Ever since the Jumpstart Our Business Startups Act (JOBS Act) was signed into law in 2012, there's been a great deal of buzz about Title III, the final provision of the law to be implemented. This so-called "equity crowdfunding" measure would open new pathways for small businesses to raise capital from nonaccredited investors. On Oct. 30, the U.S. Securities and Exchange Commission (SEC) approved the final rules for Title III, signaling that the long wait for equity crowdfunding would soon be over.
But the public's anticipation of Title III belies the reality that it is already possible to raise capital from nonaccredited investors. By using certain federal securities exemptions — referred to generally as direct public offerings (DPOs) — businesses (and, in some cases, nonprofits and cooperatives) can employ a number of cost-effective strategies that allow them to directly appeal to potential investors, all the while tailoring the terms of the offering to their specific desires.
What is a direct public offering?
A direct public offering is the process of using a federal securities exemption to directly sell equity to virtually anyone. These offerings are approved by state regulators, so the rules vary a bit depending on each state's relevant statutes.
"It's a very flexible strategy," Brian Beckon, vice president of Cutting Edge Capital, told Business News Daily. "[The terms of the offering] are really up to the entrepreneur. This is what's great about a DPO; you don't have a negotiated investment. What the regulators approve is the offering, which is non-negotiable and exactly what the entrepreneur wants."
Investors can choose to buy in or opt out based on those established terms, but the issuer remains in the driver's seat every step of the way. Beckon's firm advises clients on the steps involved in undergoing a DPO, from reviewing financials and preparing documentation to attaining approval from regulators. Once regulators in the state where the offering will take place grant a permit, all that's left to do is pitch to potential investors, with the aim of accumulating capital.
"The vast majority of times, there's no other alternative for small businesses," said Michael Bissonnette, CEO of Bissonnette Funding Solutions. "Banks require either too much profitability or too much collateral, so most small businesses don't qualify. Moreover, when you take a loan from a bank, you have to pay it back."
DPOs have been around for quite some time. Ben & Jerry's famously used a DPO in the 1980s to attract Vermont-based nonaccredited investors as a way to raise capital in a socially conscious manner. They weren't the only ones to employ the technique, but by the early '90s, the usage of DPOs began to taper off for unknown reasons. Beckon has his own theory for why DPO usage declined around that time.
"My own opinion — and it might be a bit cynical — is that [DPOs are] just not profitable enough for law firms, so when someone asks their lawyer about DPOs, they tell them not to do it," Beckon said, adding that his firm charges about $15,000 to $25,000 for the average DPO. Now, though, these types of offerings are making a comeback, Beckon said. He speculated that this might be due, in part, to the rise of digital technology and its ability to reduce the cost of a comprehensive advertising campaign.
What kinds of direct public offerings are there?
There are several ways a business can conduct a DPO. The type of DPO your business pursues is a personal choice based on your business's wants and needs. Using these strategies, issuers can offer common and/or preferred stock, debt securities or revenue sharing, attaching desired terms and conditions as needed. Professionals can help guide a would-be issuer through the nuances of their options, but here is a list of the most common types of DPOs:
- Rule 147/Intrastate exemption: This federal securities exemption stems from the idea that if an offering doesn't cross state lines, it is not of interest to federal regulators and should be left to the state government to oversee. Issuers pursuing this option must register with the state, and once approved, the offering typically has no maximum limit on how much capital can be raised. Some states do have caps, as well as per-investor contribution limits, but these provisions vary.
- Rule 504/small corporation offerings registration: This type of DPO is more flexible than the intrastate exemption in that it can cross state lines, as long as the offering complies with each state's regulations. It is more limited in that there is a $5 million cap – just recently raised by the SEC from $1 million on Oct. 30 – on the capital that can be raised in a one year period. Issuers can engage in public offerings in multiple states, or mix and match public and private offerings as they see fit using this method.
- Regulation A+: Also created by the JOBS Act, this federal exemption can cross state lines much like the small offerings exemption, and it features two distinct variations. The first version includes a $25 million cap and requires no financial audit, but issuers have to comply with all relevant state laws. The other variation boasts a $50 million cap and preempts state law; however, this avenue does require a financial audit and a "mini registration" with the SEC.
What are the steps involved in issuing a direct public offering?
Like any public offering, DPOs require diligence and patience. Issuers must weigh their options carefully and ensure they are in compliance with all government regulations as they move through the process. Again, consulting an experienced professional before moving forward is highly recommended. In the most basic terms, a DPO has three distinct steps:
1. Preparation and review: Depending on the size, structure and complexity of an issuing entity, this step can take less than a week or up to several months. Much of this step involves going over records and finances, ensuring that everything is ready to be sent to regulators for approval. This is also when issuers decide on the specific type of security they want to sell. In some cases, this might require converting your company to a different kind of entity. Finally, all required documentation is prepared, the most central of which is the Offering Memorandum.
