Online IPOs Falling Short of Expectations

When Harold J. Gallagher wanted to raise money for his start-up company, he turned to the Internet.

Gallagher, founder of a Fresno business developing a digitized magnetic compass, was inspired by the success a year earlier of Spring Street Brewing Co., a New York City microbrewery that made Wall Street history by becoming the first company to do an initial public offering over the Internet. After researching Internet-based IPOs for months, Gallagher spent hundreds of thousands of dollars on attorney’s fees, securities registration and a Web site with information in four languages and the latest multimedia trimmings to acquaint potential investors with the offering.

But it wasn’t enough.

Since its launch four months ago, Directional Robotics’ IPO has raised only $200,000, a fraction of the $5-million target. A disheartened Gallagher now says he’ll turn to more traditional fund-raising channels, abandoning the Internet as an idea whose time is yet to come.

“There’s no doubt it will be an important source of funds for companies like mine in the future. I’m only disappointed the timing is too early for us,” Gallagher said.

Directional Robotics’ experience is not unusual. Since Spring Street made headlines, dozens of companies have tried Internet stock offerings, but successes are the exception, not the rule.

The Securities and Exchange Commission helped set the scene for Internet IPOs several years ago when it created several new categories of limited stock offerings that are exempt from normal registration requirements. Under the new rules, companies can raise up to $1 million through a Small Corporate Offering Registration, or SCOR, or up to $5 million through a Registration A filing.

Companies undertaking SCOR or Reg A offerings can use a Web site to publish a prospectus and market and sell shares. Some do so because they don’t want to pay the steep fees associated with a traditional underwriter, others because their business is too small or untested to attract any other financing.

But many have found that raising money online is not nearly as easy as they expected.

“There’s a perception that you can put an offering on the Net and investors will find it so compelling they’ll buy it on the spot,” says Leo Feldman, a Houston securities broker and proprietor of IPOnet, a Net-based stock promoter. “But that’s not true. Securities aren’t bought, they’re sold.”

Companies such as IPOnet, Direct IPO and Direct Stock Market have jumped into the breach, using their principals’ experience in public relations or securities to market multiple Net-based IPOs from a single Web site.

But they’ve been slow to deliver on promises of widespread exposure. In the last 12 months, Santa Monica-based Direct Stock Market has completed a dozen deals, but none used the Internet exclusively. IPOnet has closed three deals, and Direct IPO none.

Regulators have endorsed using the Internet, but they closely monitor stock promoters and companies that do so. Several times over the last year, the SEC has forced companies to pull information off the Web or halted other questionable activities.

Muddying the waters are con artists eager to cash in on the dual opportunities presented by the Internet boom and the abbreviated filing requirements. Such scams can be seen on Web sites like one pitching a $295 software program purporting to explain how to “raise up to $1 million that you don’t have to pay back!”

Skeptics maintain that Net IPOs are not simply before their time, they’re fatally flawed--mainly because the companies attempting them would be bad investments no matter what the venue.

“An offering is an offering is an offering. If you’re selling stock in a company with bad fundamentals, it doesn’t matter how you offer it to them,” said Jeff Himstreet, associate counsel with the North American Securities Administrators Assn. in Washington, which represents state securities regulators.

But supporters believe Net IPOs will be commonplace once companies come up with the right formulas for driving investors to their Web sites and the public is more comfortable with buying investments online.

“It won’t happen overnight, but as more real companies do these, they’ll be more popular and be a viable way of raising capital,” said Jeffery Gaul, chief financial officer at Digital Planet, a Culver City Web design shop preparing for a Net IPO.

Certainly, investors are pouring online to track and trade NYSE, Amex and Nasdaq stocks, and mainline brokerages and mutual funds have begun using e-mail and Web pages to disseminate information about their holdings.

Under the SEC’s watchful eye, other companies have started Internet trading boards, bulletin-board type services that allow shareholders to buy and sell stock in one or several companies without going through a traditional exchange.

Such activities could fundamentally change consumers’ behavior toward investing, securities experts said.

“Three years ago, if you wanted to see a public company’s 10K or 10Q, you had to call them or physically go to a state regulator or the SEC or pay a service to get it. You can get them online today for nothing,” said Mark Astarita, a New York securities lawyer and creator of the https://www.SECLAW.com Web site. “The availability of information promotes the concept of investing and, in theory, should make better investors.”

It was almost a year and a half ago that former securities lawyer Andrew Klein struck upon the idea of using the Internet to help sell shares in his fledgling microbrewery, Spring Street Brewing. The company raised $4.9 million in two offerings, and Klein started a second company, Wit Capital, to run a trading board for Spring Street shareholders. The SEC moved swiftly to shut down the board, claiming Klein was acting as an unlicensed broker, but allowed him to resume trading with the proviso that a registered broker-dealer handle transactions.

Despite the run-in with regulators, Spring Street was considered a success. But most of its followers have failed to live up to early expectations.

Last fall, Netter Digital Entertainment, a North Hollywood company that produces the “Babylon 5” TV series, announced a $5-million offering. By the time the offering closed in March, Netter had raised only $425,000--mostly from offline sources, said Richard Fransen, counsel for W.J. Gallagher, the Pasadena broker-dealer that helped on the deal.

Another company, start-up BrainTainment Resources in Laguna Beach, is halfway through an eight-month SCOR offering and has raised $200,000 of the $500,000 it’s hoping for. So far, about 75% of investors found out about the company online, either by visiting BrainTainment’s Web site or its listing on Direct Stock Market.

Another local company hoping to repeat Spring Street’s performance is Web site designer Digital Planet, known in Internet circles for its work with Hollywood studios and the Postal Service.

Digital Planet CFO Gaul studied the market for a year before deciding to hook up with Direct IPO, which was started last year by former stockbroker Mark Perlmutter and Michael Terpin, a Los Angeles public relations industry veteran.

But the firms ran into trouble in early April, when a press release announcing the partnership appeared on Direct IPO’s Web site before Digital Planet had registered the offering with the SEC, an action the federal agency considers an illegal conditioning of the market.

The SEC demanded Direct IPO remove any mention of Digital Planet from the site, which it did, and executives are careful not to discuss details of their relationship.

Direct IPO’s Perlmutter maintains the incident hasn’t hurt his plans to complete 10 deals this year, including Net IPOs and private placements.

“I’ve always wanted to be a venture capitalist. This is the closest I’ve come without having $40 million of my own,” he said.

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Michelle V. Rafter, a regular contributor to The Cutting Edge, can be reached via e-mail at mvrafter@deltanet.com