Tuesday, September 30, 2014

New Deal-Makers: Who Let the Little Dogs Out? (article 1 in a series of 14 articles about Deal-Makers)

By Jim Verdonik
I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals , have authored multiple books and teach an eLearning course for entrepreneurs. You can reach me at JFV@WardandSmith.com.Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or read my newspaper articles at
 This article is one of 14 articles in a series of articles about Deal-Makers called:
Do you "do deals?"
You know who you are:

·         Venture Capital Managers
·         Investment Bankers
·         Business Brokers and Other M & A specialists
·         Finders
·         Real Estate Developers
·         And the newest members of the dealer-makers club: people who operate technology platforms that showcase companies that are raising money and Social Media consultants who attract potential investors to offerings.

What these people have in common is that they all live by doing deals.

 That's OK, so do I.

A lot is changing in the deal-making world these days.

Three very different groups are being thrown together: 

·         Wall Street investment bankers and brokers, who run worldwide securities markets.
·         Main Street finders who introduce people they know to other people they know.
·         Silicon Valley technology platforms and Social Media consultants, who open the digital world to businesses that are trying to raise capital.

Together they cover the world of investing.  But each group brings different strengths and weaknesses to the table.  They each operate in different ways.  And they each serve different parts of the capital markets and different customer groups.

 Traditional securities laws and regulations failed to protect both investors and businesses in the 2008-2009 crash.  As a result:

  • Some of the mighty have fallen.
  • And some of the meek are inheriting the earth.
  • But of course, some of the mighty remain mighty.
  • Both the mighty and the weak are scrambling to adapt their businesses to new technology and to new securities regulations.
Amidst all these changes, one thing remains constant:  Deals need money.  If you cut off the money supply, deals die.  So do the businesses who need to do deals to raise capital.

Recent deal-making changes and how money is flowing into deals are being shaped by a combination of:

  • How people are using technology.
  • Economic restructuring.
  • New securities regulations.
These three changes are not happening in isolation.  Each of these changes affects the others. 

Each change causes people to ask: "If this is changing, why can't other things change?"

Both the Securities and Exchange Commission and the entrenched Wall Street firms that the SEC both regulates and protects, are scared we may experience a chain reaction of change that will destroy the order the SEC and Wall Street have worked so hard to establish.  Both have vested interests in limiting the roles Silicon Valley and Main Street have in deal-making.

The focus of our series of fourteen articles as we examine the rules that regulate deal makers will be to:

·         Explain the current rules and their basis.
·         Explore how the rules apply to deal makers on Wall Street, Main Street and Silicon Valley.
·         Examine how the SEC is going beyond the powers delegated to it by statutes when the SEC expands the scope of broker-dealer registration laws beyond the statutory language primarily for the purpose of the SEC's own administrative convenience. 
·         Discuss what changes make sense for each group of deal makers and how these changes can promote the interests of both investors and businesses that need to raise capital.

Broad Public Policy Issues

This first article in this series deals with broad public policy issues that are driving change. 

Before we jump into details of technology platforms, how finders work and securities regulations, it's useful to understand what is driving change.  Since change is an ongoing process, it's not enough to just chronicle where change has led us to date.  The future is where we find opportunities.  We want to look at the map that lies ahead of us to predict future changes.  Understanding WHY things are changing helps us to make better predictions 

Other articles in this series will focus on a range of specific securities regulatory issues that affect deal making and explain why these issues are related, including:

  • The traditional regulatory framework for brokers in private placements, including recent SEC efforts to include more people in the list of people who have to register as brokers.
  • The exemption Section 201 (c) of the JOBS Act created for unregistered intermediaries in Rule 506 offerings and how the SEC's interpretation of the limited scope of this exemption is depriving investors of important tools they need to protect themselves.
  • How to make a living in the "crowd."  The economics of crowdfunding platform operators dictated by SEC rules.
  • Proposals to provide exemptions that will free unregistered finders to play more constructive roles in private placement transactions.
  • How to comply with a recent SEC created exemption for M & A brokers.
  • The rise of online venture capital in the form of single purpose investment and buy-out funds as deal-makers switch from being agents to principals and how the Investment Advisers Act (which for decades has had limited impact) is becoming more important to deal-making.
  • The role of Social Media consultants on the capital raising team.
  • A reminder that state laws still regulate brokers.
Let's start by quickly reviewing how securities laws have created the deal-making world we have known for several decades and why a consensus has been building that change is necessary.

