Wealthier Investors Are an Essential Part of Community Capital Markets

Wealthier Investors Are an Essential Part of Community Capital Markets

The Securities and Exchange Commission has recently estimated that approximately 10% of all U.S. Households are now in the “Accredited Investor“ category (for individuals, that means $1m in net worth not counting primary residence, or $200k of income). Assuming that’s accurate, there are now over 12 million households in the U.S. that meet the definition of Accredited Investor (“AI”).

The SEC defines the AI to determine their eligibility to invest in Private Placement offerings (i.e. funding rounds of securities that are sold not through a public offering (IPO), but rather through a private offering, and mostly to a small number of chosen investors). And as the private placement market edges toward $60 billion of deals a year, that may seem to most people as a sizable amount to participate in, with lots of opportunities to get in on the next big home run deal.

Some of those AIs, however, have begun to look for more than just a company swinging for the fences, but rather companies that look out for profits, people andthe planet. The rise of socially responsible or impact investing has now begun to take hold. And there are now more financial advisors becoming familiar with these kinds of investments, and helping their clients to find such deals.

Unfortunately, financial advisors feels constrained (for good reasons) to only show their clients deal opportunities of a certain size and nature. Many even limit their scope to only companies traded on public markets so that they reduce the risk of breaching their fiduciary duty to their clients. Other more adventurous advisors will brave the private investment landscape, where, with the right amount of due diligence, they can recommend impact deals to their clients that will also provide something close to market returns (whatever that really means).

But there’s another opportunity for AIs to make a significant impact. They can invest AND play an essential role in the stabilization, growth and resilience of the communities they live in or relate to. They can do this by participating alongside of the rest of the non-accredited investor community into investments offered by community entrepreneurs.

The kinds of investments I refer to here are Direct Public Offerings and certain state securities crowdfunding opportunities, both of which allow for investors to directly interact and engage with the entrepreneur/issuer. I wrote recently about this in previous blogs here, and also earlier today in a Locavesting article. As these crowdfunding offerings and the platforms they list on become more populated, investors will begin to find it easier to find offerings. Also, as we help clients obtain their approvals for DPOs, we post the offerings up on our CEX site so that investors can more easily find the issues and link to their sites.

The role AIs can play to support these much needed community enterprises cannot be emphasized enough. For one thing, as companies begin to turn more to using tools like DPOs to raise their funds, the size of the raise is going to increase well above the $1 million limit that the state or federal crowdfunding laws impose. DPOs, if done via the Intrastate exemption, are typically unlimited, as long as the state regulators approve them, and we are starting to see many more offerings in the $5-10 million range. Companies offering stock will want to limit the number of non-accredited investors to 500, and the total number of investors to 2,000, or face becoming “publicly reporting,” which is expensive to maintain. This means the offerings truly need the AIs to meet their targets.

Another key reason is the experience AIs may be bringing to these offerings. Clearly just because one is an AI does not mean one has the financial expertise of a typical VC or Angel who do this for a living or hobby. But there is no doubt that many AIs have some experience with investments, and likely more than their non-accredited counterparts. This can be very important when a company is even considering how to structure their offering, if they can learn beforehand what an AI will want to see before they participate.

And then there is, of course, the leverage an AI can bring to the offering, just by signing on and showing up. Some AIs provide the “prime to the pump“ so that the offering can take hold. Some even offer a matching approach. It can be an important signal to the non-accredited investors that they don’t have to shoulder the offering alone. Also, regardless of the wealth divide that exists, every member of the community can come together to make an offering successful. AIs can be an important kind of hero to this movement, while still obtaining enough of a return. Their participation can also lend the right kind of pressure to the entrepreneur to keep them on their toes, and striving to meet their mark.

AIs might do their own homework (due diligence), as they look at these investments, or they may be able to find a new breed of financial advisor who are willing to help analyze the offering, even if they stop short of making recommendations and risk their duty. And there are also new pioneers, like Marco Vangelisti, who has taken it upon himself to begin offering daylong workshops for community investors.

