Bypassing Wall Street

                                             Direct Investing Routes Open Now

Bypassing Wall Street is already happening.  It is part of the trend toward disintermediation in finance and business.  [Paul Hawken includes a chapter on "Disintermediation" in The Next Economy, Holt, Rinehart and Winston, 1983, pages 117-132]  Direct investing routes are operating right now.  Most of them are serving individual investors, providing a way for them to go directly to the organization that will be using their money.  Here are some of them.

TreasuryDirect

We hear so much about how the United States is being financed by selling its debt to other countries, especially China.  But can you guess who purchased 86% of the new Treasury securities sold in the first quarter of 2009?  Individuals in the United States.  [Andrew Batson, “Households Start to Rival the Chinese in Treasury Market,” The Wall Street Journal, August 17, 2009, page C6] 

The United States Treasury is the largest money raiser in the world.  To encourage individuals to invest in Treasury securities, it operates TreasuryDirect.  There is no charge at all for buying securities online directly from the federal government.  The only requirements for opening an account and buying securities are a Social Security number, a U.S. address of record, bank account and routing numbers, an email address and use of a computer with a web browser.  The minimum purchase was dropped in 2008 from $1,000 to $100.  Compare this with the minimum $5,000 that Wall Street requires for purchasing local government bonds.

The mechanics of this direct investing route are about as easy as possible. TreasuryDirect is an online service for buying, holding and selling treasury securities.  Its 2010 website describes the service this way:  “In your TreasuryDirect account, you can purchase and hold Bills, Notes, Bonds, Treasury Inflation-Protected Securities (TIPS), and savings bonds and it's available to you 24 hours a day, 7 days a week.  Your TreasuryDirect account is protected by a password of your choosing. The system allows you to conduct most of your transactions online, -- you can purchase, reinvest, sell securities, and perform account maintenance from your home or work computer. You can also view all your account information, including pending transactions. TreasuryDirect offers you all of these features with no maintenance fees, no matter how much you have invested.”  [www.treasurydirect.gov/indiv/myaccount/myaccount_treasurydirect.htm]

The 2008 version of this page said:  “TreasuryDirect is our web-based system that allows you to purchase the full range of Treasury consumer securities in one convenient online account. TreasuryDirect is our primary retail system for selling our securities. This system allows us to establish direct relationships with you as an investor, enabling you to do business with us electronically using the Internet and conduct transactions without personal assistance from us.  In TreasuryDirect, you can purchase and hold Treasury bills, notes, bonds and inflation-protected securities (TIPS) as well as savings bonds, and manage your holdings online in a secure environment.  Our long-term goal is to consolidate all retail sales of Treasury securities in TreasuryDirect. With this consolidation, we'll realize savings in administrative costs and be able to enhance our customer service.”

What TreasuryDirect doesn’t say flat out is that you’ll never need Wall Street to buy and sell U.S. Treasury securities.  By using this direct route, you will always get the best pricing, the greatest transparency and the lowest transaction costs.  You can even participate in Treasury auctions, right along side the Wall Street institutions.

Commercial Paper

The commercial paper securities market is a way for large corporations to borrow money for up to nine months, at a lower cost than borrowing from a bank.  Wall Street acts as a dealer for some commercial paper, but many corporations have employees who sell their paper directly to fund managers and other corporations with excess cash to invest.  Bypassing Wall Street saves the issuer about a half of one percent on each transaction, equal to $5,000 per $10 million.  Commercial paper doesn't have to be registered with the SEC if the money raised is for working capital purposes, that is, to be "used for current transactions."  [Securities Act of 1933, section 3(a)(3), http://taft.law.uc.edu/CCL/33Act/sec3.html]  The economic policy behind the commercial paper exemption was that the financial strength and reputation of the issuers were sufficient protection for the very sophisticated investors who participated in the market.  Wall Street managed to hijack and grossly abuse the commercial paper exemption by packaging and selling "asset-backed commercial paper." They transferred long-term mortgage securities into "bankruptcy-remote" shell companies, which then issued short-term commercial paper.  Investors were mostly money-market mutual fund managers, going after the higher yield, trying to outperform their competition.  In the panic after Lehman Brothers, the Federal Reserve came to the rescue of Wall Street's buy side with purchases, guarantees and loans. The basic commercial paper market survives, with about a trillion dollars outstanding.  [Tobias Adrian, Karin Kimbrough, Dina Marchioni, "The Federal Reserve's Commercial Paper Funding Facility," Federal Reserve Bank of New York Economic Policy Review, http://www.newyorkfed.org/research/epr/forthcoming/1006adri.pdf]  Back in 2001, nonfinancial issuers had $250 billion dollars in commercial paper outstanding.  That has shrunk to about $150 billion.  [Federal Reserve Release, www.federalreserve.gov/releases/cp/]  

Family and Friends

At the other end of the spectrum from the world’s largest money raiser are the would-be entrepreneurs who need money for a start-up business.  Most of them first use up all their savings, credit cards and garage sale proceeds.  Then they turn to family and friends, who make up 92% of all “informal investing,” where the money does not go through a bank, broker or other financial intermediary, according to the Global Entrepreneurship Monitor.  [www.gemconsortium.org/default.aspx] 

Information about informal investing is understandably difficult to gather.  Every three years, the Federal Reserve Board surveys U.S. households to estimate the percentage of households owning part of a private business in which no household member is active in managing. In 2007, approximately 1.6% of U.S. households were passive owners in a private business.  For 2009, the Global Entrepreneurship Monitor survey showed that 4% of U.S. residents ages 18 to 64 had made an informal investment in someone else's business in the past three years.  The average amount invested per business was $7,200 a year.   [www.gemconsortium.org/] A 2004 study limited to accredited investors—generally, individuals with either a million dollars in assets or annual incomes of $200,000—reported that 10.5% had made an informal investment during the previous three years.  [Paul D. Reynolds and Richard T. Curtin, New Firm Creation in the U.S.: A PSED I Overview, Springer, 2009]

A problem with informal investing, particularly friends and family, is simply that it is informal.  Any written documentation is often absent or incomplete.  Enforcement of the terms can get very complicated and unpleasant.  Asheesh Advani responded to this problem in 2001 with CircleLending, his “specialty loan administration company,” and with his 2006 book.  [Asheesh Advani, Investors in Your Backyard:  How to Raise Business Capital From the People You Know, Nolo Press, 2006]  CircleLending was acquired in 2007 by Virgin Money USA, owner of Virgin Airlines and other businesses. In its first six years, CircleLending had set up $200 million in loan volume while maintaining a default rate of less than 5% on private loans and less than 1% on private mortgages. VirginMoney’s website has a timeline for its business development, showing the volume of what it calls “social lending” at a $1.8 billion annual rate in 2009.  [www.virginmoneyus.com/Home/AboutVirginMoney/History/tabid/181/Default.aspx]

According to a blog, VirginMoney is winding down its business.  www.p2plendingnews.com/2009/11/virgin-money-united-states-business-closing/.

Another site offering a similar service is www.lendingkarma.com.

Direct Community Offerings

Local communities have often offered securities directly to their residents, to finance a local project or business.  Some small towns have turned to direct community offerings to replace local businesses that were lost from “big box store” competition or declining population.  [Sharon Earhart, “Making Merc work: When Powell, Wyo., lost its main retail clothing store, residents rolled up their sleeves and opened their own,” and companion analysis by Shellie Nelson, “Western towns sell it their way,” Headwaters News, March 2, 2005

Plentywood, Malta and Glendive, Montana, along with Powell and Worland, Wyoming and Ely, Nevada, all lost anchor stores in their downtowns.  They are all in counties with fewer than 10,000 residents. “When the Stage department store in Plentywood, Montana closed its doors, community leaders created a limited liability corporation and sold shares for $10,000 apiece to raise the $200,000 it took to open the doors of the Little Muddy Dry Goods.”  Inspired by the success of the Plentywood store, Malta leaders sold shares for its community-owned store for $500 a share.  Community leaders in Powell formed a corporation and also sold stock for $500 a share, with a 20 shares maximum purchase. The towns of Worland and Ely followed, selling shares and opening stores.  “The stores are all making money, but their presence in the communities is serving a much more crucial role. They are drawing other businesses to the area and serving as a destination for area shoppers.”  [www.headwatersnews.org/p.earhart030205.html..  Also, www.newrules.org and “Community-Owned Stores: New Anchors for Older Main Streets,” www.uwex.edu/ces/CCED/downtowns/ltb/lets/LTB1204.pdf  See Stacy Mitchell, “Some Communities Don't Depend on Chain Department Stores--They Own Their Own,” 2004.  Stacy Mitchell is senior researcher with the Institute for Local Self-Reliance and a newsletter publisher. www.hometownadvantage.org]

An early biofuel venture, ethanol, required plants to process corn and they cost from $50 million to $125 million each.  Scores of the plants were funded by farming communities through direct community offerings.  “Wall Street has little to do with this decidedly grass-roots investment boom.” [Scott Kilman, “In Midwest Investment Boom, corn-to-Fuel Plants Multiply,” The Wall Street Journal, March 9, 2005, page A1]

