Small businesses are an integral part of the American landscape. In the big picture, they function as a key element of the country’s economy by creating jobs and developing new products. On a more personal scale, the small business is an American icon: the ability to establish one’s own business and pursue success, depending only upon one’s own mind and muscles, is a fundamental premise of the "American Dream." Those who take this step, however, will learn that they face unique challenges as they seek to establish their business in the marketplace. One such challenge is obtaining sufficient financing to grow and exploit new opportunities, or in some cases, simply to survive.
While adequate access to capital has plagued small businesses for decades, perhaps new technologies exist or are being developed which can be used to mitigate the problem. One such possibility seems to be the Internet. The goal of this article is to examine the long-standing small business access to capital problem and ask whether the Internet, which has revolutionized many segments of our lives, might likewise be a tool for revolutionizing, and thereby improving, the ability of small businesses to obtain the capital they need. Specifically, this article asks whether the Internet holds promise for allowing small businesses to access the equity markets in ways which, up to this time, have been impossible.
With this goal in mind, Part II of this article examines the ability of small businesses to obtain financing, asking whether there really is a problem and, if so, whether it is a problem about which we should worry. Part III then focuses on whether improving access to equity financing is a vital part of the solution. Turning to the Internet itself, Part IV explores the allure of the Internet as a tool for helping small businesses better access the equity markets, looking at various ways the Internet might be used and the concomitant problems that might thwart such uses. Finally, Part V looks at the posture adopted by the Securities and Exchange Commission (the "SEC" or "Commission") in the face of pioneering attempts to harness the Internet for financing purposes.
II. Small Business’ Access to Capital
Small businesses vary widely in the amount of capital they need depending upon the type of product or service offered, maturity of the company, and plans for the future. Despite these variances, however, all businesses need some amount of capital to establish operations and expand to meet demand. This section starts by briefly exploring whether a problem that affects small businesses is something of general relevance or something about which only small business owners should worry. The section then goes on to describe two scenarios which illustrate the typical effects of insufficient capital. Typical patterns of financing among small businesses are also examined. Finally, the section then moves on to ask whether, as a general matter, small businesses are able to capture sufficient financing, looking at both systemic problems and recent developments which may have coalesced to exacerbate the situation.
A. Is Small Business Access to Capital a Problem Deserving of Widespread Attention?
Before embarking upon an exploration of whether small businesses are able to obtain sufficient financing, it makes sense to ask whether, even if such a problem exists, it is something that should cause worry. Is access to capital an issue that small business owners alone need worry about, or does the issue have implications that should cause wide-ranging concern? Given the significant role of small businesses in the American economy, it seems this latter question should be answered in the affirmative.
Small businesses[1] make up a considerable part of the economic engine of this country. First, small businesses have significant productive output: they accounted for fifty percent of the United States’ private gross domestic product in 1994.[2] Second, small businesses are important employers: in 1994 they employed fifty-four percent of the private work force in this country and were responsible for sixty-two percent of the new jobs created.[3] In light of their important role, evidenced by these statistics, any problem which affects the health of small businesses will likely affect the nation’s overall economy. Therefore, if it turns out that access to capital is a problem which negatively affects small businesses, it seems reasonable to be concerned about the problem and to expend some energy in search of a remedy.
B. The Importance of Capital to Small Businesses
One scenario in which it is easy to see the importance of sufficient capital is the start-up business. A company in this phase may have a terrific product or idea and may have spent significant time and money developing and refining that product or idea. However, if the business lacks sufficient capital to invest in the facilities or people needed to actually produce the product, the business may fail before it ever gets its product into the marketplace. Or, the company may manage to produce the product, but may fail before revenues begin to come in as a product of having insufficient working capital to meet short-term operating expenses. The rate of failure among new businesses is high and "[u]ndercapitalization is one of the chief causes of failure of start-up businesses."[4]
Another scenario illustrating the importance of adequate capital involves a more mature but rapidly growing company. Such a company, likely started out of personal resources of the owner, has funded its growth only by reinvesting its profits. In such a case, the company’s growth is limited by its sales. A problem arises, however, if the company’s product becomes hot, orders begin coming in faster than expected, and the company lacks the capital required to fund the production of the stock to fill the orders. These rapidly growing companies can consume large amounts of capital as they try to balance simultaneously normal operations and expansion, requiring investments in new equipment and facilities.[5] An undercapitalized company in this situation can fail even though it was about to grasp success.
