Tag Archives: London

How Much Trouble Could Big Banks Be In? Lots!

The future of the Euro and the Eurozone is bleak and will likely look like a series of prolonged, rolling crises that slowly evolve to reveal just how critically the financial health of each country is affected by their individual sovereign debt and their failing banks.

The inevitable result will be severe Eurozone-wide stress, emergency liquidity loans from the IMF and the European Central Bank and politicians from all the countries involved increasingly attacking each other  over allegations of blame and corruption. To no good end.

Even the optimists now say openly that Europe will only solve its problems when there are no options left and time has run out. Less optimistic analysts increasingly think that the Eurozone will break up because all the proposed solutions are essentially Pollyannaish jokes. Let’s say the realists are right, and Europe starts to dissolve. Markets, investors, regulators and governments can stop worrying about interest-rate and credit risk, and start worrying about dissolution risk.

More importantly, they need to start worrying seriously about what the repricing of risk will do to the world’s thinly capitalized and highly leveraged megabanks. European officials, strangely, appear not to have thought about this at all; the Group of 20 meeting last week seemed to communicate a weird form of complacency and calm.

So, for all of the European officials and the U.S. bankers, here’s what dissolution risk means:  If you have a contract that requires you to be paid in euros and the euro no longer exists, what you will receive is not real clear. See? That’s dissolution risk.

Let’s say you have lent 1 million euros to a German bank, payable three months from now. If the euro suddenly ceases to exist and all countries revert to their original currencies, then you would probably receive payment in deutsche marks. You might be fine with this — and congratulate yourself on not lending to an Italian bank, which is now paying off in lira.

But what would the exchange rate be between new deutsche marks and euros? How would this affect the purchasing power of the loan repayment? More worrisome, what if Germany has gone back on the deutsche mark but the euro still exists — issued by more inflation-inclined countries? Presumably you would be offered payment in the rapidly depreciating euro. If you contested such a repayment, the litigation could drag on for years.

What if you lent to that German bank not in Frankfurt but in London? Would it matter if you lent to a branch (part of the parent) or a subsidiary (more clearly a British legal entity)? How would the British courts assess your claim to be repaid in relatively appreciated deutsche marks, rather than ever-less- appealing euros? With the euro depreciating further, should you wait to see what the courts decide? Or should you settle quickly in hope of recovering half of what you originally expected?

What if you lent to the German bank in New York, but the transaction was run through an offshore subsidiary, for example in the Cayman Islands? Global banks are extremely complex in terms of the legal entities that overlap with business units. Do you really know which legal jurisdiction would cover all aspects of your transaction in the currency formerly known as the euro?

Moving from relatively simple contracts to the complex world of derivatives, what would happen to the huge euro-denominated interest-rate swap market if euro dissolution is a real possibility? Guess what? No one really knows.

But, what I am really talking about here is the balance sheets of the really big banks. For example, in recently released filings with banking regulators, JPMorgan Chase & Co. revealed that $50 billion in losses could hypothetically bring down the bank. JPMorgan’s total balance sheet is valued, under U.S. accounting standards, at about $2.3 trillion. But U.S. rules allow a more generous netting of derivatives — offsetting long with short positions between the same counterparties — than European banks are allowed. HA!

The problem is that the netting effect can be overstated because derivatives contracts often don’t offset each other precisely. Worse, when traders smell trouble at a bank that has taken on too much risk, they tend to close out their derivatives positions quickly, leaving supposedly netted contracts exposed. Remember the final days of Lehman Brothers?

When one bank defaults and its derivatives counterpart does not, the failing bank must pay many contracts at once. The counterpart, however, wouldn’t provide a matching acceleration in its payments, which would be owed under the originally agreed schedule. This discrepancy could cause a “run” on a highly leveraged bank as counterparties attempt to close out positions with suspect banks while they can. The point is that the netting shown on a bank balance sheet can paper over this dynamic. And that means that JPMorgan’s regulatory filings vastly understate the potential danger.

JPMorgan’s balance sheet, using the European method isn’t $2.3 trillion, but closer to $4 trillion. That would make it the largest bank in the world. Holy Moly!

What are the odds that JPMorgan would lose no more than $50 billion on assets of $4 trillion, much of which is complex derivatives, in a euro-area breakup, an event that would easily be the biggest financial crisis in world history? Slim. And, None.

No one on these shores seems to see the storm coming. In an effort to forestall the impending global crisis, the Federal Reserve should be insisting that big U.S. banks increase their capital levels by suspending dividends, and set up emergency liquidity facilities with an emergency and across-the-board suspension of dividend payments, but it won’t. The Fed is convinced that its recent stress tests show U.S. banks have enough capital even though these tests didn’t model serious euro dissolution risk and the effect on global derivatives markets.

The Fed is dead wrong about that, and the pending Euro-crisis is very real. Our mega-banks are in no position to weather even the known storm, let alone the real storm when all the European counter-parties pony up to the bar with their real exposures, and the true sovereign debt gets exposed. Then, what do you think that means for smaller banks? 

How do you think that might affect the U.S. economic recovery? What is gold trading at? $1,575 an ounce?  Hmmmm.


Spain Teeters.


Just when you thought the financial crisis in Europe had reached its boiling point as exemplified by the Greek election message earlier this week, Spain has quietly begun to waive its own white flag.

In an attempt to avoid an international rescue like Ireland needed to shore up its financial system, Spain is now asking lenders to increase their bad-debt provision by another 54 Billion Euros (to 166 Billion) which will be enough to cover defaults on about 50% of loans to property developers and construction companies (according to the Bank of Spain).

It does nothing however, to address the $2 Trillion in home loans and corporate debt.

Taking those into account, banks would need to increase provisions by as much as five times what the government says, or 270 billion euros, according to estimates by the Centre for European Policy Studies, a Brussels-based research group. Plugging that hole would increase Spain’s public debt by almost 50 percent or force it to seek a bailout, following in the footsteps of Ireland, Greece and Portugal.

“How can you only talk about one type of real estate lending when more and more loans are going bad everywhere in the economy?” said Patrick Lee, a London-based analyst covering Spanish banks for Royal Bank of Canada. “Ireland managed to turn its situation around after recognizing losses much more aggressively and thus needed a bailout. I don’t see how Spain can do it without outside support.”

