Capital

Across the nation, ordinary businesses are peddling their stock. It's not that easy

Forget those dignified ads announcing stock offerings in the Wall Street Journal. These days entrepreneurs are trumpeting their stock sales any way they can--on tags hanging off clothes in stores, on six-packs of beer, and inside boxes of macaroni and cheese. What's going on here? Enterprising company owners are using direct public offerings (DPOs) to sell stock directly to investors rather than through Wall Street brokers.

For most of this century, companies have tapped interstate public markets through underwriters and complied with the stringent disclosure requirements of the U.S. Securities and Exchange Commission. Then, in 1989, the SEC approved a simpler way for small businesses to make a public offering, best known as a small corporate offering registration (SCOR). Companies can use SCORs to raise up to $1 million in a 12-month period without filing with the SEC. Today 45 states allow this kind of offering. Companies register with state regulators and answer a series of questions about their business, financial history, and plans. For companies raising more than $1 million, there are other DPO options, such as a Regulation A offering. (See "What Is a Direct Public Offering, Anyway?" below.)

How common are DPOs? Last year 31% of all companies trying to raise public equity capital in the United States for the first time used DPOs instead of going through Wall Street. As the SEC continues to ease restrictions and the Internet becomes a more appealing venue for selling stock directly, that number promises to increase. Regulation A offerings, for example, were recently made available to companies with up to $10 million in assets--up from a previous limit of $5 million.

Although they're attractive to capital-hungry entrepreneurs, direct public offerings don't represent easy money. As Barry Guthary, chairman of the Small Business Committee of the North American Securities Administrators Association, puts it, "There's no simple way to get money from the public." According to the SCOR Report, a newsletter published by Tom Stewart-Gordon, there were 253 DPO registrations filed last year. However, in Stewart-Gordon's experience, about 60% of DPOs fail. Statistics from the state of Washington, which was the first state to approve the offering format used in SCORs, are even more pessimistic. According to Bill Beatty of the Washington State Securities Division, only about 27% of the state's DPOs succeeded in raising their minimum offering amounts.

The reasons for the high failure rates are simple. "A SCOR is typically the last resort for a lot of people," explains Beatty. "It's a good tool, but it doesn't turn a company that wouldn't be a good candidate for the public markets into one." In addition, entrepreneurs may excel at selling their product yet have little experience selling stock. Without a ready market for their offering, many companies can't overcome the absence of an underwriter. Those that do generally sell to affinity groups--customers, employees, suppliers, distributors, friends, and next of kin. "If you don't have a strong affinity group, you'd better have a good marketing concept," advises Lisa Sireno, assistant director of the Missouri Innovation Center. Many DPOs fail even with a loyal following and a strong marketing plan. Still, it is possible for ordinary small companies to raise money through this new method--but there are plenty of hurdles.

For starters, there's the nagging problem that most of the general public has no idea what a DPO or a SCOR is. "Investors are naturally cautious because they're dealing with both a company and a type of offering they've never heard of," explains Stewart-Gordon. Even if you have a ready-made pool of potential investors, selling stock directly is difficult. Thanksgiving Coffee Co., a coffee and tea wholesaler with projected 1996 revenues of $4.6 million, wasn't a bad DPO candidate. After 22 years, the Fort Bragg, Calif., company had a loyal customer base to approach. But the offering was still hard. "You think that everybody who knows about you will line up around the block to buy stock, but you have to put the offering in front of potential investors' faces seven times to get them to take action," says Thanksgiving general manager Rick Moon.

Moon did just that. He put offering notices on coffee-bean bags. In stores he hung announcements on bean dispensers. Vendors got the advertisements, as did mail-order customers. Information about the stock sale appeared on the company's World Wide Web site, in its catalog, and in advertisements in targeted magazines. Anyone who called about the stock got regular updates on the offering. In the end, the huge effort paid off. By the time the offering closed, this past September, Thanksgiving Coffee had sold 20% of its stock for $1.25 million.

Sound like a massive undertaking? Consider what Michael Quinn went through last year to sell his Regulation A offering. Quinn, owner of Hahnemann Pharmacy, in Albany, Calif., knew it would be hard to explain homeopathy--a form of natural medicine--and sell stock at the same time. Instead, he bet that homeopathy enthusiasts would be interested in shares of his homeopathic-remedy company, which projects 1996 sales of $750,000. The challenge: tracking them down.

