The How and Why of Direct Public Offerings
James McKillop, Tiber Creek Corporation
When most people talk about going public, they think of an underwritten initial public offering (IPO). In an IPO, an investment bank, such as Merrill Lynch or Goldman Sachs, helps a company navigate filings with the SEC (U.S. Securities and Exchange Commission) and NASD (National Association of Securities Dealers) and raise capital by encouraging bank clients to buy shares in the company.
Underwritten IPOs are an expensive proposition with no guarantee of success. Investment bankers typically require $35 million to $40 million in revenues, and one of the primary requirements to list on NASDAQ is $750,000 in earnings for at least two of the previous three years.
Still, it's a common misconception that only large, established business can go public or that it pays to invest in a public shell, which in fact can be very expensive and ineffective. The truth is one can take a startup or even a development-stage company public without an underwriter or public shell through a direct public offering (DPO).
How DPOs Wor
Companies that issue stock directly to the public can trade in two places:
Over-the-Counter Bulletin Board
(OTCBB)—This is an electronic trading service offered by the NASD. Companies listed on the Bulletin Board must file an annual audit and quarterly reports with the SEC and comply with certain Sarbanes-Oxley requirements.
—This is a daily publication compiled by the National Quotation Bureau (NQB) containing price quotations for OTC (Over-the-Counter) stocks. Companies quoted on the Pink Sheets system do not have to meet minimum requirements or file periodically with the SEC. Although to be listed they must submit a one-time audit to the SEC. A company listed on the Pink Sheets can move up to the Bulletin Board or even NASDAQ later.
The process of offering stock directly to the public on the OTCBB begins with the entrepreneur taking their business plan to a securities attorney, who files a registration statement with the SEC. The registration statement includes a description of the company's history, intentions, management, audited financials, strengths, weaknesses, and securities being registered. Revisions to the registration statement are made until the SEC is satisfied, at which time it declares the registration "effective."
The entrepreneur also retains a market maker (e.g., a broker-dealer firm that facilitates trading in a security) to file a listing application with the NASD, which issues stock symbols.
Pros and Cons
For small- to medium-sized companies that want to raise public money, DPOs offer several benefits. They require no minimum level of sales, profit, assets, or time in business. Other benefits to going public in addition to raising capital, which apply to DPOs, include increased ability to:
- Use stock to acquire other businesses.
- Use stock as currency to purchase assets such as media advertising.
- Provide employee stock options as an incentive and/or compensation.
- Create wealth and liquidity for investors.
- Obtain loans from financial institutions using stocks as collateral.
- Gain prestige and respect.
- Reduce the need for expensive venture capital and bank financing.
- Formalize estate planning.
Companies that go public typically see higher valuations, meaning that the market value of a public company is, on average, substantially higher than the same private company. The classic example of a company twenty-five years ago that offered shares directly to the public and used the increased value of its stock to acquire other companies is Blockbuster.
Going public via a DPO also can be beneficial to companies that don't need to raise capital immediately. A public company with a higher valuation can do a private placement at a deep discount with the provision that investors hold the stock for a period of time. Because the investors can buy the stock at a deep discount to the open market price, it gives them an incentive to invest.
Just as significantly, going public can enhance a company's prestige. Rolls Royce Aerospace, Nestle Chocolate, and Heineken Beer all trade on the Pink Sheets. Having an established stock symbol and price provides investors with a benchmark they can monitor daily as well as the ability to sell the stock through any online brokerage firm, all of which increases incentive and confidence to invest in smaller companies.
It's important to realize that there are circumstances in which a DPO would not be recommended. Companies able to secure an underwriter gain exposure to larger markets and liquidity for shareholders-and can thus raise significantly higher sums. A DPO takes about four months to issue and costs about $100,000 in legal and other fees. Assuming investors like the company, it may be possible to raise capital usually in the range of $1 million to $10 million. A DPO would not make sense for a company that needs to raise less than that or for which annual audit and legal fees would be too costly. A company that needs to raise more than that usually requires an underwriter.
A Powerful Tool
Regardless of the path chosen, becoming a public company provides an entrepreneur with a powerful tool for accomplishing many goals. Going public via a DPO is not right for everyone. And it doesn't mean money rolls in. But given the key ingredients of any successful company—a good business plan, strong management team, and positive growth and earnings potential—a DPO can make it easier.
© 2006 Ewing Marion Kauffman Foundation. All rights reserved.
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