Big and Global vs Small and Local

Of course, capital markets are not the only part of the business community that is experiencing change. 

·         Local retailers are fighting big box chain store that operate worldwide.
·         Both are fighting Internet based retainers. 
·         Complex systems are assembled from parts made around the world. 
·         Virtual companies using contractors dominate many industries.  Employees are becoming endangered species.
·         Most information is now free and can be accessed anytime from anywhere. 

 Virtually every aspect of business is undergoing such massive changes that very little is done like it was two decades ago.  The same forces that are shaping these changes are affecting deal making.

 We often focus on the results of change that favor big and global.

 But at the same time that business is going global, local and small business is creating new niches for itself.  Main Street is reinventing itself to survive and in many cases prosper:

·         Craft breweries are popping up virtually everywhere. 
·         Restaurants are buying local produce.
·         People pay craftsmen a premium for handmade products.

In many cases, Main Street's renaissance is based on using the same technology tools that helped to globalize business to reduce expenses create customer specific products and services.  You no longer have to be a big business to use technology to reduce your production costs, to communicate globally and identify niche markets for your products:

·         Small Apps developers are becoming important players in information technology. 
·         3D printing technology promises to allow any local producer to provide custom designed products that don't require large work forces.
·         Virtual companies contract for most services and hire experts from around the world instead of being forced to rely on a limited pool of local employees. 

This struggle between big and global vs small and local sometimes conflicts with laws and regulations.  Because the capital raising industry is more highly regulated than most industries, there are greater tensions with securities laws and regulations when capital raising practices change than in other industries.

Our challenge is that we face a securities regulatory environment that is promotes the flow of capital into big and global and impedes the flow of capital into small and local. 

 Securities laws started in the 1930s when America was full of large companies that ran capital intensive production lines.  Investment banks that securities laws regulate grew bigger and bigger under the protection of SEC regulations.  Big investment banks make big money by doing big deals.  Is it surprising then that modern securities laws work well for big investment banks to raise big money for big companies?

 But the survival and growth of local small business to work and grow alongside big global companies also depends on raising capital.  That means we have to have securities laws that make it both cost efficient and efficient for smaller companies to raise capital.

If we fail to do that, we risk eroding fundamental principles of securities laws.

 Adapt Capital Raising Regulations to Preserve Fundamental Principles

Taxes, environmental, labor and other laws proved powerless to halt worldwide changes in business and technology.  People will find ways to achieve their goals.  They obey laws as long as the costs in time and money to comply with laws do not prevent them achieving their business goals.  If the time and money costs of compliance become too great try to find ways around the laws:

·         Businesses build plants in foreign countries that offer better deals.
·         Businesses hire contractors instead of employees.
·         Businesses place intellectual property ownership in low tax jurisdictions.

Our world is being shaped by these strategies businesses develop to conduct business on a time and cost efficient basis.

Why would anyone think capital-raising would be immune from these changes?

 The only thing different about capital-raising is that Government regulations play a much larger role than in most other industries. 

 Securities regulations have been holding back changes the way a dam holds back a river.  But that can last only so long.  If you don't release water from the dam's reservoir, the water eventually finds a way around the dam.  Eventually, the water erodes the dam's foundations. 

That's why securities regulations must adapt to changing technology and capital needs – to preserve the fundamental principles from erosion by trying to channel the river of changes instead of trying to stop it.

 So, our task is to develop new securities rules that protect fundamental values like stopping and punishing fraud, while facilitating deal making and the flow of money into productive businesses.

 This article is one of a series of articles that discuss how recent changes in technology and securities laws are reshaping the deal-making world.

This series of articles discusses two parts of the deal-making world that are critically important to both small business and young growing businesses:

·         The rise of digital deal-making as new Rule 506 (c) and Crowdfunding rules allow deal-makers of all shapes and sizes to communicate directly with large numbers of potential investors and lenders instead of having to go through traditional gatekeepers. 

