Alternatives to an IPO - Direct Public Offerings
By David R. Evanson
Where's the Money?, Fall, 1999
Summary: This primer on direct public offerings was written as a chapter in the book called, Where's the Money. I wrote the book under agreement with its' authors Dwayne Moyers and Art Beroff and with Entrepreneur Media, Inc.
RESUME: DIRECT PUBLIC OFFERINGS
Definition or Explanation: The direct sale of shares in a company to individual investors. After the shares are sold by the company to these investors, they may or may not trade on a stock market or exchange.
Appropriate For: Direct public offerings work better with established companies, but they can be used for start-up and emerging companies as well. One of the most important characteristics a company should possess for a successful direct public offering is a strong affinity with its customers, the surrounding community or the industry in which it does business. In a direct public offering, these affinity groups become the shareholders of the company.
Supply: Vast. For years, individual investors have heard about the millions, and in some cases billions of dollars made by venture capitalists through investments in companies in their formative stages of development. These same investors would like the chance to play venture capitalist, and your direct public offering may give them the opportunity.
Best Use: Financing the expansion of profitable operations. Direct public offerings can be used to finance research and development, but public investors often become impatient during long periods of product development. When they are unhappy, they can cause problems for the company as it tries to raise money later on to finance the marketing and rollout of the product or service.
Cost: Expensive. It's less expensive than an initial public offering with an investment banker, but only moderately so. The absence of underwriter's commissions is sometimes more than offset by the all of the marketing expenses which a company must bear in a direct public offering. In addition, like a conventional initial public offering, the company must surrender a significant hunk of ownership to its direct public offering investors.
Ease of Acquisition: Difficult. Any transaction that invokes securities is going to be challenging. The absence of an underwriter can make the process at once easier and harder. Easier, because the company can call the shots without recrimination. Harder, because an underwriter has experience with IPOs, and a company typically does not.
Range of Funds Typically Available: $500,000 and up.
THE DPO ORIENTATION
Direct public offerings are at once exactly like initial public offerings and at once completely different.
Here's how the two are alike. A direct public offering and an initial public offering involve the sale of a piece of a company's ownership to the public. A direct public offering and an initial public offering may [italicize may] be carried out under the same federal securities laws, specifically the Securities Act of 1933, and Securities Exchange Act of 1934.
Here is how they are different. Direct public offerings are sold by the company, not by an intermediary such as a broker or investment banker. Unlike conventional IPOs, DPOs can, in addition to full federal securities registration, be sold under a myriad of state laws, and federal securities laws exemptions. Unlike conventional IPOs, which typically trade on a recognized stockmarket after they are completed, DPOs many times do not trade at all. And finally, unlike IPOs which are typically bought by investors who are speculating, DPOs are bought by investors who have some natural affinity for a company. They invest in a company because they are somehow connected to it.
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Shop Talk: Did you ever wonder why, at the dawn of the 21st century, the epicenter of securities laws were written in 1933 and 1934? These laws were put in place by Congress to prevent a re-occurrence of the Crash of 1929, and today, they still represent the great divide between commercial and investment banking.
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A CASE IN POINT
After 10 years in business, Michael Flynn wanted to go national. But his Flynn Laboratories, Inc. which manufactures homeopathic medicines, needed to become an FDA-licensed pharmaceutical manufacturer if it was actively market product across state lines. Where would Flynn get the capital to make a new facility?
"I went to a bank, and they said, 'definitely not,'" recalls Flynn . Investment bankers didn't offering much hope either. But the light went on when Flynn realized that if just 200 of his more than 28,000 customers invested about $2,000 each, his Flynn Labs would have the patient equity capital it needed. What Flynn did next was an end run around traditional brokerages, and marketed common shares directly to individual investors.
While people interested in alternative medicine are not those typically interested in the stockmarket, Flynn says he had a unfair advantage. "Our deal, which in a way was an alternative public offering, was attractive to these investors."
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A Good Deal: If you are considering a DPO, make sure your offering memoranda is on the Internet. This distribution medium can save you a lot of money in printing and postage costs.
