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by on June 6, 2011 Leave a Comment

Can startup MLMs sell positions to fund their businesses?

This is an important question and one I get asked often by startup entrepreneurs: Can I sell top positions in my prelaunch business to fund it? To quote my least favorite answer from law school, the answer is:

it depends

On multiple occasions, I’ve been asked about the legality of three different methods. The first method is the most common: the selling of top positions i.e. pay $50,000 in exchange for a master position in the pay plan. In a nutshell, this arrangement would be categorized as a security. See below for more info on what constitutes a “security.” If something is a “security” it needs to be registered or fit within some sort of exception. If it’s not registered, a regulator can pursue a company for selling unregistered securities.

The second method is a little more elaborate and involves selling “revenue shares” in the compensation plan for x dollars. As an example, suppose Company ABC wants to create a revenue sharing pool whereby 1% of all company revenue gets skimmed into a separate revenue pool. Company ABC thereby makes available 3 spots to share in the revenue at a $50,000 charge per spot. Do the simple math and Company ABC can conceivably “raise” $150,000 with this method. Again, this would be considered a security.

The third option is the least common. It involves the charging of enrollment fees to give users an early enrollment option and access to a “beta” version of the product or service. With a successful “prelaunch” phase, the company can generate early interest and adequate revenue to scale out the business. Unless the core product is actually sold in these early days, commissions should never be cut. However, true value can still be provided in exchange for the enrollment fee; thus, bolstering the argument that it’s not a security.

What is a “Security?”

In the Securities and Exchange Act, the term “security” is defined broadly. If you want the full definition, click here. Warning: it’s boring beyond belief. Basically, for purposes of this analysis, the important question should be: what’s an investment contract? The U.S. Supreme Court addressed this issue a long time ago in 1946. The Court held an investment contract to be:

“A contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party.”

In the SEC’s case against MLM great, Glenn Turner, the court ignored the plain meaning of the word “solely” and held, “We adopt a more realistic test, whether the efforts made by people in the organization other than the investor are the undeniably significant ones, those essentially managerial efforts which affect the failure or success of the enterprise.”

Confused yet? But wait, there’s more!

Although the Howey Test represents the position of the Supreme Court and the Securities and Exchange Commission as well as a majority of the states, there are some states that apply an additional test. This is known as the “risk capital” test set forth by the California Supreme Court. There are only a few states that use this test; however, according to a colleague of mine, it’s worth knowing. The Hawaiian state supreme court provided the following factors to help clarify this test. Those factors are:

(1) An offeree furnishes money; and (2) a portion of this money is subjected to the risks of the enterprise (i.e. we’ll take this money and build the business with it); and, (3) the investor is promised a return on the investment as a result of the the enterprise (i.e. the investment will grow without the investor doing anything); and (4) the offeree does not receive the right to exercise practical and actual control over the decisions of the business.

Using the risk capital test, a classic example of a “security” would be the “sale” of membership dues for the development of a country club. If the club is simply an idea, the collection of membership fees on the promise of having a country club eventually might be considered a security. However, as pointed out in an American Bar Association article, timing is everything as to when the funds are collected. The article states,

Start quote The risk capital test looks at whether the money being put to work in a given venture will be used to develop or acquire the business or enterprise in which the interest is offered. If that test is satisfied, then such interest is deemed to be a security. Thus, a key factor under the risk capital test in determining whether what is offered and sold constitutes a security can be the extent of the development of the business at the time the interest is purchased.. . . [W]hen analyzing the purchase of a country club membership, it is possible that otherwise identical club memberships may be a security in the hands of one member and not in the hands of another member depending on the time the member acquired the membership and the maturity of the club itself at such time.” End quote

Again, the risk capital test is not used by the SEC and is only used in a few states. But when it’s a factor, it’s a factor when people collect funds in anticipation of fleshing out a concept. If there’s a little development behind the business, it might be a different outcome. In the MLM world, it could potentially be an issue if a company collected fees from participants (in the few states that actually use the test) without providing any value in return.

Translated in English

Can a company hypothetically sell top positions for $50,000 to help fund development?