Marco is a veteran of global finance who walked away from the industry in 2009 after a 25-year career, and is now helping communities around the country understand the role investors can play in support of community. He created Essential Knowledge for Transition – an initiative to empower communities with a basic understanding of the large systems affecting our lives. Marco’s next workshop will be in Irvine CA the 7th of May, and after that, we intend to try cloning him so that we can help ALL kinds of investors, AIs and non-accrediteds alike, everywhere, to align their investments with their values, and create the world we want, and need.

Invest  in Who You Know – Part 2

Invest in Who You Know – Part 2

Most people don’t have the ability, flexibility or funds to invest like a professional, and a more common approach for ‘investing in what you know’ takes the form of how well you can follow a company, mainly by looking at what you (or others who you trust) know about the company, or what the company has disclosed or reported about itself.

In the public markets, this means what a company publicly reports, and we (or the analysts) will read their “Form 10-Qs” and “10-Ks,” which publicly reporting companies must file with the SEC every quarter and year, respectively. We might also listen in on their webcasts, track their progress in the news, and even monitor their competition as a comparison.

The SEC reporting is still based mainly around financial information, with much less attention devoted to other material actions and impacts, but this is starting to change. There’s a lot of great work underway by organizations such as the Global Reporting Initiative (GRI), and Sustainable Accounting Standards Board (SASB), who are creating sustainability performance measures for these publicly reporting companies, and then monitoring and reporting on them separately. The largest database of corporate sustainability reports is still the UN Global Compact Initiative, which they publish on their website.

For private companies, there are also some new approaches, such as the GIIRS rating system for companies or funds, allowing companies to voluntarily report measurements on social and environmental impacts. B-Lab’s “B Corporation” label allows a company to do a self-assessment, which they claim leads to “B Analytics to help investors consider whether a company is properly managing its socially responsible impacts, with as much rigor as their profits.”

While these new reporting approaches try to help investors assess whether companies are meeting certain “sustainability” standards, trying to define these standards are can be a daunting task, especially as the definitions are too murky or continue to change and new reporting tools are created.

We first saw screening tools applied to companies (e.g. no oil, weapons or bad actor sovereignties) in an attempt to label the good ones as “socially responsible investments.” Then came the dawn of “sustainability,” which sounds good, but has many different definitions. Nor has “triple bottom line,” “ESG” (environmental, social, governance), or even “Impact” given us clarity in terms of a definitive metrics-based idea for understanding whether a company is really contributing to our world in a positive and replenishing way, or simply another extractor of resources leading us closer to the demise of our species.

Even if the definitions or surveys are well thought out, is a company’s reporting enough for us to rely on to know that they are really making the kind of “impact” we want to see? When a company receives a “good company” sort of label, in whatever new socially responsible format we like, does that mean that the label was strict enough to ferret out all of its behaviors? Can companies fudge, omit, or cleverly interpret the ratings questions so that the answers fit the right frame they want to display?

While the efforts to bolster transparency about private companies is a great step in the right direction, reliance on only the reporting approach to make investment decision poses meaningful risks. Borrowing the famous quote from Albert Einstein, I would refer to this as the investment equivalent of Spooky Action at a Distance. A potential investment candidate may have received high marks from an outside rating group, and only later might we find them to be acting in ways we deem distasteful. Maybe we didn’t realize they were hoarding revenues offshore to avoid paying U.S. taxes, or providing their services to any kind of planet damaging company while espousing high-minded values, or grabbing federal funds while really only focusing on driving profits to its shareholders.

How do we know from a label whether a company truly practices all of the values they received high ratings on? Similarly, how do we know from a report whether they might be making certain private compromises to what they publicly report in order to bolster their bottom line?

If we don’t know the people behind the company, we may be left with only our faith in the reports, provided mainly or only from information supplied by the company itself, with little if any recourse for misrepresentations or omissions (except possibly a future rescission of their seal of approval, or being publicly shamed for their hypocrisy). Unfortunately, there are likely as many forms of greenwashing today as there are new efforts to heighten transparency, so relying only on modern internet-based tools or chat groups should be done at every investor’s peril.

