DIRECT PUBLIC OFFERINGS

A direct public offering (DPO) is a financial tool that enables a company to issue stock directly to investors—without using a broker or underwriter as an intermediary—and avoid many of the costs associated with "going public" through an initial public offering (IPO). DPOs are a form of exempt securities offering, which means that companies choosing this form of offering are exempt from many of the registration and reporting requirements of the Securities and Exchange Commission (SEC). DPOs first became available to small businesses in 1976, but they only gained popularity beginning in 1989, when the rules were simplified. In 1992, the SEC established its Small Business Initiatives program, which eliminated even more of the barriers that had limited the ability of small companies to raise capital by selling stock. Another factor that has boosted the use of direct public offerings in recent years is the Internet. In fact, an estimated 200 small companies went public in the latter half of the 1990s via this route, either by offering stock online directly through their own Internet sites or by listing with one of several online DPO forums.

Prior to the establishment of DPOs, selling stock to the public through IPOs was often the only alternative available to private companies that needed funds for expansion and growth. But staging an IPO is a very time-consuming and expensive process. A small business interested in going public must apply to the SEC for permission to sell stock to the public. The SEC registration process is quite complex and requires the company to disclose a variety of information to potential investors. This process can take as little as six months or as long as two years, during which time management's attention is distracted away from day-to-day operations. It can also be quite expensive because of underwriting fees, legal and accounting expenses, and printing costs. Furthermore, the public ownership of the company has a significant impact on the amount of control that rests in the hands of its management.

Although many small businesses need the capital that an IPO can provide, they often lack the financial strength and reputation to appeal to a broad range of investors—necessary ingredients for a successful IPO. For other small businesses, the loss of control, the strict reporting requirements, or the expense of staging an IPO are prohibitive factors. "Under certain circumstances, though, federal law allows companies to issue stock without registering with the SEC in the normal manner or filing periodic reports. These direct public offerings—direct because the company can market them without a broker—are often registered only with state securities commissions," according to Robert L. Lowes in Medical Economics.

ADVANTAGES AND DISADVANTAGES

DPOs, private placements of stock, and other exempt offerings provide small businesses with a quicker, less expensive way to raise capital. The primary advantage of DPOs over IPOs is a dramatic reduction in cost. IPO underwriters typically charge a commission of 13 percent of the proceeds of the sale of securities, whereas the costs associated with a DPO are closer to 3 percent. DPOs also can be completed within a shorter time frame and without extensive disclosure of confidential information. Finally, since the stock sold through a DPO goes to a limited number of investors who tend to have a long-term orientation, there is often less pressure on the company's management to deliver short-term results.

DPOs also have disadvantages, however. For example, the amount that a company can raise through a DPO within any 12-month period is limited. In addition, the stock is usually sold at a lower price than it might command through an IPO. Stock sold through exempt offerings is not usually freely traded, so no market price is established for the shares or for the overall company. This lack of a market price may make it difficult for the company to use equity as loan collateral. Finally, DPO investors are likely to demand a larger share of ownership in the company to offset the lack of liquidity in their position. Investors eventually may pressure the company to go public through an IPO so that they can realize their profits.

TYPES OF DPOS

Companies interested in raising capital through a DPO have several options from which to choose. The most common type of DPO is known as a Small Corporate Offering Registration, or SCOR. The SEC provided this option to small businesses in 1982, through an amendment to federal securities law known as Regulation D, Rule 504. SCOR gives an exemption to private companies that raise no more than $1 million in any 12-month period through the sale of stock. There are no restrictions on the number or types of investors, and the securities can be freely traded. The SCOR process is easy enough for a small business owner to complete with the assistance of a knowledgeable accountant and attorney. It is available in most states.

