The Ups and Downs of Internet Direct Public Offerings

The Internet has spawned a new model for public stock offerings: the DPO. Read on to find out if this cyber-offering is the right alternative for your company.

When Spring Street Brewing Co., a Manhattan microbrewery, raised $1.6 million in an exempt, do-it-yourself direct IPO in 1995, it became one of the first companies ever to conduct a Web-based direct public offering (DPO). In lieu of hiring an investment banker to find professional investors or, as many capital-hungry entrepreneurs do, hitting up their friends and family for money, Andrew Klein, president of this small firm, sold stock directly to people who were enthusiastic about beer and the concept of their business. In a precedent-setting move, the Securities and Exchange Commission (SEC) granted Spring Street permission to use the Internet as part of their fund-raising activities. With the SEC's sanction, and Spring Street's subsequent success, a huge amount of publicity was generated, and a whole new world of fund-raising possibilities opened up to entrepreneurs. The Internet suddenly made it possible to reach millions of potential investors and raise money quickly and cheaply, directly from the public.

Filling a Financing Gap

Traditionally, raising capital has been an ongoing challenge for small businesses. Most operate at a revenue level that is too low to interest investment banks and venture capitalists, yet they are often too large for other sources, such as family and friends. Because of this, many small businesses have trouble securing growth capital. Those that don't need the high amounts offered by the big institutions, but need enough to get their companies growing and prospering, often have a hard time raising cash. In fact, the estimated aggregate need for funds for companies seeking between $250,000 and $5 million is estimated to be $60 billion by the Small Business Administration (SBA). The problem is so prevalent that the organization gave the gap in funding its own name: "capital chasm."

With the advent of the Internet -- and a trend that sees small businesses finding creative ways to use it to their advantage -- the financial landscape for small firms with the need for seed and growth capital may soon change. Business owners who need a few million dollars in capital but don't want to go to the expense of an initial public offering or give up control to a venture capitalist are opting for this new method of going public, the DPO.

What Is a DPO?

A DPO is registered and regulated like any other public security offering. However, DPOs differ from traditional public stock offerings in several ways. For starters, the issuer of a DPO -- which is the company itself -- sells its stock directly to the public via the Internet, while performing the underwriting, structuring, filing, and selling of the offer without an underwriter and selling syndicate, as in a traditional IPO.

By cutting out underwriters' fees and enabling investors to track issuing companies online, the DPO allows firms to raise capital at considerably less cost: several thousand dollars vs. several hundred thousand dollars in a traditional IPO. In the past, DPOs were limited to the state in which the company making the offering was based. But in 1980, the SEC, following Congressional passage of the Small Business Investment Incentive Act, removed the restriction by deferring to the states oversight of securities offerings of less than $1 million.

Typically, businesses that offer direct stocks are companies in the consumer products markets, such as microbreweries, food and mail-order firms. These businesses have to comply with specific SEC regulations, with the primary difference being the amount of financing involved. SEC regulations for DPOs stipulate a maximum amount of $5 million raised during a 12-month period, but because of the costs involved, companies are advised to raise at least $3 million. The SEC's Regulation A, however, does allow for secondary offerings.

The DPO, which permits businesses to raise capital via a public or private placement of shares, has been in existence for two decades. Prior to the advent of the Internet as a business tool, companies used strategies like sending out mailings to prospects or using other methods to announce the sale of their stock. One food product manufacturer, for example, conducted a DPO that not only used the Internet, but also included an announcement for interested investors in every package of food it sold. Likewise, Spring Street Brewery pushed the sale of its stock on the back of every bottle of beer.

With the increasing popularity of the Internet, a number of companies -- including resellers -- have started offering financial, legal and marketing services for DPOs to investors through Web sites.

"Companies who choose to conduct a DPO via the Internet have the ability to control their own destinies to a larger degree than [those who use] traditional underwriters," says Michael Terpin, chairman at Direct IPO, Inc.. "High-profile marketing-driven companies can leverage their visibility and hoopla to market their securities directly to the buying public."

The Downsides of Internet DPOs

According to Brad Sinrod, president and chief executive of Philadelphia-based IPO.com, DPOs are often not all that they're cracked up to be. In Sinrod's experience, he has found that many early-stage growth companies are not ready for the scrutiny of a public offering, let alone the responsibilities that go along with conducting a DPO. "An entrepreneur may do a good job of building their business, but may not be able to play the role of securities lawyer, investment banker, stockbroker and investor relations professional -- all of whom you'd normally include in a full-blown public offering," Sinrod explains. In fact, Sinrod, whose company reports on the IPO market, says a small- to mid-sized firm should rely on sources like friends and family for start-up funding.