Some who work directly in the area of socially responsible investment advising have seemingly given up on trying to identify the right term or the right actions, now hoping they can simply determine whether a company is behaving “responsibly.” And perhaps it really may be more meaningful to apply a “smell test” than to blindly rely on a label or a report. To paraphrase SCOTUS Justice Potter’s famous line from the Jacobellis pornography case…trying to define terms like Sustainability, Impact, or Socially Responsible using shorthand descriptions can quickly become unintelligible. But, like Justice Potter, perhaps we can apply that same personal test… I know it when I see it!

And that then begs the question…how do you see it? One very well tested method is to invest in who you know, and that means being able to find and get to know the companies, and the team, before you invest. Community capital markets provide just that opportunity. Community capital markets enable companies and investors, connected geographically or in fellowship, to engage with each other on a personal level. These kinds of capital markets can take the spooky out of the action, by bringing a personal touch to our awareness, and engaging with each other in financial transactions that support each other.

Invest  in Who You Know – Part 2

Invest in Who You Know – Part 1

There’s an old saying that you should “invest in what you know,” but what’s far more valuable is when you can “invest in who you know” as well.  The new crowdfunding laws are not designed to nurture this; they are meant to prohibit investment conversations with the company insiders when the opposite has historically been the case.

Wealthy individual investors and funds (angels and VCs), will often do both, and it makes a lot of sense, when you have the time and the wherewithal to afford due diligence, apply your previous experiences, and meet with the founders or senior management to determine whether an investment is a good one.  A secondary benefit to this approach is that you often get to insert your previous knowledge (i.e. what you know) into the equation, because you have invested enough to have a voice.

Aside from reading the company’s reports, the other main component to making an investment decision is the ability to get to know who you are investing in.  This is arguably the more important component, especially for those with limited amounts to apply toward investing.  But does this mean that all of the new opportunities to make investing available to everyone via crowdfunding helps us in this regard?

The last few years have been exciting ones for those following new crowdfunding laws at both the state and the national level. I am not speaking to donation-based crowdfunding here (such as Kickstarter, Indiegogo and the rest) but rather investment crowdfunding (that involves actual return on investment).

When the JOBS Act was passed and as we watched and waited to see what rules our federal government would create, the states took earlier actions to implement their own forms of state-based securities crowdfunding.  However, many of the new rules are going in the exact opposite direction of how investing has historically been done, and those rules have created more barriers, not fewer, in terms of getting to know who you might invest in.  For examples, the JOBS Act rules (and those of many states) that require a company to only post their offering onto a third-party “intermediary” platform, and that limit what a company can say directly to its potential investors, creates such a barrier.

Investing has almost always been more interaction than any reaction to data before a transaction is completed, where the personal aspects of the interaction weigh heavily in favor of any successful transaction.  How many times have we used, heard or relied on the old adage that you need to look someone in the eye before you can do a deal with them? In this modern age of SEO, and the multitudes of interweb communications, there are still many dealmakers that need to meet, and should be able to meet, the other person first before any deal gets done.  The same has held true for our investing in other businesses since the dawn of investments began, and still holds true today.

Consider most companies that raise funds privately, through a broker-dealer, or even those that go public via a IPO.  In each and every case, the company or its representatives sell those offerings, and the investors only buy (invest) if they can get to know the team.  With private offerings, the company goes directly out to the accredited investors that already know them, or to whom they have been introduced.  Broker-dealers help companies with their offerings by introducing them to investors they know, and those investors then get to know the company.  And broker-dealers are supposed to ensure that the deal is suitable for every investor they bring in.  Even IPOs have a personal connection component. The main underwriter will take the company team out on a roadshow, and introduce the team to its potential syndicate of other dealers to bring them in to an IPO.  Those potential dealers put a lot of weight into meeting that team, and likely would not consider investing without a chance to get to know them personally.