Football and soccer teams have been particularly successful with direct community offerings.  In the United States, the Green Bay Packers completed four offerings, from 1923 through 1998.  The last offering raised more than $24 million from over 100,000 shareowners.  [www.packers.com/history/fast_facts/stock_history/]  In England, some 1,500 soccer fans recently pledged $70.50 each to buy a team, using a web site called myfootballclub.co.uk.  [Max Colchester, “One Team Gets 26,000 Owners—All With a Vote on Who Plays: Fifth-Tier English Soccer Side Set to Become First Pro Team Run by an Online Community” The Wall Street Journal, January 2, 2008, www.online.wsj.com/article/SB119922623784960703.html]  

Woody Tasch was chairman of Investors' Circle, whose individual and foundation members invest in early stage businesses that are seen as serving social and environmental purposes.  He uses the term “slow money” to describe investing in local food businesses.  [Woody Tasch, Inquiries into the Nature of Slow Money: Investing as if Food, Farms, and Fertility Mattered, Chelsea Green, 2008,  www.slowmoneyalliance.org]  Local ownership of farms and food processors has been studied as the Community Food Enterprise.  [www.communityfoodenterprise.org/introduction/types-of-cfe-models] 

Perhaps the most established form of direct community offering is the co-op or mutual form of business organization.  “U.S. cooperatives serve some 120 million members, or 4 in 10 Americans. Worldwide, some 750,000 cooperatives serve 730 million members,” according to the National Cooperative Business Association.  [www.ncba.coop/abcoop.cfm]  Mondragon Corporation, begun in Spain in 1956, is an international model for multiple cooperatives, owned by communities of customers, employees and neighbors.  [http://www.mondragon-corporation.com/ENG.aspx]    Direct community offerings of co-op ownership can even work well for financial intermediaries.  For instance, borrowers from mutual savings banks become voting owners, as do the owners of life insurance policies issued by mutual insurance companies.  Mutual insurance companies have a much lower cost of entering the business than their capital stock competitors.  [Andrew Tobias, The Invisible Bankers, Washington Square Press, 1982, page 296]

The legal form of cooperative corporation is not necessary for a business to be community owned and financed.  Grameen Bank, the Nobel Prize-winning pioneer in microlending, is 94% owned by its thousands of borrowers, with the rest owned by the Government of Bangladesh and two banks.  For 2006, they received dividends equal to their entire investment.  http://www.grameen-info.org/index.php?option=com_content&task=view&id=294&Itemid=282

Direct Local Government Bond Offerings

You might think that local governments are a natural for marketing bonds directly to their local residents, the people who will benefit from the public facility that is to be financed by the bonds.  Those governments even have the huge advantage of paying interest that is exempt from federal and state income tax. 

For over a century, there has been a trickle of direct local government bond offerings.  Legislatures have even ordered state departments to market bonds to average citizens, but the programs always fizzled out, or never even got started.  Instead, local governments continue to do business with Wall Street, paying large commissions for bonds sold in $5,000 minimum purchases and usually placed with insurance companies and mutual funds.  One reason the system hasn’t changed is because investment bankers make campaign contributions to elected officials and pay fees to people with political access.  Rules against this “pay-to-play” haven’t been seriously enforced and, according to former SEC chairman Arthur Levitt, “”Fraud in the municipal market and incompetence, which in some ways is worse than fraud, has never been greater.’” Even so, “Some 70% of the debt in the municipal market is held by individual investors.”  [Martin X. Braun, “Can the SEC Get Its Street Cred Back?,” Bloomberg BusinessWeek, April 12, 2010, page 28]

During the 1980s, several governments experimented with direct marketing of bonds.  Many of them were offered in minimum purchases of much less than the traditional $5,000.  That earned them the sobriquet “minibonds.”  When direct bond offerings actually happened, they have generally been highly successful.  For instance:  The Salt River Project, a Phoenix, Arizona electric utility, sold $267 million in bonds to 21,000 residents, at a $200 minimum purchase and a $10,000 maximum.  Purchasers could cash in a bond at any time, paying a 3% redemption fee.  East Brunswick, New Jersey sold its first mini-bond in 1978, raising $529,000 to build a public works garage.  They had a second, $500,000, offering the next year.  Massachusetts and Ocean County, New Jersey each had $1 million offerings in 1979.  Assistant State Treasurer James Hosker said, “We opened the line at 9 a.m. and shut it off at 11.  We could have sold $5 million that first day.”  [Thomas G. Dolan, “Mini-Municipals:  A Quiet Revolution in Tax-Exempt Finance, Barron’s, August 6, 1979, page 11]

Yet, when California was desperately searching for a way to sell its bonds in late 2008, it still clung to the usual intermediaries.  The state spent $250,000 on radio and print ads in San Francisco and Los Angeles.  It set up a special website for the bond sale, which told individuals:  “You must have an account with one of the brokerage firms participating in the bond or note sale. Bonds and notes cannot be purchased directly from the State. If you do not have an account at one of the participating firms, you may open one and purchase bonds or notes during the early order period.  Investors are encouraged to begin the New Account process well in advance of the sale. Depending on the brokerage, internal new account procedures may take some time to process. Each firm has its own requirements for opening an account. The State does not endorse any particular brokerage firm. Additionally, the State does not guarantee that any one of these firms will open an account for an investor.” [Kevin Yamamura, “Buy State Bonds, Schwarzenegger Urges,” The Sacramento Bee, October 10, 2008] 

A prospective investor in the California bonds asked, "Why pay a broker?  There's no fee with U.S. savings bonds, and I can buy those online."  A spokesman for the California Treasurer responded that, unlike the federal government, the state can't legally sell notes or bonds directly, "so we have to have a middle man. That's standard procedure."  [Jon Ortiz, “California sells $5 billion in short-term bonds,” Sacramento Bee, October 17, 2008, page 10B]  You might think that California’s financial crisis would prompt a change in any law or procedure that stood in the way of direct offerings. 

So far, introduction of the Internet has done little to loosen Wall Street’s grasp on selling local government bonds.   Muniauction.com, operated by the Grant Street Group, has daily auctions of bonds.  [www.grantstreet.com/auctions].  Initially, sales on the Internet were only to bond dealers, but they seem now to include institutional investors and corporations.  Individuals have to go through a broker.  “More companies are getting ready to issue small portions of their debt needs online.  Only a few, though, have been willing to step forward because many don’t want to anger dealers.”  [Toddi Gutner, The E-Bond Revolution,” Business Week, November 15, 1999]

In his 1914 book, Louis Brandeis described direct public bond offerings made in 1913 by five American cities, in what he referred to as “over-the-counter” sales.  Testimonials by local officials describe the success from marketing bonds directly to local residents. [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, Frederick A. Stokes Company, 1914, republished by National Home Library Foundation, 1933, Kessinger Publishing’s Rare Reprints, page 81]  If the success of direct public offerings of local government bonds was discovered as early as 1913, why have they been used only sporadically in all the years since?  One answer is the human reluctance to accept responsibility if there is no promise of significant personal reward.  There is not much in it for a public official to go against “the way we’ve always done it” and risk failure.

[For information about direct public offerings of municipal bonds, see:  Municipal Minibonds: Small Denomination Direct Issuances by State and Local Governments, by Lawrence Pierce, Percy R. Aguila, Jr. and John E. Petersen, Government Finance Research Center of the Government Finance Officers Association (February 1989);

“The ‘Mini’ Trend in Municipal Finance: Minibonds,” Comment by Christina L. Jadach, Harvard Journal on Legislation, Vol 19:393 (1982);

“Mini-Municipals: A Quiet Revolution in Tax-Exempt Finance is Afoot, Barron’s, August 6, 1979, page 11;

“Boston’s Offering of Minibonds’ Proves Good Lure,” by Johnnie L. Roberts, The Wall Street Journal, September 13, 1984, page 37;

About New York’s Municipal Assistance Corporation proposal:  “Issue of ‘MiniMacs’ Pleases Politicians, Riles Bond Lawyers,” by Daniel Hertzberg, The Wall Street Journal, June 8, 1977;

“The Muni E-Bond Revolution,” by John E. Petersen, Governing.com: The Magazine of States and Localities, April 2000;

“The Mini trend in Municipal Finance: Minibonds,” by Christine L. Jadach, 19 Harvard Journal on Legislation 409, Summer 1982;

South Carolina’s program, www.treasurer.sc.gov/mini_bonds_information/ and www.highbeam.com/doc/1G1-65255507.html;

Sales this month of ten-year bonds in Bergen County, New Jersey, www.co.bergen.nj.us/bcresources/mini-bonds.html;

New York City bonds, www.nytimes.com/gst/fullpage.html?res=9E0CE7D7123AF931A35750C0A964958260;

Crowdfunding/Fanfunding

There is a space between making a donation to a cause, on the one side, and making a loan or buying shares on the other side.   Some charities and political campaigns have moved a bit into that space, by offering ways for donors to participate in the organization’s activities.  The appeal is to a motivation beyond that reached by auctions, souvenirs, name recognition and other perquisites.  It is directed to a desire to be a part owner, economically and in governance.  Some businesses are finding ways to be in that same fundraising space, to offer a sense of ownership, without running afoul of the securities laws.  Several approaches are described in http://p2pfoundation.net/Crowdfunding;

www.socialinnovationexchange.org/files/201 Crowdfunding.pdf; http://crowdfunding.pbworks.com/  and http://twitter.com/crowdfunding.  Jeff Howe, in his book, Crowdsourcing says:  “Crowdfunding isn’t new.  It’s been the backbone of the American political system since politicians started kissing babies.”   [Jeff Howe, Crowdsourcing: Why the Power of the Crowd Is Driving the Future of Business, Crown Business, 2009, page 253]

As crowdfunding sites have proliferated, some have gone beyond "only token compensation such as coupons or free samples," including "a 2% cut of the store's revenue over four years."  [Emily Maltby, "Tapping the Crowd for Funds," The Wall Street Journal, December 9, 2010, page B5]  By December 2010, crowdfunding sites in operation included:  IndieGoGo.com, Kickstarter.com, RockeetHub.com, Peerbackers.com and ProFounder.com.

