Internet IPOs: Winners and Losers in a Paradigm Shift of Capital Formation

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Table of Contents

  1. Anatomy of a Traditional IPO
  2. Aspects of Internet IPOs

  • Who the Players Are and What They're Like

  • Examples of Internet IPOs
  • Recommendations for Competing with Traditional IPOs
  • Conclusions

    • Anatomy of a Traditional IPO

    An initial public offering (IPO) is the process by which a formerly privately held company sells itself to the public by issuing stock. IPOs have traditionally been conducted via the underwriting process. An underwriting consists of one or more investment banking firms marketing the issuing company and its shares to investors. The investment bankers advise the issuing firm on topics ranging from the number of shares to be issued and price at which to issue, to choosing between Nasdaq or the New York Stock Exchange to list on.

    An investment bank will take a long hard look at a firm before it decides to take on the job of lead underwriter. Some of the other important issues that it will consider are:

    Once an investment bank decides to take a company public the investment bank will assemble an underwriting syndicate. A syndicate consists of the lead investment bank plus other investment banks that it has recruited to help market the issue. Relatively small issues may consist only of the lead underwriter while very large international IPOs may have syndicates involving upwards of thirty or more underwriters.

    There are two methods used in traditional underwriting: firm commitment and best efforts. In a firm commitment the investment bankers buy the shares from the issuing firm and then resell them to the public. The issuing firm sells the securities to the members of the underwriting syndicate, less a spread which serves as compensation to the lead underwriter. In a firm commitment, the underwriting firms assume the full risk that the issue will be fully subscribed at a profitable price on the offering date.

    In a best efforts offering, an investment bank will assist the offering, but will not actually purchase the shares issued. The syndicate acts as an intermediary between the issuing firm and the public and does not bear the risk of a poorly performing IPO. Because the share price of an IPO is far from certain, the best efforts method is more widely practice.

    Investment bankers also advise the issuing firm in filing a preliminary prospectus with the Securities and Exchange Commission (SEC), called a red herring, describing the details of the offering and the prospects of the company. This document is called a red herring because of a statement printed in red that states that no attempt is being made to sell the issue until it is formerly approved by the SEC. The final, approved document which includes the price of the offering, is simply know as the prospectus.

    While waiting for final SEC approval, top executives from the issuing firm along with the investment bankers will go on a road show. This promotional effort is set up by the underwriters with the purpose of getting the company’s story out to the institutional investing community and to generate demand. The company executives sell the sizzle and pitch which differentiates their firm from the rest of their competition. The difference between a successful roadshow and a flop can be millions of dollars to the issuing firm.

    IPOs are a time honored method of raising funds in the capital markets. They usually raise tens of millions, yet can also cost companies millions in fees, promotions, brokerage services and stock options. Estimated costs for a traditional IPO include, but are not limited to, the following:

    Not surprisingly, many smaller firms find traditional IPOs cost prohibitive. Also, many may not meet the issuing requirements of the SEC. Within the past several months a new, less expensive and less regulated issuing option has arisen: the Internet. Many leading capital market experts, such as The Owen Graduate School of Management’s Professor of Finance Bill Christie see the Net as the only alternative for companies that have no other methods available to penetrate the capital markets, and do not view the Net as a threat to the powerhouse investment banks of Wall Street. However, Web entrepreneurs like Andrew Klein, the man who conducted the first Internet IPO (Spring Street Brewing Company) and who now runs the world's first investment bank for bringing companies public over the 'Net (Wit Capital Corp.) are working hard to prove the the establishment wrong.

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    Aspects of Internet IPOs

    The Internet is extremely efficient due to the power of instantaneous exchange of information. Clearly this outdates the traditional mediums which are much slower and more expensive in comparison. In the future, security issues will be addressed with even more sophisticated encryption technology. Currently, the infrastructure for financial services and Internet IPOs in particular is in its infancy. Several advantages of Internet IPOs include cost savings, time savings, and favorable regulatory advances. These are discussed below. Also, some concerns of cypberspace investing conclude this section.

