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Direct Public Offering


"Through a direct public offering you can increase your pool of potential investors from the 1% to the 100%."



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Business Finance


 

Direct Public Offering


As an entrepreneur, it can be quite overwhelming to evaluate your options for raising capital.  

You might be surprised to find that there are options for raising capital that you may have never heard of.  

We can help you make sense of all of the options and find the one that makes sense for you.


The Challenge of Raising Capital for Small Business

Raising capital is one of the most difficult challenges faced by today’s entrepreneurs.

  • Bank loans are very hard to get
  • Risk capital investors (angels and venture capital funds) expect high growth and rapid exit, which are not options for a huge majority of businesses
  • Complicated securities regulations place severe limits on who can invest


Our Services

 For entrepreneurs and nonprofit organizations – we help you raise capital without sacrificing control




What is a security and why does it matter?

If something falls within the definition of a security under applicable law, it will be governed by extensive rules and regulations
that can be quite complex and expensive to comply with. The definition of a security can be quite broad!

Over the years, many schemes for raising capital have been devised in attempts to avoid application of the securities laws.
For this reason, the U.S. Supreme Court has stated that any “contract, transaction or scheme whereby a person invests
his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party”
is a security. In other words, if someone gives money to someone else with the expectation of getting some
kind of financial return, that person has purchased a security. Examples of securities include stock, LLC interests,
notes (debt), and investment contracts.

In some states, the definition is even broader. Both the federal law and the laws of any state where you are
trying to raise capital will apply. Many states apply the “risk capital test” for determining whether something is a security.
This test considers whether

  • funds are being raised for a business venture or enterprise;
  • the transaction is offered indiscriminately to the public at large;
  • the investors are substantially powerless to affect the success of the enterprise; and
  • the investor’s money is substantially at risk because it is inadequately secured.

This definition is so broad that even things like pre-sales of memberships and gift cards could be considered a security. 

If something is a security, it may not be offered or sold without state and federal securities law compliance.

 

What is the most common way that enterprises raise capital in compliance with the law?

The most common way that enterprises raise capital in compliance with the law is by doing a private offering to all accredited investors

This type of offering is subject to much less regulation than others.


What is an accredited investor?

The definition under federal law is extensive, but generally it means (1) an individual with a net worth of $1 million excluding his or her
primary residence or at least $200,000 in annual income (or at least $300,000 in annual income with a spouse),
or (2) an entity such as a corporation or LLC with at least $5 million in assets. The Securities and Exchange Commission estimates
that approximately seven percent of the U.S. population is accredited. For the complete definition, see 
http://www.sec.gov/answers/accred.htm.

Venture Capitalists and Angel Investors are the main types of accredited investors.


What is a private offering?

A private offering is one where there is no public advertising or general solicitation. This means that there are no email blasts,
notices on the company web site, media campaigns, etc. All offerings must happen through private communications.


What are some of the problems with private offerings directed to accredited investors only?

From the entrepreneur’s perspective, it is very difficult to raise capital this way. Less than one percent of businesses
are funded by accredited investors. This money is very hard to come by and “pitching” to accredited investors can be a
very time-consuming and taxing process. And even if an entrepreneur is able to find enough accredited investors to
raise the needed capital, the investors are usually in the driver’s seat because this source of capital is so hard to get.
They often demand significant control of the business, which may even include the right to fire the founders at will.
They also often demand very large and fast returns on their investment which may cause conflict for mission-driven
businesses that care about more than just fast profits or an early exit.

From the investor’s perspective, as long as investments are limited to accredited investors, unaccredited investors
are locked out of investment opportunities they might be very interested in. Many investors are looking for alternatives
to the stock market, but they are excluded from investing in enterprises they might want to support.


What is a Direct Public Offering (DPO)?

A DPO is an alternative to the mainstream way of raising capital described above. Unlike private placements
that are only open to accredited investors, 

DPOs are open to everyone.

DPO offerings can be advertised on the web, on TV, on billboards, at events, etc. 

There are no limits on the number of investors, accredited or unaccredited.