·         How finders work the person-to-person side of capital raising that is especially important for small and new businesses that want to grow.  Finders are the crafts brewers of the capital raising world.  They work in niche markets that are too small for bigger competitors.

 Barriers to entry are falling.  People who didn't traditionally do securities deals are now joining the deal-making party.  New deal makers include:

·         Registered crowdfunding platform operators.
·         Platform operators that operate under new Rule 506 (c).
·         Digital marketing experts that attract investors through Social Media.
·         Traditional finders who have new business models.

Some of the people entering the deal-making world never did a deal before.  They are attracted by:

·         New technology.
·         New securities rules.
·         A conviction they can do it better than the old pros of Wall Street.

Only time will tell the extent to which these new players will:
·         Replace existing deal makers.
·         Work with existing deal makers.
·         Be acquired by existing deal makers.

We may not know exactly where change will lead us, but one thing is certain:  Old dealmakers will have to learn new tricks to survive in this new competitive environment.

 But before we talk about new tricks, let's briefly review current rules s why they don't work for many types of people who raise capital.

Traditional Broker-Dealer Regulation

Broker-dealer regulation has traditionally been a one size fits all type of world.  If you do securities deals, you have to comply with all the same securities regulations that apply to Goldman Sachs and Merrill Lynch – even if you have a much simpler business model that makes complying with many of these regulations pointless.

For example, many securities regulations for broker-dealers are meant to safeguard the money and the securities brokers hold for their clients.  But most people who introduce businesses raising capital to potential investors never hold any money or securities of investors or the businesses that raise capital.  The money and securities flow directly between issuers and investors, or sometimes through their lawyers' escrow accounts.  Why should anyone be required to have a money-laundering policy, if they never touch and don't hold anyone's money? 

There are countless other rules that it doesn't make sense to apply to people who just introduce people to one another and then help facilitate their negotiations.  For example, regulations about suitability and churning accounts are meant to protect clients from brokers working for brand name financial institutions that use large advertising budgets to convince unsophisticated consumers they are working for the client's interest in a long-term relationship. 

It makes some sense to protect unsophisticated consumers who do not fully understand their relationship with brokers because expensive mass media advertising promotes.  But smaller finders don't use mass media.  They attract clients based on personal interactions.

Economics of Regulation

Obviously, Wall Street's big dogs might not like all the broker regulations, but this series of articles isn't about the big dogs.  At least the big dogs generate enough revenue from big deals and a constant flow of mid-sized deals that allows them to pay an army of lawyers and administrative staff to comply with all the regulations.

 But if you are a smaller player, the cost of complying with these regulations freezes you out of the deal-making business.  Or burdensome regulations force you to become one of the many smaller players that operate in the shadows without registering as a broker-dealer.

This regulatory compliance cost becomes a barrier to entry for new competitors in many industries.  That's why big businesses make peace with the big regulatory state.  They might not like complying with all the details, but they like how regulations reward established companies by keeping out new competitors.

Our primary concern really isn't about small deal makers who are burdened by unnecessary regulations.  Instead, our concerns focus on the adverse effects these regulations have on the capital raising process – especially for:

·         New businesses.
·         Small businesses trying to grow.
·         The owners of small to medium size companies who want to sell their business.
·         And even small investors who are being excluded from deals, because securities laws push the best deals to wealthy people.

These people cannot achieve their goals if they don't have effective deal makers.

 That's why it's important to ask: 

·         Is applying extensive broker-dealer regulations to finders, new technology platform operators and other people who help get deals done creating positive results? 
·         Or have one size fits all securities regulation of deal makers created unpleasant unintended consequences?

Big Regulation Created Too Big to Fail

Big regulation has created big financial institutions, because small competitors can't afford to pay the same regulatory costs from a small revenue base.  But is big really better?

