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LEGAL ISSUES

He SCORs!

A company founder describes the process he went through to file a small-corporate-offering registration to raise money.
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Pioneer direct marketer Real Goods Trading Corp. was growing nicely, and so was its need for capital. Founder John Schaeffer blazed a new trail to raise money from the public

Last August about 150 shareholders of the environmental-products catalog Real Goods Trading Corp. gathered for their first annual meeting in a field near the company's Ukiah, Calif., headquarters. CEO John Schaeffer stepped up to the pondside podium and nervously surveyed the bucolic scene and the people who had a few months earlier become co-owners of his company. "I'm a little embarrassed to say that not only have I never led a stockholders' meeting before -- I've never even attended one," he confessed. "Just out of curiosity, how many of you have never been to one before, either?" All but a few raised their hands.

Not so long ago owners of small, young companies like Real Goods would have given scant consideration to selling stock to the public. The time and expense of complying with Securities and Exchange Commission filing requirements and the continuing responsibility for disclosure were too daunting. Moreover, most companies going public do so with investment bankers, who prefer to underwrite offerings of $10 million or more.

But small companies can get around those impediments. The process for going public hasn't changed, but there are other, albeit smaller-scale ways to sell shares to the public. One approach, the small-corporate-offering registration (SCOR) has been around since 1989 -- and offers a simplified process to raise up to $1 million. It's designed for finance tyros, like John Schaeffer, who own demonstrably solid companies and who want to raise money from outside investors.

Back in the 1980s a federal securities regulation, Rule 504, exempted companies that wanted to raise modest amounts of capital from the exhaustive process of registering with the SEC and filing a conventional public offering, often referred to as a '33 Act registered offering. The exemption allowed for simplified registration requirements, filed on a state-by-state basis.

In 1985 a group of lawyers and securities administrators transcended routine regulatory obfuscation to devise the unimaginable: they crafted a universal form that not only could be used from state to state but also was easy enough for any competent businessperson to use. That formidable task took a good three years, and in 1989 Washington became the first state to process SCORs. Today 36 states endorse such offerings, variously known as SCORs, ULORs (for uniform limited offering registration), and U-7s (for the name of the form).

For Real Goods, stumbling on the SCOR vehicle was a piece of good fortune. Started in 1986 with just $3,000 to cover its first mailing, the company never was handsomely financed, growing by cash flow alone. Customers prepaid for the solar-power products and composting toilets Schaeffer sold by direct mail. That allowed him to drop ship orders directly from his distributor, slowly building inventory stock in his house.

But cash flow took the company only so far. By late 1988 Real Goods needed a computer, a new phone system, and a warehouse. Schaeffer managed to borrow $250,000 informally from customers who had responded to a blurb he'd published in the Real Goods catalog. He'd offered 10% interest.

The loans didn't go far, and the company soon needed more cash. "By 1991 we were doing about $5 million a year," Schaeffer says. The company was, he says, in the infamous black hole of mail order, "when you're between $3 million and $7 million in sales and your growth rate is far outstripping the available capital. The nature of that black hole is that your debt-to-equity ratio shows you way undercapitalized; we had probably a 10-to-1 or 15-to-1 ratio." A loan wouldn't be easy.

Raising money by taking the company public was one option that didn't cross his mind until 1991, when the Wall Street Journal's profile of Real Goods inspired readers to offer growth strategies. "I had gotten probably 200 phone calls from all kinds of wackos around the country," says Schaeffer, when securities lawyer Drew Field, who wrote Take Your Company Public! The Entrepreneur's Guide to Alternative Capital Sources (New York Institute for Finance/Simon & Schuster, 800-227-6943; from New York City, 212-344-2900; 1991, $29.95) rang up to tell him how he could easily sell shares to the general public. Smelling snake oil, Schaeffer's first reaction was to remember that "my mother taught me if it sounds too good to be true, it probably is." But he agreed to meet with Field over lunch.

Field described the advantages of filing a SCOR: Schaeffer could handle the paperwork himself. The offering costs -- legal, accounting, printing, and registration expenses -- would run a relatively modest $100,000. There would be no need for underwriters or a road show. There were no limits on the number of investors or on their wealth or sophistication. And once Real Goods had gone public, there would be no disclosure requirement to file financial reports. Moreover, because the company was a direct marketer with a large customer database, it had a ready pool of potential investors.

The simplicity of a SCOR parallels its limitations: The offering could raise no more than $1 million. There was the risk that Real Goods wouldn't be able to line up enough subscribers. Because each state required its own filing, there would be tiresome, although not complicated, paperwork. Some of Schaeffer's target states had never before processed a SCOR. Furthermore, since the company wouldn't be eligible to list its stock on any exchange, an order-matching service would handle all buy and sell transactions. That compounded the downside to the investors: they risked finding themselves unable to dump their stake when they wished.

Schaeffer did consider a standard offering but was dissuaded by the tremendous cost -- 20% to 25% of what he raised, he was told. For one thing, he worried about putting together the historical financial statements. "To get an accounting firm to go through shoe boxes in the garage with any authenticity seemed nearly impossible," he says.