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Flynn sent out more than 35,000 offering announcements. The announcements resulted in about 1,700 requests for prospectuses. He also fulfilled 400 requests for prospectuses from friends, family, associates, colleagues and contemporaries. Of the initial 2,100 investors which received a prospectus, Flynn says that about 240 eventually invested.
Not that any of this was quick or easy. It took Flynn 12 and a half months to close his deal's $430,000 minimum. And of his 240 investors, Flynn says that just 15%,mailed in a check after reading the prospectus. To get the other 200 or so, Flynn had to prospect over the telephone. In total, he estimates that he talked to 700 to 800 investors on the telephone. Nor was any of this cheap, either. Legal, audit, printing and marketing costs totaled $102,000, says Flynn .
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Shop Talk: Financiers sometimes refer to an "minimum offering" Many private transactions, as well as alternative public offerings have a minimum amount they seek to raise, and a maximum amount. Once this minimum amount is raised, the funds are disbursed to the company, while it continues to try to raise the balance to the maximum amount. It's not uncommon that the minimum on a $1 million deal be $100,000 or $200,000. Why? Because no company wants to get part of the deal done, and have to give all the money back simply because they over-estimated what they could raise.
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Although the effort took time and money, there were side benefits. "Sure there were days when I wished I would run into just one person who had $500,000." But he says it was a real learning experience talking to so many customers. "Reaching out to so many people and telling your story is never bad for a business if it's done with the right kind of heart and attitude."
In fact, sales of $691,000 during the year when Flynn was most preoccupied with selling the deal were about $100,000 higher [italicize higher] than the previous year. And the momentum spilled into the next fiscal year where sales had surged ahead by 15% at mid-year.
DIRECT PUBLIC OFFERING LIMITATIONS
According to Drew Field, an attorney, and author of the book Direct Public Offerings published by SourceBooks, DPO deals are no easier or less complex than conventional IPOs. "But direct public offerings represent a more manageable way to go because you do not have to accommodate, or rely upon others, such as investment bankers or brokers, who can prove to be difficult and dangerous. You can manage a direct public offering just like you would any other project."
But expert Field is quick to point out that DPOs are not for everyone. If you are considering such a deal, he says, you must be able to operate within the natural limitations of this financing technique. Specifically:
- Little or no trading market for the common shares. Remember, the reasons for going public are diverse. In addition to plain old raising money, entrepreneurs often take their company public to make estate planning easier, and also to provide an "exit" for people who invested earlier on the in the company's development. Unfortunately, it's difficult for DPOs to serve these purposes because, when completed, there is not an active market for a company's common stock.
- Stock probably cannot be used to acquire other companies. Many companies go public to use their stock as a "currency" to acquire other companies. Unfortunately, without an active trading market, there's not much of a reason why a seller would take such stock in lieu of cash. Therefore, unless they have a whole lot of cash in the bank, companies which plan to achieve their growth through acquisitions should probably not consider using a direct public offering.
- Little personal gain. It's hard to get filthy rich on a direct public offering. It might help build a company that pays you a tremendous salary, but in terms of cashing out by selling your own holdings in the company to public investors, it just doesn't happen. What could [italicize could] happen is that a company financed with a DPO could grow to a size and scale where it "graduates" to a real stockmarket, and attracts new investors or an investment banking firm that wants to underwrite a real deal. But all of that happy activity is a long way off. Here and now, a DPO will add to your company's coffers, but not much else.
When you add it all up, direct public offerings are plain vanilla. They provide a financing solution for companies which need equity capital from investors who will give the company the room it needs to grow, frequently referred to as "patient" equity capital. When your needs extend beyond this, into estate planning, acquisition strategies, personal wealth building, corporate prestige, the effectiveness of a DPO becomes compromised.
In truth, however, patient equity capital is all most companies need anyway. The romance of a full-blown IPO, with it's inevitable aftermarket trading often turns out to be a hollow love. In fact, the time and effort spent kowtowing to public investors and analysts after the deal is done is precisely what cause many chief executives to run their businesses into the ground.