    Advantages of Internet IPOs

    Cost and Time Savings. The offering documents necessary to begin the process of an IPO can now be completed by multimedia computer software programs, one of which is called CapScape. It takes an estimated 11 hours to complete the Regulation A filing forms (discussed below) with CapScape, versus 900 hours as estimated to complete the standard form.

    If using software such as CapScape, companies can keep the legal and accounting costs between $15,000 and $26,000, savings of perhaps tens of thousands of dollars. Another large cost savings by using the Internet is that for printed material. Costs of printing the prospectus can run as high as $20,000, which are avoided because the prospectus is online. Total cost savings have been estimated at $40,000 and up.

    How do Internet IPOs differ in total cost from traditional financing options? Consider that the costs of simply finding a traditional underwriter to take your company public can be as much as $200,000, plus 6% of the authorized shares. Internet IPOs can bypass much or all of these traditional underwriting fees. Similarly, companies that use traditional venture capitalists will find the total cost of issuing around $5 million in equity to be $700,000.

    Considering the relatively small amount of capital that Internet IPOs aim to raise (for regulatory reasons discussed below), it is not surprising that the traditional IPO options have been prohibitively expensive for many firms. Using the Internet and a software program such as CapScape, issuing companies can expect costs of around $100,000 or less.

    Regulation of Internet IPOs

    IPOs and all other financing activities in the US are regulated by the The Securities and Exchange Commission. The U.S. Securities and Exchange Commission’s mission is to administer federal securities laws that seek to provide protection for investors. The purpose of the laws are to make sure that securities markets are fair and honest, and to provide the means in which to enforce the securities laws through sanctions where necessary.

    Two events which have opened the field for companies soliciting capital through the Internet are the attitude of the SEC and a recently revived securities law, Regulation A.

    The SEC’s attitude towards Internet IPOs has been open-minded, yet cautious. The SEC is receptive to the idea of Internet IPOs. According to Andrew D. Klein, Spring Street Brewing Company President and former securities lawyer, "From top to bottom, the SEC really does support both small business and innovative uses of technology. The also do not come across as institutionally opposed to distermediation of the securities markets."

    However, a critical test of the success of Internet equity raising lies in the hands of SEC and state commissions that are "regulating in real time." While the potential for legitimate businesses to raise capital unfolds, so do the opportunities for con artists, scams, and other illegal activities. The regulatory climate is still very much in flux.

    Many of the recent Internet IPO offerings have come to fruition through an (until now) infrequently used small issuer exemption called Regulation A under the Securities Act of 1933. Under Regulation A, companies can raise up to $5 million in a 12 month period. The benefits to small issuers under Regulation A are:

    In the past Regulation A was pretty much forgotten are rarely used. That's because the high costs associated with traditional IPOs, coupled with the $5 million limit or raising equity, made these small IPOs too costly. Internet IPOs have been responsible for raising Regulation A from the dead.

    Securities Regulation Links. The preceding discussion is intended to present, in layman’s terms, the regulatory environment and specific concerns for Internet IPO issuers. For more detail on the SEC and the requirements for issuing public securities, please visit the following Websites:

    Concerns Regarding Internet IPOs

    Future Regulation in Cyberspace. Although the SEC is favorable towards the idea of cyberspace capital formation, there are legal concerns for companies considering issuing capital via the Internet. In any environment where regulation is being developed simultaneously with the technology itself, many issues will arise, perhaps retrospectively, which hinder the progress and public trust of the industry. Take nuclear energy. Retrospectively, many electric utilities now regret the decision to invest in nuclear energy and their nuclear plants. However, in the 1970’s, jumping on the nuclear energy bandwagon was the right choice to make. We can only hope for a better future for cyberspace financial services.

    Blue Sky Laws. A serious threat to Internet IPOs involve the so-called Blue Sky laws. Founded in 1911 by the state of Kansas, these laws were enacted to prevent the sale of securities which had nothing behind them but "the blue sky." Many states ratified similar laws. The federal government began regulation of investment activity years later, in 1933.

    Issuing companies must be registered in each state they are soliciting securities. But, by the very nature of the Internet, anyone, anywhere has access to the Web-sites and thus the offerings. This clearly violates Blue Sky laws unless registration in each state is completed. In a much broader sense, there must be regulatory consistency for Internet IPOs going forward.

