Direct Offerings on Net Can Pull in the Cash . . . at a Cost

Josh Reynolds has always been something of a New Age pioneer.

A biofeedback clinician-turned-inventor, the Newport Beach-based entrepreneur gave the world the Mood Ring and was the muse behind the ThighMaster exercise machine. Now he’s heading a start-up called Cognitive Diagnostics Inc., which is developing intelligence-enhancing “brain software” for people worried about keeping their gray matter in shape.

But it is Reynolds’ method for raising $500,000 in capital for the venture that is truly unorthodox. Cognitive Diagnostics is marketing stock directly to the public via the Internet, without the aid of underwriters, brokers and other high-priced Wall Street players.

“As a pioneer, you end up with a lot of arrows in your back,” Reynolds said. “But I want to give investors direct and easy access to stock ownership.”

Ignored by investment banks, snubbed by lenders, a small but growing number of firms like Cognitive Diagnostics is making an end run around Wall Street and going straight to Main Street for capital.

Known as direct public offerings, or DPOs, these do-it-yourself stock sales are the product of changes in federal securities laws that make it easier for the small fry to go hat-in-hand to the public without the expense and red tape of conventional public offerings.

More than 350 companies gave it a try last year. That’s up from just a handful in the early 1990s, thanks to an insatiable demand for capital by small businesses and to growth in Internet technology that has given entrepreneurs an inexpensive way to market these deals.

But don’t break out the champagne for that “going public” party just yet. Experts say these securities remain a tough sell given their lack of liquidity. And they caution investors that just because a company can post a prospectus on the Internet doesn’t mean it’s ready to go public.

At least two-thirds of the 1,200 or so companies that have attempted DPOs since 1990 have failed to attract enough investors to complete their offerings, according to Tom Stewart-Gordon, publisher of the Dallas-based newsletter SCOR Report.

Still, firms that have succeeded predict the market for DPOs will continue to expand, providing an important new source of capital for small businesses willing to endure the rigors of going public.

“It was a tremendous commitment of time and energy, but it was well worth it,” said Michael Quinn, a manufacturer of homeopathic remedies who raised $476,000 to build a new laboratory in Northern California. “After all, the bank certainly wasn’t going to lend it to me.”

Although entrepreneurs have used DPOs of one form or another to raise capital for centuries, going public in the modern age is a costly and highly regulated affair that was out of the reach of many small firms until 1982.

That’s when the Securities and Exchange Commission adopted Rule 504, permitting companies to raise up to $500,000 annually in a public offering free from federal registration requirements. That dollar limit was later expanded and other state and federal regulations liberalized, making DPOs more appealing to small companies.

There are several classes of DPOs, but the simplest is known as a Small Corporate Offering Registration, or SCOR. It allows a company to raise up to $1 million over a 12-month period by filing a standardized disclosure document with state securities officials. Such offerings are permitted in 45 states, including California.

Other DPOs require SEC disclosure, but they also allow companies to raise larger amounts of money--from a maximum of $5 million under what’s known as a Regulation A offering, to an unlimited amount under an SB-2 offering.

Some well-known firms have used modest DPOs as a steppingstone to prepare for a larger, underwritten public offering. Vermont-based Ben & Jerry’s Homemade Inc. scraped together $750,000 to build its first ice cream plant by barnstorming the state to sell shares directly to residents.

That early capital enabled the company to grow large enough to launch a “real” public offering that raised $6.5 million. Today the stock is traded on the Nasdaq exchange.

“A lot of Vermonters wanted to see this thing succeed,” said Ben & Jerry spokesman Rob Michalak. “In the end, something like one in every 100 households bought a piece--or should I say scoop--of the action.”

Industry watchers say that type of devotion is the key to pulling off a successful direct stock sale. After all, one of the biggest attractions of a DPO--the ability of a company to sell shares directly without having to pay hefty underwriting fees--is also one of its biggest drawbacks since there is no experienced third party promoting the stock to potential investors or supporting the stock during rough patches.

That means most companies have no choice but to raise the cash from those who know them best, such as customers, local residents and others with an intense interest in their product or mission, according to Lee Petillon, a Torrance-based securities lawyer and DPO expert.

“DPOs make sense primarily for companies that have a passionately loyal, almost fanatical following,” Petillon said. “That core base of constituents is critical for success.”

Reaching those hard-core fans on a shoestring budget has made for some quirky and eclectic marketing campaigns.

Forget slick presentations and pricey tombstones in national business publications. Most of Quinn’s affinity group--devotees of alternative medicine--had never owned stock and were suspicious of Wall Street to boot. So he swapped mailing lists with a homeopathic bookseller, ran ads in alternative medicine newsletters and shipped announcements out with every drug order.

He also spent countless hours on the phone with customers.

“We’d start with the basics, like what is a stock,” said Quinn, whose Albany, Calif.-based Hahnemann Laboratories Inc. logged sales of $691,000 last year. “It was incredibly time-consuming, but it also helped me connect with my customers.”