DPOs allow enterprises to:

  • Offer debt, stocks, and other kinds of investment opportunities to the public;
  • Advertise the investment opportunity to the public;
  • Accept as many investors as they want or need – both accredited and unaccredited; and
  • Do all this without violating the state and federal securities laws.

A DPO is a generic term that can involve several different legal compliance strategies, some of which are surprisingly simple and easy to do!

One benefit of DPOs is that once you complete the compliance process, you can generally use it to raise money perpetually.

How does this relate to the JOBS Act that was signed by the President in 2012?

In April 2012, the President signed the JOBS Act into law. One of the provisions was called the CROWDFUND Act.
This provision was designed to make it easier for enterprises to raise capital from both accredited and unaccredited
investors and to advertise to the public (but via a platform and not directly like in a DPO).
The CROWDFUND Act still has not gone into effect because both the Securities and Exchange Commission
and FINRA must complete a rulemaking process first.

The new crowdfunding exemption that will be put into effect under the CROWDFUND Act is often confused with DPOs.
However, there are several important differences between DPOs (which are legal today and have been for decades)

and the new crowdfunding exemption, the details of which are still unknown.

 

What are some examples of successful DPOs?

 

  • Farm Fresh to You is offering loans to California residents – the interest is payable in credits for organic produce – 
  • they raised approximately $300,000 in the first year and renewed their securities offering permit so they could continue to raise funds indefinitely.
  • People’s Community Market is offering preferred stock to California residents to open a grocery store in Oakland – 
  • they have raised approximately $650,000 and renewed their securities offering permit so they could raise more.
  • Quimper Mercantile is offering common stock to Washington residents to open a community-owned store in Port Townsend – 
  • they have raised approximately $600,000 and renewed their securities offering permit so they could raise up to $1 million.
  • Real Pickles raised $500,000 in two months by selling non-voting preferred stock to Vermont and Massachusetts residents.

There are 100’s of others

Can people invest their retirement funds in DPOs?

Yes. There is a tool called the Self Directed IRA that makes this a relatively simple process. It’s done everyday.

 


For Investors

 

Should I invest in a DPO?

All investments are risky. You should carefully read all the materials associated with a DPO investment before making a decision whether to invest.
It is always possible that you could lose your entire investment – keep this in mind before making a decision.

DPOs are usually registered with state and/or federal securities regulators. However, this does not mean that the regulators evaluated the offering or endorsed it any way.

Although there is no magic formula for making successful investment decisions, factors you may want to consider include

  1. How long has the enterprise been in business? Does it have a history of success?
  2. Do you know the key players in the enterprise and does your experience with them lead you believe that they are honest and deal fairly with others?
  3. How much experience does management have in the industry and in business? How successful were the managers in previous businesses?
  4. Do you know enough about the industry to be able to evaluate the company and make a wise investment?
  5. Does the company have a realistic marketing plan and do they have the resources to market the product or service successfully?
  6. What are the details of the security being offered? How do investors get paid back and how long is it likely to take?


Will I be able to sell the investment?

 

This depends on the specific terms of the investment. In many cases, securities sold in DPOs are unrestricted, meaning that they can be re-sold,
sometimes after a waiting period. However, this does not mean that you will be able to easily sell them to someone else.
You should not count on being able to re-sell the securities as a way of getting an instant profit out of any investment.




For Entrepreneurs

How much can be raised in a DPO?

Generally speaking, there are no limits. However, under certain circumstances it will be necessary to limit your raise to $1 million per year. 

Once you do one DPO, doing additional ones is relatively easy so that you can raise more when you need it.


What kinds of investments can I sell in a DPO?

This is completely up to you to decide. You can sell equity, debt, revenue share/royalty agreements, memberships, presale of goods or services, etc. 

You can even sell a combination such as preferred stock plus a discount card. For more information about these options,


How much does it cost to do a DPO?

The cost can vary a great deal depending on the type of investment you choose to offer, which states you want to make your offering in,
whether any legal clean-up work is needed, how much assistance you need preparing your prospectus, etc.