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Don't Forget: It's not where you start, but where you end up that counts. A DPO may seem like a humble way to raise capital, but it can open a gateway to the upper tiers of the market, if the company grows and prospers.
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CHARACTERISTICS OF DPO CANDIDATES
If you can operate within these limitations, you are almost home. But not quite. A DPO still may not be a viable technique for your business. According to author Field, not all companies possess the right mix of traits. He says DPO candidates should have some or all of the following characteristics.
- Your business is easily understood. Consultant field says that individuals who participate in DPOs have a limited scope of interest. "They do not purchase shares in companies which they do not understand. In addition, because individual investors are by definition, individuals, and not brokerages or institutions with research departments behind them, the scope of what they understand is much narrower."
- Your business is profitable. Make no mistake, start-up and unprofitable companies can [italicize can] successfully complete a direct public offering. After all, as suggested earlier in this chapter there are lots of individual investors who want to be venture capitalists. But there just happens to be a lot more [italicize more] potential investors if you are talking about a profitable and established business. In many instances, institutional venture capitalists get their courage to invest in fledgling businesses from the OPM factor. That is, they are investing Other People's Money. Individuals on the other hand, are investing their own [italicize own] money, and they are reluctant to turn it over to a business which will lose it.
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A Good Deal: Companies that make money always get better terms than those which are in the red. If you can, hold off on a DPO until you can show a profit. This strategy will save you precious points of equity when the time comes to raise funds.
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- Your business has some sizzle. In a conventional public offering, the broker promotes a company's sizzle through his or her direct selling efforts. In a direct public offering, the selling and promotion efforts, which are usually conducted by a company's management and founders are tightly regulated and constrained. Therefore, says Field, direct public offerings require a lot of motivation on the part of the investors. Unfortunately, it's difficult for mundane enterprises to inspire the required level of action among investors.
- There are easily identifiable groups which have an affinity for your company. Customers, clients, vendors, allied grass-roots political organizations and the community in which the company does business all have an affinity or potential affinity for an organization. It's through this relationship that much of the direct public offering will be sold. Entrepreneurs however must evaluate whether or not the affinity they perceive is mutual, and strong enough to motivate prospective investors to consider their offering.
People Who Need People
Below are some likely DPO candidates based on strong affinity relationships.
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1. Manufacturer of unique home appliances (hot tub, wood burning stove, solar panels)
2. An agricultural cooperative
3. A lawn care company
4. A unique resort
5. A publisher
6. A microbrewery or winery
7. A catalog merchandiser
8. A training or educational concern
9. A pet care service
Unlikely DPO Candidates Based on
Weak or Inappropriate Affinity Relationships
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1. A biotechnology company conducting research and development
2. A prison management company
3. A government contractor
4. A manufacturer of industrial abrasives
5. A funeral home
6. A fast food restaurant
7. A personnel agency
8. A book distributor
9. An auto dealership
10. A money manager
REGULATORY FILINGS FOR A DPO
The legal aspects of a direct public offering are some of the most challenging, and thats' why hiring an attorney is typically one of the first steps in the DPO process.
If you want to go public by selling more than $1 million in securities, in several states, and trade on a recognized U.S. stock market, then chances are, you will need to file a federal [italicize federal] registration statement under the Securities Act of 1933. These filings are done with:
- Forms SB-1 and SB-2. These federal filings for an initial public offering for a small business issuer, though simplified from year's past, are one of the most difficult hurdles of a conventional or direct public offerings. The required audited financial statements which accompany these filings, and other financial disclosures, add expensive accounting and legal fees.
- Regulation A Filings. For offerings up to $5 million issuers can take advantage of so-called Regulation A. Rather than a registration of securities, Regulation A is a 'qualification' of securities, and is designed to be a less rigorous and expensive filing process. For instance, there is a 'testing the waters' provision where a company can see if there is sufficient interest to proceed with an offering. Also, Regulation A does not require audited financial statements, though most states will require them for offerings of a certain size.