These two illustrative cases show that sufficient capital is important to a small business: it can mean the difference between success and failure. Even if failure is not the result of insufficient capital, other harmful effects can follow. In a survey of small business owners, respondents who reported a shortage of capital noted the following effects:
Clearly, inadequate financing can have deleterious effects on a company. While the lack of capital may not always cause failure, it is likely to have a negative impact on the vitality of the company.
C. Typical Small Business Financing Strategies
In looking at whether small businesses are able to get the capital they need, the first step is to look at the sources most often used. A large number of small businesses are launched with, and rely in their early stages upon, personal resources of their owners.[7] In such cases, the small business owner turns to his or her savings, personal loans, or even credit cards to supply the money needed in the business. "Angel" financing is another common source of capital for small businesses. These so-called Angels are usually wealthy friends, family, or clients of the business owner. Such individuals may contribute fairly substantial amounts of money and may accordingly take substantial ownership positions in the business; rarely, however, do they seek to be involved in the day-to-day operations of the company.[8] Finally, for established small businesses, retained earnings are a standard source of capital.
D. Are Small Businesses Able to Obtain Sufficient Financing?
Given these common sources, the question remains: are small businesses able to obtain sufficient capital? For at least some businesses, the answer is clearly no: in 1995, nearly one out of four small businesses reported that during the preceding year they had been unable to secure needed financing.[9] Others contend that while most financing needs are met, there remain "gaps" in availability that can pose serious problems for those small businesses that happen to encounter one of these "gaps."[10]
There appear to be two types of problems behind small businesses’ difficulty in raising capital. First, there are systemic problems which have hindered small businesses for decades.[11] These problems appear endemic to the current capital-raising structures used in this country. Second, there are recent developments which have further handicapped small businesses in their attempts to get adequate financing.
1. Systemic Problems
Systemic problems exist for small businesses with regard to securing debt financing. Banks are often hesitant to lend to small businesses because of the inherently risky nature of such enterprises. Also, small but rapidly growing businesses typically exhibit erratic bursts of growth and downturn, a pattern which makes banks nervous since they cannot tell if the latest downturn is just part of the pattern or is the beginning of the end for the company.[12] Finally, when banks are willing to lend to small businesses, they will usually want the personal guarantee of the owner. Even if the owner has sufficient assets to provide such a guarantee, he or she might hesitate to risk complete personal solvency for the sake of financing the growth of their business.
There are also systemic problems faced by small businesses with regard to securing equity financing. First, since much of the cost of an equity offering is essentially fixed,[13] the marginal cost of capital becomes increasingly higher for a small offering. Second, actually placing stock of a small company can be difficult because potential purchasers will be worried about the stock’s lack of liquidity.[14] Third, finding an intermediary to assist in the process of a smaller offering may not be possible: investment banks usually do not want to handle deals for less that $10 million.[15] To the small business owner seeking to raise capital, it likely appears that while the equity markets have developed into a machine for funneling money into large businesses, there is no similar mechanism to help with his needs.
2. Problems Arising Out of Current Trends
In addition to these two categories of systemic problems, there are two recent trends which have made access to capital an increasingly forbidding proposition for the small business. First, following the S & L crisis in this country came a period of increased regulation of banks by the federal government. The regulations placed upon banks, whether requirements for loan loss reserves, capital ratios, or lending portfolio concentration, had the effect of causing banks to restrict their lending practices. Smaller banks, traditionally the main lender to small businesses, showed the greatest reduction in lending activities in response to the increased regulatory activities.[16]
Second, there is a rising tide of bank mergers and consolidations. As a part of this trend, many small, local banks are being bought by larger regional or national banks; this supplanting of local banks with larger banks has an effect on loan availability for small businesses. Where a small business owner once had a long-standing, carefully cultivated relationship[17] with a local bank, she might now be forced to deal with a new entity unfamiliar with the owner and her business. Apart from the problem of reestablishing relationships, larger banks are generally less interested in making loans to small businesses. When a large bank acquires a small bank with a portfolio of small business loans, the usual result is that the number of such loans declines.[18] If the trend of bank mergers and consolidations continues, as it seems likely to do,[19] it will become increasingly difficult for small businesses to find alternative banks to satisfy their credit needs.[20]
The implication of both the systemic problems and the recent developments is that small businesses face considerable barriers in their drive to raise capital. One part of the solution may be to push for less bank regulation in hopes of increasing access to loans. Another part may be to encourage lending by non-bank financial institutions, such as commercial finance companies, insurance companies, and private/public sector cooperative organizations.[21] Yet another piece of the solution might be to explore ways of increasing the access of small businesses to equity financing. That is the solution upon which this article focuses.