But not all securities crowdfunding takes the unfortunate approach that you need to separate the company from the investor and utilize technology platforms in the place of that person interaction.  In addition to the Direct Public Offerings (DPO) that have been around for decades, there is also, for example, the new Oregon Community Public Offering (CPO).  DPOs are federally exempt offerings that must be filed with any state in which the offering is conducted, either using a federal exemption that currently limits the raise to $1m (but allows you to file in multiple states), or what is known as the Intrastate Exemption that typically has no dollar limit but requires the company and all investors to be in just one state.  The Oregon CPO, which was championed by Amy Pearl and Hatch Innovation, was designed to be a community capital raising tool, and companies are actually encouraged, not discouraged from raising those funds directly from their communities via meet-ups that actually allows people to look the CEOs in the eye.

Whether it’s a DPO, CPO, or another kind of offering that provides for and encourages direct and interpersonal connections, an investor is provided with a very valuable opportunity to meet the people behind the veil and to use their own personal assessments in addition to what a company states in its materials or ratings it’s received.  And those personal connections then make a significant impact on those inside the company who are taking investments from people they now know.  The decisions companies make are likely highly informed by how connected the investors are to them.  And while we have not experienced DPO investors who have abused that personal connection, what we have seen is a deeper, richer and more connected community as a result – a community of investors and companies who actually know each other

Today’s SEC Release Regarding Title III JOBS Act Crowdfunding

Cutting Edge Capital Applauds Today’s SEC Release

Regarding Title III JOBS Act CrowdfundingDirect Public Offerings!

The Securities and Exchange Commission’s announcement today was monumental – but not for the reasons most people had been anticipating.

While the final rules are now out for Title III of the JOBS Act regarding crowdfunding, Cutting Edge Capital was most excited to see that the Commission has also proposed new amendments for Intrastate and Regional Securities offerings!

The proposal is to increase the aggregate amount of money that may be offered and sold for Direct Public Offerings using the federal exemption from $1 million to $5 million and apply bad actor disqualifications to this Rule 504 offerings to provide additional investor protection.

Highlights of the Proposed Amendments to Rule 147

The SEC has proposed modernizing Rule 147 to permit companies to raise money from investors within their state without concurrently registering the offers and sales at the federal level.  The proposed amendments to Rule 147 would:

  • Eliminate the restriction on offers, while continuing to require that sales be made only to residents of the issuer’s state or territory.
  • Refine what it means to be an intrastate offering and ease some of the issuer eligibility requirements in the current rule.
  • Limit the availability of the exemption to offerings that are registered in-state or conducted under an exemption from state law registration that limits the amount of securities an issuer may sell to no more than $5 million in a 12-month period and imposes an investment limitation on investors.

Highlights of the Proposed Amendments to Rule 504

The proposed amendments to Rule 504 of Regulation D would increase the aggregate amount of securities that may be offered and sold under Rule 504 in any 12-month period from $1 million to $5 million and disqualify certain bad actors from participation in Rule 504 offerings.

The Commission will seek public comment on the proposed rules for 60 days.  The Commission will then review the comments and determine whether to adopt the proposed rules.

Needless to say, Cutting Edge Capital will be supporting the Commission’s efforts to “assist smaller companies with capital formation consistent with its investor protection mission.”

JOBS Act – Crowdfunding

The SEC also finally adopted all of the major final rules via Title III of the JOBS Act[1].

These new rules create a federal exemption under the securities laws so that 6 months from now, companies can offer and sell securities on approved crowdfunding platforms[2] to raise a maximum aggregate amount of $1 million in a 12-month period.  A company must conduct its offering exclusively through one intermediary platform at a time.

Cutting Edge Capital’s DPO Lab will be offered to companies that need state-of-the art tools to best prepare for creating their own offerings.

Also, the SEC will now permit individuals to invest in securities-based crowdfunding transactions on a federal level via approved platforms or through registered broker dealers, but subject to certain investment limits.

For example, individuals who have annual income or a net worth of less than $100,000 will be limited to an investment of $2,000 or 5% of the lesser of their annual income or net worth.  If an individual investor’s annual income and net worth are equal to or more than $100,000, the limit will be 10% of the lesser of their annual income or net worth.  However, during a 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000.

Note – How these limitations will be enforced, and who will be obligated to ensure these individuals do not exceed their limits will be left for the soon-to-be published rules, and FINRA to determine.