Unemployment in Spain today is 24% and investors are talking in sentences that contain the phrase, “too big to fail.” In Ireland and now Spain, loans to real estate developers are now looking to be the most toxic.

If losses reach only 5 percent of mortgages held by Spanish lenders, the cost to those banks will be about 250 billion euros. That’s three times the 86 billion euros that the Irish domestic banks, bailed out by their government, have lost as real estate prices tumbled there.

“Spain is constantly playing catch-up, so it’s always several steps behind,” said Nicholas Spiro, managing director of Spiro Sovereign Strategy, a consulting firm in London specializing in sovereign-credit risk. “They should have gone down the Irish route, bit the bullet and taken on the losses. Every time they announce a small new measure, the goal posts have already moved because of deterioration in the economy.”

Without aggressive writedowns, Spanish banks can’t access market funding and the government can’t convince investors its lenders can survive a contracting economy, said Benjamin Hesse, who manages five financial-stock funds at Fidelity Investments in Boston, which has $1.6 trillion under management.

Spanish banks have “a 1.7 trillion-euro loan book, one of the world’s largest, and they haven’t even started marking it,” Hesse said. “The housing bubble was twice the size of the U.S. in terms of peak prices versus 1990 prices. It’s huge. And there’s no way out for Spain.”

Spain’s home-loan defaults were 2.7 percent in December, according to the Spanish mortgage association. Home prices are propped up and default rates under-reported because banks don’t want to recognize losses, according to Borja Mateo, author of “The Truth About the Spanish Real Estate Market.” Developers are still building new houses around the country, even with 2 million vacant homes.

If Spain keeps up the charade, the banks will lose all credibility and soon, not unlike Ireland who tried to stick banks’ creditors with losses and was overruled by the EU, the IMF will declare again that defaulting on senior debt will raise the specter of contagion and spook investors away from all European banks, and thus dis-allow it.

The EU was protecting German and French banks, among the biggest creditors to Irish lenders, said Marshall Auerback, global portfolio strategist for Madison Street Partners LLC, a Denver-based hedge fund.

“Spain will be the new Ireland,” Auerback said. “Germany is forcing once again the socialization of its banks’ losses in a periphery country and creating sovereign risk, just like it did with Ireland.”

“Spain will have to turn to the EU for funds to solve its banking problem,” said Madison Street’s Auerback. “But there’s little money left after the other bailouts, so what will Spain get? That’s what worries everybody.”

Germany is about to own some really nice Greek islands, and it would probably like to add the Canary Islands to its new tourist book. Germans love the sun.

Why I Am Leaving Goldman Sachs.

This is an article written by GREG SMITH in today’s New York Times.
goldman sachs logo

TODAY is my last day at Goldman Sachs. After almost 12 years at the firm — first as a summer intern while at Stanford, then in New York for 10 years, and now in London — I believe I have worked here long enough to understand the trajectory of its culture, its people and its identity. And I can honestly say that the environment now is as toxic and destructive as I have ever seen it.

To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money. Goldman Sachs is one of the world’s largest and most important investment banks and it is too integral to global finance to continue to act this way. The firm has veered so far from the place I joined right out of college that I can no longer in good conscience say that I identify with what it stands for.

It might sound surprising to a skeptical public, but culture was always a vital part of Goldman Sachs’s success. It revolved around teamwork, integrity, a spirit of humility, and always doing right by our clients. The culture was the secret sauce that made this place great and allowed us to earn our clients’ trust for 143 years. It wasn’t just about making money; this alone will not sustain a firm for so long. It had something to do with pride and belief in the organization. I am sad to say that I look around today and see virtually no trace of the culture that made me love working for this firm for many years. I no longer have the pride, or the belief.

But this was not always the case. For more than a decade I recruited and mentored candidates through our grueling interview process. I was selected as one of 10 people (out of a firm of more than 30,000) to appear on our recruiting video, which is played on every college campus we visit around the world. In 2006 I managed the summer intern program in sales and trading in New York for the 80 college students who made the cut, out of the thousands who applied.

I knew it was time to leave when I realized I could no longer look students in the eye and tell them what a great place this was to work.

Blankfein     Gary Cohn

When the history books are written about Goldman Sachs, they may reflect that the current chief executive officer, Lloyd C. Blankfein, and the president, Gary D. Cohn, lost hold of the firm’s culture on their watch. I truly believe that this decline in the firm’s moral fiber represents the single most serious threat to its long-run survival.

Over the course of my career I have had the privilege of advising two of the largest hedge funds on the planet, five of the largest asset managers in the United States, and three of the most prominent sovereign wealth funds in the Middle East and Asia. My clients have a total asset base of more than a trillion dollars. I have always taken a lot of pride in advising my clients to do what I believe is right for them, even if it means less money for the firm. This view is becoming increasingly unpopular at Goldman Sachs. Another sign that it was time to leave.

How did we get here? The firm changed the way it thought about leadership. Leadership used to be about ideas, setting an example and doing the right thing. Today, if you make enough money for the firm (and are not currently an ax murderer) you will be promoted into a position of influence.

What are three quick ways to become a leader? a) Execute on the firm’s “axes,” which is Goldman-speak for persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit. b) “Hunt Elephants.” In English: get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don’t like selling my clients a product that is wrong for them. c) Find yourself sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym.

Today, many of these leaders display a Goldman Sachs culture quotient of exactly zero percent. I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It’s purely about how we can make the most possible money off of them. If you were an alien from Mars and sat in on one of these meetings, you would believe that a client’s success or progress was not part of the thought process at all.

It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail. Even after the S.E.C., Fabulous Fab, Abacus,God’s work, Carl LevinVampire Squids? No humility? I mean, come on. Integrity? It is eroding. I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact.

It astounds me how little senior management gets a basic truth: If clients don’t trust you they will eventually stop doing business with you. It doesn’t matter how smart you are.

These days, the most common question I get from junior analysts about derivatives is, “How much money did we make off the client?” It bothers me every time I hear it, because it is a clear reflection of what they are observing from their leaders about the way they should behave. Now project 10 years into the future: You don’t have to be a rocket scientist to figure out that the junior analyst sitting quietly in the corner of the room hearing about “muppets,” “ripping eyeballs out” and “getting paid” doesn’t exactly turn into a model citizen.