2. Compliance filing: All of the records and materials prepared during the first phase are submitted to the necessary state and/or federal securities regulators during this stage of the DPO process. The required documentation includes the Offering Memorandum, supporting documents and financials, which typically don't have to be audited. This process varies a bit from state to state, but if regulators accept and approve the proposed offering, then it's time to move on to the fun part.
3. Selling the offering: Once the offering is approved, issuers can sell and advertise it directly to potential investors. The entire DPO process usually takes several months to navigate, with the offering period generally lasting for one year after that, subject to renewal.
What are the potential drawbacks of direct public offerings?
There are some inherent risks to be aware of when it comes to DPOs. When considering whether a DPO is right for your business, it's important to keep a few things in mind.
"Some types of companies are more likely to have a successful offering than others," Beckon said. "[T]he offering has a greater likelihood of succeeding if you have an existing network of potential investors, or you've got a really compelling story that will get people fired up if they only knew about you. The ones that sometimes have trouble are those that don't have either."
In addition, DPOs are not a source of fast money. Sometimes, it can take a few months before you're ready to actually sell the offering, and depending on how long it takes to get approval, you might need access to capital sooner than that.
"If you've got connections with big investors, it's quicker and simpler to do a private placement," Beckon said, adding that friends and family are also a common source of capital for small businesses. "Those would be the low-hanging fruit. But even in those instances, we might map out a strategy for plucking that low-hanging fruit while we prepare for a DPO."
And, like anything else, there are costs associated with undertaking a DPO. It's an investment that requires a deft hand in courting potential investors, Bissonnette said; otherwise, it might not yield the desired return.
"There are costs … of money, time, and a requirement of a certain quality of expertise," said Bissonnette, who successfully used DPOs to fund his companies AeroGrow International and Voice Powered Technologies. "You better have the ability to sell, know how to pitch and put together a presentation to connect with people."
Bissonnette founded AeroGrow to produce a device that could easily grow herbs and produce indoors, without the need for soil or direct sunlight. Before he even sold one unit of his product — now known as the Miracle-Gro AeroGarden — Bissonnette raised $2.5 million using the intrastate exemption in Colorado. He used the money to perform the research and development necessary to make his product a reality. Then, after launching the original AeroGarden, Bissonnette raised another $9.5 million in a second round and took the company public on the NASDAQ Stock Market, where it is still traded today.
"AeroGrow is the world's first and only company with a kitchen crop appliance; that is, an appliance that grows organic herbs and vegetables [indoors] all year round," Bissonnette said. "That's been a big hit, and I funded it all using DPOs."
How is Title III different from a direct public offering?
You might be thinking that DPOs sound very similar to Title III equity crowdfunding, but there are a few key differences. Title III has some more onerous regulations than most DPOs, Beckon said.
"[Title III] allows you to raise money from investors in multiple states. It does, however, have a cap, and it's an exemption with a lot of restrictions," Beckon said. "It will be available for issuers who want to raise money from investors in multiple states at a $1 million cap. It does preempt state law, so if you comply with the federal regulations, you don't have to worry about state laws. But you do have to use a third-party intermediary, which you don't [do] with DPOs. Intermediaries will charge 5 to 7 percent of what's raised. For DPOs, you might have to pay for marketing, but there's no intermediary who takes a cut."
The big advantage here, Beckon said, is that one federal compliance filing gives you the green light to sell the offering in multiple states, similar to Rule 504. The major drawback is the requirement for intermediaries, which are being called "funding portals" under the JOBS Act. Title III also prohibits issuers from directly advertising to potential investors.
Democratizing the world of investments
Beckon believes DPOs can be used for more than simply raising startup capital. His vision is to leverage them as a tool to help revitalize and strengthen local economies, as well. Instead of venture capitalists or distant shareholders trading on an exchange reaping all of the dividends, he said, why not bring in the people who actually patronize the business and live in the same community?
"DPOs had a surge of popularity in the 1980s, but kind of disappeared from the scene," Beckon said. "We picked up the baton four or five years ago as a firm. Our founders realized [DPOs] were an underutilized strategy that has a potentially powerful democratizing effect in creating impact investment opportunities for nonaccredited investors, which are about 97 percent of the population."
Without DPOs, Beckon said, these investors would have no other avenues available to support the small, local businesses they believe in. Of course, they could still invest in publicly traded stocks or mutual funds, but that money wouldn't wind up supporting the actual company, he said.
"If you put your money into the stock market, in the secondary market, you are buying shares from other shareholders," Beckon said. "Not one penny goes to the company of the stock you're buying. As a nonaccredited investor, you have no opportunity to invest in alignment with your values and small, local businesses, but with the DPO you do. We see it as a powerful vehicle from the investors' point of view.