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

Michael quinn's dilemma was a common one, but his solutionwas not.

After 10 years in business, Quinn wanted to go national. But hisHahnemann Laboratories Inc., a San Rafael, California, company thatmanufactures homeopathic medicines, needed to become a Food andDrug Administration-licensed pharmaceutical manufacturer if it wasgoing to market its product across state lines. Where would Quinnget the capital to outfit a new facility?

"I went to a commercial bank, and they said `No way,'" recalls Quinn. Investment bankers weren't offering muchhope, either. But Quinn had an epiphany when he realized that ifjust 200 of his more than 28,000 customers invested about $2,000each, Hahnemann Labs would have the equity capital it needed.

What Quinn did next was an end run around traditionalbrokerages. He marketed common shares directly to individualinvestors in what is known as a direct public offering, or DPO.

The Time Is Now . . . Maybe

San Francisco attorney Drew Field, author of a new how-to booktitled Direct Public Offerings (Sourcebooks Inc.) andadvisor to Quinn on his DPO, says the time is ripe for companies tosell their shares directly to the public. The reasons are diverse:Disillusionment with traditional Wall Street offerings, moreuniformity in state securities regulation, and increases in savingsand investments all play a part. "But mostly," saysField, "we are in the early part of a period of taking moreresponsibility for our lives. Because of this, individuals are morewilling to invest in companies they do business with or have anaffinity [for]."

Field says that while a DPO is no less complex or challengingthan a traditional initial public offering (IPO), it is a moremanageable way to go. "With a DPO, entrepreneurs do not haveto accommodate or rely on investment bankers to get the jobdone," says Field. "You can manage a direct publicoffering just like you would any other project."

But in addition to possessing the required skills for handling aDPO, entrepreneurs must also be able to grow the company within thelimitations intrinsic to this technique. Specifically:

• Absence of liquidity. Companies that, in addition toraising capital, must provide an immediate exit for earlierinvestors or accurate valuation for estate planning purposes willfind that DPOs fall short in helping them reach their ultimateobjectives.

• Limited use as currency. Companies that need to gopublic so they can use their common stock as a currency to acquireother companies should not use a DPO.

• Little personal gain. It would be all but unheard of forthe founder of a company to sell his or her shares to investors ina DPO. In addition, with no active trading market, there'slittle hope of selling the shares on the market after the deal isdone.

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

• The business is easy to understand. Individuals whoparticipate in DPOs tend not to purchase shares in companies theydo not understand. And because they are individuals, not brokeragesor institutions with research departments, the scope of what theyunderstand is much narrower.

• The company is established and profitable. The DPOprocess, which involves little direct selling but a lot of readingand evaluation on the part of would-be shareholders, tends toattract cautious investors.

• The business is exciting. DPOs require a lot ofmotivation on the part of the investors because of restrictionsplaced on the company's securities marketing activities. As ageneral rule, it's difficult for more mundane enterprises toinspire the required level of action among investors.

• The company has natural affinity groups. Customers,clients and the community in which the company does business allhave an affinity for the company. And it's through thisrelationship that much of the DPO is sold. One of the fundamentalquestions entrepreneurs face is whether the affinity they perceiveis mutual and strong enough to motivate prospective investors toconsider their offering.

Based on these criteria, some companies are good DPO candidates;others are not. For instance, a manufacturer of stained-glasswindows for homes is a likely candidate; a biotechnology companystill in the research stage is not. An agricultural cooperative isa good candidate; a manufacturer of industrial abrasives probablyis not. A lawn-care company is a good prospect, while a businessthat provides "correctional" services to governmentsprobably is not.

A Case In Point

In the case of Hahnemann Labs, Quinn had a natural affinitygroup in his thousands of customers. Generally, people interestedin alternative medicine are not those typically interested in thestock market, says Quinn. But his deal--which, in a way, was an"alternative" public offering--seemed to have a uniqueappeal to these investors.