“Many entrepreneurs have found that they don’t need to borrow funds or sell equity in their companies – if they have a solid fan base, there are many ways to tap into that resource for funds.  Strategies in this category include pre-selling, customer financing, crowdfunding, memberships, donations, and sponsorships.  The great thing about this strategy is that securities law does not apply.”  Examples: “Awaken Café – pre-sold “café-creator” cards that allowed them to fund the build-out of the café and entitled buyers to purchase products once the café was open – raised over $14,000!  Little City Gardens – told its story on a crowdfunding site and solicited donations in exchange for t-shirts, stickers, newsletter subscriptions, etc. – raised over $17,000!”  [Cutting Edge Capital, http://cuttingedgecapital.com/financing-strategies/]

According to the Fan-Funded Forum website, there are numerous offerings being made to sports, music and art fans.  However, many of them seem to have intermediaries who operate and charge like brokers.  [www.fanfundedforum.com/category/fan-funding-sites/, www.music4point5.com/blog/why-fan-funding-is-the-way-to-go/]

(We had an intriguing call in the early 1990s, asking us to meet with a lawyer for members of the Grateful Dead.  It ultimately didn’t go anywhere and then Jerry Garcia died in 1995.  The band was a great “what if” exercise for a virtual DPO.  It had a data base of 150,000 deadheads for its magazine/catalog, most of whom were the “true believers” that form the base for successful direct offerings.  Shares could be sold at concerts.  The prospectus could have a Garcia-designed cover and the perquisites to be offered shareowners would be a marketer’s dream.)

Peer-to-Peer Financing/Social Lending

Social websites are all about direct communication among people with shared interests.  Around 2007, several of them sprang up for people to lend each other money, without going through any intermediary.  (I posted a commentary about them in 2008, at www.dfdpo.com/Commentaries Direct Community Finance.htm.)   As they started out, the sites allowed borrowers to post the amount, term and purpose of the loan they wanted.  Lenders could then bid the amount they wish to lend and the rate of return they were looking for.   The site manager’s role was limited to operating the site, assigning ratings based on a borrower’s credit history and administering the loans. 

Most of the early P2P sites had researched and complied with state lending laws.  However, they did not deal with federal and state laws for selling securities.  That all came to a head in 2009, with regulatory challenges.  Some sites closed permanently, while others were reopened after settlement agreements with the SEC and the North American Securities Administrators Association.  The survivors were forced to go through contortions to comply.  Several of the sites have introduced financial intermediaries—mutual funds or broker-dealers—into the middle of the money flow, so that it is no longer a direct relationship among members of a community.

Prosper Marketplace is the leader for P2P sites in the United States.  Since it was launched in 2006, it has made $200 million in loans.  When the regulatory battle came, Prosper spent $4 million dealing with it, even shutting down its operations for nine months.  Prosper's lobbyist got the House to put P2P lenders under the jurisdiction of the new consumer agency to be created by the 2010 reform bill, but the SEC blocked the provision in the Senate.  Prosper's CEO Chris "Larsen claims the company now spends more than $1 million annually on legal fees and audits, and makes more public disclosures--about two a day--than almost any other company.  The filings include details on each potential borrower's credit score and why they need money."  Robert Schmidt and Jesse Westbrook, "An Online Lender Takes On the SEC," Bloomberg Businessweek, June 14--20, 2010, page 25]

You can keep up with developments in P2P or Social Lending at  www.p2plendingnews.com,  www.wiseclerk.com, www.netbanker.com and www.rateladder.com.  Other P2P sites  provide rental markets for automobiles, homes, tools and other privately-owned property.  Barrett Sheridan, "Stranger, You Can Drive My Car," Bloomberg Businessweek, December 13-19, 2010, page 39, http://www.businessweek.com/magazine/content/10_51/b4208039643579.htm.  

Angel Investors

Venture capital in the 1950s meant investment partnerships of wealthy individuals who sought out early stage businesses to support with their money and experienced judgment.  Then it morphed into professional money managers for huge institutional funds, taking percentage fees for betting on the companies that would soon do a Wall Street initial public offering, or quickly sell out to a big business. 

The lost spirit of financing entrepreneurs may have been reborn with “angel investors.”  These are usually local groups of individuals who meet to receive proposals and sometimes jointly make investments in young businesses.  A recent count came up with 340 groups of angel investors.  [Angel Capital Education Foundation, http://www.angelcapitaleducation.org/research]  Another source of data tracking angel investments found that 90% were made within a half day's travel time of the investors' homes.  [Center for Venture Research, University of New Hampshire, Jeffrey Sohl, Director, www.wsbe.unh.edu/files/2008_Analysis_Report_Final.pdf+center+for+venture+research&hl=en&gl=us&pid=bl&s]

Some angel investors have become fairly large and diversified and are called “super angels.”  [Spencer E. Ante, “Super Angels Shake Up Venture Capital, Business Week, May 21, 2009, www.businessweek.com/magazine/content/09_22/b4133044585602.htm?link_position=link4]  Intermediaries have stepped in, offering to arrange meetings with angel investors for fees from $125 up to $5,000, a process called Pay-to-Pitch.  [Scott Austin, "Start-Ups Get Free Chance to Pitch to Angel Investors," The Wall Street Journal, June 17, 2010, page B5 and Ty McMahan, reporter for Dow Jones VentureWire, “Free Pitches,” The Wall Street Journal, August 16, 2010, page R7]

As angel investors become "super angels," it may be inevitable that they evolve along the same path as venture capitalists did in the last century.  After successfully investing their own money, often in conjunction with other angels, they have begun raising funds from institutions and wealthy individuals, aggregating $8.5 million to $73.5 million each. “What elevates super angels into an unofficial upper class generally is the magnetic effect their participation in a deal has on other investors—a main reason entrepreneurs like to do business with them.  And, for super angels, investing has evolved into something more than a hobby.  These players are now raising funds with outside money, investing full time and competing with venture capitalists.”  [Pui-Wing Tam and Spencer E. Ante, “’Super Angels’ Fly In to Aid Start-Ups,” The Wall Street Journal, August 16, 2010]

Is it just a matter of a few years before angel investing will have transmogrified into just another financial intermediary, collecting fees as money flows through?  Many websites purport to link entrepreneurs with angel investors.  Some seem to be facades for commissioned money-matching services.  Others, like www.thefunded.com, describe information services for communities of entrepreneurs and investors.  Angel investors can share experiences through the Angel Investors Association, which has a list of members at www.angelcapitalassociation.org/directory/.  Doree Shafrir has described the peer-to-peer relationship between angel investors who built their own companies and the start-up entrepreneurs they finance and mentor. [Doree Shafrir, “Pennies from Heaven,” Newsweek, November 29, 2010, page 38, http://www.newsweek.com/2010/11/18/angel-investors-are-going-where-vcs-fear-to-tread.html]

Doree Shafrir

Scott Shane, citing the Census Bureau’s Survey of Business Owners, reports that only 2.7 percent of startup companies got financing from any outside source; only 2.8 percent of those seeking funds from angel investors actually received financing, citing http://angelsoft.net, compared to less than a 0.2 percent success rate from venture capitalists.  [Scott Shane, author of Fool’s Gold: The Truth Behind Angel Investing in America, Oxford University Press, 2008, in “Why Equity Financing Eludes Startups,” Bloomberg Businessweek, July 9, 2010, www.businessweek.com/smallbiz/content/jul2010/sb2010079_119155.htm?link_position=link9]      

Search Funds

In the underwritten public offering arena, Wall Street does “blank check” or “blind pool” offerings, where an experienced management team forms a corporation without any operating business or even a plan for a business.  Investment bankers sell shares to investors who trust that the managers will find a business to buy and operate profitably. 