Where have decades of big securities regulations that created a virtual fundraising monopoly by Wall Street's big dogs gotten us?  Here are a few answers that explain where we are now and how we got here:

  • Too big to fail that left taxpayers holding the bag.
  • Social resentment about Wall Street's high salaries, bonuses and bail outs.
  • Market imbalances with big investment banks chasing bigger and bigger deals and too few people focusing on the small deals.  In the 1970s investment banks were still going small IPOs to raise as little as $5 million.  Then the minimum became $20 million.  Now, $100 million is a relatively small deal.
  • For several decades this void created by big investment banks moving toward bigger deals was filled by the venture capital industry.  Few people noticed or cared that the investment banks weren't dong small deals, because young businesses could raise money from venture capital funds. 
  • When the professionally managed venture capital industry started in the early 1970s a venture fund have a total of $10 million of capital and might invest $500,000 in a deal.
  • But when the professional venture capital industry began shrinking in year 2000, the surviving venture funds mimicked the investment banks by focusing on bigger deals.  That change in the venture capital fund industry created a deal-making dessert for new businesses to start-up, small businesses to grow and provide exit strategy alternatives for medium size businesses.
Finders fill the gaps created by big investment banks and changes in the venture capital industry.

The venture capital industry grew in a low regulatory environment.  Very few venture funds and their managers had register with the SEC.  For the most part, the SEC believed the venture fund industry was not required to register.

Likewise, most finders don't have to register with the SEC.  But unlike venture capital investment funds, the SEC thinks finders are required to register as broker-dealers.

 The expenses of registration and compliance that drove registered investment banks away from smaller deals have caused most finders to decide not to register.  But expenses aren't the only reasons finders don't register. 

 There is a mismatch between the experience and skills required to be a good finder and what regulators think registered brokers need to know.  The reason why many finders don't take the tests required to become registered is that it's often simply a waste of time.  Securities broker examinations that are required to obtain licenses cover very little that is of practical use for your average finder in a private placement.  Most finders use practical business experience to get deals done.  Many investment bankers and retail brokers lack this practical experience.

 Finders typically are from "Main Street," not "Wall Street."  They usually use Main Street skills and experience and Main Street business contacts.  The technology platforms that are changing how business and investors interact generally reflect Silicon Valley values and experience.  That's why regulating finders and technology platforms like you regulate Wall Street don't make much sense.

 Creating a regulatory system that is adapted to delivering each of these unique bundles of skills and experience in what makes sense.  So, let's talk about the regulatory framework and how this impacts the availability of capital for new and growing businesses.

Primary Regulatory Reform

 When you mention securities law reforms, most people focus on two different issues:

·         At the high end of the market, the focus is on the exotic financial engineered debt securities deals that lost Trillions of dollars in 2008 and 2009.  The Dodd-Frank Act of 2010 was supposed to fix this problem.  We'll see whether it will make much difference.
·         Crowdfunding by small businesses and Rule 506 (c) that permits advertising and general solicitation under the Jumpstart Our Business Startups Act of 2012 (JOBS Act) is at the other end of the spectrum.
What we have learned is that too big to fail also usually means too big to succeed in the mission of creating efficient capital raising markets for new businesses and growing businesses.  The verdict is still out on how much the JOBS Act will change the capital raising market for these smaller players.  It depends on how the SEC implements the changes the JOBS Act requires.  So, far the SEC's hostility to these changes does not bode well for the JOBS Act becoming as effective as it could be.

The problem we face is that new rules don't by themselves change market forces.  You need people who are willing and able to take advantage of changes.  That creates the competition that brings about real change.

Reducing Systemic Risk by Open Market Competition

There has been a lot of talk about reducing systemic risk created by large global scaled banks and investment banks.  Most of the systemic risk reduction talk has been about imposing greater regulation on large institutions.

But another way to reduce systemic risk is to encourage smaller deal makers to fill the void created by big institutions who concentrate on global deals.  Then, even if the big dogs fail, the rest of the capital raising system that wasn't plugged into the worldwide network of registered institutions could continue functioning.  This framework would be like having giving you house two sources of power for different parts of the house.  If one power system fails, half your house goes dark.  If you want to read, just move to the other half that still has power for lights.

Creating greater flexibility for finders and technology platform operators to service small to mid-sized businesses would allow these markets to function better even if the global markets are undergoing stress.  Well-functioning alternative capital raising market run by people outside the big banks will not eliminate systemic risk, but it makes it more likely that when Wall Street gets sick Main Street businesses will have local doctors to prevent Main Street businesses from dying. 