If firms do undertake a "do it yourself" DPO, Sinrod advises working with professionals who will truly assist in the offering process. "[Not only do they] bring experience to the table, but investors are much more comfortable when professionals are involved," he says. "Investors feel that there are actually professionals involved who have done some due diligence - because an investment bank or a broker/dealer needs to do due diligence and take liability for the companies they raise money for. There's also a better chance that the stock will be priced at fair market value. We've seen a lot of entrepreneurs who think their garage-based business is worth $100 million, and they may be correct, but they need to go through the normal process to determine the true value of the company."

Sinrod adds that one primary reason that companies go public is to possess a publicly traded security that provides liquidity for investors and a potential exit strategy for investors. "Unless a company is working with professionals with experience in the process, it's not an easy task to accomplish," he advises. "There have been a few companies that have done DPOs with some success, but any company that can find an investment bank should."

Terpin agrees. "All self-underwritten offerings are, by definition, 'best efforts,' meaning they may sell or may not sell, depending on market conditions and the strength of the marketing effort behind the offering. Of course, the same could be said about traditional offerings, but at least 'A-level' investment houses have a built-in stable of investors who will follow them into deal after deal so long as they continue to make money."

Strange Bedfellows?

Until Internet-based services develop established customer bases and access to a liquid market for secondary trading, industry experts agree that they pose little threat to traditional Wall Street investment banks that charge clients some 7 percent to underwrite and manage an offering. "The real threat may come from renegade online discount brokers who are willing to risk being frozen out of traditional syndicates for the opportunity to make their names as discount IPO shops," according to attorney Constance Bagley and Robert Tomkinson, co-authors of a February 1998 National Law Journal article about online securities offerings. "Such players could potentially undercut traditional underwriting fees. Those best positioned are companies already doing business online and who use aggressive pricing."

The most likely scenario, suggest Bagley and Tomkinson, is that traditional underwriters will partner with existing online brokerages. In such a marriage, traditional underwriters would guarantee credibility and liquidity to the online public offering market, while online brokerages would bring technical expertise to the transaction.

"The Internet DPO market, originally scoffed at, now has the serious attention of the traditional banking community," says Terpin, adding that this is, in large part, due to the overwhelming success of e-brokers who have quickly carved out a large slice of the retail brokerage community. "It doesn't take a rocket scientist to assume that many of the millions of folks who can't get into most IPOs and who do most of their investments online will consider an online IPO - but only if it meets the same criteria that traditional underwriters look for in a good deal: good name recognition, hot industry sector, strong management, record of rapid growth, potential for significant profits to justify the market cap, and a large multi-billion industry they are attacking."

What Works?

When Internet Ventures, Inc., an Ashland, Ore., provider of broadband and dial-up Internet service, conducted its own DPO in 1997, the company raised $5 million. But according to Tim McGrath, the firm's vice president of investor services, the process took much blood, sweat and tears to complete. He refers to his company's DPO experience as "extremely successful," and advises all small- to mid-sized firms looking for similar success to assign a dedicated person or persons -- not the company CEO -- to handle the DPO.

"In smaller firms, it's the company president or CEO that's trying to do the DPO, and they're also trying to do a million other things at once," says McGrath, who has 25 years of experience working with growth-oriented firms. "Companies must assign a person or team that can be 'laser focused' on the task at hand."

According to Terpin, historically, the industries that have experienced the most success with Internet DPOs have been food and beverage, particularly beer and wine. "The costs of advertising the offering can be lowered by putting a tombstone ad on the bottles or boxes of their products," he explains. "Direct mail and clothing companies have used this, as well." For Internet companies, he says, a consumer or business-to-business site with high name recognition and/or a large user base will create a similar effect of branding itself, disseminating the news of its offering widely and being able to take advantage of affinity marketing by selling to users of its own products.

According to Terpin, companies interested in conducting their own Internet DPO should:

A number of companies and sites on the Internet can assist companies conducting a DPO. Simply punching the keyword "DPO" into an Internet search engine will reveal an eyeful of the hundreds of firms that are ready and willing to help sell your company to the world. Perhaps the best words of advice are: Use caution, ask for referrals, and thoroughly investigate any partners you choose to involve in your company's DPO -- and do it well in advance of the actual offering date. To start your search, try a few of these DPO-related resources on the Web:

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