Disclosure by Companies 

The new JOBS Act rules impose specific disclosure requirements on issuers for certain information about their business and the securities offering.  Companies will be required to file certain information with the Commission and provide this information to investors and the intermediary facilitating the offering.

These disclosures are fairly typical of what any securities offering should have, including:

  • A description of the business and the use of proceeds from the offering;
  • Information about officers and directors as well as owners of 20 percent or more of the company;
  • The price, the method for determining the price, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount;
  • A discussion of the company’s financial condition;
  • Financial statements of the company that, depending on the amount offered and sold during a 12-month period, are accompanied by information from the company’s tax returns, reviewed by an independent public accountant, or audited by an independent auditor.
    • A company offering more than $500,000 but not more than $1 million of securities relying on these rules for the first time would be permitted to provide reviewed rather than audited financial statements, unless financial statements of the company are available that have been audited by an independent auditor;

In addition, companies relying on the crowdfunding exemption would be required to file an annual report with the Commission and provide it to investors.

Note – The SEC has set a “reviewed” audited financial statement requirement here for first time filers.  While this is not as onerous or expensive as having to file audited financials at first, it is certainly not the same as having to file “compiled” financials.  There will still be significant costs to have reviewed financials created.  Also, the cost of preparing for and filing annual reports with the SEC is still unknown at this point.

Crowdfunding Platforms

A funding portal (i.e. “intermediary”) will need to be registered with the Commission, and become a member FINRA.

The SEC rules require intermediaries to:

  • Provide investors with educational materials that explain, among other things, the process for investing on the platform, the types of securities being offered and information a company must provide to investors, resale restrictions, and investment limits;
  • Take “certain measures” to reduce the risk of fraud, including having a reasonable basis for believing that a company complies with Regulation Crowdfunding and that the company has established means to keep accurate records of securities holders;
  • Make information that a company is required to disclose available to the public on its platform throughout the offering period and for a minimum of 21 days before any security may be sold in the offering;
  • Provide communication channels to permit discussions about offerings on the platform;
  • Provide disclosure to investors about the compensation the intermediary receives;
  • Accept an investment commitment from an investor only after that investor has opened an account;
  • Have a “reasonable basis” for believing an investor complies with the investment limitations;
  • Provide investors notices once they have made investment commitments and confirmations at or before completion of a transaction;
  • Comply with maintenance and transmission of funds requirements; and
  • Comply with completion, cancellation and reconfirmation of offerings requirements.

The rules also prohibit intermediaries from engaging in certain activities, such as:

  • Providing access to their platforms to companies that they have a reasonable basis for believing have the potential for fraud or other investor protection concerns;
  • Having a financial interest in a company that is offering or selling securities on its platform unless the intermediary receives the financial interest as compensation for the services, subject to certain conditions;
  • Compensating any person for providing the intermediary with personally identifiable information of any investor or potential investor;
  • Offering investment advice or making recommendations;
  • Soliciting purchases, sales or offers to buy securities;
  • Compensating promoters and other persons for solicitations or based on the sale of securities; and
  • Holding, possessing, or handling investor funds or securities.

Note – How an intermediary platform will meet the FINRA standards for all of these requirements will be interesting.  For example, how an intermediary will “take measures to reduce the risk of fraud,” provide communication channels, disclosures, meeting the “reasonable basis” regarding the investor limits, and even maintaining certain books and records related to their transactions and business, all will make for an interesting new FINRA regulatory role.

FINRA is currently the regulator for most all exchanges and broker dealers in the U.S. and anyone familiar with FINRA knows that regulation can be a significant issue in terms of compliance, policies, procedures, communications channel oversight, and staffing. And following FINRA audits and reviews, fines will likely become a significant issue should a platform be found to not be in compliance.  An intermediary will need to ensure that they are receiving enough compensation from every transaction to afford to be regulated by FINRA, and this will make for interesting financial dynamics.

[1] Those final rules and forms will become effective 180 days after they are soon to be published in the Federal Register.

[2] The forms enabling funding portals to register with the Commission will be effective Jan. 29, 2016.