Quinn started with his customers. He posted an ad for the offering in the pharmacy, packed announcements with shipments, and chatted with hundreds of customers. "I had to explain to half of them what stocks are. Actually, had to learn what stocks are prior to doing this," says Quinn.

To make his offering successful, Quinn needed to broaden his base of potential investors. He swapped mailing lists with a homeopathic bookseller and a homeopathic software company and sent announcements to their customers. Then he used a national homeopathy organization's mailing list as well. Finally, he reached the homeopathic community through its newsletters, magazines, and physicians. More than 35,000 offering announcements later, Quinn had 242 investors and had raised $467,000 in exchange for approximately one-third of his company. Despite a pricey estimated offering cost of $103,000, Quinn is satisfied. "It was worth it," he argues. "I ended up with $364,000, which no bank was going to lend me."

There's nothing fun about that kind of intensive, dogged selling. Just ask Walter Lewis and Memory Elvin-Lewis of WoundFast Pharmaceuticals, in St. Louis, two biologists who are more comfortable researching plants in Peru than selling stock in their start-up. The Lewises have been promoting their SCOR offering in a way that suits their style--at receptions in their home--yet it's still a struggle. By this past October the couple had raised $200,000 but needed another $150,000 to meet their minimum goal. "I'm not a salesman," admits Walter Lewis. "If I had it to do over, I'd let somebody else do the selling and I'd stay in the background as a scientist."

Given how hard it is to sell stock, entrepreneurs are exploring every alternative--including the Internet. Thanks to the success that a young company called Spring Street Brewery had with its Regulation A offering over the Internet, on-line DPOs have lately received plenty of press. But for many companies, the Internet may be more helpful at keeping down offering costs than at closing stock sales. When David Loring of Interactive Holdings, in New York City, did a Regulation A offering to fund his Internet and television-programming start-up, he naturally gravitated toward the Internet, since he could cheaply publish critical information there. Loring ran the business's offering circular on-line, along with legal contracts, sales material, registration forms, and company bylaws. He even posted advertising icons at other sites, such as on-line financial publications, that linked back to his home page. Since Loring developed the site himself, his Internet marketing effort cost less than $5,000 out of pocket.

Loring found that his Web site generated thousands of leads and lots of calls--but it took a human being to close most sales. That's not surprising, according to William D. Evers, a partner at San Francisco­based Miller, Mailliard & Culver who has handled DPOs. "The Internet is merely a road sign on the highway. And nobody buys from a road sign," Evers explains. Nevertheless, Loring raised his required minimum and intends to finish his offering by year's end. He says, however, that next time he would hire a broker to handle the follow-up required to make sales. "Some people never have to go face-to-face with schoolteachers and tell them why they should hand over some of their IRA accounts," says Loring. "That's a big responsibility."

It should be. A DPO is the beginning of an organization's new business existence as a public company. After conducting DPOs, companies have to keep shareholders up-to-date, although mailed annual reports are sufficient for most small offerings. Then there's the sticky question of shareholder liquidity. Since many companies doing DPOs are too small to be listed on any national or regional exchange, they must find other mechanisms if shareholders are to trade stock. In reality, some operate more like companies that have conducted private placements: shareholders hang on to the stock until the company is sold, does a traditional public offering, or buys back the shares. Other companies maintain in-house matching services for buyers and sellers, and still others hire a broker-dealer to match orders. Larger companies may eventually be listed on public exchanges. More options are developing: the Pacific Stock Exchange, for example, has received SEC approval to build a SCOR Marketplace, where SCOR and Regulation A offerings will be traded.

It's too early to tell how all this SEC experimentation with small public offerings will pan out. Given how risky small companies are, it's an open question whether the bulk of DPO investors will end up satisfied--or furious. There's more than just business risk to worry about: as the number of companies selling stock directly increases, so do the possibilities for the kind of rampant consumer fraud and abuse that have plagued the penny-stock market. According to Joe Cella, chief of the SEC office of market surveillance, the SEC recently beefed up efforts to prowl the Internet, an area of particular concern.

Company owners also have to be careful, as David Whalley of Renaissance Design found out. Before he raised $550,000 for his $4-million Portsmouth, N.H., research company, Whalley says, he wasted seven months with a brokerage firm that assured him it was experienced in DPOs. When the brokerage's promises fell flat, Whalley and his partners ended up filing the offering themselves. "Make sure you're dealing with people who can prove they have done it before," he cautions.