It was in March 1991 that Schaeffer, who owned 100% of the company, first began to weigh the idea, and by that October, Real Goods was mailing formal prospectuses. He offered 200,000 shares at $5 each for a total of more than 7% of the company. Here's what he did in the next seven months:

Schaeffer wrote the prospectus using a computer program to guide him through the highly formatted SCOR preparation. It asked questions about the risk factors, the competition, and how the proceeds would be used. "That one was real fun," Schaeffer says, "seeing how easy it is to spend a million dollars in a half hour." Most state securities agencies provide the software free or for a nominal price, and it's available for $10 from the North American Securities Administrators Association, in Washington, D.C. (202-737-0900).

As the document developed, he and his lawyer traded it back and forth to refine it. "It was the sword and the shield concept: I'd write with a sword to try to make sales, and he'd write with a shield to protect us from getting sued. You learn how to talk in bland terms like 'there can be no assurances that . . .' " Schaeffer estimates it took about 80 hours of his time over three weeks to produce the 55-page document. Legal fees cost about $50,000 -- compared with the $200,000 he believes lawyers would have charged him to prepare a standard offering.

He hired Deloitte & Touche to prepare an audit of the most recent year's financial statements. That cost $16,000. For a traditional offering, a company as old as Real Goods would have been required to provide three years of audited financials.

He assigned the company a value of $14 million. "That's one of the hardest things because it's inherently arbitrary," Schaeffer says. He settled on that figure -- three times present earnings, two times projected earnings -- by comparing Real Goods with other catalog companies, such as Lillian Vernon.

Schaeffer hired a Ukiah stockbroker to be the company's order-matching service. In effect, the broker was the stock exchange for the company, keeping the lists of people who wanted to buy and sell stock after the offering was closed.

The company registered in 11 of the 22 states that then allowed SCORs. The filing was the same from state to state, with the addition of a separate one- to two-page cover sheet. The states charged registration fees ranging from $50 to $2,000.

Schaeffer focused on how and to whom he should pitch the sale. He picked Real Goods customers residing in SCOR-processing states who had spent more than $75 in the two most recent years. To those 15,000 people, Real Goods mailed a tombstone -- a notice of the offering -- and a return envelope. Some 5,000 people requested a prospectus, and within six weeks Schaeffer had commitments for the first $400,000, the minimum for the offering to be a go. By the end of January 1992 it was fully subscribed by 750 new shareholders. He had to turn away $350,000.

Things have worked out quite satisfactorily. Fees totaled about $130,000 on the $1 million raised, or 13%, an amount he considers extremely efficient. The regulatory paperwork requirements have been negligible. He had to submit a filing with the SEC when the offering was completed but not much more. Although it's not mandatory, Real Goods issues quarterly stockholder reports as well as a company newsletter. "The time requirements have mostly been reading stockholders' letters and taking their phone calls of suggestions and ideas," Schaeffer says, "not a tremendous amount of time."

The payoffs of what Schaeffer calls "joint ownership," have been considerable. The $870,000 that Real Goods netted came essentially with no strings attached. Shareholders have become fiercely loyal zealots on behalf of the company. And the company's profile has heightened as Real Goods has become one of the most successful models of how a SCOR works.

Still, the company continues to grow, and so of course do its needs. Schaeffer has applied to the Pacific Stock Exchange and is in the process of filing a new stock offering, called a Regulation A offering, through the SEC. Recent changes in the Reg A procedures allow a company to raise up to $5 million, using the same simplified SCOR paperwork.

He can't talk much about his Reg A offering because of the SEC-mandated "quiet period." He does say, though, that he chose Reg A as the next step -- rejecting, again, a full-blown offering -- because of its lower costs and because he simply didn't want to use underwriters and get involved in "the hype-ishness of it all." Instead, he hopes to repeat "that certain magic of doing it in-house."


TO MARKET, TO MARKET TO BUY A FAT PIG (IN A POKE?)

Regulators persevere in trying to enable small businesses to raise money more easily without unduly jeopardizing the funds of unsophisticated investors. With those goals in mind, the Securities and Exchange Commission last summer adjusted its regulations in several ways:

Regulation A offerings may now raise as much as $5 million, up from $1.5 million.

Small-corporate-offering-registration (SCOR) documentation is acceptable for Reg A filings.

Rule 504 now permits SCOR companies to advertise their offerings.

Companies with revenues of less than $25 million may file offerings using a streamlined disclosure document, Form SB-2, that replaces the more exhaustive Form S-18.

The investor, however, had best beware. Directors of state securities agencies who belong to the North American Securities Administrators Association (NASAA) maintain that the changes go too far in opening up the process. In a letter to the SEC, NASAA charges, "You are embarking on an attempt to facilitate the sale of the riskiest securities in the market to the least sophisticated of buyers . . . . [W]e believe that the Commission has become too eager to favor small-business concerns over those of the small public investor."




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