 

A Tale of Two Capital Markets Or – The Case of the Missing Economy

A Tale of Two Capital Markets Or – The Case of the Missing Economy

YES Illustration

YES! illustration by Jennifer Luxton.

Two recent publications show the significant disparity in how people are thinking about fixes to the capital system.  Each has great merit, but the differences in scope and focus say a lot about how much attention and funds go toward the uber-financialized economy (the one where all the very big pools of newly printed dollars continues to flow), and why more attention needs to be drawn toward the other economy – the one that the rest of us live and play in.

I had been anxiously awaiting the recently released UNEP Inquiry’s global report, “The Financial System We Need: Aligning the Financial System with Sustainable Development” that was launched 8th October in Lima on the occasion of the IMF/World Bank Annual meetings.  The thesis of this report is that the “heartland” of the global economy (i.e. the financial system) can evolve to serve its “core purpose of growing and sustaining the real economy.”

The release of this 112 page report summarizes its 3 key findings:

– A ‘quiet revolution’ is underway as financial policymakers and regulators take steps to integrate sustainable development considerations into financial systems to make them fit for the 21st century.

Momentum is building and is largely driven by developing and emerging nations including Bangladesh, Brazil, China, Kenya, and Peru, with developed country champions including France and the UK.

– Amplifying these experiences through national and international action could channel private capital to finance the transition to an inclusive, green economy and support the realization of the Sustainable Development Goals.

This Report does a credible job of focusing on the very important goals needed in the attempt to harness or govern the uber-financialized system toward a more sustainable path, toward less destruction of the planet, less devastation of our natural resources, and outlining an attempt to reign in the faster growing wealth and income disparities that continue to produce more poverty, ill health and societal ills.  However, I was also disappointed that the scope of this Report paid little or no attention to the re-establishment of a capital market structure for the vast majority of companies, and for almost all individuals that could participate in helping to fund those companies.

Earlier this year I had been contacted by Mr. Simon Zadek, one of the three individuals primarily involved in this report, and we discussed its framework and whether there was anything I could contribute.  Having come from the world of regulating several U.S. stock exchanges, and teaching a course on capital markets at one of the sustainable MBA graduate schools for many years, Mr. Zadek was hopeful that I might have a particular view that could be helpful to this report.

What we both discovered during out conversations, however, was that the focus on this upcoming report had little to do with what we at Cutting Edge Capital are doing – i.e. working to build healthy resilient capital markets for everyone to participate in; capital markets that can help smaller companies raise funds from all types of investors who currently see few to no options to fund companies that they feel connected to either by geography, community, or some other meaningful affiliation.

And then there is this new article by Keith Harrington, “Patient Finance: Why Slower Money Is the Key to a Real Economic Recovery.”  One sentence (among many) in this article stands out to me.  Mr. Harrington first shows a keen grasp of the capital markets that attract the vast majority of attention (and large funding dollars to study), and explains well why we continue to be bested by this system that is built for speed and crashes, and then states, [b]ut one thing is for certain: If we don’t find a way to shift our increasingly financialized economy to stable ground, the next big crash is inevitable.”

He refers here to the very same lack of attention that I encountered with those writing the UNEP Report.  Much is made of how we might begin to bring additional measures and actions to bear to make more transparent how the one capital market might make itself more “sustainable,” whatever you take that to mean.  But why not also provide a well-funded report on how a new economy, or as Mr. Harrington states, a “new financial landscape” is beginning to take hold.

As one of the proud members of Mr. Harrington’s “checkerboard revolutionaries,” I continue to be amazed at this discrepancy of attention, but we revolutionaries will not be dissuaded by this lack of notice.  It is understandable that so much time, focus and funds are spent on a massive economic system fueled by funds that flow as if created almost magically out of thin air.  But those funds do very little to touch us in our communities and in our relationships with each other.  That one massive capital market system seems almost mythical in its proportions and in the equally massive wealth it creates for just a few.  For the rest of us, however, it would seem that we are left to our own devices for building this new economy.  And build we will, because the one we are creating is the Community Capital Market that truly impacts us.  It is the one we can participate in and know we can make a difference by supporting each other and the communities we identify with.

Viva la Community Capital Revolution!