Drew Field
Direct Public Offerings

June 1997
By David R. Evanson

Direct Hit
With direct public offerings entrepreneurs can take financing into their own hands.

Michael Quinn's dilemma was a common one, but his solution was not.
After 10 years in business, Quinn wanted to go national. But his Hahnemann Laboratories Inc., a San Rafael, California, company that manufactures homeopathic medicines, needed to become a Food and Drug Administration-licensed pharmaceutical manufacturer if it was going to market its product across state lines. Where would Quinn get the capital to outfit a new facility?
"I went to a commercial bank, and they said 'No way,' "recalls Quinn. Investment bankers weren't offering much hope, either. But Quinn had an epiphany when he realized that if just 200 of his more than 28,000 customers invested about $2,000 each, Hahnemann Labs would have the equity capital it needed.
What Quinn did next was an end run around traditional brokerages. He marketed common shares directly to individual investors in what is known as a direct public offering, or DPO.


San Francisco attorney Drew Field, author of a new how-to book titled Direct Public Offerings (Sourcebooks Inc.) and advisor to Quinn on his DPO, saves the time is ripe for companies to sell their shares directly to the public. The reasons are diverse: Disillusionment with traditional Wall Street offerings, more uniformity in state securities regulation, and increases in savings and investments all play a part. "But mostly," says Field, "we are in the early part of a period of taking more responsibility for our lives. Because of this, individuals are more willing to invest in companies they do business with or have an affinity [for]."
Field says that while a DPO is no less complex or challenging than a traditional initial public offering (IP0), it is a more manageable way to go. "With a DPO, entrepreneurs do not have to accommodate or rely on investment bankers to get the job done," says Field. "You can manage a direct public offering just like you would any other project."
But in addition to possessing the required skills for handling a DPO, entrepreneurs must also be able to grow the company within the limitations intrinsic to this technique. Specifically:

  • Absence of liquidity. Companies that, in addition to raising capital, must provide an immediate exit for earlier investors or accurate valuation for estate planning purposes will find that DPOs fall short in helping them reach their ultimate objectives.
  • Limited use as currency. Companies that need to go public so they can use their common stock as a currency to acquire other companies should not use a DPO.
  • Little personal gain. It would be all but unheard of for the founder of a company to sell his or her shares to investors in a DPO. In addition, with no active trading market, there's little hope of selling the shares on the market after the deal is done.

But even for companies that can operate within this framework, a DPO still may not be viable. Success requires certain traits that not all businesses possess. Field says viable candidates will fulfill the following criteria:

  • The business is easy to understand. Individuals who participate in DPOs tend not to purchase shares in companies they do not understand. And because they are individuals, not brokerages or institutions with research departments, the scope of what they understand is much narrower.
  • The company is established and profitable. The DPO process, which involves little direct selling but a lot of reading and evaluation on the part of would-be shareholders, tends to attract cautious investors.
  • The business is exciting. DPOs require a lot of motivation on the part of the investors because of restrictions placed on the company's securities marketing activities. As a general rule, it's difficult for more mundane enterprises to inspire the required level of action among investors.
  • The company has natural affinity groups. Customers, clients and the community in which the company does business all have an affinity for the company. And it's through this relationship that manufacturer of stained-glass windows for of the DPO is sold. One of the fundamental questions entreprenuers ace is whetherthe affinity group they perceive is mutual and strong enough to motivate prospective investors to consider their offering.

Based on these criteria, some companies are good DPO candidates; others are not. For instance, a manufacturer of stain-glassed windows for homes is a likely candidate; a biotechnology company still in the research stage is not. An agricultural cooperative is a good candidate; a manufacturer of industrial abrasives is probably not. A lawn-care company is a good prospect, while a business that provides "correctional" services to governments is probably not.


In the case of Hahnemann Labs, Quinn had a natural affinity group in his thousands of customers. Generally, people interested in alternative medicine are not those typically interested in the stock market, says Quinn. But his deal-which, in a way, was an "alternative" public offering seemed to have a unique appeal to these investors.
Quinn sent out more than 35,000 offering announcements. The announcements resulted in about 1,700 requests for prospectuses; another 400 requests for prospectuses came from friends, family, associates, colleagues and other acquaintances. Of the initial 2,100 prospects who received a prospectus, about 240 ultimately invested.
Not that any of this was quick or easy. Quinn started drafting his prospectus in July 1994, and 12 and a half months later, in August 1995, he closed his deal's $400,000 minimum-with investments to spare. Of his 240 investors, Quinn estimates that just 15 percent, or 36 investors, sent in a check on their own after reading the prospectus. To get the rest, Quinn had to dial for dollars. In all, he figures he talked to some 700 to 800 potential investors over the telephone. Nor was any of this cheap: Legal, auditing, printing and marketing costs totaled $102,000, Quinn says.
Parenthetically, it's worth mentioning that the process described above underscores one of the primary reasons why so-called Internet IPOs are difficult to get done. Says Field, "Right now, the Internet works as a cost-effective delivery medium, but it does not work as magic. The fact is, most people will invest in an [offering] only if they already know and feel good about the company."
Although the entire effort took valuable time and resources away from his business, Quinn says it was not without benefits above and beyond raising the money. "Sure, there were days when I wished I would run into just one person who had $500,000,Quinn recalls, but he says there was also a tremendous benefit to talking to so many customers and finding out what their needs and attitudes were. "Reaching out to so many people and telling your story is never bad for a business if it's done with the right kind of heart and attitude.
In fact, sales during Hahnemann's fiscal year 1996 were $691,000-about $100,000 higher than sales for fiscal 1995. That momentum has spilled into fiscal 1997, with sales of some $400,000 at midyear.


From a regulatory perspective, DPOs face the same challenges as underwritten IPOs. That is, companies that want to raise more than $5 million and want to trade on a stock exchange or the top two tiers of the NASDAQ stock market must file a registration statement with the Securities and Exchange Commission (SEC). This is a major undertaking.
Businesses that need less money and are more flexible in their requirements for aftermarket trading may enjoy less burdensome regulatory challenges. For instance, companies that want to raise less than $5 million can take advantage of the exemption from federal registration by filing under what is known as Regulation A of the Securities Act of 1933, which Quinn used for Hahnemann's offering.
Companies that want to raise less than $1 million in a DPO may take advantage of the Small Company Offering Registration (known as SCOR), which is accepted in 43 states and requires almost no filings with the SEC. The SCOR form, also known as Form U-7, is still no day at the beach, however: It has several parts, and once complete, looks suspiciously like a prospectus.
One of the real advantages of these unregistered offerings is that in many cases, a company's shares can still trade on the NASDAQ Bulletin Board, which is the next-to-the-lowest tier of the NASDAQ stock market. Remember, to trade on the NASDAQ SmallCap Market, the NASDAQ National Market System or any of the major stock exchanges, companies must periodically report to investors via the Securities Exchange Act of 1934. This adds a host of requirements that a very tiny public company that just completed a very tiny DPO may not want to burden itself with. Trading on the Bulletin Board eliminates these headaches.
For his part, Quinn has not been too concerned with aftermarket trading. He has left that to a stockbroker who keeps a book matching buyers and sellers. But most of the investors are holding onto their shares, says Quinn. The company's upside potential seems to be the reason: It would be nearly impossible for one of the major pharmaceutical companies to grow 10 times bigger," he says. "But we definitely can."

David R. Evanson, a writer and consultant, is a principal of Financial Communications Associates in Ardmore, Pennsylvania.