III. Equity: Why and How?

A. Debt vs. Equity
Why might a small business decide to seek equity financing? As intimated by the discussion in the preceding section, a company might have to seek equity financing out of necessity - the firm may have explored all avenues for additional debt financing and found them insufficient. Even if further loans were possible, the company may have reached the point where it makes sense to shift to equity because of the inherent drawbacks of debt. Such drawbacks include forcing the company to adhere to a set repayment schedule and requiring the company to enter into restrictive loan covenants. Additionally, having too much debt in relation to equity can be risky for a business. If a company is too highly leveraged and business takes a downturn or interest rates fluctuate too much, there is no operating cushion, and the company can quickly find itself in financial trouble.[22]
Apart from problems with debt financing,[23] there are affirmative reasons why a company might seek equity. Foremost among these reasons is the fact that money raised through selling shares of the company is money that does not have to be repaid. This new capital can be used to invest in equipment or to develop a new product without regard to a fixed repayment schedule as would be the case with a loan. Another reason for adding equity is that it will improve the company’s debt-to-equity ratio and may thereby open up additional debt financing, possibly at better terms than previously offered.[24]
B. Questions Facing A Company Poised to Pursue Equity Financing
When a company reaches the point of deciding that it wants or needs to pursue equity financing, it will need to address the question of whether doing so is feasible. An initial public offering ("IPO") is the goal many companies have when they make this decision. Two threshold issues must be addressed by the company at this point.
First, the company must look at the market conditions and ask whether it makes sense to try to place an offering into the market at that time. Market conditions can seriously impact investors’ receptiveness to the offering as well as the pricing of the offering.[25] An offering that might do well given one set of market conditions may fizzle in another.
Second, the company should try to determine whether it, as a company, is really suited for an IPO. In general, a company considering an IPO should have annual sales of at least forty million dollars, have a profit history equal to or better than industry averages, and be in a large, stable or growing market.[26] An important exception to these guidelines would be so-called "glamour" companies. These are companies in industries which have received significant attention from the media and investors and may thereby have an easier time placing securities.
A recent example of the glamour phenomenon is the plethora of high technology companies producing Internet-related products that went public in 1996. Companies producing such products were undoubtedly hot that year and many who went public probably would not have done so, or at least would not have had their offerings fully subscribed at such high prices, were it not for the glamour effect. Interestingly, the glamour effect can have a backlash: the poor performance of many of those 1996 offerings have made investors in 1998 hesitant to purchase securities of companies in the Internet product arena.[27] At any rate, it is clear that only companies of certain size with certain financial credentials, or maybe those in certain glamour industries, should seriously entertain going public.
C. Going Public - Advantages and Disadvantages
If a company determines that it is indeed a good candidate and the market conditions are right for an IPO, it should then look at the benefits and burdens that accompany the move to becoming publicly held. Although a careful examination of these is outside the scope of this article, a quick discussion of a few such benefits and burdens follows.
There are many advantages that going public will provide to a company. First, if the IPO goes well and a vigorous aftermarket develops, the company will likely be able to raise additional capital in the near future -- something a growing company will have to do -- at favorable terms and with minimal worry.[28] A second advantage is that being publicly held will allow for effective use of stock options and other stock rights in programs designed to attract and retain top employees or meant to increase employee productivity. Third, a public company is more visible and often enjoys an increase in prestige.[29] Fourth, being a publicly held company may improve credibility with suppliers and customers: they may feel more confident in entering into relationships with a public company.[30] This may even lead to better credit terms with suppliers. A fifth advantage to going public is that doing so will give the owner or owners of the company liquid and marketable securities, something which may be important for a large holder who wants to diversify his portfolio. Holding marketable securities also allows exit for those who may be ready to leave the company.