What if the management team is just out of school, without ever having run a business?  Stanford Professor Irv Grousbeck helped conceive of the “search fund” and advises many of the entrepreneurs.  This definition of search funds is on the website for the Center for Entrepreneurial Studies, Stanford Graduate School of Business: “Conceived in 1984, the search fund is an investment vehicle in which investors financially support an entrepreneur's efforts to locate, acquire, manage and grow a privately held company. MBA and law school graduates are using this approach more and more frequently to become entrepreneurs, often shortly after graduation, despite a relative lack of operating experience.” [www.gsb.stanford.edu/ces/resources/search_funds.html]  This site has extensive written and video materials on search funds, including reports on its studies of search fund performance. The Center “has identified and tracked over 71 search funds raised since 1984, many of which have purchased companies successfully in the United States or United Kingdom. A 2005 CES analysis of 49 qualifying search funds found investor returns to be over 37%.”

Advice on the Stanford site includes:  “Search funders should contact high net worth individuals, most of whom were known beforehand. The goal is to amass a group of 10-20 individuals who each contribute $15,000 to $20,000 to fund the search, raising a total of $150,000 to $400,000. These funds are used to pay the entrepreneurs (frugally) and to cover the expenses of the search, which is expected to consume 1 to 3 years. . . . Search funders have been known to have anywhere from 8 to 25 investors.”

More information about search funds is available from the Center for Private Equity and Entrepreneurship, Tuck School of Business at Dartmouth College, [Elnor Rozenrot, Case Study #50034, updated October 18, 2005, under the supervision of Adjunct Associate Professor Fred Wainwright, http://mba.tuck.dartmouth.edu/pecenter/research/pdfs/search.pdf]  You can watch a Wharton School of the University of Pennsylvania panel discussion about search funds at http://knowledge.wharton.upenn.edu/signup.cfm;jsessionid=a83035824d7da987595b1111f35a321e7024?CFID=10862081&CFTOKEN=46722360&jsessionid=a83035824d7da987595b1111f35a321e7024] Financial intermediaries already have their noses under the tent in search funds.  One venture capital/private equity firm has a section on its website about search funds.  [www.housatonicpartners.com/search_funds.html]

Results have been mixed for investors in the the 141search funds that have been started so far.  "Nearly one-third of search funds launched to date have lost all their investors' money. . . . And just 38% of all search funds have posted a positive return, down from 48% two years ago."  [Kyle Stock, "Risky 'Search Funds' Draw Entrepreneurs," The Wall Street Journal, July 12, 2010, page C1]

Incubators

Money for most new businesses comes from their founders’ savings and personal borrowings.  A second round may come from “friends and family.”  These beginning businesses can only survive by keeping costs as low as possible, including what they pay for advice and services.  To meet this need, there are “incubators,” which provide operating space, office support services and some level of management consulting.  Many of them also introduce their tenants to venture capital or angel investors.

The first incubator began in Batavia, New York in 1959.  One example of contemporary business incubation is Plug and Play, started in 2006.  It  “provides startups with everything they need to get up and running quickly: office space, data and telecommunications services, networking events, recruiting services, and most of all, contact with fellow startups and potential investors.” [Robert D. Hof, “Keeping the Faith in Silicon Valley,” Business Week, August 24&31, 2009, page 058, www.businessweek.com/magazine/content/09_34/b4144058838022.htm]  Prospective investors come to the site for presentations by the tenants.  Any investment is negotiated directly between the entrepreneur and the investor. 

The National Business Incubation Association is now 25 years old and has nearly 2,000 members, about 1200 of whom operate business incubators.  [www.nbia.org/]  The Association says that the survival rate after five years is 87 percent for incubator clients, compared to 44 percent for businesses that don't use incubators.  About 80 percent of incubators begun in the past few years deal with businesses in one or two sectors.    [Lauren Hatch, "Betting on Incubators to Create Jobs," Bloomberg Businessweek, August 16-29, 2010, page 20]

The federal government has shown signs of supporting incubators.  Congress has a bill pending that would authorize the Commerce Department’s Economic Development Administration to make grants to incubators for operations and support services, in addition to construction and renovation projects.  Another bill would spend $250 million to fund business incubators targeting high-growth industries.  Lauren Hatch, “Betting on Incubators to Create Jobs,” Bloomberg Businessweek, August 16-29, 2010, page 20]

Community Supported Agriculture

In Community Supported Agriculture, customers pay in advance for a share in the season’s harvest.  The farmer uses this money to grow food, instead of borrowing money from a bank and repaying it when customers buy at harvest time.  The United States Department of Agriculture describes it as “a community of individuals who pledge support to a farm operation so that the farmland becomes, either legally or spiritually, the community's farm, with the growers and consumers providing mutual support and sharing the risks and benefits of food production.”  [Alternative Farming Systems Information Center, www.nal.usda.gov/afsic/pubs/csa/csa.shtml]

Community Supported Agriculture is not only a way to market shareownership in food being grown for the table.  It has been used for other agricultural products.  Former television news producer Susan Gibbs has a flock of sheep and goats producing for her Internet wool and yarn business.  She offered a 1% share in the spring shearing, delivered as yarn or as wool for spinning.  Word of the offering was spread by bloggers.  [www.fiberfarm.com/about and article by Robert Tomsho, “Shepard’s Tale” The Wall Street Journal, April 19, 2008, http://online.wsj.com/article/SB120855353496127337.html] 

Suppliers as Shareowners 

Just as a business can raise money from its customers, it may also have its suppliers become shareowners.  An example is Fabindia, which sells hand-woven clothing and furnishings through its nearly 100 stores in India.  Started in 1960 by an American, John Bissell, Fabindia had $65 million in sales by 2008.  Its products are purchased from over 20,000 weavers, organic farmers and other artisans.  Each of the suppliers is encouraged to buy shares in the company, at $2 each.  Collectively, about 15,000 of them own over 25% of the business, with Fabindia employees and private investors owning the rest.  The shares can be sold, to other shareowners, during two periods each year.  [Manjeet Kripalani, “Weaving a New Kind of Company,” Business Week, March 23 & 30, 2009, page 064]

Rights Offerings

One of the oldest direct securities marketing methods is the rights offering, where a business offers new securities to the people who already own its shares.  The term “rights offering” comes from the days when U.S. corporation laws and corporate charters required the company to offer any new shares to the present shareowners, before they could be sold to outsiders.  Some European companies still have these “preemptive rights.”  Their purpose is to allow owners to maintain their same percentage ownership and not be diluted by a new issue sold to others.

In a rights offering, shareowners can purchase new shares in proportion to the number they already own.  They usually have up to 20 days to decide after receiving the offer.  There can be a timing advantage because rights offerings do not need the prior shareowner approval that would be required for companies listed on a stock exchange.  The requirement for SEC registration is the same as any other public offering, although state securities laws often exempt rights offerings.  Because the offering price is usually a bit below any public trading market quotation, shareowners can sell their rights for someone else to use.

A rights offering can be handled entirely by the company.  If an investment banker has a role in a rights offering, it is a limited one.  They may provide a “standby commitment,” or “backstop,” to purchase any leftover shares at the offering price.  They may also act as a “dealer manager,” following up with shareowners to sell them on exercising their rights.  The commissions are far less than an underwritten offering.  As you might expect, investment bankers have generally frowned upon rights offerings. But now, according to one major corporate law firm, “the negative perception often associated with rights offerings is dissipating. The time is right for the rights offering to be viewed as a

viable capital raising technique for U.S. issuers.”  [www.dechert.com/library/Corporate_&_Securites_SA_06-08_Rights_Offerings_The_Time_is_Right.pdf]

Between 1935 and 1955, rights offerings accounted for about half of the common stock issues that exceeded $1 million each. Yet, since 1980, only a small percentage of public issuers in the United States have used them, with the exception of the financial services industry.  In the last half century, corporations have gotten larger, small publicly-held businesses have disappeared and ownership is dominated by institutions.  The rights offering has little appeal to Wall Street money managers and speculators who purchase shares for short-term price movement, not for long-term shareownership of a business.  [Professor B. Espen Eckbo, Tuck School of Business, Dartmouth College, “Equity Issues And The Disappearing Rights Offer Phenomenon,” Journal of Applied Corporate Finance, Vol. 20, No. 4, Page 72]

DRIPs and DSPPs

An early opportunity to bypass Wall Street came with dividend reinvestment programs.  The first DRIPs were public utility corporations with large numbers of individual investors living in their service area.  They saw it as a way to recapture money they paid out in dividends.  For the investors, it was a way to increase their investment in companies they liked, without having to take money out of their spending budget.  It was also an exercise in “dollar cost averaging,” since they were buying in steady amounts, while the share price might be going up and down.  Most of the companies don’t charge for purchases and some even give a small price discount. 

The next step for DRIPs was to allow shareowners to invest more than the amount of their dividends, by adding their own money to the dividend amount.  Some businesses have even gone to letting someone buy their first shares directly, without ever having to go through a broker.  That led to direct stock purchase plans.  These DSPPs can include corporations that don’t even pay dividends but allow anyone to buy their shares directly. 