When I was a first-year analyst I didn’t know where the bathroom was, or how to tie my shoelaces. I was taught to be concerned with learning the ropes, finding out what a derivative was, understanding finance, getting to know our clients and what motivated them, learning how they defined success and what we could do to help them get there.

My proudest moments in life — getting a full scholarship to go from South Africa to Stanford University, being selected as a Rhodes Scholar national finalist, winning a bronze medal for table tennis at the Maccabiah Games in Israel, known as the Jewish Olympics — have all come through hard work, with no shortcuts. Goldman Sachs today has become too much about shortcuts and not enough about achievement. It just doesn’t feel right to me anymore.

I hope this can be a wake-up call to the board of directors. Make the client the focal point of your business again. Without clients you will not make money. In fact, you will not exist. Weed out the morally bankrupt people, no matter how much money they make for the firm. And get the culture right again, so people want to work here for the right reasons. People who care only about making money will not sustain this firm — or the trust of its clients — for very much longer.

Greg Smith is resigning today as a Goldman Sachs executive director and head of the firm’s United States equity derivatives business in Europe, the Middle East and Africa.

Al Gore Takes Aim at “Unsustainable” Capitalism

Former Vice President and Current TV Chairman and co-founder Al Gore speaks during the panel for Current TV's ''Politically Direct'' at the Television Critics Association winter press tour in Pasadena, California January 13, 2012.  REUTERS/Mario Anzuoni

Former Vice President and Current TV Chairman and co-founder Al Gore speaks during the panel for Current TV’s ”Politically Direct” at the Television Critics Association winter press tour in Pasadena, California January 13, 2012.

Former U.S. Vice President Al Gore wants to end the default practice of quarterly earnings guidance and explore issuing loyalty-driven securities as part of an overhaul of capitalism which he says has turned many of the world’s largest economies into hotbeds of irresponsible short-term investment.

Together with David Blood, senior partner of  ‘green’ fund firm Generation Investment Management, the environmental activist has crafted a blueprint for “sustainable capitalism” he wants the financial industry to adopt to support lasting economic growth.

“While we believe that capitalism is fundamentally superior to any other system for organizing economic activity, it is also clear that some of the ways in which it is now practiced do not incorporate sufficient regard for its impact on people, society and the planet,” Gore said.

At a briefing ahead of Thursday’s launch, David Blood said capitalism has been blighted with short-termism and an obsession with instant investment results, which had ramped up market volatility, widened the gap between rich and poor and deflected attention from the deepening climate crisis.

The former CEO of Goldman Sachs Asset Management put forward five key actions which he hoped would revive the discussion on how to clean up capitalism and put companies, investors and stakeholders on the path towards long-term, sustainable profit.

These include ending quarterly earnings guidance from companies, which the authors said incentivized executives and investors to base decisions on short-term factors at the expense of longer-term objectives.

Companies have also been encouraged to integrate financial reporting with insight on environmental, social and governance policy so investors can clearly see how performance in the latter can contribute to the former.

“This is a direct appeal, dare I say, attack on short-termism in business,” Blood said.

“Today the average mutual fund in the U.S. turns over its entire portfolio every 7 months; 20 years ago (in 1992) it was every 7 years. Something has fundamentally changed and the problem with that is it means we’re not making good investing decisions… and not delivering proper and efficient wealth creation.”

After hitting mainstream consciousness in the early part of the last decade, the 2008 financial crisis brought efforts to make global business more environmentally and economically sound to a virtual halt.

But with so many roots to that crisis found in skewed asset valuations and irrational short-term trading, the authors want to restate the case for change while the pain of the credit crunch was still fresh in the memory.

“We went down this path because we fundamentally believe this is relevant to business. This has always been about value creation and this whole conversation about sustainable capitalism is not a new movement,” Blood said.

“While governments and civil society will need to be part of the solution to these challenges, ultimately it will be companies and investors that will mobilize the capital needed to overcome them.”


To offset the disproportional influence of short-term traders like hedge funds on global markets, Generation has proposed the issuance of loyalty-driven securities to reward investors who nurture real business growth by holding a company’s shares for a number of years.

The blueprint also recommends significant changes in corporate compensation structures, putting more emphasis on bonuses linked to multi-year performance instead of individual fiscal years.

Gore said pension funds had a vital role to play in coaxing their managers to make longer-term investment decisions, which by extension, could result in a healthier society and planet.

“(They) have a fiduciary obligation to maximize the long-term performance of their assets to the maturation of their long term liabilities,” Gore said.

“If pension funds turn to managers of their assets and compensate them with a structure that incentivizes them to maximize performance on an annual basis, they should not be surprised if that is what their managers end up doing.”

Blood said the campaign for sustainable investment had been hit by worries that change would cost more than it would ultimately deliver, but many businesses were still to grasp how value-destructive some elements of modern capitalism had become.

“…in America, as soon as you say the word ‘sustainability’ people think of socially-responsible investing, tree-hugging and we don’t believe that at all. We think sustainability is just best practice in business,” he said.

Europe’s Banks Reluctant to Aid Companies in Need of Cash.

The death spiral continues.

Petroplus, the largest independent oil refiner in Europe, said it was filing for insolvency after lenders demanded repayment on $1.75 billion of outstanding debt.
Petroplus, the largest independent oil refiner in Europe, said it was filing for insolvency after lenders demanded repayment on $1.75 billion of outstanding debt.

 European governments are not the only ones struggling with debt — so are some of the region’s companies.

As profits and sales slip, some European businesses are scrambling to pay their bills. With banks reluctant to lend, the fear is that companies will be unable to come up with the cash and will be forced to take drastic action, further weighing on the economy.

“There’s a lack of business confidence across Europe” said Jonathan Loynes, chief European economist in London at the research organization Capital Economics. “Lending to the private sector is deteriorating, and there’s enormous stress on the European economy.”

The pressure is mounting. Insolvency — when a firm’s debts exceed its assets and cash flow — is expected to rise 12 percent this year in the euro zone. Countries like Greece, Spain and Italy are expected to record the highest annual increases. In the United States, the number of insolvencies is falling.

