Direct Public Offerings

Related Terms: Initial Public Offerings

A direct public offering (DPO) is a financial tool that enables a company to sell stock directly to investors—without using an underwriter as an intermediary. The company can thus avoid many of the costs associated with "going public" through an initial public offering or IPO. DPOs are, as it were, IPOs "lite." The business choosing this route is exempted 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 only gained some popularity in 1989 when the rules were further simplified. In 1992, SEC established its Small Business Initiatives program; the program eliminated even more of the barriers that had limited the ability of small companies to raise capital by selling stock. The development of the Internet stimulated this route because it promised at least the possibility that companies could sell their stocks directly on the Internet. Thus whereas the demanding structure, the reporting requirements, and high costs of IPOs (average cost in the mind-2000s was $3.5 million) arose in an environment or reform and discipline in the wake of the Depression, DPOs developed during a period of exuberant market expansion.

The principal differences between a full-fledged IPO and a DPO is that 1) DPO stock is not registered and trading in such stock is difficult, 2) amounts of capital that may be raised are delimited in various ways, 3) the costs of a DPO are lower, and 4) the very strict adherence to the requirements of SEC-imposed disclosures, accounting methods, and conformity to requirements of the Sarbanes-Oxley Act (a consequence of Enron) do not apply.

The principal similarity is that in both cases stock is sold to the general public; the business, therefore, is able to reach beyond its intimate circle of friends to raise capital.

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.

ADVANTAGES AND DISADVANTAGES

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 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' disadvantages include limitations on the amount that a company can raise within any 12-month period. 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: 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

The most common 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; 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 accredited investors. Accredited investors must be people/institutions of substantial means ($1 million in assets for individuals, $5 million for institutions). The business may sell stock to up to 35 people/institutions who do not meet this test. The SEC's purpose in requiring such qualifications arises from the fact that "accredited" investors are presumed to be knowledgeable and sophisticated enough not to be taken in by a scam.

Another type of DPO is outlined in SEC Regulation A. This option is frequently referred to as a "mini public offering": it follows many of the same procedures as an IPO; the securities may also 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.

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