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 mind2000s 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.
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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 12month 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.
A final type of DPO is available through the SEC’s intrastate filing exemption, Rule 147. This option allows companies to raise unlimited funds through the sale of securities as long as the stock is sold only in the primary state in which they do business. Both the company and all the investors must be residents of the same state. This exemption is intended to provide local businesses with a means of raising capital within their locale.
In the late-1990s, the “magic hand” of the Internet (as one might call it) was touted as a way taking dot-coms public and selling their DPO stock on the Web. Very little of that actually happened, looking back. According to Jack A.
Rosenbloom writing in Journal of Internet Law, “During the boom, funding from venture capital was occurring at an astonishing rate, peaking at almost $100 billion in 2000… . Businesses with nothing more than an idea and a half finished business plan were going public at astonishing rates, peaking at 1,017 IPOs filed in 2000… . Businesses simply did not see the need to conduct their own Internet DPOs when more established alternatives were so readily available.” By 2003 the venture capital had dried up—and it is venture capital that really comes from “accredited” investors. In that year only 118 IPOs were filed. When IPOs are hard to get, so are DPOs.
In any case, the hang-over after the dot-com collapse has brought it home to many that the Internet is not an amplifier of information as television is but, rather, a multiplier of it. To make a DPO stock offering visible on the Internet, the seller of stock must be assured of a high rate of traffic to begin with. If such traffic does not exist, it is like putting a notice on the backside of a suburban garage.
Although DPOs can simplify the process of raising capital, there is no guarantee that an offering will be successful. Robert Lowes noted back in the boom times writing in Medical Electronics: “In all types of DPOs, the companies usually declare a minimum amount needed to carry out the business plan. Seven of every ten SCORs fail to reach that target—to ‘break escrow,’ in the parlance.” Small business owners considering a DPO need to realize that there is hard work involved. In fact, the business may suffer during the offering period: management often lacks time both to promote the offering and run the company. For this reason, DPOs are most likely to be successful in companies that are not overly dependent on their top management and that have a sound business plan in place.
DPOs are also more likely to be successful for companies that have an established and loyal customer base.
Customers are often the best potential investors.
Companies initiating DPOs can advertise their stock to customers on product packaging, through mailing lists, with posted messages in offices or other facilities, or by making the prospectus available on an Internet site.
Experts suggest that any company gauge investor enthusiasm before launching a DPO—because costs for attorneys, accountants, and marketing materials can add up, warned Carol Steinberg in Success.
Finally, companies can improve their chances for a successful DPO by availing themselves of expert securities advice. “Whether an offering is properly exempt from registration with the SEC is a matter for competent legal counsel and careful structuring of the offering. Errors must be avoided, since a faulty offering generally gives investors the right to get their money back,” according to Zeune and Baer. The fact that a DPO does not have to be registered with the SEC does not release a company from compliance with the antifraud provisions of U.S.
securities laws. Potential investors must have ample, accurate information to make an informed decision about whether or not to buy stock in the company.
Finally, securities laws vary by state, so it is important that small business owners interested in pursuing a DPO consider the laws applicable to their companies.
See also: Initial Public Offerings