Yes, but it would likely be illegal (unless they registered the security). Applying the Howey test (developed by the Supreme Court) referenced above, ask the following question: Is there a transaction where the person expects a return based on the efforts of other people? Using the looser standard published in the Glenn Turner case, the answer would undoubtedly be an emphatic “yes.” With a $50,000 payment, even if the investor intended on building the business, the payment would be considered a security assuming the business owner promised a lucrative return on the value of the position.

Can a company create a revenue pot to be divided between investors?

Same answer as above. In this scenario, there’s no fudging. When a top position is sold, there’s at least a tiny argument that the outcome of the investment will be largely influenced by the payor’s performance. In this scenario, the money is driven 100% by the performance of the company, not by the skill or talent of the investor. In this scenario, the business owner selling the hypothetical spots would undoubtedly show financial projections demonstrating the value of those spots i.e. “if we earn $15,000,000 in revenue, you would earn $x for your $50,000 payment” Clearly, this arrangement would be considered a security.

Can a company run a prelaunch and charge enrollment fees with the hopes of raising enough money to flesh out a business?

It depends. This is where the “risk capital” test might come into play. Again, the SEC does not use this, so if it’s a concern for someone, it should only be a concern at the state level (in the states that use it). Using the traditional Howey test, the answer would likely be “no, it’s not a security.” The Howey test involves an investment whereby the person expects a return based on the efforts of other people. Charging an enrollment fee would unlikely be considered an “investment contract” under Howey. Distributors would undoubtedly understand that the enrollment fee would not appreciate in value and entitle them to future earnings. However, if they live in a jurisdiction that goes a little farther and uses the risk capital test, the question then becomes: Is the enrollment fee being used to develop the business? If yes, what’s the stage of development at the time the enrollment fee was collected? If the business was in early stages at the time the fee was collected, was the payor induced by the business owner’s promise that a benefit of some kind, over and above the initial value, will accrue as a result of the enterprise? In my opinion, based on what I’ve read, the risk capital test is rarely a factor and when it is, the investments are usually substantial. The solution: be sure to offer something of value in exchange for the enrollment fee. Instead of treating it as an enrollment fee, treat it more like a sale. If there’s a beta version of the product or service, use the prelaunch phase to test it with early adopters. Throw in some free training, perhaps give them early access to future products or give them various discounts. And be sure to wait to pay commissions until the service is fleshed out. With this scenario, the moral of the story: do not sell the enrollment as an investment opportunity and add value in exchange for the money. And ideally, get the cash before you embark on the arduous journey.

Conclusion

It’s always a challenge for MLMs to get their businesses funded. Traditional angel investors are skeptical of the models and usually want a large chunk of equity in exchange of their investment. Due to these challenges to raise funds via traditional means, many executives rely on creative methods to get the cash they need. Some of these methods are legal, some are not. The methods discussed in this post are some of the most common that I see on a monthly basis. I hope you’ve found this article informative. I’d love to know your thoughts about all of this. What do you think?

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by on May 23, 2011 1 Comment

Free Shipping: consumer expectations are changing

The most compelling statement in this piece: “61% of consumers are at least ‘somewhat likely’ to cancel their entire purchase if free shipping is not offered.”  It’s hard to upsell a shipping fee.  What are your thoughts?  Should MLMs start offering free shipping options?  

Screen-shot-2011-05-17-at-3-15-01-pm


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Author Kevin Thompson is one of the most sought after MLM Attorney in the country. He owns and operates The Law Office of Kevin Thompson and specializes in providing legal services for startup direct sales organizations. Kevin Thompson has extensive experience in the direct sales space and helps entrepreneurs launch their businesses on secure legal footing.  He can be reached from his website here.             

 

posted via email by poseterous

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by on May 22, 2011 Leave a Comment

The Original "Wall"

Photo

posted via email by poseterous

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by on May 19, 2011 Leave a Comment

Old School Marketing vs. Relationship Marketing

The market rewards people that add value daily, helping others win. As the CEO of Coca Cola recently said at the Chick-Fil-A Leadercast, “Customers are increasingly basing their decisions on a number of factors that never existed five years ago. They want more empowerment and they want to know that the company is socially responsible.” I agree! Marketing is changing to a more relationships-driven environment fueled by permission. The direct sales has been ahead of this curve for decades. The space is growing substantially and it’s only going to get better.