Offsetting these advantages, however, are some considerable burdens which accompany the decision to go public. First, the cost of the offering itself can be burdensome. Combined costs of accounting, legal, printing, and registration fees added to the underwriter’s commission can result in total costs as high as 35% of the offering price in some cases.[31] Second, being a public company will entail continuing costs after the offering from preparing the requisite disclosure documents and updating such information. A third disadvantage is that being publicly held can change management focus from long-term to short-term as a product of pressure from shareholders for constant increases in growth, earnings and dividends.[32] Fourth, management’s freedom will be greatly constrained, requiring approval of the board for major matters and even shareholder approval for fundamental changes such as mergers.[33] Fifth, there is the potential that the owner could lose control of the company if a large block of shares come under the control of dissidents.[34] Finally, the disclosure requirements incumbent upon public companies will mean a loss of privacy. Information the company would prefer to keep secret, and which it was able to do so when privately held, may now have to be disclosed.
D. Alternatives to Going Public
After weighing all these considerations, many small businesses will decide that going public may not be the right thing to do. Perhaps the company will decide it did not have the reputation or financial vigor to attract enough investors for a successful IPO. Or maybe the public offering process will simply seem too expensive in relation to the amount of capital desired. For a business that reaches such a conclusion, there are alternatives to going public which may make sense. These alternatives are possible by way of exemptions from the registration requirements of the Securities Act of 1933[35] (the "Securities Act"). Avoiding the registration process means a substantial savings of time and money for the company. Also, not having to register means the offering can be completed more quickly, thereby making it easier to take advantage of good market conditions.[36]
Regulation A and Regulation D of the Securities Act offer appropriate exemptions[37] for small business issuers. These exemptions are based either on the fact that the public offering is small or of limited character,[38] or on the idea that the transaction does not involve a public offering.[39] Accordingly, there are restrictions which accompany these exemptions, either limiting the amount of stock that may be offered[40] or restricting to whom the stock may be sold.[41] Depending upon the exemption used, there may be other applicable restrictions under the Securities Act, such as a ban on general solicitation or general advertising[42] and limitations on resale of the securities.[43] On the other side of the coin, these exemptions incorporate some unique features that make them particularly useful for small issuers. One example when operating under a Regulation A exemption is the ability of the issuer to "test the waters" to determine likely investor response to the contemplated offering.[44] This provision, as well as other beneficial features of the exemptions, will be discussed in the context of their application to Internet use in the next section.
IV. Can the Internet Improve Access to the Equity Markets?
Many of the hurdles mentioned above,[45] which prevent small businesses from fully exploiting the equity markets, have been recognized for decades.[46] Technological innovations that have occurred in the meantime, such as the proliferation of computers, have not yet provided a solution. Are there any reasons to believe that the great innovation of the past decade, the Internet, will be any different? Or can the Internet be harnessed to solve some of these long-standing problems?
What is the unique promise offered by the Internet, if any? Given the needs of small businesses, the mechanics of IPOs and private placements, and the attributes of the equity markets, is the Internet a tool which can specifically address and facilitate small business access to equity financing? If so, are there are any lurking problems which threaten to minimize the advantage delivered by using the Internet?
It is clear that the Internet has made an auspicious debut in the universe of investing. On-line trading of stocks has become quite commonplace, with various firms offering Internet trading services.[47] The number of on-line accounts continues to grow, and it is estimated that over nine million such accounts will exist by the year 2001.[48] As the Internet continues to penetrate into more homes, and as those most comfortable with computers and the idea of investing in cyberspace age and begin to accumulate wealth to invest, it seems that the Internet will find expanded use in the investment realm.
Even if the Internet has gained some acceptance as a tool in personal investing, what assistance might it be able to offer a business wanting to access the equity markets? Are there any particular advantages that an Internet-based IPO or private placement might hold over a traditionally executed offering? It seems that the Internet does have certain characteristics which make it uniquely suited to helping a small issuer carry out an offering. These characteristics hold out the promise of revolutionizing certain parts of the offering process and thereby mitigating some of the problems that have prevented small businesses from raising equity capital. Along with this promise, however, are some obstacles.