In January, Petroplus Holdings of Switzerland, the largest independent oil refiner in Europe, said it was filing for insolvency after lenders demanded repayment on $1.75 billion of outstanding debt. The company, facing dwindling margins as a result of high oil prices and weak economic conditions, tried to negotiate with creditors. But BNP Paribas of France, Credit Suisse of Switzerland and other lenders already dealing with the fallout from the European sovereign debt crisis decided that Petroplus was not worth the risk. When Oil companies start to fail, you know there is a real problem.

“We were ultimately not able to come to an agreement with our lenders to resolve these issues given the very tight and difficult European credit and refining markets,” the company’s chief executive, Jean-Paul Vettier, said in a statement on Jan. 24.

Now, other companies, including energy multinationals and private equity firms, are sifting through the pieces. Nearly 40 bidders are assessing the British operations of Petroplus, according to PricewaterhouseCoopers, which is overseeing the sale of the assets in Britain.

It is a bad omen. Roughly two thirds of European companies that become insolvent will eventually file for bankruptcy, according to Ludovic Subran, chief economist of Euler Hermes, a credit insurance firm in Paris.

“The business environment has become worse,” Mr. Subran said. “Many companies are losing their competitiveness and being hit by a reduction in consumer spending.”

This year is shaping up badly for the Continent. The International Monetary Fund said on Jan. 24 that the euro zone’s gross domestic product would fall an estimated 0.5 percent in 2012. The downturn will be most severe in Southern Europe, where Italy’s economy is expected to contract by 2.2 percent and Spain’s by 1.7 percent.

The economic headwinds are wreaking havoc on corporate profits. As Europe grapples with recession, unemployment is rising, consumer confidence is plunging and manufacturing orders are falling.

Consumer-focused companies have been hit especially hard. In January, the giant British retailer Tesco issued its first profit warning in more than 20 years, and said earnings for 2012 would be $709 million lower than analysts’ expectations. Carrefour of France, the global grocery chain that recently replaced its chief executive, has estimated that operating income for last year would fall by 15 to 20 percent, with sales taking a hit in France and Southern Europe.

“Banks are being more conservative about who they lend to, and Europe’s economic problems are weighing on companies’ future prospects,” said Brian Lochead, a business recovery services partner at PricewaterhouseCoopers in London. “One problem is driving the other.

Without the financial lifeline banks can provide, debt-laden businesses are selling assets and cutting investment in order to conserve cash.

To restructure its finances, Punch Taverns, a British pub chain that borrowed $7.4 billion to expand rapidly in the last decade, decided to split itself in two last year. A smaller group, the Spirit Pub Company, was created with Punch’s most profitable locations. Punch, which was left holding 75 percent of its $4.8 billion of outstanding debt, is now trying to sell more pubs to reduce its burden. Roger Whiteside, the chief executive of Punch, said the plan would help return the company to growth within the next five years.

Some companies are running out of options.

In December, Seat Pagine Gialle, the Italian yellow-pages publisher, said it would not pay $72 million to creditors as the company looked to restructure its balance sheet. It was the second time Seat had defaulted on its debt in less than a year, although creditors have yet to push the company into insolvency.

Others may follow. European companies with credit ratings below investment grade have a combined $72 billion of debt to repay this year, according to Standard & Poor’s. Defaults among this group are expected to rise by as much as 8.4 percent in 2012, S.&P. estimates.

The sovereign debt crisis is only exacerbating the problems. A recent survey released by the European Central Bank showed that institutions had cut back on the credit available to companies in the third quarter of last year, the latest figures available. More worrying for Europe’s corporate sector, banks also said they would pull back even further in the final three months of 2011.

“If companies aren’t viable and don’t have access to refinancing, banks don’t want to throw good money after bad,” said Ángel Martín Torres, head of restructuring for Spain at the accountancy firm KPMG.

Regulators’ attempts to spur lending have yet to pay off. In December, the European Central Bank moved to provide the financial sector with 489 billion euros ($639 billion) of low-interest loans. Authorities had hoped the money would ease the credit pressure on European banks so they would start lending again to the wider economy.

But instead of offering the money to credit-starved companies, institutions have preferred to deposit the cash with the central bank for safekeeping. On Jan. 18, officials said European banks had parked about $700 billion in overnight deposits with the central bank, the highest level since the euro was established in 1999.

The distress could open the doors for potential takeovers. Cash-rich multinationals, including Siemens of Germany and Philips of the Netherlands, have been hunting for attractive assets at troubled companies. And private equity firms that specialize in buying distressed assets also are on the lookout.

In January, Sun European Partners, the private equity firm, bought Bonmarché, a division of the insolvent British fashion chain Peacocks that caters to older women. Sun European already owns other retailers in the sector, and it plans to use the acquisition to expand its market share.

“Many companies have good assets but bad capital structures,” said Mark Sterling, managing partner of law firm Allen & Overy’s restructuring and insolvency practice in London. “So if they are good underlying businesses and have no sources of refinancing, that creates opportunities.”

Crowdfunding: The Next Big Disruptor!

Social networking comes to finance

Crowdfunding may be a big disruptor. The arcane world of Wall Street and the City of London have kept a tight grip on world of finance for so long and has become so incestuous and expensive (in the US, the legal fees alone for a ‘direct public offering’ could run to $100,000), it is no surprise that people who want to start an enterprise are finding many ways to side-step them. Crowdfunding, sometimes called crowdfinance or crowdsourced capital, is in the process of reinventing finance $100 at a time.

Rather than imagining that you can develop a fat business plan to convince a single investor, crowdfunding allows you to pitch to a large number of people simultaneously and get small dollops of investment that can add up to the amount you seek. But there are some limitations.

SEC Restrictions: The SEC 502(c) Rule prohibits issuers from general solicitation and general advertising for private placements, but one method of demonstrating that the sale of a security through a private placement is not the result of general advertising or general solicitation is for there to be a “documented substantial and pre-existing relationship” between the issuer and the prospective investor, such as ‘friends and family.’ This is a way that crowdfunders can avoid sanction. The interesting thing is that there is no definition of what constitutes a “pre-existing” relationship. “Substantive” means that if the company (or a person acting on its behalf) has reliable knowledge or information regarding the prospective investor it should be sufficient that it can evaluate the investor’s financial circumstances and level of sophistication.