What are your thoughts?

Photo courtesy of @Kathy Sierra

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by on May 17, 2011 4 Comments

Amazon White Paper: Why direct sales organizations should pay attention

There’s a rather lengthy white paper on the dominance of Amazon in the ecommerce space. It’s safe to say that Amazon is absolutely dominating e-commerce. In my opinion, Amazon’s dominance impacts direct sales organizations and the white paper below is worth studying. Due to Amazon’s amazing commerce platform, it’s easier than ever for a small business or an individual to create an online presence, market private labeled products to the public, house those products in one of Amazon’s warehouses, use Amazon’s shopping cart system to process orders and use Amazon’s logistics and fulfillment capabilities to ship those products. The moral of the story is simple: if a MLM is private labeling a product and does not have the exclusive rights to a formula, the time span between uniqueness and commodity is rapidly shrinking given the low barriers to entry. With MLMs today, it’s imperative to fortify operations with unique and proprietary offerings. When the MLM sales force no longer have unique offerings and instead have to compete on price against an individual leveraging Amazon’s service, Wal Mart or any other big box retailer, they’ll lose. Due to the speed at which people can knock-off products via private labeling, MLMs need to focus on proprietary.

As a MLM lawyer, I often encourage people to lock down proprietary rights early. This includes securing a patent or negotiating an exclusive arrangement from a vendor with a patent. The more fortified your business with exclusive rights, the better positioned your leaders will be in the marketplace. Enjoy the white paper below and tell me what you think..

Amazon White Paper

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by on May 4, 2011 Leave a Comment

YTB Settles Fraud Charges with Illinois AG

YTB Travel, a MLM that found itself in serious hot water a couple years ago against multiple state attorney generals, recently settled its dispute with the Illinois Attorney general.  Part of the settlement was a payment of $150,000 for restitution to help settle allegations of fraud.  The story can be found here: http://www.stltoday.com/business/local/article_ec8848e4-654d-11e0-b312-001a4bcf6878.html
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Author Kevin Thompson is one of the most sought after MLM Attorney in the country. He owns and operates The Law Office of Kevin Thompson and specializes in providing legal services for startup direct sales organizations. Kevin Thompson has extensive experience in the direct sales space and helps entrepreneurs launch their businesses on secure legal footing.  He can be reached from his website here.             

posted via email by poseterous

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by on April 28, 2011 1 Comment

The End of Class Action Litigation in MLM?

This is an enormous Supreme Court decision for MLM companies. In a 5-4 decision, the Supreme Court held that consumers (distributors) can waive their right to participate in a class action lawsuit. The full article can be found here. The lawsuit was a case between AT&T and Concepcion. In the original lawsuit, Concepcion served as a class representative for consumers against AT&T over a nominal sum of money per consumer: $30. Clearly, $30 is not worth suing over; hence, the purpose behind the class action. But in the fine print in AT&T’s agreement there was a clause where the consumers waived their right to participate in a class action lawsuit and instead were required to arbitrate their disputes. Clever. And apparently enforceable.

This is nothing entirely new for MLM companies. However, it bolsters the argument that all disputes should occur in arbitration instead of aggregating mass numbers and filing a class action lawsuit. There’s a little bit of healthy criticism over the fairness of arbitration proceedings. As stated in the article, “Modern arbitration practices have been the target of watchdog group
Public Citizen for several years. Bills to create an Arbitration Fairness Act were filed in Congress in 2007 and 2010. In a release supporting the 2007 bill, organization president Joan Claybrook blasted the “take it or leave it” forced nature of the clause, the lack of oversight of the process, and supposed bias: ‘…(A)rbitration companies are beholden to big corporate players for repeat business, which creates a bias. They do not bite the hand that feeds them. For example, public data show that in the portfolio of one California arbitrator who ruled in 532 cases, 526 were in favor of business – a mere 1.14 percent for the ordinary consumer.’”