Entrepreneurs also face a variety of often-conflicting state regulations. Jim Bernau, who has conducted 13 DPOs during the past seven years, has encountered his share of regulatory roadblocks while raising money for a vineyard and five microbreweries. He complains that, in one state, he twice didn't get approval until two weeks before the offering closed. Meanwhile, one state official demanded that certain information be included in Bernau's prospectus at the same time the counterpart in another state forbid its inclusion. "Lots of states have lotteries, with no control of how much people invest," Bernau gripes. "And here I am with an army of attorneys and accountants going through a regulatory process that takes eight months, just to raise $700 to $900 each from beer enthusiasts to build a brewery."

Despite all the problems, DPOs can be useful vehicles for small-scale companies to acquire equally small-scale investors. When Joe Murphy, president of Community Grocers, in Mount Ayr, Iowa, needed to fund his grocery-store start-up, he rallied the local community around his cause--and his DPO. A huge grocery chain had bought and later shut down its only competition in town, and that stirred resentment. "We marketed by asking people if they were interested in having another grocery store," says Murphy, who hired someone to cold-call people with that question. If residents said yes, the caller launched into the offering pitch. Murphy also relied on his 13-member board to spread the word. "It was a small-town deal," he says. "The big corporation had a negative impact when it turned us into a one-store town. People would give money to stop that."

Lots of money, it turns out. In July of this year, Community Grocers was still short on cash, so the board asked backers to either increase their investments or ask friends to join. Five weeks later Murphy had doubled his capital and his investor base. Community Grocers' offering won't be finished until February, but with $385,960 in September, the company had already raised its required minimum--in exchange for 62% of its stock. In the 5,400-person county, more than 300 are investors, which Murphy says carries an added benefit. "It's not mandated that they'll become customers. But if you're deciding between grocery stores and you own stock at one of them, chances are, you'll go there."

It's too soon to tell if Murphy's start-up will succeed. In that respect, Community Grocers' offering is like DPOs themselves: an unusual financial experiment where the worlds of Wall Street and Main Street, of stock sales and produce sales, intersect. In the long run, DPOs may prove to be a passing business fad--or an important source of small-business capital. For now, we can only wait and see.

Source: Tom Stewart-Gordon, the SCOR Report, Dallas.
What Is a Direct Public Offering Anyway?
Most common types RULE 504 UNDER of DPOs REGULATION D (SCOR) REGULATION A INTRASTATE
Brief description A small corporate offering A short form of registration for a small public offering An offering of securities restricted to one state
Also known as... SCOR, ULOR, or U-7 Reg. A Rule 147
Maximum offering $1 million $5 million No federal limit; amount varies by state requirements
Time period 12 months 12 months No federal limit; varies by state requirements
SEC requirements Filing of form D Offering statement must be filed with the SEC None, except can't resell outside state for nine months
State requirements State registration State registration State registration
Interstate offering possible Yes Yes No
Filings last year* 145* 77 10*
General solicitation and advertising allowed? Yes Yes Yes
Restricted to accredited investors, who meet certain wealth standards? No** No** No**
*There were 21 additional filings whose category could not be easily determined. They were either SCORs or intrastate offerings.
**One exception: California allows only accredited investors to invest $2,500 or more in a DPO.

Checklist: Could You Do a DPO?

Drew Field, a specialist in direct public offerings, has identified some of the most common characteristics of companies that conduct successful DPOs. Does your company share them?

1. Does your company have a history of consistently profitable operations under the present management?

2. Is your company's present management honest, socially responsible, and competent?

3. In 10 words or fewer, could you explain the nature of your business to laypeople new to investing?

4. Would your company excite prospective investors, making them want to share in its future?

5. Does your company have natural affinity groups, such as customers with strong emotional loyalty?

6. Do members of your natural affinity groups have discretionary cash to risk for long-term gain?

7. Would your company's natural affinity groups recognize your company's name and consider your offering materials?

8. Can you get the names, addresses, and telephone numbers of affinity-group members, as well as some demographic information on them?

9. Can a high-level company employee spend half-time for six months as a DPO project manager?

10. Does your company have--or can you obtain--audited financial statements for at least the last two fiscal years?

Source: Adapted from questions developed by Drew Field of Drew Field/Direct Public Offerings, San Francisco.


