With a battle cry of "disintermediation," a small troop of Web-based businesses that facilitate online capital-raising is setting up shop to take advantage of the Internet's legendary ability to cut out the middleman. But what these advocates of the direct public offering aren't shouting about is that in saving the little companies money by cutting out underwriters and brokers, such deals carry greater risk and less liquidity for investors.
This week has seen the launch of Wit Capital and IPO.com, both of which offer a chance to get in on start-ups through direct public offerings. A DPO is a public stock offering sold directly by the company to its investors. The play is generally as a long-term investment, since the shares are not traded on traditional markets.
The appeal is the possibility of getting shares in a company well before the market is onto it. In the hot IPO market of the past couple years, the custom by which mutual fund managers and thick-walleted insiders have issues to themselves during the first day of trading has peeved many a small investor. It's that little guy, who missed out on Netscape and @Home, who's being targeted with the DPO idea.
Democratization, with risk
"It's the democratization of capital," says Clay Wormack, president of Direct Stock Market, a firm that assists small companies with DPOs by publishing prospectuses on a Web site and marketing the offering.
But not all IPOs are Netscapes. Indeed, about half of IPO stocks fall from their offering price during their first year of trading. And direct public offerings have an added layer of risk - they have not undergone the due diligence of an independent investment bank for assurance that the company is fairly presented and the stock priced appropriately. Most companies doing DPOs are too small to afford an investment bank. Some don't meet banks' criteria.
"Anybody who tries to deny the virtues of technology is foolish in the extreme," says Stuart Kaswell, senior vice president and general counsel of the Securities Industry Association. "But there is a reason why issuing companies come to underwriters."
Aside from the due diligence that many investors - and regulators in all but the smallest deals - look for, underwriters take over the financial liability for new offerings.
"IPOs are not for everybody," argues Tom Taggart, a spokesman for the brokerage house Charles Schwab & Co. "We don't think it is responsible to push these onto the average investor who doesn't understand the investment and doesn't have the financial wherewithal to accept a loss."
Most direct public offerings have been geared toward loyal customers, who want to invest in the company because of their love of the product. Such was the case of Spring Street Brewing Company, a Manhattan brewery that went public in 1995 in one of the Net's great financing success stories. Spring Street raised US$1.6 million of the $5 million it was apparently aiming for - then an additional $500,000 in a second offering.
A low success ratio
But the latest variety DPO, with its prospectus hosted online and a firm hired to market it, is clearly aimed at a wider audience. Still, those eager investors looking to catch up with the first-day Netscape buyers would do well to think of the venture capitalists' rule of thumb: For every 10 start-ups, one or two might go big, but more than half are likely to fail and take your money down with them.
"Hundreds have tried. The number of successful direct IPOs you can count on the proverbial one hand," says Joseph Meshi, executive vice president of Genovation Inc., which attempted an IPO over the Internet and failed. He says a successful direct offering needs two things: the ability to reach a lot of people who might be interested in the company and a secondary market for the stock.
The first criterion is being met, Meshi believes, by the rash of businesses now hosting prospectuses and marketing IPOs, like Direct Stock Market, Direct IPO, IPOnet and, newcomers IPO.com and Wit Capital.
The secondary market for these stocks is a more elusive goal. Spring Street briefly operated an electronic bulletin board called Wit-Trade (the precursor to Wit Capital) for its stockholders to meet and arrange to buy and sell Spring Street shares. In trying to foster this secondary market venue, the company itself acted as a middleman in the trades. That led the SEC to shut down the service, saying Spring Street needed an independent broker to handle those trades, the company says.
Now, with the site's relaunch - expanded to handle the capital for as many 110 small firms and to address the SEC's concerns - Wit chief Andrew Klein defends direct public offerings, whether or not there's a secondary market.
"With private placement stock, the stock can be sold in another private transaction - you could sell it to your next-door neighbor - but you can't call a stock broker and say, 'Sell it,'" says Klein, who has signed up five companies so far. For their part, people who make early-stage equity investments aren't very eager to sell, he adds.
Offerings that worked
Despite the skeptics and the tough odds, a few Internet direct public offerings have succeeded, and the number of those attempting them is growing quickly. IPO Data Systems, a research firm, says 51 Net-based direct offerings have been done or are under way.
Among the success stories are Optical Cable Corp., which raised $7 million via both the Internet and direct mail; Interactive Products & Services Inc., which is close to reaching its $5 million goal, again employing both the Net and direct solicitation; and BrainTainment Resources Inc., a software-maker that has raised about $350,000 of a $500,000 target. Annie's Homegrown Inc., a maker of organic macaroni-and-cheese popular with baby-boomer parents, used the Internet along with a call for cash on macaroni boxes.
The SEC opened the door for such offerings a few years ago by creating two new categories of investments under the Securities Act. One allows companies seeking to raise less than $5 million to conduct their own offering and file an abbreviated registration statement with the SEC. Another allows for Small Corporate Offering Registrations for companies aiming to raise no more than $1 million. They file an even briefer registration statement. Both regulations still require issuers to undergo an audit and to publish a prospectus, but they require far less disclosure and less due diligence than a full-blown offering seeking tens of millions of dollars or more.
That's why small investors need to show a little diligence of their own.