There are "exemptions" to federal securities laws which companies can take advantage of for the DPO. Specifically:
- Rule 504, Regulation D. Offerings of less than $1 million are exempt from registration under the Securities Act of 1933 through the SEC's Rule 504 of Regulation D.
- Intrastate Offerings. Offerings sold to investors within a single state do not have to file under the '33 Act, in recognition of the state's rights.
If you are considering a direct public offering that will take advantage of federal exemptions, you must still deal with state securities laws. Each state sports its own laws, and coordinating an offering that was exempt from federal securities laws, but tried to comply with the securities laws of say, 10 states, would prove to be a challening, perhaps even impossible task. Below are some choices for overcoming the challenge of state securities laws
- Take advantage of state exemptions. Just like the feds allow you to structure an offering so that you do not have to register under federal securities laws, there are ways to structure an offering so that it is exempt from filing under state securities laws. The exemptions most often relate to the size of the offering, generally $1 million or less, and the number of investors who can participate, generally between 5 and 50. Since many state's exemptions are different, it's difficult to sell securities in an exempt offering in more than one state, but it can, and has been done.
- SCOR Offerings. Small Company Offering Registrations or so-called SCOR deals represent a quantum leap forward in unifying the myriad state securities laws into one (almost universally accepted) filing. With a SCOR filing, a company can sell up to $1 million of securities to investors in a public offering. Even though most states have agreed to accept the SCOR filing, predictably, there are some differing requirements among the separate state securities regulators which can make the approval process frustrating. The recently enacted "coordinated review" process, whereby the comments of a group of states are aired out among themselves, rather than having the company which is issuing the shares interact separately with each state, is proving successful.
INFO BOXES:
A Good Deal: Exemptions from state and federal securities laws are a great deal for companies seeking to raise capital. Many securities laws date back to the 1930s, are difficult to understand, possess vast gray areas, and worst of all, require significant legal fees to negotiate. By taking advantage of exemptions at the state and federal level simultaneously, you can avoid altogether the onerous state and federal filing requirements that can and do stifle the capital formation process.
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PLANNING A TRADING MARKET
Almost every investor wants to know how they can sell their shares. In truth, this is an unfortunate and, in some ways irresponsible desire on the part of the investor. After all, when a professional venture capitalist puts capital in a company, they often have a five to seven year time frame for the investment to reach fruition. The criteria for a direct public offering, which is often called public venture capital, shouldn't be any different. In truth then, trading shouldn't even enter into the picture. If the company truly succeeds, then, in one fashion or another, the investors will be rewarded.
The above issue notwithstanding, you must plan for the resale mechanism of your direct public offering. Here are your options.
- Order matching systems. This is the best system for a very tiny public company which has completed a direct public offering. In essence, with an order matching system, a stockbroker at a brokerage firm gets referrals from the DPO company of investors who have expressed interest in buying shares, and sellers who have expressed an interest in selling shares. If there appears to be a match between a buyer and a seller, in terms of price and quantity, the broker then facilitates the transaction.
The resale of shares may be regulated in the state where the sale takes place. With an order matching system, there can be, but there generally is not, a bid or ask price which is published. The liquidity, or the ease with which shares can be turned into cash, is not high with an order matching systems, but it represents the kind of accommodation which can make big difference to individual investors considering an investment in your company.
- Nasdaq stock markets. The National Association of Securities Dealers (NASD) operates the Nasdaq National Market System, for larger companies, and the Nasdaq SmallCap Market, for smaller companies. These are sophisticated markets for trading securities. Companies which have completed a direct public offering can trade on Nasdaq, but it will require them register to shares under the Securities Act of 1933 and the Securities Exchange Act of 1934, which covers periodic reporting requirements.
Since these are the complex legal and accounting documents that many companies sought to avoid in the first place with their direct public offering, Nasdaq trading may be impractical. In addition, trading on any of the Nasdaq markets requires at least two brokers who are willing to be market makers -- that is middlemen to match buyers and sellers -- for a company's securities.
