It comes packaged in a 3-inch thick offering memorandum or prospectus. It lands with a thud on the table, the heft of the document sure to impress you as a potential investor. Maybe it was your golf buddy or your brother-in-law. Maybe it was even your CPA or your broker. Whoever it came from, the line went like this:
“I/we have a limited opportunity to offer shares in this deal. This is a very exciting opportunity and has great potential.”
If this pitch sounds like your neighbor trying to get you into his online multi-level marketing scheme, maybe that should be a big red flag.
The next half of the pitch will be about how this unique opportunity is only available to experienced and sophisticated investors just like you. That’s right pal, you’ve arrived. Now you’re getting into the good stuff. The stuff they don’t show the lower class. (In reality the SEC had originally limited investment in private programs to investors with a substantial net worth or income who the SEC felt could sustain a total loss of investment. Wonder why they did that?)
Maybe it’s a startup tech company that is “going to be the next Google.” Or a can’t-lose oil and gas drilling programs (the tax benefits!). Perhaps a private real estate trust that’s going to buy Trump Tower or a train car or ship leasing program that “yields” 7%.
There is a simple reason why this 250 page offering document represents a terrible investment, and it is the same reason that the deal is in front of you:
This is, without a doubt, the worst possible way for a company to raise money. It is so wildly expensive that either the management of the company is completely ignorant or (more likely) they have exhausted every other funding source and now must settle for a Reg D private offering.
Let’s imagine for a moment that you are the founder of a small startup in need of some financing. If you actually have potential, the first place you are going to turn is to angel investors and venture capitalists. If you have revenue (I hear there are still startups that do this), you could get a private loan or even a bank loan. In today’s environment you should secure financing well under 10%. Angel investors will be happy to be a part of your successful ideas, and the VC guys know they are planting many little seeds hoping one will be a grand slam.
Raising money through a Reg D offering is a long, painful and expensive proposition.
First you are going to pay tens of thousands of dollars in legal fees to create the offering document and file it with the SEC. Hundreds of thousands if you are raising more money. There’s a good chance you’ll also pay to create a few new business entities in the process so you are not selling 100% of the equity in your business. Then you take your brand new stock shares to a brokerage firm to be thrust upon their unsuspecting clients. You might pay the brokers a fee for a cursory “suitability” review. This is basically paying their lawyers to make sure they have CYA’ed, but they want the deal so they can collect their share of the commissions.
But the brokers aren’t going to work for free. They want something now: a piece of the deal for themselves, or a listing fee. And then the brokers get to work, pushing your deal on unsuspecting clients for a nice 8% or 9% commission. Then there will be a 2% management fee and a 1% distribution fee and maybe you will get $0.85 of each $1 invested in the program. For the client to get an 8% return on their dollar, you have to produce a 9.4% net return before fees on the $0.85.
So what kind of company will raise money under these conditions? One that has failed to raise money any other way.
I’ve seen two beneficiaries of private investment deals. One is the startup founder who is using investor capital to bankroll his salary, not investing the money back into the company. He gets to use investor money to fund his lifestyle while playing around with his corporate “toy.” The other is the manager of a real estate investment or oil and gas drilling program. The manager gets a cut of the selling commission and gets to take a 2% management fee for the life of the program, regardless of the performance of the asset. They are also usually given a partnership share so that in the event the program actually makes some money, they get a cut of that too.
And of course along the way the brokers who sell this garbage get their 8% rake off of every dollar. Typically only 80-90% of the invested dollar is actually going to a program, which is probably a bad investment to begin with. So the next time someone slaps an offering document down on the conference table in front of you, run as quickly as possible away from this person. They are not looking out for you.