Brian Fitzpatrick, law professor from Vanderbilt, said if the ruling went in favor of AT&T, it would “end class-action litigation in America as we know it.” Given this recent ruling, it just got a lot easier for companies to skim a little here and there from consumers without much threat of consequences aside from a PR backlash. There’s not going to be single agreement now where there’s no class action waiver, which really takes power out of the hands of an aggrieved community, also referred to as a “class.” I have mixed thoughts on this one. What are your thoughts?

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by on April 18, 2011 4 Comments

Ending the Hype: is it posible?

Travis Flaherty uncorked a great debate on his facebook page. Speaking of facebook, fan him up on the Travis Flaherty fan page here. In a facebook note, included below, he challenges people to end crazy hype when representing a network marketing opportunity. After reading his note, I immediately got flashbacks from when I was in the field several years ago. I’m guilty of making the same mistakes referenced by Travis in his article. In fact, I was WAAAAY worse! I never mentioned the company or its products. Instead, “I drove traffic to fortune 500 websites like Disney, Home Depot and Bass Pro Shops whereby they paid us for loyalty.” I left out the part that I only received a sliver of an affiliate kickback from those stores. When asked if selling was required, I said we simply built communities of people and drove revenue to product suppliers that paid us to transfer spend from our grocery budgets and buy products from our own business. I would say, “We’re a buyer’s club and they pay us for loyalty.”  Yep, I’m guilty of breaking the rules mentioned below. With the story I was weaving, you would’ve thought I was building the next Google. Instead, I was building Amway.

Note: I’m not suggesting how I promoted the Amway business was typical for all Amway distributors. I mention this illustration to make a point: I completely understand Travis’s call to end with hype. However, when there’s a focus on recruitment over product sales, or if the value proposition is out of line with comparables in the marketplace, it’s impossible to avoid hype and hyperbole because it takes a strong emotional pitch to overcome peoples’ gut instincts. When the value proposition is off, the glorified hype is inevitable.

The first impression when a prospect joins a business is crucial. It sets the framework for their entire experience. It’s the seed that influences their behavior going forward. When you’re in the field, education for the newbie is crucial. It’s important to inform them, at some point, they’re entering a sales and marketing business. Their function as a distributor is to move product volume, hence the word “distributor.” And companies, it’s important to publish and enforce standards designed to lead to proper positioning of your brand in the marketplace so you can properly educate and, if need be, weed out the people misrepresenting the particulars of your business. Yes, there are companies out there that are willfully (and blissfully) ignorant of how their product or service is being positioned in the marketplace. But in the end, when a business fails to deliver on some of the basic elements presented in the leaders’ presentations, it burns down quick.

Travis’s note is below.

I thought about abridging it but there’s too many good points. It’s included in full below. What are your thoughts? Do you think it’s realistic to expect hype to end?

You are entering a no Spin Zone…
Warning: This article is probably the most controversial article I have written. By continuing to read on, you run the risk of being offended. If this is you, then it is likely you need to hear this information! My intent in writing this is to raise some clarity on what it means to be a TRUE ‘Network Marketing Professional’. It’s important to point out much of what I will be talking about, the examples I will be giving, I HAVE DONE PERSONALLY! As leaders, we are eager to share our victories – but forget there is even more wisdom in sharing our mistakes and past failures. It is my hope that my trial and error can help you to avoid some of the same pitfalls I’ve fallen in over the years.

There is a serious issue running rampant in Network Marketing. In fact, I believe this issue is so big – it threatens the very livelihood of our industry. Unless we, as leaders, take a stand against this problem our profession will never be taken seriously. The issue I am referring to is “The Spin” that goes on in Network Marketing. Others might describe it as “Hype”. In other words, I am referring to saying or representing something in a manner, in which the intent is to have someone assume something, that otherwise would not be true.