DRIPs and DSPPs are sometimes referred to as “no-load stocks,” because there is no commission paid by the buyer or the company issuing the shares.  They are very different from no-load mutual funds, although both are sold directly to the investor, without a financial intermediary collecting a fee.  The mutual fund is itself an intermediary, collecting money from people who buy its shares and then reinvesting that money in a portfolio of shares, bonds or other investments, while charging a percentage management fee.

Jeff Fischer of The Motley Fool describes the mechanics of DRIP programs at www.fool.com/dripport/howtoinvestdrips.htm.  Michael Robertson provides that service for DSPPs, at www.getrichslowly.org/blog/2009/04/07/direct-stock-purchase-plans-a-better-way-to-invest/.

Folio Services 

There are “folio services” firms for those who want to build a diversified portfolio with modest regular purchases.  They will purchase shares for individuals in a fixed amount each week or month.  The investor sets the amount and chooses the companies.  The service provider records ownership of fractional shares, to make the amount come out even. 

This automatic investing through a folio service is a useful way to employ “dollar cost averaging” and to provide the disciplined investing of set amounts at regular intervals.  However, the service doesn’t strip away the financial intermediary and create a direct relationship between the investor and the business.  The purchases are made in the trading market, rather in new issues that raise money for growing the business.  The company’s shares are only a marker for gambling on price movements and dividend yields.

When they started, the services were buying shares directly from the company.  While the folio services company was sort of a financial intermediary, the investor didn’t have to open a brokerage account.  Then, one of the folio services companies, Sharebuilder, which started as NetStock Direct in 1996, was acquired in 2007 by ING, the huge bank/broker.  It dropped the direct purchase feature and now promotes purchases in its own mutual funds and electronically traded funds.  ING Direct charges for each purchase.

Posting Services

Part of what a financial intermediary is supposed to do is to identify prospective investors and tell them about an offering of securities.  Nearly everyone who does that must be part of the broker-dealer monopoly.  If they don’t pass the tests and meet the qualifications for registration as a broker-dealer, the SEC, the Financial Industry Regulatory Authority and the state securities regulators can close them down, impose fines and put them in jail.  Anyone with a broker-dealer license must comply with the rules for acting as a go-between in a company’s sale of shares to investors.

A lot of ingenuity has gone into finding ways to assist businesses in raising money from public offerings, without being forced into becoming a broker-dealer.  Some of the attempts have been to escape supervision of nefarious practices.  But others have been motivated by a desire to provide an honest and open marketplace where entrepreneurs may display their proposals and investors can look them over—sort of a Craig’s List, where the offering business pays a fee to tell its story and the investor then deals directly with the business.

Since the early days of the Internet, there have been websites offering to find money for businesses.  Most sites that come up from a search turn out to be commissioned intermediaries.  Some of them offer to prepare business plans and others say they will provide all the services to locate, present, persuade and close a funding.  Some are registered broker-dealers, while others claim to do things that may or may not require that license.  One site that is close to simply posting is GoBig Network, which calls itself “an online network of funding sources. . . . You can either advertise to investors, with what we call a funding request posting or you can browse through our member pages and subscribe so that you can directly contact the members most relevant to you. Both of these paid services, the request and subscription, are available at either a monthly recurring, or one-time annual fee.” [www.gobignetwork.com/helpfiles/HowItWorks.aspx] 

A key to avoiding regulatory interference is that only accredited investors may participate as prospective investors.

Another posting site is RaiseCapital.com, which says “RaiseCapital.com is a website that introduces entrepreneurs and investors. Some fund raising efforts may require SEC and/or other regulatory approval. These issues should be reviewed on a case-by-case basis. RaiseCapital.com does not guarantee the regulatory compliance of any post.”  [www.raisecapital.com/faq.php] There is no charge to register as an investor or to post a request for funding, by text or video.  Revenue for the site apparently comes from its sponsors and advertisers.

DPOs

DPOs--short for direct public offerings--are not just IPOs, skipping the investment banker intermediary.  Direct public offerings bring investors from a very different group of individuals.  To test this, we did follow-up surveys of people who had expressed interest in DPOs, including those who had purchased and those who had not.  We found that fewer than 10% of the investors had accounts with a brokerage firm, or had ever owned shares in a corporation, except through mutual funds or retirement plans.  Yet they had actually read the prospectus and done the same risk/reward analysis that you’d expect from a professional analyst.  Those who purchased shares intended to own them for an indefinite number of years, so their decision was based on long-term factors like management quality, competition and growth potential.

The Internet is a magnificent tool for direct public offerings.  Our client, Annie’s Homegrown, succeeded with the first Internet direct public offering in August 1995.  With later offerings, we were able to have prospective investors receive a share offering, read the prospectus, order shares and pay for them by credit card or online check—all in one sitting at their computer.  The power of raising small amounts of money through the Internet, from a very large number of individuals, has been dramatically demonstrated by recent political campaigns.  Professor William K. Sjostrom, Jr., Adjunct Professor of Law at William Mitchell College of Law, published a paper on “Going Public Through an Internet Direct Public Offering: A Sensible Alternative for Small Companies?” [53 Florida Law Review 529, 2001, available at SSRN: http://ssrn.com/abstract=831906]

Why aren’t there more DPOs?  Some say the answer is tied to the personality of CEOs: that, like self-publishing for an author, they’re afraid people will think their business couldn’t attract an underwriter.  Cynics claim that the CEO needs someone to blame when an offering fails.  Others suggest that gullible CEOs actually believe the investment banker’s letter of intent is a firm commitment to underwrite the offering.   Executives more careful of detail could be put off by the need for direct offerings to comply with state filing requirements.  State filings are time-consuming and may result in blocking a direct public offering to residents of a state. By contrast,   Congress exempted underwritten offerings from state laws, since they could be accepted for exchange listing.  [Securities Act of 1933, section 18(b)(1), www.law.uc.edu/CCL/33Act/sec18.html]  The regulatory thicket is especially intimidating because nearly every experienced securities lawyer is with a large law firm, where they "only do underwritten offerings."  (We've had securities lawyers in those firms tell us that they won't risk offending their broker-dealer clients, or that they have reciprocal business referral understandings, where underwriters send them business and the lawyers refer prospective IPO clients to the underwriters.)  It's a similar picture when looking for an audit.  The big accounting firms are wedded to Wall Street and the smaller ones don't have the securities offering qualifications.

Those entrepreneurs who get through the lawyer/accountant barriers find that resistance from the market is not a real limitation to marketing their securities.  Over 90% of the DPO investors don't have an account with a securities broker-dealer, so they are free of the "that's not the way it's done" syndrome.  Of course, the major limit on marketing DPOs is the lack of money for investing.  As Jeff Gates puts it:  Expecting a broad base of wage earners to buy their way into significant ownership (i.e., from their already stretched paychecks) is what I call 'Marie Antoinette Capitalism'--only instead of urging 'Let them eat cake,' the modern refrain is 'Let them buy shares.'"  [Jeff Gates, The Ownership Solution: Toward a Shared Capitalism for the Twenty-First Century, Addison-Wesley1998, page 23]

Louis Brandeis asked the same question about why there weren’t more direct offerings, back in 1913.  One of his Harpers Weekly articles was called “Where the Banker is Superfluous.”  As to why issuers nearly always use investment bankers, Brandeis said:  “It is not because the banker is always needed.  It is because the banker controls the only avenue through which the investor in bonds and stocks can ordinarily be reached.”  [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, Frederick A. Stokes Company, 1914, republished by National Home Library Foundation, 1933, Kessinger Publishing’s Rare Reprints, page 74] 

(I find some comfort in the history of other new ways of doing things, like the fax machine.  The first patent on facsimile transmission was issued in 1843 and the first commercial use began in 1922.  I remember watching a facsimile machine work in a U.S. Army show in the late 1940s.  My first one was a Xerox telecopier in 1976.  Then they were suddenly ubiquitous from the 1980s until scanning caught on.)

One of our clients asked us to explain, for its board of directors and other backers, why a direct public offering would be good for the business and for society in general.  This is an edited version of our response:

Why a DPO is good for your business:

1.  A direct public offering is consistent with your values.  Creating a community, based upon shared beliefs, is a logical extension of your values.  The “small group of thoughtful, committed individuals,” from your Margaret Mead quotation, becomes even more capable of making change when it is joined in ownership of a national business.

2. Shareowners are better customers and goodwill ambassadors.  Businesses that have marketed shareownership directly to their customers find that shareowner customers purchase two to three times the average for other active customers. 

3.  Long-term shareowners provide stable relationships.  Individuals who have purchased shareownership directly from the business will generally have a several-year horizon for their investment and will hold through ups and downs, if they are kept informed with regular information.  This contrasts with institutional money managers and the securities analysts who serve them, who are generally focused on quarter-to-quarter performance. 

4.  Price volatility/litigation risk is reduced with community share ownership.  Money managers and other analyst-influenced investors tend to transact in large blocks and move as a herd on short notice.  The resulting large price changes can bring lawsuits.  Long-term individual investors do not sell on isolated events, particularly if they are kept informed, and they act independently.  They tend not to be interested in being part of a class suing their directors and management.