Can start-ups do DPOs?

Yes. DPOs can be effective for both start-ups and established businesses and nonprofits.

No Oil or Mining, or Blank check Corporations.


How do I know if I am a good candidate for a DPO?

If you can answer yes to most of these questions, you are likely to be a good candidate for a DPO.

  1. Is your business something that might excite potential investors or appeal to a particular affinity group?                                                                                                           For example, do you find that your customers love you and want to be your fan on Facebook?                                                                                                                     Does your business do something or operate in a way that has a positive impact?
  2. Does your team have a reputation for integrity and honesty? Is your past free of any “red flags” that might make people think twice about investing in your business?
  3. Do you have a track record of running a successful business?
  4. Is your business model easy to understand for the average person or at least to a decently-sized affinity group?
  5. Do you have a network of contacts and affiliations that could serve as a channel to get the word out about investing in your business?
  6. Are you comfortable with promoting your business to potential investors or do you have someone else on your team who can?
  7. Is there someone on your team with time to devote to a fundraising process? You may need to devote several hours per week to communicating with potential investors and completing compliance work.


 

How long does a DPO take?

This is common question and the answer is – it can vary based on several factors.

There are three stages of a DPO:

  • Preparation
  • Regulatory filing
  • Selling the investment opportunity

Preparation

The preparation to do a DPO can take as little as a few days or several months. This process involves

  1. Ensuring that the entity that is making the offering (the “issuer”) is in good shape –                                                                                                                                  making sure any previous financings complied with applicable securities law; the entity has clean and up-to-date financials; 
  2.  the required legal formalities for the entity have been observed; etc.
  3. Sometimes the kind of security you want to sell will not be consistent with your entity type and you will need to convert to a different kind of entity
  4. The first step once you decide you want to raise money for your business. is to decide what kind of investment vehicle you want to sell.

 

There are lots of options and each one will have different implications for your business over the long term. Also, what kinds of investments you can sell depends
to some extent on how your business is structured. Are you a nonprofit, an S Corp, an LLC? You may decide you want to change your structure if you decide you
want to sell an investment that does not fit with your current structure.

The following is a list of some of the options you have to choose from:

C Corporation

  • Common stock (includes voting rights)
  • Preferred stock (may or may not include voting rights; generally provides a preference to investors on payment of dividends and upon liquidation)
  • Debt (a loan for a certain term with a certain interest rate)
  • Convertible debt (a loan that can convert into stock when certain conditions are met)
  • Revenue share (payment of a percentage of revenues over a set period of time)

S Corporation

An S Corporation can offer all of the same things as a C Corporation except that it cannot offer preferred stock. S Corporations can only have one class of stock. 
If you want to sell preferred stock, it is very simple to convert to a C Corporation.

LLC

  • Membership interest – this can be structured in many different ways – with or without voting rights, with or without preferences on receiving profits, with or without a capital interest, etc.
  • Debt (a loan for a certain term with a certain interest rate)
  • Convertible debt (a loan that can convert into a membership interest when certain conditions are met)
  • Revenue share (payment of a percentage of revenues over a set period of time)

Nonprofit

  • Debt (a loan for a certain term with a certain interest rate)
  • Revenue share (payment of a percentage of revenues over a set period of time)

Note that nonprofits that are tax-exempt under the Internal Revenue Code (e.g. Section 501(c)(3)) may be prohibited from paying above market rate returns.

What kind of instrument to sell and what the characteristics of that instrument will be is a very important decision. 
The type of instrument you use can affect your relationship with your investors for years to come.

Here is an example: You decide to sell preferred stock to your investors. You decide not to pay any dividends and invest all profits back into the company. 
After a while, your investors start to get restless – they’re not getting any return on their investment. They start to pressure you to sell the company so they can get their money out.

Compare that to this scenario: Before selling preferred stock you do some projections. You determine that you should be able to pay an annual dividend starting in year three and that,
if you set aside some funds each year, you should be able to buy back the stock from your investors at the original price they paid by year eight. You therefore put provisions into your
articles of incorporation stating that you will pay an annual cumulative dividend and that preferred shareholders will have the right but not the obligation to sell their stock back to the company
starting in year eight at the original issue price.