A related type of DPO is outlined in SEC Regulation D, Rule 505. This option enables a small business to sell up to $5 million in stock during a 12-month period to an unlimited number of investors, provided that no more than 35 of them are non-accredited. To be accredited, an investor must have sufficient assets or income to make such an investment. According to the SEC rules, individual investors must have either $1 million in assets (other than their home and car) or $200,000 in net annual personal income, while institutions must hold $5 million in assets. A DPO registered through Regulation D, Rule 506, allows a company to sell unlimited securities to an unlimited number of investors, provided that no more than 35 of them are non-accredited. Under Rule 506, investors must be sophisticated, or able to evaluate the merits and understand the risks of the transaction. In both of these options, the securities cannot be freely traded.

Another type of DPO is outlined in SEC Regulation A. This option is frequently referred to as a "mini public offering," because it follows many of the same procedures as an IPO and the securities may be freely traded. However, companies choosing this option may only offer up to $5 million in securities in any 12-month period. Regulation A offerings are allowed to bypass federal SEC registration and instead are filed with the Small Business Office of the SEC.

Two further types of DPOs are available to businesses with less than $25 million in annual revenues. A Small Business Type 1 (SB-1) offering enables a company to sell up to $10 million in securities in a 12-month period and has simpler paperwork. A Small Business Type 2 (SB-2) filing enables a company to sell an unlimited amount of securities and has more difficult paperwork.

A final type of DPO is available through the SEC's intrastate filing exemption, Rule 147. This option allows companies to raise unlimited funds through the sale of securities as long as the stock is sold only in the primary state in which they do business. Both the company and all the investors must be residents of the same state. This exemption is intended to provide local businesses with a means of raising capital within their locale.

ONLINE DPOS

Direct online stock offerings emerged as a strategic option for small, capital-hungry businesses in the late 1990s. Business owners wishing to explore this financing route can pursue two different strategies. One option is to sell shares yourself through your own Web site, which can save expenses associated with printing documents and payments to investment banks for stock-selling services. But analysts warn that companies that pursue this avenue often have difficulty catching the attention of potential investors.

The second option for small business owners is to sign up with one of several Internet sites that are devoted to making DPOs on behalf of clients. Inclusion on one of these sites can provide a company with an additional air of legitimacy, for these forums generally require audited financial statements and other information. In addition, these online DPO operators can provide clients with valuable assistance in preparing the offering. Businesses considering an online offering on one of these sites should conduct extensive research beforehand on cost of services, breadth of preparation services offered, reputation of the forum, and the number of investors signed up to the site.

PROCEEDING WITH A DPO REQUIRES CAUTION

Though DPOs can simplify the process of raising capital for small business growth, there is no guarantee that an offering will be successful. "In all types of DPOs, the companies usually declare a minimum amount needed to carry out the business plan. Seven of every ten SCORs fail to reach that target—to 'break escrow,' in the parlance," Lowes noted. Small business owners considering a DPO need to realize that there is hard work involved. In fact, the business may suffer during the offering period, because management often does not have time to promote the offering and run the company simultaneously. For this reason, DPOs are most likely to be successful in companies that are not overly dependent on their top management and that have a sound business plan in place.

DPOs are also more likely to be successful for companies that have an established and loyal customer base. Customers are often the best source of potential investors for growing businesses. Companies that initiate DPOs can advertise their stock to customers on product packaging, through mailing lists, with posted messages in offices or other facilities, or by making the prospectus available on an Internet site. "Experts suggest that any company gauge investor enthusiasm before launching a DPO—because costs for attorneys, accountants, and marketing materials can add up," warned Carol Steinberg in Success.

Finally, companies can improve their chances for a successful DPO by availing themselves of expert securities advice. "Whether an offering is properly exempt from registration with the SEC is a matter for competent legal counsel and careful structuring of the offering. Errors must be avoided, since a faulty offering generally gives investors the right to get their money back," according to Zeune and Baer. The fact that a DPO does not have to be registered with the SEC does not release a company from compliance with the antifraud provisions of U.S. securities laws. Potential investors must have ample, accurate information to make an informed decision about whether or not to buy stock in the company. Finally, securities laws vary by state, so it is important that small business owners interested in pursuing a DPO consider the laws applicable to their companies.

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