A. Disintermediation
Perhaps the most revolutionary change the Internet may offer is the elimination of underwriters and other traditional intermediaries normally associated with a stock offering. The idea behind "disintermediation" is that by helping the issuer reach potential buyers, technology such as the Internet could take the place traditionally filled by underwriters.[49] An advantage of this "direct" public offering ("DPO") would be significant cost reduction for the issuer. Part of the savings would be in avoiding the underwriters' commission, which can be as much as ten percent of the offering price.[50] Additionally, since there is evidence that IPOs conducted by underwriters are systematically underpriced,[51] the price of capital might be further reduced by avoiding this underpricing phenomenon.
On the other hand, there is considerable skepticism among commentators over the idea that the Internet will completely replace traditional intermediaries.[52] Underwriters perform many functions in an offering beyond merely giving the issuer access to potential purchasers. Most of these functions, it appears, cannot be readily duplicated merely by shifting the offering to the Internet. One such function is in the lending of the underwriter’s reputation to the offering. The reputation of the underwriter is important in generating investor interest and confidence in the offering.[53] Similarly, the underwriter will have a client base upon which it can draw in placing the stock. The underwriter will also assist in sustaining interest in the stock by issuing reports to securities analysts and making presentations to investor groups.[54] Working from its experience and expertise, the underwriter may also be able to provide the issuer with valuable research and analysis during the planning stages of the offering.[55] Finally, there is the saying that "securities aren’t bought, they’re sold." In this regard, the underwriter makes selling efforts that many convince may investors to buy the stock and thus help guarantee the success of the offering.
It is clear that the Internet cannot, in and of itself, address all of these concerns; the Internet is merely a tool available for shaping and implementation by outside agents. Thus, an issuer who chooses to undertake a DPO is not going to get any "reputational claim" regarding the quality of the offering by way of the Internet as it would by using a well-known investment bank. Accordingly, what is developing, and what is likely to be the most effective use of the Internet in this regard, is an amalgam of the traditional underwriter and the Internet-based IPO.
One such approach is that of Wit Capital, an on-line investment banking and brokerage firm which bills itself as "a pioneer in the offering and trading of securities through the Internet."[56] Wit Capital does not seek to dispose of outside underwriters; rather, the company’s claim is that it offers issuers and its members a chance to connect in IPOs lead managed by major investment banks. By avoiding the process whereby underwriters traditionally sell newly-offered shares to preferred customers such as institutional investors and certain wealthy individuals who often seek to profit by "flipping" these shares to smaller investors, Wit Capital claims it "eliminate[s] layers of intermediaries and reduce[s] transaction costs."[57] The result, claims the company, is cost savings to issuers and unprecedented access for individual investors to shares at the offering price.[58] Wit Capital offers similar services for private placements, promising a unique ability to match issuers interested in such placements with its member base of accredited investors.[59]
While Wit Capital’s approach is novel, it certainly does not represent complete disintermediation. Even apart from the fact that the issuer retains a lead underwriter, Wit Capital itself functions as an intermediary, albeit one which is nontraditional. Nonetheless, the approach does streamline the offering process by exploiting the ability of the Internet to provide low-cost, widespread distribution of information. This is disintermediation to a limited extent, eliminating some, but not all, of the offering intermediaries.
Another approach to blending the traditional underwriter with the Internet-based IPO is being investigated by some major investment banks. These institutions are seeking to marry their reputation and expertise with the advantages of Internet communication and distribution by acquiring on-line brokerages.[60] Such combinations would allow these underwriters to bridge the gap between their traditionally executed offerings and Internet-based IPOs. This approach may produce some gains in efficiency; however, like the Wit Capital approach, it does not represent the achievement of disintermediation.
Implicit in these "hybrid" approaches to Internet-based offerings is perhaps a recognition of the value of intermediaries. It seems that underwriters perform services sufficiently important to a successful offering to ensure that true DPO’s remain at the fringe of capital formation strategies. Nonetheless, the Internet’s ability to reduce some of the intermediary involvement, such as in WitCapital’s approach, could still work to reduce costs and bring stock offerings within the reach of a wider range of companies.