    Spring Street Brewery (the first Internet IPO) faced the nightmare of meeting the state requirements (Blue Sky laws). Pennsylvania, for now, states that as long as companies clearly indicate where they are registered and who may purchase securities, the state has no problem. But we feel this is a nebulous region. What exactly is "clearly indicate"? According to what standards? CapScape hopes to capitalize on this dilemma by incorporating a program in their March 1997 version which will file with all 50 states in order to fulfill all Blue Sky laws.

    Cases of Fraud and Abuse. Both registration issues and enforcement are important issues; however, the SEC has had its hands full with the latter. Because of lack of regulation on the Internet in general, many fraudulent solicitations are taking place at this moment. For a more detailed discussion of fraudulent activity, how to spot fraud, and current SEC fraud cases, visit the SEC's web-site on Investment Fraud and Abuse.

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    Who the Players Are and What They're Like

    A myriad and growing number of players have important roles in the development of Internet IPOs. The roles these participants played are similarly varying. Some players are attempting to transform the future of financial services completely. Others provide both new and traditional services (underwriting, stock trading, etc.) on-line. Still others don’t even try to replace the role of traditional underwriters and brokers--rather they work in conjunction with them. But all do in one way or another attempt to save clients and investors money. New players are entering the Internet IPOs arena every month; however, this list gives a good flavor of some of the established players today.

    Companies

    In March 1995, Spring Street Brewing Company launched the first Internet IPO, bypassing the traditional route of securing public capital through investment bankers and brokerage firms, and raising $1.6 million in the process. Since then more than 30 companies have issued direct public offerings via the Internet. These companies, all of them rather small and each of which raised minuscule amounts by Wall Street standards (less than $5 million), are remarkably diverse industry. To view a partial list of some Internet IPOs, see Examples of Internet IPOs.

    On-line Investment Bankers and other Financiers

    Wit Capital Corporation: Wit Capital Corp. was recently formed to become the world’s first investment bank dedicated to arranging the public offering of securities through the World Wide Web. Wit will perform the following traditional underwriting functions, albeit in an on-line setting: 1) due diligence; 2) valuation determination; 3) deal structure; 4) prospectus preparation. In addition to providing an on-line prospectus, Wit will make available additional audio and video promotional material. Issuers’ shares will be offered and sold directly to the public without the necessity of brokers or other middlemen. Wit expects clients and investors to realize substantial cost savings relative to traditional investment banking options.

    However, Wit will also offer a brokerage service of its own to encourage investors to open accounts and keep large investment balances with Wit. Wit will go beyond brokering shares of its clients exclusively--Wit will also trade listed and NASDAQ stocks at "better than the national best" bid/ask spreads. The founder and president of Wit Capital Corp. is Andrew Klein, who completed the world’s first Internet IPO in 1995 as the CEO of Spring Street Brewery.

    Direct IPO, Inc.: Direct IPO is creating a new financial category that one might call "discount venture capitalist." Direct IPO raises capital (up to $5 million) over the Internet for clients for about 25% of the company, or about half of what traditional venture capitalist firms require.

    Direct IPO provides public relations and Internet marketing services to issuers who wish to offer their public stock for sale over the Internet. Direct IPO alleviates the issuer’s burden of finding investors by conducting a massive WWW hyperlinking program and simultaneously launching a traditional public relations media campaign to drive thousands of potential investors to the client’s Web site.

    Rather than try to replace the role of the traditional investment banker, Direct IPO’s financial strategy includes handing off their clients to a traditional underwriter for a secondary offering after 2-4 years. According to Direct IPO, "by handing off to a NASDAQ level underwriter, the client company gains the support of traditional market makers and financial analysts creating true liquidity for the stock.

    Consultants and Other Services

    CapScape: CapScape is a highly interactive, multi-media computer software program that helps companies complete up to 85% of the Regulation A Securities and Exchange Commission (SEC) filing forms--the offering document--by themselves. The creators of CapScape assert that instead of spending 900 hours to complete this complex form in the traditional manner, most companies can complete the process in 11 hours using CapScape. In addition to saving time, CapScape can save companies thousands in legal and accounting fees related to filing. In addition, CapScape allows companies to publish the prospectus on the Internet, which can save the cost of printing the prospectus (as much as $20,000). CapScape can print the required documents for each of the 50 states to fulfill all state filing regulations (Blue Sky requirements), providing enormous savings in time and money. Below and to the right is a screen shot of CapScape's on-line filing form. CapScape is supported by the consulting firm of Ben Ezra, Weinstein and Co., Inc. (see below).