Quinn sent out more than 35,000 offering announcements. Theannouncements resulted in about 1,700 requests for prospectuses;another 400 requests for prospectuses came from friends, family,associates, colleagues and other acquaintances. Of the initial2,100 prospects who received a prospectus, about 240 ultimatelyinvested.

Not that any of this was quick or easy. Quinn started draftinghis prospectus in July 1994, and 12 and a half months later, inAugust 1995, he closed his deal's $400,000 minimum--withinvestments to spare. Of his 240 investors, Quinn estimates thatjust 15 percent, or 36 investors, sent in a check on their ownafter reading the prospectus. To get the rest, Quinn had to dialfor dollars. In all, he figures he talked to some 700 to 800potential investors over the telephone. Nor was any of this cheap:Legal, auditing, printing and marketing costs totaled $102,000,Quinn says.

Parenthetically, it's worth mentioning that the processdescribed above underscores one of the primary reasons whyso-called Internet IPOs are difficult to get done. Says Field,"Right now, the Internet works as a cost-effective deliverymedium, but it does not work as magic. The fact is, most peoplewill invest in an [offering] only if they already know and feelgood about the company."

Although the entire effort took valuable time and resources awayfrom his business, Quinn says it was not without benefits above andbeyond raising the money. "Sure, there were days when I wishedI would run into just one person who had $500,000," Quinnrecalls, but he says there was also a tremendous benefit to talkingto so many customers and finding out what their needs and attitudeswere. "Reaching out to so many people and telling your storyis never bad for a business if it's done with the right kind ofheart and attitude."

In fact, sales during Hahnemann's fiscal year 1996 were$691,000--about $100,000 higher than sales for fiscal 1995. Thatmomentum has spilled into fiscal 1997, with sales of some $400,000at midyear.

Rules And Regulations

From a regulatory perspective, DPOs face the same challenges asunderwritten IPOs. That is, companies that want to raise more than$5 million and want to trade on a stock exchange or the top twotiers of the Nasdaq stock market must file a registration statementwith the Securities and Exchange Commission (SEC). This is a majorundertaking.

Businesses that need less money and are more flexible in theirrequirements for aftermarket trading may enjoy less burdensomeregulatory challenges. For instance, companies that want to raiseless than $5 million can take advantage of the exemption fromfederal registration by filing under what is known as Regulation Aof the Securities Act of 1933, which Quinn used for Hahnemann'soffering.

Companies that want to raise less than $1 million in a DPO maytake advantage of the Small Company Offering Registration (known asSCOR), which is accepted in 43 states and requires almost nofilings with the SEC. The SCOR form, also known as Form U-7, isstill no day at the beach, however: It has several parts, and oncecomplete, looks suspiciously like a prospectus.

One of the real advantages of these unregistered offerings isthat in many cases, a company's shares can still trade on theNasdaq Bulletin Board, which is the next-to-the-lowest tier of theNasdaq stock market. Remember, to trade on the Nasdaq SmallCapMarket, the Nasdaq National Market System or any of the major stockexchanges, companies must periodically report to investors via theSecurities Exchange Act of 1934. This adds a host of requirementsthat a very tiny public company that just completed a very tiny DPOmay not want to burden itself with. Trading on the Bulletin Boardeliminates these headaches.

For his part, Quinn has not been too concerned with aftermarkettrading. He has left that to a stockbroker who keeps a bookmatching buyers and sellers. But most of the investors are holdingonto their shares, says Quinn. The company's upside potentialseems to be the reason: "It would be nearly impossible for oneof the major pharmaceutical companies to grow 10 timesbigger," he says. "But we definitely can."

Contact Sources

Drew Field, 534 Pacific Ave., San Francisco, CA 94133,(415) 296-7820;

Hahnemann Laboratories Inc., 828 San Pablo Ave., Albany,CA 94706, (510) 527-3003.

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