The SEC has given little guidance on using the Internet as a tool for raising capital, but may soon change as crowdfunding sites become more creative using their own online social network of “substantial and pre-existing” friends among the crowd. For now, it seems that many crowdfunders are not offering ‘securities’ as such. This is the case with Profounder (see below) that remunerates lenders by paying a royalty on sales.

In 2010, the Sustainable Economies Law Center petitioned the SEC to allow crowdfunding, within certain limits. Their submission makes interesting reading. As do the responses. It’s a matter of ‘watching this space’. Chances are high that the SEC will make a pronouncement before too long. If you want to keep up with the discussion, one way you can follow it is on Change Crowdfunding Law.

Nonetheless, it may be that the noose is tightening around crowdfunding platforms. Prosper, a closely held corporation based in San Francisco, was formed in March 2005 to operate Prosper.com, an online platform to connect borrowers and lenders. By late 2008, over $170 million in loans had been processed through the platform.

On November 24, 2008, the Securities and Exchange Commission (SEC) imposed a cease-and-desist order against Prosper because the SEC determined that the loans offered on the Prosper web site were securities and Prosper had never registered the offering of loans on its web site.

In a decision published on May 4, 2011, Hellum v. Breyer, the California appeals court in San Francisco held that members of Prosper’s board of directors who were not employees of the company could be held personally liable for the securities law violations committed by the company under California law.

The prosper.com website was still operating the following day and with over 1 million members and now with $230 million worth of loans handled, it will be interesting to follow developments.

Commenting in May 2011, the Wall Street Journal said, “With regulators considering easing fund-raising rules for start-ups, social-networking sites that link entrepreneurs to large pools of donors are gearing up for a boom.”

By November 2011, the US House of Representatives had passed HR 2930: Entrepreneur Access to Capital Act. It now needs to pass in the Senate, but it’s unlikely it will fail.

HR 2930 amends the Securities Act of 1933 to exempt from the prohibitions against use of interstate commerce and the mails for sale or delivery after sale of unregistered securities, including unregistered security-based swaps, any transactions involving the issuance of (crowdfunded) securities for which:

  1. the aggregate annual amount raised through such issue is $5 million or less; and
  2. individual investments in the securities are limited to an aggregate annual amount equal to the lesser of $10,000, and 10% of the investor’s annual income.

HR 2930 authorizes an issuer to rely upon certifications provided by investors. It amends the Securities Exchange Act of 1934 to exclude persons holding crowdfunded securities under this Act from application of “held of record” requirements with respect to mandatory registration of securities. It also amends the Securities Act of 1933 to exempt such crowdfunded securities from state regulation of securities offerings.

A shot across the pondEarlyShares, a UK crowdfunding platform has readied itself for a US launch, just as soon as the ink is dry on the Entrepreneur Access to Capital Act.” Crowdfunding is working well in the UK. It is time for the U.S. enjoy the same success,” says Maurice Lopes, the company’s CEO, having already raised over $2.5M for six companies from hundreds of small investors in only a few months.

Raising money–a blastWindowfarms, the open source hydroponic farming system and social network, has raised over $223,822 dollars on Kickstarter. This is $173,822 more than their goal, making Windowfarms Kickstarter’s most successful food project to date and one of their more successful projects period.

Obama led the way: As lawyer Tom Kappel from Nashville wrote in a law review article, “Barack Obama’s campaign raised nearly three-quarters of a billion dollars largely in small amounts over the Internet. The campaign’s ability to mobilize and monetize supporters using the Internet is often cited by pundits of all political stripes as a principal factor in Obama’s victory. If nothing else, Obama’s fundraising figures are evidence of people’s willingness to give financial support to someone they believe in—sometimes referred to as ‘crowdfunding’.”

Loan Guarantee Fund: IndieGoGo (see below) is supporting a loan guarantee fund (like the loan guarantee fund of the SBA) for small crowdfunded businesses. The money will be used as a guarantee for a loan to an entrepreneur selected by his/her peers. The Entrepreneur Commons Mutual Guarantee Fund is a project of Community Ventures, a 501(c)3 nonprofit organization.

Kiva microfinance: I am a huge fan of Kiva, the P2P micro-lender and will soon have made my 100th loan to microfinance individuals and small teams, largely in the developing world. It has used the Internet to connect small businesses in the Third World with philanthropically minded lenders in the First World. Only five years old, $74,235,600 in loans were posted on Kiva in 2010–in 54 countries.

Kiva’s marketing has been excellent and combined the use of both old and new media, to huge effect.

Crowdsourcing is itself and really rampant phenomenon now. It makes good sense when you are wanting to share your story. Or have others share theirs with you. Or both of you wanting to pool resources to some extent. So it’s not surprising that crowdsourcing is being used to get ideas, offer services, find skills–and in this case, find money. The best way into understanding crowdsourcing is to read Crowdsourcing: Why the Power of the Crowd Is Driving the Future of Business.

In the innovations field, probably the best known example of crowdsourcing is InnoCentive. It’s a place where organizations—corporations, large and small, not-for-profits and governments—turn when they have important problems that need solving. Their expertise is in Open Innovation (OI). They help expand companies’ innovation capabilities by building a more collaborative approach to problem solving, and providing the means to tap into the best minds within the company as well as creative problem solvers throughout the world.

A really interesting experiment has been mounted in Washington State: a group of East Jefferson County, Washington, citizens who are interested in facilitating financial investments to help local businesses and individuals has formed a Local Investing Opportunities Network, or LION. LION creates opportunities for local individuals and businesses to connect with local investors to build prosperous local businesses, keep investing money in our community, and help build a more resilient and sustainable economy in East Jefferson County.

LION is not a bank, lending institution, or financial consultant. In effect it’s a form of crowdfunding and its membership consists of local citizens who want to invest their money locally, thereby putting their investing money to work within our community. Keeping funds local facilitates greater economic self-sufficiency, job growth, economic development, and a dollar-multiplier effect whereby a dollar kept within the community can be spent many times over for a far greater benefit than a dollar invested away from our community.