    Ben Ezra, Weinstein and Company, Inc.: Ben Ezra, Weinstein and Company ("BW") is a consulting firm that was formed in September 1995 to facilitate initial and secondary offerings of common stock over the Internet. BW advises in the preparation and filing of Regulation A offerings, as well as state registrations of offerings. BW also designs and, in some cases, operates the Web sites for each client selling its stock over the Internet. Figuring out how to spread the word of clients’ offerings is one of BW’s most important functions. BW identifies sites to use as pointers to its clients’ sites, including investment club pages, user news groups, chat rooms and electronic bulletin boards.

    Regulators

    The Securities Exchange Commission: The U.S. Securities and Exchange Commission’s mission is to administer federal securities laws that seek to provide protection for investors. The purpose of the laws are to make sure that securities markets are fair and honest, and to provide the means in which to enforce the securities laws through sanctions where necessary. The SEC's attitude towards Internet IPOs is open-minded, yet cautious. State regulatory agencies have their own set of laws, called "Blue Sky" requirements, which must be satisfied in each state that compaines expect to offer stock. It is safe to say that on-line securities regulations are still in flux. For more on this topic see Regulation of Internet IPOs.

    Information Providers

    IPO Data Systems: IPO Data Systems is a provider of comprehensive, descriptive data on both traditional and Internet IPOs of common stock underwritten and offered in the US. Its mission is to deliver high quality information to sophisticated equity investors. IPO Data Systems is a subscription-based service. Fee options include $15 per month and $150 per year.

    IPO Central: IPO Central offers the latest news on traditional and Internet IPO filings, offerings, and after-market performance.

    Virtual Market Makers

    SCOR-Net: SCOR-Net is creating an electronic "curb" for trading share of companies that are neither listed on exchanges nor traded over the counter but rather those that sell stock directly to the public. SCOR-Net is attempting to mitigate the liquidity problem that is inherent in matching buyers and sellers of stock in lesser-known companies. The SCOR-Net name is a takeoff of a type of regulatory filing utilizing the uniform Small Corporate Offering Registration. This reflects the type of companies with which SCOR-Net and other on-line IPO services are currently affiliated and targeting.

    The Direct Stock Market, Inc.: The Direct Stock Market, Inc., provides investors, small business owners and the securities industry with current, complete and instantaneous information about small business public offerings. The company also provides firms that issue stock in direct public offerings a central location from which to distribute their documents and reports electronically. It serves public companies that may not have active market-makers for their stock. Subject to regulatory approval, the Direct Stock Market’s electronic bulletin board for posting bid/ask offers will be available to all Direct Stock market-listed companies’ shareholders.

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    Examples of Internet IPOs

    IPO's over the Internet are not just limited to a few well-publicized stocks such as Spring Street Brewery, but rather to a whole host of companies and industries. The range of companies jumping on the bandwagon include casinos, acoustic engineers, abalone farms, and even a casket company. Furthermore, these companies range wildly in their expected clientele base. For example, Spring Street requires a minimum $550 investment while the Online Casino requires a minimum $500,000 investment. As noted eariler, the majority of companies offering equity over the Internet are small and most raise no more than $5 million. The following list summarizes several recent companies that have issued direct public offerings over the Internet, as well as the type of industry each company is in. For a more complete list, visit IPO Data System's page of direct public offerings, on which this list is based.

    The process by which by to obtain stock online is similar to how one would purchase stocks in these companies if the Internet did not exist: via a direct public offering. The direct public offering (DPO) allows the company to sell its stock directly to the purchaser, rather than through an underwriter. Since an underwriter is not involved, the issuer can keep prices to a minimum. However, since the Internet does exist, companies can use it as a marketing medium to promote the sale of stock.