Other entrepreneurs have used their own products as a marketing tool, slapping stock offering announcements on everything from beer labels and clothing tags to coffee-bean bags and macaroni-and-cheese boxes.

Red Rose Collection Inc., a Burlingame, Calif.-based mail order house, went a step further. Not only did the company plug its shares in its catalogs, it offered its 450,000 customers the opportunity to receive a lifetime 10% discount on all future merchandise purchases as a reward for buying at least 10 shares of the $10 stock.

The company got 5,000 takers and raised more than $2 million in expansion funds. In addition, Red Rose has cemented a lifetime relationship with some of its best customers, who, as shareholders, will be reluctant to shop elsewhere, says co-founder and President Rinaldo Brutoco.

“I’d rather give a 10% rebate to my existing customers than spend a lot of money looking for new ones,” Brutoco said. “This is the ultimate in relationship marketing.”

None of this comes cheap, however.

Although there are no underwriting fees coming straight off the top as there are with a traditional IPO, expenses for legal, accounting, marketing and other crucial services can add up fast in a DPO. And because these costs are spread over a much smaller offering amount, they can look pretty pricey in percentage terms.

Consider that Quinn spent more than $100,000 on upfront fees, or about 21% of the amount raised. Brutoco estimates that after figuring in people costs, about 30% of his offering went to expenses.

That compares with an average of 11.6% for conventional IPOs, according to a study of 1,200 offerings done by Richard Carter, associate professor of finance at Iowa State University.

“If all you’re doing is raising capital, it’s expensive,” Brutoco said. “I look at it as marketing when I’ve converted customers into true believers.”

But what do you do if you’re a start-up and don’t have a huge customer base to tap for funds? If you’re like Spring Street Brewing Co., you put your stock offering on the Web and raise $1.6 million directly from people who may never have even tried your product.

The New York-based microbrewery’s successful 1995 offering, the first-ever Internet initial public offering, created a heady buzz about the medium’s potential to circumvent Wall Street and turn the securities industry on its ear. So far, however, reality hasn’t matched the hype. Successful cyber offerings like Spring Street Brewing are a rarity.

But entrepreneurs like Clay Womack believe the Net will ultimately prove a boon to capital-hungry firms and investors alike. Womack’s Santa Monica-based company, Direct Stock Market Inc., is one of a handful of online clearinghouses where investors can find information about DPOs and private placements that they otherwise might never have known about.

“Wealthy investors shouldn’t be the only ones to have the opportunity to invest in early-stage companies,” Womack said. “This gives the little guy a chance to build his own venture capital portfolio.”

The only hitch is that there’s no secondary market for most DPO shares at present, meaning that buyers have no easy means of recouping their investment, much less realizing a profit.

Petillon says an investor who purchases these securities, particularly a SCOR stock, essentially is betting that the company will grow large enough to do a bigger public offering--a la Ben & Jerry’s--that will lead to active trading of the shares.

In an attempt to generate some liquidity, the Pacific Stock Exchange recently created the SCOR Marketplace program for secondary market trading of SCOR and Reg A securities. But so far no small firms have been listed under the program, meaning they either can’t meet the exchange’s listing requirements or found the process too costly to bother.

Likewise, Womack is working to secure regulatory approval for an Internet-based bulletin board trading system that would allow buyers and sellers of these stocks to find one another online.

“The key to the success of [the DPO market] is an efficient secondary market,” Womack said. “Without a secondary market, there is no primary market.”

Improved liquidity would no doubt fuel small investors’ interest in DPOs. But experts warn mom-and-pop stock pickers to use caution.

Although this new technique for raising capital is no more likely to attract securities scam artists than any other (and arguably less so because there’s less money to be made), DPOs are emerging as a last resort for companies unable to raise capital elsewhere, says Blake Campbell, assistant commissioner with California’s Department of Corporations.

The means that for every promising venture using a DPO to take its business to the next level, there is an ill-qualified candidate that meets all the regulatory requirements for making the offering but that really has no business going public.

“Some small businesses resort to SCORs and Reg A’s simply because they aren’t great businesses,” Campbell said. “That doesn’t mean they’re fraudulent. It just means that no venture capitalist or bank would touch them. Investors should take that into consideration.”

At a time when the public is still leery of using credit cards on the Internet, much less buying securities of small companies they’ve never heard of, Reynolds of Cognitive Diagnostics isn’t fazed by the steep odds against pulling off a successful DPO.

He says the company is already halfway to its $500,000 goal and is gearing up for an Internet-based ad campaign to reach more potential investors.

“People were afraid of cash machines when they first came out,” Reynolds said. “The climate is changing. There is a growing confidence factor in using the Web for financial activity. This is the future.”

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Growth in DPOs

Number of U.S. direct public offerings:

1996: 358

Through August 1997: 190