5.  Direct share marketing more efficiently manages capital formation.  Financing through intermediaries often requires catching “a window of opportunity” in the market, whether or not it fits with the uses a business has for new capital.  Direct public offerings are far less subject to fads, so they can be coordinated with capital budgeting. 

6.  Your shareowner communities support management’s vision.  Individuals who buy their shares directly from you have made their own decision to invest, not because of a broker’s recommendation.  They are joining your founders as a shareowner, not just buying a financial instrument as an impersonal investment.  Hostile tender offers or proxy solicitations are not likely to attract them.  They can be marshaled to assist the business in issues involving customers, government agencies or the media.

7.  Individual shareowners require less management time.  Individuals do not expect to tell management how to run the business.  Nor do they seek selective disclosure of  nonpublic information by quizzing management, unlike institutional money managers, who demand frequent CEO/CFO telephone interviews, in-person road shows and special reports.  Executives of companies that have marketed shares directly to individuals have found they spend a fourth as much time on shareowner communications as their institutionally-owned peers.

8.  You can use direct purchase plans to maintain market demand.  People who invest through brokers generally view it as a single transaction rather than a continuous process.  You can have a program for monthly share purchases through direct debits to the shareowner’s designated bank account. 

9.  Cost of capital will be lower with a DPO.  Transaction costs in a DPO are generally half or less than an underwritten public offering.  More significant, your offering price and number of shares offered are determined by the board of directors, rather than by a securities broker-dealer whose primary interest may be serving its buy-side customers with underpriced shares.

10.  DPOs don’t create shareowner veto powers.  Institutional investors, who dominate the underwritten offering market, have recently made demands on CEOs and directors about how they run the business.  Private financings, such as venture capital or “angel” investors, include covenants in the investment documents to restrict management.  When individuals buy in a direct public offering, they don’t expect to interfere in management.         

Why a DPO is good for society in general:

1. Direct share ownership increases democracy in business.  Much more of what affects our lives now emanates from business, rather than from government.  Yet, most “publicly-owned” businesses are actually controlled by a small group of professional money managers, using funds gathered from the public through retirement plans, insurance, public charities and mutual funds.

2.  DPOs cause a natural selection of businesses, so they reflect shared values.  Institutional money managers base their investment decisions upon limited risk/reward analyses about expected short-term share price performance.  We have seen that individuals invest in DPOs for dual motives:  They do the same risk/reward study (generally for a much longer term).  But they also involve their social and moral values in deciding whether they want to support this business.   Over time, surviving businesses will reflect society’s shared values.

3.  Individual shareownership provides better corporate direction.  The objectives of the “investment community” of brokers and money managers are different from the objectives of customers, employees, neighbors and other members of a business-based community.  Direct ownership helps people learn about business from the viewpoint of an owner, not just a consumer and employee.  They add a much broader perspective for management.

4.  Direct share ownership can free individuals from wage dependence.  The path to financial independence can be a long, slow one with diversified managed investments, like retirement plans and mutual funds.  In contrast, economic security frequently happens from the ownership of shares in one or two companies, through investment or employee stock options.  DPOs can bring financial independence to early investors, so that they can contribute their time, experience and wisdom without needing a salary.

5.  Direct shareownership provides a sense of power.  There is a frustration that comes from evidence that business controls governments, universities, think tanks and other powerful institutions.  Owning some shares, being able to vote for directors, participating in annual meetings—these can provide some sense that individuals can ultimately change the values and actions of business.

6.  Direct shareownership relieves the sense of alienation.  Most of us have an “us against them” attitude about business.  It may be the workers against the bosses or the powerless many versus the powerful elite.  Owning shares creates a sense of community, in the context of a business.  

7.  DPOs create new wealth, reversing the continuing concentration.  Ownership of capital has evolved into smaller and smaller percentages of the population, especially in the last few years.  Some broadening of ownership has come from employee stock options, which have made multimillionaires of a few thousand former wage earners.  DPOs bring that opportunity to individuals who pick the right early stage company.

8.  Businesses can survive that don’t fit the traditional mold.  Access to capital is usually a test of conformity.  Venture capitalists, bank loan officers, government small business program administrators, even “angel” investors tend to have conscious and unconscious standards that cause them to reject business concepts and entrepreneurs who are too different from the norm of their experiences.  DPOs allow people with new ideas to find others like them and join together in ownership.

9.  Owning shares directly allows people to vote with their capital.  So many of us question whether our political votes mean much at all.  Through DPOs we can use some discretionary capital to vote for a business concept, or a management team that may be effective in doing the right thing, as we believe that to be.  Our investment may be small, but DPOs bring together like-minded people, so that together we can make a difference.

10.  The ability to attract capital from individuals will be a competitive tool.  DPOs of corporate shares are the lowest cost, permanent capital available.  Businesses that can do DPOs to meet their objectives will succeed over those who must rely on traditional sources. 

We have thought that DPOs would catch on if a high-profile business used the concept, so I’ve tried to recruit some very public opportunities to demonstrate how a direct public offering could work.  The companies have had communities of many thousand true believers.  They have had great stories and colorful leaders.  One was the Chrysler Corporation in 1979, when the federal government was asked to use taxpayer money to keep the carmaker out of bankruptcy.  It had just hired Lee Iacocca to sell its cars and turn the business around.  I wrote him and Chrysler board members, explaining how a direct public offering of shareownership to Chrysler’s “true believers” would raise the $1.5 billion that eventually came from taxpayer-guaranteed loans.  I never heard back, but it’s been fun to imagine what Chrysler’s path might have been the last 30 years with more than a million active individual shareowners.

Another “might have been” is Google.  Its 2004 IPO had been the subject of comments and competition for years before it happened.  Would it be a traditional underwritten public offering?  Who would be the managing underwriters?  What innovations could Google force onto the process?  The final outcome was a “modified Dutch auction.”  Google set the minimum bid price and the total number of shares being offered.  Anyone could bid to purchase a number of shares at a price per share. Bids were accepted, starting with the highest price bid and proceeding down, until the total number offered were included.  All accepted bids were then at a price equal to the lowest accepted bid.  The modification came in Google’s last minute decision to price the offering even lower than the formula result.

I sent Google a letter in 2001 with reasons why it should do a direct public offering.  There was no reply and, given what Google has done as a public company, we can see why our arguments would not have been persuasive.  Here are the points from the letter: 

You don’t have to turn over control of your public offering.  In a DPO:

•  You control the timing.  Individuals who already believe in Google will purchase all of the shares you wish to offer, whenever you choose to offer them.  You don’t have to fit through a “window of opportunity” defined by money managers and investment bankers.

 •  You control the amount offered.  Why sell $100 million in an initial offering, when your need for cash and for share liquidity could be met with a much smaller offering?  Direct offerings can be made to match operating needs, avoiding the pressure to invest excess cash.  Dilution can be reduced by a series of offerings, each priced to reflect increasing value.

•  You control the pricing.  All of the shares you offer will be purchased, almost regardless of the price.  Your board can set the price in a direct public offering, based upon a pricing analysis that is free from the drama of the first-day “pop” and the need to present favored professionals with trading profits.

•  You control with whom you share ownership.  Direct public offerings are purchased by individuals who already have a relationship with the business.  The average investment is about $1,000.  Shareownership would reinforce the community you have created.

• You control who joins your management.  You do not have to “put in place financial managers and processes that resonate with Wall Street,” in the words of the current Business Week article.  With direct public offerings, your board can continue to use its own experience and wisdom.

• You control the offering process.  Your direct offering can be designed, staffed and implemented under your direction.  Communications with investors will be electronic, without the road shows, one-on-ones and unexpected diversion of management time and resources.

You don’t have to compromise your way of doing business to go public.  In a DPO:

• You are relieved from the pressure for quarterly performance and comparison with analysts-defined peer groups.  People who use your services will invest because they have watched an excellent team prove itself in an extremely competitive environment.  They have no short-term expectations.

•  You will have a much more stable aftermarket price.  Volatility is very much affected by having large blocs of shares held by professional money managers who act alike.  After a direct offering, you will have thousands of individuals, holding small amounts each, with long-term objectives and making their own independent decisions. 

•  You will have far less concern over shareholder litigation. Sudden share price drops create the profit in shareholder class actions.  Market prices after direct offerings have moved gradually, even upon very negative news.  Because you have managed your own offering, you will not be attacked for claimed abuses in the distribution of shares.

•  You will be free from interference with management decisions.  Individuals who have invested small amounts do not expect any participation beyond the annual shareowners’ meeting.  You will not be threatened with analyst downgrades or major sales if you ignore recommended mergers, acquisitions, alliances or policy shifts into the latest trend.

•  You will spend far less time servicing shareowners.  Direct purchases will include an election to receive all communications from you by posting on your website and email.  Your SEC filings and news releases will be sufficient.  You will not have to hold telephone conferences or attend analyst/money manager meetings.)