    The method by which one would purchase shares of stock in Internet IPOs today is as follows: First, the purchaser must obtain a subscription agreement, which can be done either on-line or through the mail. Next, the purchaser sends the agreement along with a check for the appropriate amount. Within five days of the company's receipt of the agreement and money, a confirmation will be sent out to the purchaser. Lastly, within thirty days, the company will send the actual stock certificate.

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    Recommendations for Competing with Traditional IPOs

    Cyberspace IPOs are not for everybody. Although the practice of going public on-line is very new, we can already observe many tactics that, if employed correctly, enable firms to raise capital over the Internet. Many of the actions outlined below can be deployed by both the issuer and its underwriter, if utilized.

    First, firms that can identify and attract an "affinity group," a group of investors that is particularly interested in the firm’s core business, possibly based on a personal interest or hobby, are more likely to find success raising capital on the Internet. Many view firms that go public via the WWW are the firms that could not find a traditional investment bank or underwriter to promote and support their offering in the first place. In a sense, critics feel on-line offerings are made as a last attempt effort to raise capital. As a result, firms should target investors that are perhaps more adventurous, or less risk averse, than the traditional investor and who understand the commercial medium also increase the probability of a successful Internet IPO.

    Second, firms should remove themselves from the middle, where the actual purchase and transfer of funds process occurs. Generally speaking, the issuing firm is not in the business of clearing such transactions. Rather, the firm should contract an independent party such as a professional broker to handle these activities, which at the same time lends a degree of legitimacy to the offering.

    Third, issuers and underwriters should work closely with the Securities and Exchange Commission throughout the entire process. Based on the positive treatment of past cyberspace IPOs, the SEC appears willing to cooperate with issuers and approve their registration statements, assuming they are in compliance with all regulatory requirements. However, as in the physical world, firms do not want any surprises at the last minute after all the effort has been expended and all the attorney fees have been paid. The firm’s Web site should have a notice, prominently displayed in several places, stating that the offering is subject to SEC oversight. Involving the SEC consistently throughout the development and drafting phase as well as past the initial offering date also promotes legitimacy to potential investors.

    Additional proactive measures for cyberspace IPOs include promoting the idea of free and equal access to information to discourage claims of asymmetric information and insider trading. Issuers want to prevent users from shying away from the investment because they believe someone else might have more or better information. Issuers should detail on their Web site a complete transactional history of their securities. Information should include price, number of shares traded and date of last transaction. This will enable users to make more informed investment decisions.

    To generate enthusiasm for the offering, firms and underwriters should strategically place advertisements on the Internet. Attractive sites for such banner ads include investment club pages, user newsgroups, and related chat rooms and bulletin boards (related to investing and/or the business’ activities). This increases the probability of reaching a target.

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    Conclusions

    Internet IPOs are yet another example of a traditional business practice that has taken advantage of computer mediated environments. Internet IPOs offer many advantages to traditional public offerings, including reduced advertising, promotion and distribution costs, decreased underwriter fees, lower legal and accounting costs, and regulatory compliance efficiencies.

    Although on-line IPOs may not be a threat to traditional underwriters at the moment, they are currently a threat to the attorneys, accountants, venture capitalists and boutique investment firms who make their living drafting, verifying, promoting and soliciting the voluminous documentation required of such offerings. As more and more companies go public via the Internet, the preparation of a firm’s offering circular and prospectus could become increasingly standardized, thereby reducing the need for these attorney and accountant services.

    It is important to recognize that with any paradigm shift, there are winners and losers. In the case of the Internet IPO, some would argue that these start-ups would never have obtained the professional backing of a traditional underwriter because the firm is too risky or the amount of capital it is trying to raise is too small. However, it is undeniable that these IPOs have proven that there is a market now for high yield, low volume stocks, and that market can be captured in cyberspace.

    It is undeniable that there is tremendous potential for an entirely new industry to develop, an industry focused on raising funds in an on-line interactive medium. It is also clear that traditional firms must either learn the rules to the on-line game or face the aggressive competition by those who are carving out a niche for themselves.

    [Table of Contents] [Traditional IPOs] [Aspects of Internet IPOs] [Players]
    [Examples of Internet IPOs] [Recommendations] [Conclusions]