B. Access to Prospective Investors
Given the sheer volume of individuals with access to the Internet, an offering conducted on-line has the potential to reach many millions of investors. It is this potential that is perhaps the most often mentioned feature of the Internet and which is at the root of the disintermediation hope. But while there are millions of individuals "surfing the ‘net," does that fact necessarily mean that small issuers can achieve meaningful access to those individuals? Isn’t it more likely that the issuer’s information will merely be lost in the proliferation of information on the Internet? Even if such access can be achieved, are those individuals really the kind of investors to which an issuer wants to market its offering?
For a small business looking to carry out an Internet-based IPO, making sure enough investors become aware of the offering is of primary concern. How can such an issuer guarantee that anyone apart from its customers and employees will notice? Simply posting information on-line and hoping a sufficient number of investors stumble upon it does not seem a very sure strategy. One solution may be to conduct the offering through an on-line service formed specifically to advertise and promote such small offerings. Such a service might provide a locus listing a sufficient number of small issuers to achieve the critical mass necessary for investors to take notice. While a lone issuer posting his information on-line might very well pass unnoticed, a group of such issuers listed at a single location may be able to generate enough commotion to draw the attention of investors from beyond the company’s normal sphere of recognition.
One company exploiting this concept is Direct Stock Market. This company seeks to provide an "Internet marketplace for public offerings and private placements."[61] During 1997, it listed twenty-three public offerings and five private placements and has a goal of listing 150 such offerings in 1998.[62] On the company’s web site, an investor can access a list of current offerings and download the accompanying offering documents. The issuers listing on the site are diverse, ranging from high technology to restaurant to film companies.[63] The hope, of course, is that a sufficient number of small issuers located in one place will draw attention where alone they all might just slip through the cracks. Although Direct Stock Market is new and it is too early to tell how successful its plans will be, its concept appears to be one way for small issuers to make their direct offerings known to the investing public.
A slightly different approach is taken by Angel Capital Electronic Network, or ACE-Net, which was started by the U.S. Small Business Administration.[64] ACE-Net aims to pique the interest of Angel investors[65] through an on-line listing of small corporate securities. Companies looking to raise anywhere from $250,000 to $5 million can post their securities on ACE-Net. Since the concept was approved by the SEC in October 1996[66] it has been gaining momentum; currently, eleven states have decided to set up ACE-Net nodes, or local gateways.[67] The more interest ACE-Net can generate, the greater the chance that it will be a forum in which small issuers can feel confident that a sufficient number of investors will notice their offering.
Another line of thought might assert that for many small businesses, reaching a large number of investors beyond customers and employees is not a major concern. Small businesses making products that appeal to people’s interests and passions may have, among their customers and customers of similar products, a prime base for potential investors. Such investors, people who are apt to invest their money in things they like or enjoy, are known as "affinity" investors.[68] Golf equipment companies and wineries are representative examples of companies that might attract large numbers of affinity investors. Customers of these companies, in addition to being disproportionately wealthy, are often single-minded in their devotion to certain products. They do not need to be convinced that the company is "on to something." If such a company purchased a banner on a general industry web site[69] with a hyperlink to its home page, it would likely generate significant traffic to its site. Additionally, since most small businesses will be seeking to raise a fairly limited amount of capital, generating tens of thousands of investors will not be necessary.[70] Thus, although not true for all companies, many small businesses will find that their customer base provides sufficient investors to support a stock offering and therefore raising the interest of the general investing public is not a primary concern.[71]
So while there are certainly questions about whether investors may actually notice an Internet offering by a small issuer, there seem to be a few strategic responses which may mitigate the problem. On the other hand, assuming the issuer is able to reach a large audience, what is that audience going to look like? Does the composition of this audience make the success of on-line offerings more or less likely?