(We advised clients on doing direct public offerings, from 1976 until we retired in 2008, and I wrote two books about DPOs.  [Take Your Company Public!, Simon & Schuster, New York Institute of Finance imprint, 1991 and Direct Public Offerings: The New Method for Taking Your Company Public, Sourcebooks, Inc., 1997]  The DPO process is described at www.dfdpo.com/aboutdpos.htm.  Case studies of some of the DPOs we advised are at www.dfdpo.com/clientsum.htm.)  

Microlending

Microlending as an organized process began with Muhammed Yunus and his founding of the Grameen Bank.  “Grameen” stands for “community” and the bank is still today more than 90% owned by its borrowers.  The very small loans are usually to create entrepreneurs from the working poor.  Information on a continuing basis about microfinance, with several stories a day, can be gathered from Micro Capital [www.microcapital.org.  See also Elaine L. Edgcomb and Joyce A. Klein, Opening Opportunities, Building Ownership: Fulfilling the Promise of Microenterprise in the United States, Aspen Institute, 2005, http://fieldus.org/Publications/FulfillingthePromise.pdf and http://fieldus.org/index.html]

Microlending changed dramatically after The Nobel Peace Prize was awarded in 2006 to Grameen Bank and Muhammed Yunus.  Suddenly, financial intermediaries saw the opportunities in the high returns and low default rates of microlending.  It was the same story as with venture capital investing in the 1980s.  New for-profit funds were created.  Portfolios of microloans were sold as collateral loan obligations.   Microlending grew at 50% a year from 2006 into 2009.  [Eric Bellman, “India to Track Microloan Borrowers,” The Wall Street Journal, March 10, 2010, page A19]  One microlender, SKS Microfinance, backed by venture capital institutions, has filed for a $250 million initial public offering and listing on the Bombay Stock Exchange and the National Stock Exchange of India.   Banco Compartamos, a microlender in Mexico, completed a $467 million IPO in 2007 and has been criticized for charging interest at an average 68% average rate.  [Bruce Einhorn, with Ruth David, “An IPO for India’s Top Lender to the Poor,” Bloomberg Businessweek, May 10—16, 2010, page 16]  In the United States, microlenders loaned $57 million in 2008, as their attention turned to financing going businesses that could no longer get bank loans.  [Karen E. Klein, "Microfinance Steps into the Funding Breach," Bloomberg Businessweek, June 28-July 4, 2010, page 48]

As microlending caught on and seemingly everyone has jumped in, there have been abuses.  Some of the new lenders have ignored the community support side of the Grameen model, charged much higher interest rates and enforced payment in unlawful and physically dangerous ways.  Some of the borrowers have gotten loans from several microlenders, taking on more debt than they can repay.  [Ruth David, "In a Microfinance Boom, Echoes of Subprime," Bloomberg Businessweek, June 21-27, 2010, page 50]  Several organizations are working to maintain the principles, and the very low default rate, by subscribing to “Client Protection Principles,” like avoiding over-indebtedness, disclosing all the costs, not overcharging, avoiding abusive or coercive collection practices, having a mechanism for problem resolution and respecting the clients’ privacy.  [www.smartcampaign.org/about-the-campaign/smart-microfinance-and-the-client-protection-principles] One study concluded that microfinance "appears to have no discernible effect on education, health, or womens empowerment."  [Abhijit Banerjee, Esther Duáo, Rachel Glennerster, Cynthia Kinnan, "The miracle of microfinance? Evidence from a randomized evaluation," June 30, 2010, http://econ-www.mit.edu/files/6093.  But see analysis by David Bornstein, "Grameen Bank and the Public Good, The New York Times, March 24, 2011, http://opinionator.blogs.nytimes.com/2011/03/24/grameen-bank-and-the-public-good/]  A United Nations working paper describes the economic and self-esteem benefits of microfinance but argues that the poor also need government-run finance and education.  [Anis Chowbury, "Microfinance as a Poverty Reduction Tool--A Critical Assessment," DESA Working Paper No. 89,  http://www.un.org/esa/desa/papers/2009/wp89_2009.pdf.  See critique by Doug Henwood, Wall Street: How It Works and for Whom, Verso, 1997, pages 313-314]
 

The Bill and Melinda Gates Foundation gave $19.4 million to Mercy Corps to create a “bank of banks” to work with the more than 50,000 microfinance institutions in Indonesia, to test whether “linking diverse and small financial institutions together is a commercially viable and effective way to make savings, loans and other products more widely available to the poorest people." [Bob Christen, Director of Financial Services for the Poor at the Bill & Melinda Gates Foundation, at www.mercycorps.org/aboutus/pressroom/2246.]  According to The Wall Street Journal, the Gates Foundation is testing whether “commercial enterprises—banks and other profit-seeking businesses—can best serve the broadest swath of people by using tools such as capital markets to fund expansion.”  [Robert A. Guth, “Giving a Lot for Saving a Little: Gates Foundation to Invest in Programs to Help Collect Deposits for the World’s Poor,” The Wall Street Journal, July 31, 2008, http://online.wsj.com/article/SB121745942688498677.html]  The nonprofit Accion International has established its Center for Financial Inclusion, "to advance the commercial model of microfinance while upholding the interests and needs of poor clients worldwide. . . .to connect the microfinance community with the major drivers of the global economy – e.g. capital markets and technology – and harness their capabilities to address the financial needs of poor people."   http://centerforfinancialinclusionblog.wordpress.com/center-for-financial-inclusion/  The Calvert Foundation, formed in 1985 by The Calvert Funds, issues "community investment notes" to about 7,000 individuals, in amounts as low as $20 and paying interest at a half percent to two percent, depending on the maturity date.   “The community investment notes are for people who want to make a difference but not give the money away,” according to Calvert spokeswoman Carrie McGarry.  [Jeff Benjamin, "Microfinance Investment Specialist Names New Boss," Investment News, January 7, 2011, http://www.investmentnews.com/article/20110107/FREE/110109923/-1/INDaily01&dailycount=10&issuedate=20110107]

While microlending is being pursued by financial intermediaries and charitable institutions, others are working to keep both the lending and the source of funds within the community.  One way is to provide a method for community members to save.  The Consultative Group to Assist the Poor has found that “savings accounts in financial institutions serving the poor outnumber microloan accounts seven to one.”  [www.cgap.org/p/site/c/aboutus/]  Executives of the Grameen Foundation have said: “Well-designed savings products help clients plan for the future, create new business products for MFIs (microfinance institutions), and mobilize additional capital for MFIs. For even the very poorest, for whom many credit products currently being offered by MFIs may not be appropriate, savings may be a useful tool to help them access financial services.”  [Alex Counts, President and CEO of the Grameen Foundation and Patrick Meriweather, its Director of Business Development, New Frontiers in Micro Savings, March 2008,  [www.grameenfoundation.org/pubdownload/dl.php?pubID=58]

Grameen Bank has shown how a microlender can be free of dependence upon outside funding.  Muhammad Yunus responded to an interviewer’s question about the difference between philanthropy and the Grameen Bank: “We stopped taking any external money in 1995. . . . But earlier, when donors wanted to give us money, we were always swayed and took the money.  If donors hadn’t given us the money, we would have discovered earlier that we have the strength.  If it’s a business, it should be running as a business.” [Business Week, November 27, 2006, p.82]  Mr. Yunus has expressed his opposition to the attempts to imprint microlending with the Wall Street business model.  "Microcredit should not be presented as a money-making opportunity.  It is an opportunity to make an impact on poor people's lives.  An IPO gives a wrong message."  [As quoted by Eric Bellman, "IPO Pits Profit vs. Altruism," The Wall Street Journal, July 9, 2010, Page C1, C3]

But Wall Street and big charities are still trying to adapt microlending to the financial intermediary mode.  Wall Street is well on its way to ruining one of the greatest programs for making capitalists from the world’s poorest.   [Ketaki Gokhale, “A Global Surge in Tiny Loans Spurs Credit Bubble in a Slum,” The Wall Street Journal, August 13, 2009, page A1]  Using the statistics on returns on microfinance, Wall Street started over 100 funds, selling $30 billion in securities to individuals and institutions.  After taking out commissions and management fees, the remaining funds are used to buy stocks or bonds of small banks in the poorest countries.  [Rob Copeland, “For Global Investors, ‘Microfinance’ Funds Pay Off—So Far,” The Wall Street Journal, August 13, 2009, page A12]  By 2011, Muhammad Yunus would say, “I never imagined that one day microcredit would give rise to its own breed of loan sharks.”  In response to the claims that money for lending must come from the international credit markets, he pointed out that most of Grameen Bank’s 2,500 branches are self-reliant, without any outside funding.  “All borrowers have savings accounts at the bank, many with balances larger than their loans. And every year, the bank’s profits are returned to the borrowers — 97 percent of them poor women — in the form of dividends.”  [Muhammad Yunus, Sacrificing Microcredit for Megaprofits,” The New York Times, January 14, 2011, http://www.nytimes.com/2011/01/15/opinion/15yunus.html?_r=1&partner=rssnyt&emc=rss.  According to  David Korton, "The microcredit experience brings to light a larger principle: the institutional structure of a financial system determines where money flows and who benefits. In short, structure determines purpose." ["Microcredit: the Good, the Bad, and the Ugly," Yes Magazine, January 19, 2011, http://www.yesmagazine.org/blogs/david-korten/microcredit-the-good-the-bad-and-the-ugly]

Which way will become the microfinance paradigm?  One participant suggests that there will be three paths:  "straight commercial funds that obey the rules of the marketplace, social investment funds that explicitly combine social and financial aims, and pure grants. . . . Like any other donation or investment, a little research and due diligence beforehand can bring assurance that funders and those they entrust with their money share the same goals."  [Elisabeth Rhyne, Managing Director of ACCION's Center for Financial Inclusion, "Funding the Risk Frontier in Microfinance," The Huffington Post, September 11, 2010, http://www.huffingtonpost.com/elisabeth-rhyne/funding-the-risk-frontier_b_715327.html]

Local Governments as Direct Investors

Unemployment is scary for local governments.  It leads to higher welfare and law enforcement costs, lower property and sales taxes, declining populations.  Many governments have responded by offering tax breaks and other subsidies to lure a business to move.  Merced County, California, with a 22% unemployment rate and the country’s second highest foreclosure rate, decided to build its own businesses. 