Raising funds meets brand marketing

One of the advantages of raising money for your business through crowdfunding is that it provides the opportunity to engage customers, prospective customers as well as just plain friends, family and fans directly. If you tell people on your mailing list (from the SEC perspective, they have to be people you know–though the word ‘know’ is open for discussion) about your pitch, you may be surprised at how they will want to engage with you.

Thus you can raise money and promote your brand at the same time. Supporters will find it easier to commit small amounts of money, especially if you make it easy, for example by paying them back through revenue sharing in place of dividends or interest. In that way, once the business is up and running and making sales, they get paid out on a regular basis–monthly for example.

If you want to understand more about crowdfunding, then I highly recommend The Crowdfunding Revolution: Social Networking Meets Venture Financing.

The point about the marrying of finance and marketing is that it is entirely in your interest, whether you are raising funding or not, to develop a wide circle of relationships in connection with your venture.

Crowdfunding is coming center stage. I recommend it to anyone who needs seed money to start their business. I am sure there will be more books appearing, but right now the only one is The Crowdfunding Revolution: Social Networking Meets Venture Financing by Kevin Lawton and Dan Marom, who self-published it.

Crowdfunding has arisen in part, as a natural consequence of social networking, and in part to fill a void in seed money raising not filled by the traditional banking and finance world.

If you want to follow a campaign in favor of crowdfunding in Congress, go to Startup Exemption. And lend your vote to get this passed.

Crowdfunding first; loan and equity later

If you use your own money, coupled with crowdfinance to get off the ground, your business will be much more convincing to bankers and investors later.

Let’s assume that you put in $5,000 of your own funds and raise another $5,000 from 20 members of your ‘crowd’ who each put in $250. Then you get going and make sales of $5,000 a month. Now lets assume you were prepared to offer a royalty on sales that would have amounted to 10% on lenders’ loans had the money been put up on that basis.

Your ‘crowdbackers’ would each get paid out about $2 a month (10% on $250 over a year is $25 ÷ 12 months = $2.08). In this way you would be paying out just over $40 a month on your sales of $5,000 and so the royalty you’d be paying would be just about 1%. This could be easily managed.

Now that sales would be going well, an approach to a bank for a loan or an investor for equity would be doubly convincing because your business is

  1. generating enough revenue to pay back the loan and grow the business value;
  2. trusted by 20 people who are already getting a return on their money.

If you are going to do it on a simple basis with just a handful of friends, then make sure you use a formal promissory note vehicle to protect both parties and the relationship between them.

Cutting Edge Capital–a new approach

Cutting Edge Capital is a new approach to funding that helps ventures and organizations to raise moeny in creative ways through Fan-Based Funding; Cooperatives; Direct Private Offerings; Grants and Public Private Partnerships; Direct Public Offering. Their basic philosophy is based on the idea that there is no reason why a venture should go for the 4% of funding that is available through private equity, when they could have access to 96% that is available through public equity.

Cutting Edge Capital provides small and mid-sized businesses with the information, tools, and expertise they need to raise capital in a way that fits with their unique business model and long-term goals. As experienced business lawyers, entrepreneurs, and finance experts, the CEC team has identified capital raising strategies that allow businesses to solicit non-traditional sources of funding.  In addition to being a great way to raise capital, these strategies allow businesses to build public support and recognition at the same time they are raising funds.

Before you read much further, you may want to see the advice of Cutting Edge published on their blog: Capital on Tax on Money Raised Through Crowdfunding.

Crowdfunding replaces venture capital

Times are not good for the venture capital industry. According to Deloitte’s, the VC Industry expected to contract in traditional markets (U.S. & Europe) although to gow in emerging markets (China, India & Brazil). In 2010, they also reported that in 2009 there were 12 venture-backed IPOs and 26 through the first half of 2010 compared to 86 venture-backed IPOs in 2007.

Not surprising to learn therefore, that Trampoline Systems an enterprise software vendor based in the UK became the world’s first technology business to raise finance through equity crowdfunding. The company announced a programme to raise a total of £1 million spread over four rounds. The first round of £260,000 was completed in October 2009 and a second round of £350,000 opened in August 2010.

Trampoline has worked closely with legal advisors to ensure its crowdfunding process complies with Financial Services Authority (FSA) regulations. The company is only inviting expressions of interest from people certified as high net worth individuals or as sophisticated investors, plus Trampoline’s existing shareholders.

A development that seems to be particularly significant is AngelList–a community of startups and (over 1,000) investors who make fund-raising efficient, by direct matching. To see what users think about, the reviews are well worth reading and following up. Here’s how AngelList works:

  1. First, you create a startup profile and pick which investors can see your startup. If your profile isn’t ready to share with investors, just pick zero investors. You can update your profile and investors anytime.
  2. Every investor on AngelList sees 10-20 new startups in their feed every day. Plus they have their own non-AngelList dealflow. So you may get a few intros this way and they’re working on ways to increase the rate of these spontaneous intros.

This kind of social networking is dynamic and the founders are changing the way the system works almost every day. By the time you read this, things may well have moved on.

Crowdfunding Meets Banking

The basic idea of crowdsourcing led to crowdfunding, but it now seems also to be moving into banking. Imagine the banking revolution that could result. Take a look at Civilized Money that uses people-to-people networks to create an ethical, transparent alternative to the existing financial services industry. No gambling with your money, no fractional reserve lending, no monster bonuses. It’s banking with people, not banks. Eventually Civilised Money will offer all the services that you currently associate with traditional banks, and some you don’t. You’ll be able to choose what happens with your money, whether you participate in lending, borrowing, investing, donating, fundraising or transacting.

You can set up a crowdfunding site, too

Launcht crowdfunding platform

Launcht is a company that has produced what’s called a ‘white label’ crowdfunding platform. White label means that you can use their technology and brand design your own site for fundraising, or going into the crowdfunding business.

All the tools are there and you do not need to be a systems person to set up on your own. Based in Vermont, they’ll help with the design and configuration. They can get you started with your sales, marketing and operational plans. Launcht is one of the new breed of Benefit Corporations that are equally responsible to their three main stakeholders.