The SCOR Board

Number of direct public offerings in the United States

1989: 10
1990: 9
1991: 46
1992: 109
1993: 213
1994: 267
1995: 253
1996: 163, in first six months

Source: Tom Stewart-Gordon, the SCOR Report, Dallas.


Diary of a DPO

Think selling stock is a picnic? Think again. Here's the story told by Michael Quinn, owner of Hahnemann Pharmacy, a small 11-year-old homeopathic pharmacy in Albany, Calif. Quinn sought to raise money to add a laboratory to his company, which in 1995 had sales of $590,000 and net income of $62,000.

JULY­AUGUST 1994: Quinn meets with lawyer-marketer to discuss offering and with accountants to begin first independent audit. Starts preparing offering documents. Works 10 hours a week on project. Money spent: $8,000 in legal and accounting fees.

SEPTEMBER­OCTOBER: Prepares copies of offering materials, talks to consultants. Works 20 hours a week on DPO. Money spent: $14,000 in legal and accounting fees.

NOVEMBER: Prepares pro forma financial estimates for next five years for SEC. Develops marketing plan. Accountants review most recent quarterly financials. Money spent : $9,500 in legal and accounting fees.

DECEMBER: Submits documents to SEC and California Department of Corporations (CDOC). Spends two weeks fielding SEC and CDOC requests. Gets SEC approval and is ecstatic over fast turnaround. First batch of prospectuses goes to printer. Money spent: $4,000 in legal fees.

JANUARY 1995: Meets with banker to set up escrow account to hold investors' money (to be returned to them if offering fails to reach its minimum goal by June 30). Mails out first 300 prospectuses in California. Begins filing in other states. Pays New York State $1,000 to file, and most other states from $50 to $100. Works with lawyer to figure out state regulations. Until August, spends 20 to 30 hours a week talking with potential investors. Gets first two investors, both local homeopathic doctors. Money spent: $6,000 on marketing.

FEBRUARY: Sends out 3,000-piece mailing that announces offering to recent customers. Gets roughly 200 phone calls and faxes in response. Hires part-time pharmacist to help out in the store. Gets five more investors. Company has raised $22,000 after six weeks of marketing. Money spent: $8,000 on marketing and $600 a week for the new employee.

MARCH: Sends out 10,000-piece mailing. Escrow account is up to $43,000. Money spent: $10,000 on marketing.

APRIL: Prints poster and mail-order inserts. Exchanges mailing lists with other organizations and sends out 10,000-piece mailing. With only $78,000 in escrow, Quinn asks SEC for an extension of June 30 deadline. Accountants update financials. Money spent: $9,500 on marketing and accounting fees.

MAY: Sends out another 10,000-piece mailing. Company now has $102,000 in escrow. Money spent: $4,000 on marketing.

JUNE: With Hahnemann $298,000 short of its minimum goal, Quinn receives extension from SEC. Sends out 2,200-piece mailing. By June 30 has $225,000 in the bank. Calls people to get them to mail checks and fax in subscriptions. Sends extension-agreement forms to 102 investors and tracks down those who are on vacation. Money spent: $6,000 on marketing.

JULY: Exhausted, Quinn takes a week off to celebrate his father's 80th birthday. Returns and is inundated with calls and letters. Raises a total of $272,000 by end of month. Money spent: $4,000 on marketing.

AUGUST: Quinn thinks he's over the hump. Then potential investor who had pledged $50,000 backs out. Shocked, Quinn launches a telephone campaign. Everyone at the pharmacy spends a few hours each day, including Saturdays, calling people who had requested prospectuses. Some people invest for the second or third time. Quinn works full-time on offering for the entire month. Money spent: $6,000 on marketing.

AUGUST 28: With four days left, Quinn has $319,000 in the bank. He drives with his wife from Albany to bank, in San Francisco, to hand-deliver $20,000 worth of new checks.

AUGUST 29: With checks and calls still coming in, Quinn returns to bank with another $25,000.

AUGUST 30: Quinn again drives to San Francisco, with another $27,000 worth of new checks.

AUGUST 31, 1995: With $391,000 in the bank, Quinn runs another $10,000 back to bank at 9 a.m. Returns later the same day with $21,000 that had just arrived. With $422,000 in the bank, Quinn cracks open a bottle of champagne.

POSTSCRIPT: Over the next six weeks an additional $45,000 rolls in, bringing offering total to $467,000. Money spent: $14,000, in last payment to lawyer.