Too big to fail is based on the fact that Wall Street holds Main Street hostage.  If investment bankers are laid off, that affects the economies of several big money center cities.  But in our system that depends so much on the big banks, it also affects many other non-financial businesses that depend on Wall Street to keep doing deals.  If deal-making continues through investment banking layoffs, there is less political and economic pressure to save Wall Street from itself.  If Wall Street understands that Main Street won't send the cavalry to the rescue, Wall Street might become a little more careful.

Let's examine how we can use competition to help solve problems that regulation has been unable to deal with. 

New competition is based in large part on letting Main Street and Silicon Valley values and experience compete with Wall Street.  We won't get true value from new laws, if the SEC tries to fit Main Street and Silicon Valley into a Wall Street straight jacket.

For these reasons, this series of articles will focus on whether SEC interpretations of both traditional and new securities laws are consistent with the desire to foster healthy competition in the deal-making world that was one of the driving forces behind the JOBS Act and related regulatory reforms.

Focus on the Middlemen 

What's often missing from the analysis of securities regulations is that middlemen are the glue that holds most markets together.  Trends come and go among issuers and investors, but dynamic markets usually need people who identify potential buyers and sellers who should be doing business together and then make efforts to connect them and help them down the road to closing. 

If you don't have effective middlemen, you end up with a market that looks like a failed junior high school dance:

  • The Girls standing on one side of the gym.
  • The Boys standing on the other side of the gym.
  • A lot of awkward staring across the room.
  • An empty dance floor.
America's economy can't afford to be stuck in a place where investors and innovators are not dancing together.

Technology by Itself Won't Solve Market Problems

 The JOBS Act placed a lot of faith in technology based platforms for both crowdfunding and Rule 506 offerings.

Technology is a useful tool.  Computers can connect people, but the best middlemen do more than just connect people.  It helps to have people who know how to close a sale.  What do deal makers do?  Deal makers:

·         Explain to potential buyers and sellers why it makes sense for them to do business with one another.
·         Show how to structure a deal that addresses the major issues for both sides. 
·         Help both buyers and sellers overcome the inevitable bumps on the road to closing the deal.

Are Broker Registration and Compliance Rules A Fortress?  Or a Prison?

Throughout this series of articles we will deal over and over again in different contexts with big questions for policy makers to consider: 

  • Are the high regulatory walls they built around the activities of broker-dealers a fortress that protects investors?
  • Or do these regulatory walls create a prison run by Wall Street's big dogs that eliminates competition and choice?
Effective securities reform is based on lowering the regulatory barriers to entry for new deal makers.  We'll know these reforms are working when Wall Street's big dogs start asking: "Who let the little dogs out?"

If you agree that the basic goal of securities laws is to prevent fraud and to punish those who commit fraud:

·         Why not concentrate on fraud?
·         Why worry about who is bringing investors and businesses together?  Does it matter if there is no fraud?
·         Why worry about what technology tools dealmakers and investors use?

In considering these issues, we'll talk about several recent regulatory initiatives that all head in the same the direction of letting the little dogs play the game: 

·         Section 201 (c) of the JOBS Act's exemption from registration as a broker-dealer for Rule 506 offerings.
·         Proposed Crowdfunding Platform Rules
·         Rules for operators of "private funds" who form funds to invest in one business
·         A recent M&A Broker No Action Exemption.
·         Proposals for a similar type of exemption for unregistered finders who raise capital.

But before we deal with recent rules changes, let's focus on the primary regulatory issue for deal makers:  Who is required to register as a broker-dealer?

So in our next article in this series we'll discuss the questions: 

·         Who is a broker?
·         Why does the SEC interpret the definition of the term "broker" and registration requirements for broker so broadly?
·         Are the SEC's broad interpretations of the Securities Exchange Act of 1934 really consistent with either the language or purpose of the statute or what we need to raise capital in the current environment?

If you would like to learn more, you can reach me at JFV@WardandSmith.com. 
Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or read my newspaper articles at



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