Local development agencies in the county can make microenterprise loans up to $50,000.  [Los Banos Redevelopment Agency]  The local college launched an entrepreneurial studies program and hopes to have an incubator.  According to the president of the Merced County Economic Development Corp., "It'd be nice to get a big employer, but we believe it may be more effective to provide small businesses the resources to grow. The vast majority of the 5,000 businesses in the county are small companies. If we can get just half of them to hire one person, there are 2,500 jobs right off the bat, rather than working for 10 years to get a large employer into the region."  [Amy S. Choi, “Desperate for Entrepreneurs,” Business Week, May 15, 2009, www.businessweek.com/smallbiz/content/may2009/sb20090515_314886.htm?link_position=link10]

Alternative Stock Trading Markets 

Brazilian marketing consultant Cecco Grecco persuaded Bovespa, the Sao Paulo Stock Exchange to sponsor a Social and Environmental Stock Exchange. (www.bovespasocial.com.br/institucional/home.aspx)  It is not really a trading market.  Rather, it operates more like the P2P social lending sites.  Charitable organizations submit their funding proposals to a team of evaluators, who review plans, interview principals and make site visits.  The one in ten that passes this inspection is then listed.  Donors can choose to contribute toward the amount posted. [“A Stock Exchange for Do-Gooders,” Mac Margolis, Newsweek, June 9, 2008, page 56.] 

New stock trading markets have been created for smaller businesses, without any other social criteria.  The Alternative Investment Market was started by the London Stock Exchange in 1995 and has listed 3,000 "smaller and growing companies."  [http://www.londonstockexchange.com/companies-and-advisors/aim/aim/aim.htm]  In 2009, Chinese regulators started ChiNext, "tailor-made for the needs of enterprises engaged in independent innovation and other growing venture enterprises."  [http://www.szse.cn/main/en/ChiNext/aboutchinext/]  ChiNext operates within the Shenzhen Stock Exchange and had 141 listings in December 2010, while the Small and Medium Enterprise Board had 518 listings. [http://www.szse.cn/main/en/]  Some registered securities broker-dealers have begun operating matching services for companies that have not yet had their initial public offering.  The services allow employees and early investors to cash out, selling to people who want to buy in before the IPO.  The companies, and the SEC, are watching to be sure the trading does not result in more than 500 shareowners, triggering the requirement to register and report publicly with the SEC.  [http://www.secondmarket.com, http://www.sharespost.com]http://www.sharespost.com/

Dead Ends—Direct Routes That Were Blocked

(In watching the havoc caused by mortgage securities and their derivatives, I often indulge in a couple of “what ifs” from my own experience.  One was the effort to create the Automated Mortgage Market Information Network (Amminet.)  My client, Remote Computing Corporation, was hired in the early 1970s to design and host a computer program for trading in mortgages.  The project was sponsored and funded by the federal  government agencies and government-sponsored entities in housing finance.  The concept was that mortgage lenders would post information about packages of loans they were willing to sell.  Money managers for funds could access the data, negotiate and arrange to buy mortgages.

(This was about the same time as the National Association of Securities Dealers Automated Quotation (Nasdaq) System was started.  It was initially just an electronic way for a securities dealer to post the prices at which they were willing to buy or sell a company’s shares.  Transactions would be negotiated by telephone.  Today, Nasdaq is a full electronic stock exchange.  Amminet could have developed the same way, as the Internet and other technological advances made it possible, except there would have been no broker in between the buyers and sellers.

(As I recall, the Amminet program met resistance and ran aground.  If it had been allowed to operate, perhaps an active trading market would have preempted all the mortgage securities games that Wall Street ran into catastrophe.  This was all 15 years before the Internet and Remote Computing Corporation’s business model is now coming back as “cloud computing.”  [Steve Hamm, “IBM Reaches for the Clouds,” Business Week, April 6, 2009, page 034]

(The other “what if” was the Mortgage Trust Certificate.  My client was Coast Federal Savings and Loan Association, which was one of the largest S&Ls in the late ‘70s.  Our objective was to build a more direct relationship between mortgage lenders and fund money managers.  Mortgage securities were in their infancy, several years before Wall Street’s Collateralized Mortgage Obligations that were the tools of such mass abuse.  Our concept was to match the income and cash flow needs of pension funds and other institutional investors with the return and payment projections of a pool of mortgages.  In those days, the mortgages made by S&Ls were tightly regulated and losses were negligible.

(We got a mathematical consulting group to prepare the tools for matching mortgage pools to pension fund projections.  We generated interest from fund managers but needed a triple-A rating from S&P or Moody’s to get immediate and widespread acceptance.  The rating agencies were willing but we’d need a guarantee or credit default insurance from an AAA-rated corporation.  We met with two of them.  Maybe it would have worked eventually, but commitment waned at that stage and the opportunity went by.)

Routes Around Securities Regulation

Whenever there is a “sale” of a “security,” the SEC and state securities regulators are involved.  You must either fit within an exemption in their laws or you must apply to register the securities and license anyone selling them.

The regulators and the courts have interpreted “sale” and “security” very, very broadly.  That’s not just to enlarge their turf.  The cases that present the question usually come from complaints by investors claiming fraud.  The alleged perpetrators are claiming that they weren’t selling securities, so they can’t be forced to comply with securities regulation.

How can a legitimate business raise money from strangers without all the securities law hurdles?   One of the most creative alternate routes is Kickstarter, started in April 2009.  It is a website through which “project creators” offer products, services or “rewards” to “inspire people to support their project.”  It states flat out that it is not an “investment mechanism,” that project creators “keep 100% ownership and control.” [www.kickstarter.com/learn-more]  The project creators set an amount of money which must be pledged by a set date.  If the goal is met, the pledges are charged through Amazon to credit cards and the project creator receives the funds.  If not, no one pays anything.  Kickstarter takes a 5% fee if the project is funded.  By mid-2010, over $1.5 million had been pledged among 5,000 projects on the Kickstarter site.  [John Tozzi, "Eight Companies Kick-Started by Fans," Bloomberg Businessweek, June 28-July 4, 2010 page43]

Kickstarter’s suggestions to project creators include; “·  The key to a successful project is asking your networks, audience, friends and family for help. Kickstarter is a tool that can turn your networks into your patrons; it is not a source of funding on its own.

·  Rewards are very important. Offer something of real value for a fair price. And more experiential rewards, things that loop backers into the story, are incredibly powerful.”

[http://blog.kickstarter.com/post/172227888/where-invites-come-from]

The simplicity of the Kickstarter program is all the more admirable, given the complexity of the securities laws, which protect the turf of the securities broker-dealer monopoly.  We have described “dual motive” investing, where individuals are offered the satisfaction of furthering their beliefs and values, while also getting a possible financial return.  Kickstarter caters to the first motive only, expressly disclaiming any investment payback.  Individuals can help someone they like achieve a goal in which they believe.  There may also be the fantasy that, if the project and creator are successful, they may be on the inside track to participate as an investor.  The possibility of that motivation is certainly not enough to turn the Kickstarter program into an investment, anymore than charity drives that offer prestige and visibility to their donors.

There will be more direct routes opening.  Some of them will survive attacks from Wall Street and the traffic cops who protect Wall Street.  As the head of one alternative to Wall Street predicted:

“The era of Wall Street domination is over.”

“It may take ten years, or fifty years, but the signs are clear. A relative few committed investors are driving the shift to an entirely new approach to working with money.

”If today's capital markets can be described as complex, opaque, and anonymous - based on short-term outcomes, we are beginning to see more and more financial transactions that are direct, transparent, and personal-based on long-term relationships.”  [Don Shaffer, President & CEO of RSF Social Finance, “Notes From the Leading Edge of Social Finance,” GreenMoney Journal, Spring 2010, www.greenmoneyjournal.com/article.mpl?newsletterid=45&articleid=619]