- Bulletin Board & Pink Sheets. Companies which have not registered their shares under the 1933 and 1934 securities acts can still trade on the NASD's Bulletin Board. The Bulletin Board also requires at least two brokerage firms who will make a market in a company's shares. Bid and ask prices are distributed electronically on almost any quote terminal, giving Bulletin Board companies the appearance of a real public company.
A more obscure trading venue is the Pink Sheets. In truth, so-called Pink Sheet companies are trading in exactly the same way as Bulletin Board companies, with the primary difference being that bid and ask quotes are not distributed electronically. Instead they are printed daily by the National Quotation Bureau, on you guessed it, pink paper.
- The Stock Exchanges. The New York and American Stock Exchange listing requirements make them an unrealistic choice for most direct public offerings. Of the regional stock exchanges, Boston, Chicago, Pacific and Philadelphia, the latter three have a tier for smaller companies. However, registration under the Securities Exchange Act of 1934 is required for exchange trading, making it impractical for many DPO candidates.
HOW TO GET STARTED WITH A DPO
A direct public offering is not for the faint of heart. It takes time, money and persistence. Entrepreneur Flynn at Flynn Labs talked to more than 700 potential investors in the course of finishing his DPO. In addition, he spent more than $100,000 in the process. Entrepreneurs must evaluate whether or not they have the chutzpah to see a DPO through. But if you think you do:
- Ensure you have a way to corral your affinity groups. Direct public offerings don't work well without a large group of investors that have some sort of connection with the company, its product or service. A publishing company for instance, not only has a large base of customers, but it has a lot of information on them and can easily contact them by mail, e-mail, through its own media, or on the telephone. On the other hand, in a somewhat frustrating arrangement, successful restaurants have a steady stream of customers, but almost no information on them whatsoever.
For companies facing this dilemma, salvation depends on whether or not there is a way to access rudimentary information about members of the affinity group, and once accessed, is the affinity strong enough to make a deal? For instance, a restaurant entrepreneur can easily purchase the names of people who have dined at fine restaurants. But so what? Just because someone has dined at a [italicize a] restaurant doesn't mean there is an affinity for a specific [italicize specific] restaurant.
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Don't Forget: When mailing information to investors always include a response mechanism such as a business reply card or toll free number. A couple of interested investors contacting you can be worth as many as 500 cold calls.
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On the other hand however, there are lots of likely situations where a company can find information about people who would be naturally interested in them. Flynn, for instance was able to buy the names of people who had purchased homeopathic medicines from list brokers. Other possible scenarios:
• A pet care company might fruitfully prospect among the members of PETA, or People for the Ethical Treatment of Animals.
• An environmental services company might pitch the members of the Sierra Club.
• A company making sailboats could send direct mail to the readers of Sail [italicize Sail] magazine.
- Hire an accountant. If you don't have an accountant, get one. If you do have one, start negotiating for some extra work. To raise money, you will need a set of financial statements, period. Internally generated financial statements are helpful, but to bring in outside investors, you need to have financial statements prepared by an outsider as well.
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A Good Deal: A good accountant can be one of your strongest allies in a direct public offering. As practical, you want to have one with some experience in direct public offerings.
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Even though many companies have long-standing relationships with accountants, the production of a full set of financial statements, with notes, is often the kind of thing that falls between the cracks of the relationship. This is fine on a day to day basis, but debilitating when talking to outside investors.
The beauty of most direct public offerings is that they do not require audited [italicize audited] financial statements. If your plan is to start in the lower depths of the market and eventually "graduate" to the Nasdaq stock market or the American or New York Stock Exchange, you'll eventually need them anyway. To understand the various levels of review an accountant offers and the kind of financings which require them, see the sidebar below.
Finally, owners of start-up businesses are often prone to thinking that they don't need financial statements. Here's why, in most cases they do.
First, if there has been some kind of lump sum investment either from the founder or some other investor -- an extremely strong selling point for meeting with new investors -- the financial statements will irrefutably document its existence.