Allow me to provide some specific examples of what I am referring to. (Again, picking on myself for a moment) I was recently traveling internationally with my good friend and mentor, Jef Welch. We were in a cab together on our way to a business briefing. As Networkers, we naturally sparked a conversation with the cab driver by asking the normal questions; “How long have you been driving a cab?” “Do you enjoy what you do?” etc. We had a very pleasant conversation, during the drive. When we were exiting the cab I was prompted to invite the cabby to the event we would be speaking at later that evening. (Here’s where my MLM training kicked in) I started with a quick look at my watch – to suggest I was in a hurry. I complimented the driver, I had already decided on an ‘indirect approach’ since I did not have a great report with the driver. “So let me ask you a question; WHO DO YOU KNOW that might be interested in a potential six figure income opportunity, working from home?” Of course it prompted the real question I was looking for from the driver, “What is it?” he replied. I grinned with confidence knowing that I had just gained posture in the conversation. (I thought to myself, Eric Worre would be so proud!) Then I made the invite, “If I were able to get you ticket, to a very special event on creating wealth, hosted by some very powerful people might I add – would you be able to attend?” And then I continued, “Now I’m not saying I can get you a ticket, as they are sold out. But IF I could get you a ticket, for free, would you be able to make it this evening?” Now, most reading this may not see an issue with my approach. In fact, I thought it was excellent at the time. I was doing exactly what I had been trained to do. My Mentors had always taught me when inviting to build huge audacious value.

The reality is, if you really break down what I said, I suggested that this was a ticketed event. I suggested there was a fee to attend and I implied not everyone could attend – that in some way this was exclusive. Now, I know you could argue what we were to speak on was of value, that it was exclusive or ‘invite only’ – which could justify the word “ticketed”. Believe me I tried, when I was called out on this. Later that evening, Jef and I had a discussion about leadership and how important it is to have integrity at the top. I agreed. He then surprisingly brought up my approach earlier in the day, as an example of the “Spinning” that goes on in NM.

At first I was defensive. “I did exactly what I had been taught”, I thought to myself. However, after spending 15 minutes trying to defend my position, I decided to really listen to what he was saying….And he was right! Jef Welch called me out on this and I want to thank him for doing it because it’s helped me raise my game to the next level.

“Spinning” and “Hype” have been around NM since its origination. The only difference today is it’s highly perpetuated and amplified by Social Media. Another example I often see is when people post things like “500 people just joined my business in the past 7 days”, etc. This often happens in a Binary compensation plan because it allows you to build hype around fear of loss. “Get in now or else you’re missing out!” The problem is the people who want you to THINK they’re making a fortune, aren’t! What they’re not telling you is they are part of a power leg that is growing (largely because of the people above and below them doing the same thing). More often than not, they only have a few people on their inside leg, dictating their actual pay.

How about this one: “I am looking for my next 3 people to teach how to make six figures this year.” I see this all the time on Facebook and Twitter. The sentence SUGGESTS that you have already done this in the past – when in fact 90% of the people posting things like this have not! When I started in MLM, some of the worst advice I was ever given was “Fake it till you make it”. This is still very prominent in the industry today.

Now I know many of you reading this are going to say, “Well technically what I am saying is the truth, if you really look at what I am saying”. And I hear you…The question I would ask is not, what are you saying,” technically”; it’s, what are you leading people to believe or assume? Building your business upon “SPIN” and “Hype” is likened to building a foundation on shaky ground. It won’t last! You will continue to attract the bottom feeders in your business, the people who are looking to ‘get rich quick’, or catch the next free ride. My friend Jef was right; you must have INTEGRITY AT THE TOP if you want to build something that lasts. And isn’t that why we all entered into this industry – To create a long term, residual income for our family?

In closing, if you want to be a part of raising the bar in this industry, if you want to proudly call yourself a Network Marketing Professional – then it’s time to step up and declare a “No Spin Zone!” The only true way to grow an organization is to focus on what you have to offer from a personal standpoint, a systematic standpoint and most importantly – A leadership standpoint! The moment people join your team because of what YOU have to offer, when you no longer have to rely on “Spinning” to recruit, YOU KNOW YOU’VE ARRIVED!

In the spirit of success,
Travis A. Flaherty

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by on April 4, 2011 1 Comment

Medifast Lawsuit Proceeds

I need to tip my hat to my sources.  Mel Atwood sent me the link to Rod Cook’s site.  Thanks, Rod, for breaking the story.