In both cases, you get equity investors, but in the second scenario, you have created an instrument that allows you to determine the destiny of your company and not be pressured to sell before you’re ready.

 

Preparing an offering document that describes the issuer and the offering

Preparing legal documents for the offering – for example, promissory note, stock certificate, purchase agreement, etc.

Compliance Filing

This is the submission of a package of compliance materials to the state securities regulators in every state where you will be offering securities. 

These materials include your offering document, specimen security, formation documents, financials (usually not required to be audited or reviewed), 

an attorney opinion (not always required), etc.

From the date of submission to the date you receive regulatory approval to conduct your public offering can be as little as three weeks and as much as six months.

The factors that affect this timeline include the following:

  • some States are simply faster and more experienced with direct public offerings
  • anything in your offering that is unusual will likely generate questions from the regulators – 
  • each round of questions can add a month or more to the process
  • regulators will sometimes send you many rounds of questions even if your offering is straightforward and your company has a good track record – some of them feel very compelled to look under every possible rock before approving your offering
  • if you request anything special like confidential treatment of your financials, this can add time to the process
  • there are times of year when the securities regulators are especially busy
  • some states do “merit review” and other states do “disclosure review” – merit review means the states look at whether the offering is likely to pose a risk to the investing public while disclosure review simply looks at whether there is sufficient disclosure – merit review usually takes longer

Selling the Offering

Once you receive approval from the regulators, you can sell to the public (subject to any limitations imposed by the regulators and the applicable law)!

Generally, you have one year to raise funds. You can renew the application every year and continue to raise funds indefinitely.

 

How long can I raise capital once I complete the DPO compliance process?

Regulatory approvals for DPOs generally last for one year.

At the end of 12 months or upon reaching their funding goals, some organizations may choose to discontinue their securities offering.

Other organizations, however, may find that there are advantages to continuing to raise capital for more than one year. For example, 
Farm Fresh to You, a northern California food distribution business, offered “Green Loans” to its customers through a DPO.
Through its DPO, 
Farm Fresh to You successfully raised over $300,000. Farm Fresh to You recognized that the Green Loans from
customers were a great source of capital – low-cost and an effective way to get customers more engaged –
so 
Farm Fresh to You decided to renew its DPO for another year.

Since the state regulators have already vetted the offering materials for the first offering, the approval process for an additional
year is typically very fast (in most cases just several weeks).

Continuing to raise capital beyond the initial year of a DPO offering allows an organization to meet ongoing capital needs and to
benefit indefinitely from the opportunity to allow its community, customers, and fans to become investors.


Is it a hassle to have a lot of small investors instead of one big one?

While more investors means more record-keeping, a larger number of small investors means keeping control of your company.
And there are high-quality low-cost tools to help manage your investors.


Would VCs and Angels be deterred from investing in a later financing because you did a direct public offering?

One major advantage to raising capital through a DPO is that your company can define the scope of its offering in advance —
i.e. choosing what investment instrument is most appropriate to your business, and how much you are willing to give up in return.
You can also incorporate terms that may allow you to better prepare for a larger follow-on round later, or that makes a follow-on
round more attractive to larger investors.

An angel investor or VC may decide to invest in your company (if you need them) via a DPO or later, but those investments are likely
to be on terms more favorable to you because the nature of a DPO can rebalance your bargaining power with VCs and angels.
By opening up your offering to non-accredited investors, who often have more realistic expectations for the return on their investment,
you can level the playing field and bypass taking money initially from a very small pool of private wealthy investors —
who often expect equity on terms favorable to them, big returns, and a fast exit, in exchange for a level of control over your company
that could conflict with your vision or mission.

Also, if you do choose to raise capital from traditional sources later, having managed a successful DPO can make your company more
attractive to potential angel investors and VCs by showing that there was strong interest from the public, and that your offering
was validated by a larger group of supporters.


 

 

 
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