Given the widespread use of the Internet by all facets of the public, it seems likely that the average Internet investor will be relatively unsophisticated. Also, younger investors are more likely to use the Internet as an investment tool than are older investors.[72] Thus, the typical investor reached by an Internet-based offering will have limited investment experience and modest financial resources.[73] Initially, reaching mostly investors of limited means certainly appears to be a drawback of using the Internet as an offering vehicle. From another viewpoint, however, this observation could be viewed as a gateway to a segment of the investing public that may not be reached by traditional means.[74] Moreover, the fact that the stock offered by small issuers is likely to have a fairly low price is another reason that this segment may invest more vigorously than otherwise expected.[75]
While the largest number of investors prowling the Internet may be of the order just discussed, there are also sophisticated investors searching the Internet for investment opportunities.[76] One group of such investors is comprised of professional buyers, often drawing upon expertise in a single industry, who spend their time looking for good, small companies to buy into early and then ride to success.[77] Another group is made up of investors trying to buy shares of small companies with potential for growth in the hope that the company will go public in the near future, allowing them to cash-in for big gains at that time.[78] These are investors at which an Internet-based private placement could feasibly be targeted. Since these kinds of investors are already combing the Internet in search of such opportunities, a small issuer should not have to work too hard to make its offering sufficiently visible for such investors to take notice.
Finally, there is reason to think that using the Internet as an offering vehicle may be of particular advantage to high technology companies. Technology-savvy investors are likely to be active in using the Internet to accomplish their goals, one of which may be investing. It also stands to reason that technology-savvy investors will be drawn in some measure to high technology companies.[79] Investors drawn to such companies may be more likely than ordinary investors to view the use of the Internet for financing as an indication of the company’s progressive thinking and evidence of smart, aggressive planning.[80] Thus, this category of investor offers the small high technology company a natural investor base at which it can target an on-line direct offering. Unfortunately, however, the converse of this observation means that certain investors may be naturally averse to an on-line offering, either reacting negatively out of a technology-phobia or else simply viewing use of the Internet as a gimmick.[81]
In sum, although the Internet gives small businesses unmatched ability to get inexpensive access to a large number of potential investors, there is concern that this access to everyone may amount to access to no one because no one will notice the company’s offering materials among the ocean of web pages. However, the above discussion indicates that there may be some ways for the careful issuer to overcome this worry and make meaningful contact with potential investors.
C. Testing the Waters
Since many small businesses will likely take advantage of the Regulation A exemption if they decide to issue equity, the ability to "test the waters" effectively before undertaking the offering is of concern.[82] In essence, the provision for testing the waters helps a potential Regulation A issuer to gauge likely response to the offering by allowing a mass solicitation of investors announcing consideration of an offering and inviting inquiries.[83] The ability to plumb investor reaction before committing scarce resources to an offering is especially valuable to a small, first-time issuer.
The question, of course, is whether the Internet can offer a potential issuer any substantial advantages in the process of testing the waters.[84] One commentator has stated that through using the Internet, testing the waters "becomes much simpler and more effective."[85] It seems that the process would indeed be made simpler by using the Internet: preparing a web page or mass e-mailing is obviously simpler and cheaper than preparing, printing and mailing a traditional mass mailing.
On the other hand, it is not immediately apparent that testing the waters via the Internet would necessarily be more effective. While the claim of effectiveness is probably rooted in the ability of the Internet to reach a wide audience,[86] the benefit of this ability is tempered by the fact that such wide access does not guarantee that anyone will actually take notice.[87] Where this might actually be attractive, however, is in the case of an issuer contemplating an Internet-based direct offering. In such a case, testing the waters on-line may give the issuer an indication of whether anyone will notice the on-line offering. Spending a modest amount to find out that an insufficient number of investors became aware of the on-line testing the waters materials is certainly preferable to reaching the same realization as to actual offering materials.[88] In this way, testing the waters is a kind of "testing the medium" or "testing the offering vehicle." That is, it functions as much to test the feasibility of using the Internet for an offering as it does to test investor enthusiasm for the offering. In this regard, using the Internet to test the waters reduces uncertainty and may make an Internet-based direct offering more viable.
D. Virtual Road Shows
Traditional road shows involve a series of meetings designed to introduce the issuer’s management to selected investors and at which the management makes oral presentations about the issuer and its business. These meetings are usually hosted by the lead underwriter and are designed to enhance the marketing of the offering and build long-term interest in the issuer among institutional investors, portfolio managers, and analysts. Depending upon the size of the issuer, its industry, and targeted investors, the road show may be regional, national, or international, and may last from a few days to many weeks.[89]
Can the Internet revolutionize road shows? With regard to both on-line as well as traditionally executed offerings, the Internet may be able to provide some advantages over the standard road show. There are some reservations, however, and for many issuers the traditional road show will remain the best choice.