In February of 2010, Medifast filed a lawsuit against a few of the prominent MLM detractors.  Namely, Barry Minkow, Tracey Coenen and Robert Fitzpatrick.  I’ve written about Barry Minkow’s antics game before.  Since writing the first article about Barry, he has apparently been charged with Securities Fraud (source).  Note, I have not taken the time to confirm the accuracy of the criminal charge; however, Len Clements is as reliable a source as they come.

In the lawsuits, the defendants all filed motions to have the lawsuit dismissed.  The majority of claims were dismissed.  However, based on one of Fitzpatrick’s reports where he concludes that Medifast was an “endless chain scheme,” Fitzpatrick’s motion was Denied.

This is significant for a few reasons.  First, when you’re critiquing a company, be careful.  Be sure to calculate your words to express your opinion instead of making statements of fact.  Statements of fact designed to convince others of the truthfulness of the words are actionable, opinions (in most cases) are not.  I’m not familiar with Medifast’s model and I’m not in a position to say Fitzpatrick was wrong or not.  However, I will say, the method could have been better.  Second, if there’s no settlement, there’s going to be a trial about Medifast’s business model.  In defamation actions, truth is an absolute defense.  When Medifast sued for defamation, it opened up the door for the defendants to say “it’s the truth, and here’s why.”  Sometimes, when filing a lawsuit, the gun can kick harder than it shoots.  I’m assuming Medifast was aware of this and they’re confident that their model can withstand the scrutiny.  Regardless, this is going to be a case to watch.

Start reading from page 14.

Medifast vs Minkow, et al

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by on March 29, 2011 15 Comments

Small Business Administration Prohibits Lending to MLMs

I was sent this document by a friend and professional in the MLM space yesterday. It’s a portion of a federal regulation that outlines the ineligible businesses for SBA loans. The bill prohibits lending to:

“Businesses Selling Through a Pyramid Plan.”

It further states, “Pyramid or multilevel sales distribution plans are not eligible for SBA assistance.” (see below)

This is another example of an organization, in this case the federal government, that associates legitimate network marketing with pyramid schemes. PayPal and Facebook are other organizations that come to mind. As I’ve written in the past, since there’s an ocean of gray in the networking space separating good companies from bad, it’s led to an increase of illegal exploitation of the model by opportunistic owners. Simply put, it’s difficult to distinguish the good companies from the pyramid schemes, which is leading the government and companies alike to associate all MLMs with pyramid schemes.

I’ve written an article in the past titled “Pyramid Schemes: Saving the network marketing industry by defining the gray.” The article has been viewed over 7,000 times. In an effort to help sanitize the negative perception created by pyramid schemes, the article calls for more clarity in the space. I’ve also attempt to pass an anti-pyramid scheme bill in Tennessee to create guideposts to distinguish good companies from bad ones. The DSA killed the bill. The DSA exists primarily as a lobbying organization committed to preserving the confusion in the space, which makes it easier for pyramid schemes to thrive, in my opinion. They act more like a labor union. They need more leadership, less “strength in numbers.” Given their influence, they can dramatically increase their impact if someone would step up, be honest with the issues and lead. If the DSA’s model legislation would pass, it would literally be legal for a company to sell $1,000 shots of lemonade (assuming there’s a return policy). It would be incredibly harmful for the space. But I digress.

Unfortunately, since it’s difficult to distinguish good companies from bad ones, more people are throwing in the towel and associating pyramid schemes with legitimate MLMs. In a conversation with Facebook’s compliance attorney a few months ago, he explained why they ban the promotion of MLMs in their Terms of Service. He said if they narrowed the provision and simply prohibited the promotion of “pyramid schemes,” they’d be required to prove if a company was a pyramid, which would be close to impossible. It all boiled down to the confusion. Have you ever tried to advertise a site on facebook with the words “MLM” or “network marketing” on the landing page? Did it get banned? Mine did. The gray needs to be clarified, not obfuscated, lest the negative perception grow in size and lead the FTC to step in and clarify it for us, which would be a disaster.

SBA loans and MLM

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