Second, if the founder is forgoing salary that he or she hopes to recapture when the company gets on its feet, then the financial statements are the perfect place to document the company's growing liability of its founder. To bring such an issue up three or five years down the road, and out of the blue, might severely strain relations between a company and its shareholders. Putting items such as foregone salary or, or loans to the company on the table out front, can save a lot of trouble down the road. And there's no better way to put them on the table than by putting them in a set of financial statements.
By now the message should be clear. Without financial statements, you can't get very far along the path to raising money.
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Taking Action: Not only do you need financial statements, but you need to be able to discuss their content with authority and clarity. Try a little question and answer role-playing with your CPA before talking to investors.
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SIDEBAR: THE LEVELS OF ACCOUNTING REVIEW
Here are the different kinds of financial statements that companies should consider according to Steven Mayer, a partner with accounting firm of Goldstein Golub Kessler & Company in New York City.
"First there's a compilation, which is where the accounting firm creates financial statements out of the figures that are supplied by management. In some cases, the accounting firm will simply retype numbers supplied to them by the company and might [italicize might] suggest the numbers appear [italicize appear] reasonable" says Mayer.
The next level is generally known as an analytical review. "In addition to compiling the numbers that are supplied by management, some testing is done," Mayer reports. Not testing to measure financial performance, but to triangulate, to see that everything is lining up properly. "For example, if sales are up, and commissions are down, that's a strong signal that something may be very wrong with the way the numbers were put together."
The most intensive review that an accounting firm can undertake is the audit. "Here" says Mayer "in addition to all of the testing, third party assurances are given that the figures presented are indeed accurate." This is why an audit takes so long. If a firm reports it has say, 25 microcomputers for sale in its inventory, then the auditor wants to see and count them. If they say they have 25,000, then the auditor wants to count them on a test basis.
Mayer says that an audit might start at $7,500. But that would be for a service business, where there is no inventory to verify. If there's lots of inventory, and lots of receivables, then Mayer says there's almost no practical limit to how high the fees can run.
There's a commitment of time as well. First, the accounting firm is going to camp out in your conference room for a couple of weeks. But because it's an audit, and because they issue an opinion, and because there's loads of liability behind that opinion, the accountant might tend to be more conservative on certain matters, such as recognizing revenue, than you, as the paying client, are likely to be. "So you often spend time negotiating, and reaching compromises on certain issues," says Mayer, " Frequently, it's a lot of time."
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- Hire an attorney. Securities laws are perhaps the most complicated laws in the land. There are three reasons for this. They are antiquated. They exist at the state and [italicize and] federal level. They are carried out by perhaps the most tenacious of all bureaucrats.
Even if you decide to take advantage of the many exemptions from state and federal securities laws which exist, you will still need an attorney to make sure you are in compliance with these exemptions. And of course, if you structure your offering in such a way so that it invokes state and federal securities laws, then once again hiring an attorney is standard operating procedure.
According to Flynn Lab's Michael Flynn, "It's important that you seek out an attorney with not just experience in securities matters, but with some facility in the direct public offering arena as well."
As for the attorneys, according to Joel Marks, a director of corporate finance for J.W. Charles & Company/CSG, an investment banking and brokerage firm concentrating on emerging growth companies, the attorney you hire should have a minimum experience of five deals. Marks adds that if these offerings are more than 5 years old, then it might makes sense to find another attorney, or if you can afford it, bring in co-counsel.
In addition to experience, Marks says to look at the firm's Martindale Hubbell ratings. Martindale Hubble, a publishing firm produces the most prominent directory of law firms in the U.S. Their ranking, according to Marks, has a Legal Ability component (A for preeminent, B to Very High and C for fair to high) and a General Recommendation component (V for very high, or unrated) "We look for a ratings of A-V," says Marks.
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Taking Action: Purchase the book, Direct Public Offerings. This book by author Drew Field, offers the most comprehensive step-by-step guide for how to structure a direct public offering from assembling the team of professionals to launching a direct marketing effort. Direct Public Offerings, Source books Inc., 121 North Washington Street, Naperville, IL 60540. 800-432-7444
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