You can earn your listing fee by adding some value and integrity to the process and listing only companies and projects that have a legitimate chance of success.

That might even attract other similarly ethical and capable RIAs to the game and force columnists to cast this ripe-for-abuse crowdsourcing mechanism in a better light.



April 26, 2016 — 7:36 PM

Thanks for the article on crowdfunding and the scepticism. Can you write a similar article for the crowdspeaking industry? That would peak my interest.

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