Crowds of crowdfunders

There is a fast growing list of crowdfunding sites in many industrialized countries. Each has its own particular slant and limits to the amounts that can be raised or means of repayment/rewards to lenders. The formula used by each one is different and there are differences by country, too. In the US the SEC regulates the field, but other countries are more permissive, or risky, depending upon how you see it. A crowd of crowdfunders are shown here and more are being added, almost daily.

SeedUpsSeedUps aims to plug the funding gap for early stage start-up companies raising up to $250k and allows you to gain access to a growing pool of investors, while getting a fair equity valuation and secure seed funding in your idea. You pay a low transaction fee only if funded, with follow-on growth funding. SeedUps was set up by Michael Faulkner, initially in the UK and Ireland, Seed Ups has now arrived in the US. He says, “After months of preparation and following the set up of an office in Silicon Valley, we’re really looking forward to working with tech start-ups in the US.”

Kickstarter: A fast-growing social funding site is Kickstarter. It is for creative projects rather than people starting a business as such, but some creative projects are businesses, too. Creatives pitch their idea and backers make bids to support them. An example business startup is Vere Sandal. Take a look at theirpitch on Kickstarter. The bidders generally get something back–either product, kudos or prizes.

Rockethub: Another very similar site to KickStarter is RocketHub. Describing themselves as a grass roots crowdfunding site, Rockethub’s focus is again within the creative arts, with the two audiences for the site split into ‘Fuelers’ – those providing financial assistance to cool projects, and ‘Creatives’ – those coming up with the concepts, artwork and music and in need of funding. RocketHub calls itself a community for Creatives by Creatives and as a purely indie outfit, not backed by any venture or corporate money. RocketHub is accountable to the user, they say, not bankers or the old guard.

Profounder: The Web is allowing an increasing number of innovative crowdfunding to see the light of day. The co-founder of Kiva, the first P2P microlending platform, Jessica Jackley has moved on to establish Profounder.

At Profounder you make your pitch–not a great fat business plan– and set your investment terms.

What is original is that instead of seeking capital or loans, you enter into a revenue-sharing agreement with your backers. You make money, then they do too. The web page that gets created is where you receive your funding and each quarter you post your revenues and then share them with the investors for the duration of the the investment.

Loans of up to $2m can be raised and the entrepreneur sets the terms for the royalty repayment and the term. When ‘investors’ take their money out, they can either take it as cash or divert it to a cause.

Venture Bonsai: Based in Helsinki, Venture Bonsai is a crowdfunding service for European startups looking for funding (direct investments) less than € 1m. Venture Bonsai enables entrepreneurs building what it calls online trust in order to attract investors as well as facilitates the whole investment process. The tools and processes offered include for example building the trust network, using the standardized documents and making a vendor due diligence and have it verified.

PeerBackers: It is an online funding platform that allows business owners to raise capital from their “peers”—in small increments—in exchange for tangible rewards to those who contribute. Peerbackers is led by two founders – Sally Outlaw and Andrew Rachmell, who have partnered in the past to create and produce The Next Wave with Leonard Nimoy, a television series airing on CNBC, devoted to exploring innovative technologies for both start-ups and existing companies. Peerbackers is for raising smaller sums and payback is both in kind and towards the cost of what’s being sold.

GrowvcGrowvc calls itself the Virtual Silicon Valley. Bringing a global, transparent, community-based approach to seed-funding, Grow VC can help startups secure initial funding of up to $1M US for their businesses. Grow VC will not only connect startup entrepreneurs with investors to help them discover common interests, but also provide tools for processes and transparent, new ways of doing things. Grow VC International headquarters is located in Hong Kong, with offices in the UK and Finland.

EnviuEnviu develops innovative solutions to environmental and social issues and introduces these to the market. We collaborate with a large group of young entrepreneurial people, senior executives, corporate partners and universities to co-create these innovative businesses.

Funding Circle: An online marketplace where people can lend directly to small businesses in the UK,Funding Circle eliminates the high cost and complexity of banks. People get higher, stable returns for the long term, businesses get lower cost finance to expand and develop. They trust this simple idea makes an easy to use website that hope can have a big impact. Lenders can earn annual returns estimated at 6 – 9%. Borrowers pay lenders a fixed amount each month which includes interest and a repayment amount. Loans last for 1 or 3 years.

LendFriend: here is another site where you can organize lending from friends and family. LendFriendwas founded by entrepreneurs who have had loans with friends and family. We’ve purchased our first computer with a loan from grandparents, invested in a friend to fund their first company, and helped a sister consolidate debt. By default, our Loan Management Tool is entirely free. It maintains an online record of the terms of your loan and its projected repayment schedule for your personal reference. Additionally, borrowers will receive email reminders when payments are due to their loan partners. However, if you prefer more financial security, you can also add a legally binding agreement – a Promissory Note – to your loan for a fee. LendFriend will automatically draft your selected loan terms into this document.

Raise Capital: A sort of selective Craigslist for funding, RaiseCapital allows people with business ideas to post text, photos, and videos about their projects to attract some money. That kind of funding is helpful at a time when bank loans are hard to get. Entrepreneurs can log in after paying a one-time $99 fee, and they receive a unique URL on the site as well as a visit counter to track how many people have viewed their posts. The network of investors who are interested in a particular category receive a daily update showing all the new businesses registered the day before. RaiseCapitalTV.com features new businesses in a video presentation. Charities and nonprofits are allowed to post for funding, as well.

Innovatrs: is an international, crowdsourced partnering platform. Innovatrs source the world’s most innovative entrepreneurs so people can partner with or invest in them. Innovation officers, business development or partnership directors and investors use Innovatrs to efficiently discover the most relevant entrepreneurs and ideas.

FundaBrandFundaBrand is the trading name of Crowd Source Capital Limited and is a crowd sourced funding platform where project owners can showcase their projects and raise funds to start and/or grow their businesses. Based in London, with a California office, FundaBrand offers project owners seeking funding the possibility to raise start up and/or expansion capital from a sale and lease back of their brand whilst still holding onto 100% of their equity. This is yet another variant of crowdfunding that obviates the need for compliance with SEC and equivalent rules in other countries.

CoFundIt: Based in Switzerland, CoFundIt is in Beta and already has raised quite substantial sums for projects. Members join and seek funding by making pitches in which they can have links to products or websites. The English language of the site may lead to questions.

33needs: A new crowdfunder, 33needs focuses on social enterprise. 33needs allows people to invest, make a social impact, and earn a return. Social entrepreneurs begin by applying to the 33needs investment committee, providing information and an introductory video on their project. If they are accepted, they can select a 30 or 60 day period in which to raise the chosen amount. If the goal is reached, the pledges are turned into investment, minus 5% for 33needs. Like Profounder, 33needs sidesteps restrictive US securities legislation by offering revenue sharing rather than an exchange of security.

Start Something Good: social enterprise is burgeoning–StartSomethinGood empowers people from around the world to become social innovators. By connecting social entrepreneurs with the financial and intellectual capital they need to transform an idea for improving the world into a reality, together we can turn ideas into action and impact.

Crowdrise: Like 33needs, Crowdrise is in the non-profit field. Crowdrise is about raising money for charity and having the most fun in the world while doing it. Crowdrise is way more fun than anything else aside from being all nervous about trying to kiss a girl for the first time and her not saying something like ‘you’ve got to be kidding me.’  They call it sponsored volunteerism: simply create a project page on Crowdrise to show the amazing volunteer work you’re doing and then message all your friends and family and ask them to sponsor you.

On GreenOnGreen focuses on business ideas and patents that are a part of the green economy–tries to bring inventors, entrepreneurs, and investors together by creating a “social marketplace” to connect startup businesses with the funding they need and the new technology that might help them move forward

FirstGiving: The purpose of FirstGiving is empowering passionate nonprofit supporters to raise more money than they ever thought possible for the causes they care about.partners with nonprofit organizations to allow them to plan, execute, and measure successful online fundraising campaigns. For individual fundraisers, they aim to make the process simple, effective, and even fun!  More than 8,000 non-prfoits have used them, raising over $1bn from 13 million donors. If that fails, try SocialVibe!

Supporter WallSupporter Wall gives you the ability to collect donations for any cause or project. Supporters purchase squares on your Supporter Wall. The square then displays their chosen photo and link. As squares are purchased, the proceeds go directly to you.

Catwalkgenius: On Catwalk Genius, based in UK and Ireland, you can invest in a public-funded fashion collection. You find a brand you love and buy a share for the chance to earn profits and perks. UK and Irish fashion fans can get involved for as little as £11, the price of one share. When the chosen designer makes a new collection with their public investment, supporters share in the revenues from sales.

FashionStake: is another crowd-curated fashion marketplace–FashionStake is based in New York. Along with shopping top emerging designers, you can pre-order exclusive fashion at special prices and vote up your favorite pieces. FashionStake was conceived to bring exclusive fashion from top designers directly to the public, without the large markup, restrictive choice and hassle of traveling to stores.

Indiegogo: Founded in 2008 because there are so many people in this world, with great ideas and big dreams, who are looking for the opportunity to get funding. IndieGoGo offers anyone with an idea – creative, cause-related, or entrepreneurial – the tools to effectively build a campaign and raise money. Read about Emmy’s Organics of Ithica, NY who raised $15K for their business through IndieGoGo.

Pozible: is a new crowdfunding platform and community for creative projects and ideas. Based in Sydney, Australia, Pozible has been developed for artists, musicians, filmmakers, journalists, designers, entrepreneurs, inventors, event organizers, software developers and all other creative’s, to raise funds and give project creators the break they need to realize their goals and aspirations.

SellaBand: Based in Munich and Amsterdam, SellaBand was launched in 2006 and has coordinated recording sessions for 42 artists or acts who had their albums funded by their fans. Over $3,000,000 has been invested in independent bands. Artists retain ownership of the works created and have the flexibility to determine which incentives they will offer their fans who fund them. The funding engine also allows artists the freedom to enter into deals with any label, management company, or publisher and there are no advances to pay back.

fanaticfanatic.fm is a music sponsorship platform where brands and bands can find each other. Musicians publish a new album with sponsorship from brands. No corporate sell-out – musicians take full control over choosing sponsors.

FansNextDoor: This is a Europe-based platform that empowers creatives into funding their projects, thanks to their fans’ contributions. With FansNextDoor, you submit your project online; you promote it in every way you can (online and offline); you get your funds.

CofundosCofundos helps to realize open-source software ideas, by providing a platform for their discussion & enrichment and by establishing a process for organizing the contributions and interests of different stakeholders in the idea. Cofundos is based at the Department of Business Information Systems at the Institute for Computer Science of Universität Leipzig.

CrowdCube: Based at the University of Exeter in the UK, CrowdCube is unlike many other crowdfunders in that UK-based entrepreneurs offer equity. The founders want to emulate Kickstarters, where they report the tictok venture that raised nearly $1m from 13,000 backers in a matter of weeks.

MicroVenture Marketplace: This is the financial industry’s first organization which merges peer-to-peer lending with the venture capital industry. The Austin, Texas-based MicroVentures also provides an exclusive opportunity for investors: to offer funding resources to entrepreneurs and early-stage organizations that need capital to accelerate company development.

WealthForge: Coming soon WealthForge will open new capital markets to entrepreneurs, while creating new investment opportunities for qualified investors and provide exposure and networking prospects to all users. Entrepreneurs can seek capital funding by showcasing business concepts to a network of accredited investors. Investors can easily view the best new business ideas for funding consideration. There’s also room for General Users who want to contribute services or aide in ventures.

Quirky: You might just find a product of interest on Quirky, but you can submit an idea and have it worked on by the crowd. If it wins, quirky will sell it. You might even find helpful people you’d like to link up with. Most people have earned nothing, but some have earned tens of thousands of dollars.

Starters Fund is now in Beta in Europe. It is owned by SeedFunding International Ltd, a private Limited by Shares Liability Company established in Nicosia, Cyprus. The Company belongs to the creators of startersfund.com, as well as enthusiast angel investors who financially supported the project through the early stages. Startersfund.com offers the opportunity for collecting funds through the two most common methods of crowdfunding, combining also a Virtual Business Incubator (VBI), a Business Accelerator and a specialized marketplace, in order to fully support start-up birth, growth and acceleration.