The current paradigm for using the Internet to carry out road shows is the effort of Net Roadshow, Inc.[90] Net Roadshow’s web site provides an index of road shows available for viewing by qualified investors (those typically invited to ordinary road shows) and underwriting investment banks.[91] Those wishing to view one of the road shows are required to obtain a password, thus allowing Net Roadshow to control access to the materials.[92] The road show that is available to view is the same show that is seen live -- the shows are filmed in their entirety, including questions and answers, and transmitted on a web site via streaming video and audio.[93] Last November, Net Roadshow’s first virtual road show garnered approximately 200 viewers for a $55 million registered offering underwritten by BT Alex Brown.[94]
The clear advantage that Net Roadshow’s system offers an issuer is a substantial savings of time and money. Since the show is filmed, it can be performed live just once and still be available to more viewers than if it was performed many times in many different cities. Even if the issuer decides to perform the road show more than once, perhaps to present it live in a few major cities, having the virtual version available still means access to more viewers than otherwise possible. The savings involved in limiting the number of live performances could be substantial. In addition to saving on travel costs, other costs, such as those associated with pulling key management away from their normal duties for the extended periods needed to put on a traditional road show, can be avoided as well. These savings, particularly allowing management to stay in place and remain focused, offer an advantage especially salient to small businesses.[95]
On the other side of the scale, some aspects of a virtual road show may weigh against its use. First, in addition to showcasing a company’s potential, one of the purposes of a road show is to highlight the "executive capacity" of the management team.[96] Will a filmed road show allow the viewers to sufficiently interact with and thereby assess the abilities of the issuer’s management? If the virtual version of a road show leaves viewers feeling they have only part of the information they need to accurately appraise the offering, it certainly is not a viable option.
One way to mitigate this drawback may be to make the virtual road show as interactive as possible. Rather than a pre-recorded performance, a live performance could be transmitted in which the viewer could participate to some extent, perhaps by asking questions via e-mail or a chat room-type feature. These questions could be read aloud at the performance and subsequently answered by management. Such an interactive virtual road show might allow "viewers" to become "participants" and thereby better acquire the information they need.
Another drawback to virtual road shows is potential liability for statements made in the course of the performance. Some fear that unlike the oral communications made at a traditional road show, a statement made in a road show transmitted over the Internet might, like written communications and radio or television broadcasts, be deemed a "prospectus" under section 2(10) of the Securities Act. While the SEC has intimated that it does not consider a road show transmitted over the Internet to be a prospectus,[97] many issuers and underwriters still feel there are risks involved in using virtual road shows.[98]
In the eyes of many small businesses, this discussion may appear irrelevant - small or exempt offerings rarely include road shows. Given the costs involved, including a road show as part of a $2 million offering simply does not make sense. Internet technology may nonetheless hold some promise for assisting small issuers in this regard. If costs are brought down sufficiently, a road show may begin to make sense for smaller offerings. Additionally, although short of an actual road show, issuers under Regulation A may be able to include multimedia presentations with Internet-based offering circulars.
In sum, virtual road shows offer the possibility of streamlining the road show process for some issuers. Efforts at road shows over the Internet are still largely investigative; what is revealed through the efforts of Net Roadshow should tell us more clearly whether virtual road shows will become a fixture in securities offerings or fade from existence. Although they promise significant cost savings, whether virtual road shows can equal their traditional counterparts in generating investor interest in an offering remains to be seen.
E. Secondary Markets
A traditional drawback to small company offerings is low liquidity in the issued stock. Even if an offering can be successfully completed, small company offerings usually suffer a discount to compensate for the reluctance of most investors to risk their money in a stock for which a secondary market is uncertain. Investors want to be sure they can resell the stock for liquidity and fear they will be forced to do so at a large discount if there is not a ready secondary market. In a standard offering, the underwriter may function as a market maker for the stock, facilitating secondary trading. This can be especially valuable in a small offering of a stock which does not qualify for listing on a traditional exchange such as the NYSE or NASDAQ. However, since one of the possible advantages of an on-line direct offering is the elimination of intermediaries,[99] thereby removing the underwriter as market maker, whether the Internet can also offer a solution for the lack of liquidity that would follow is important.
Various efforts have been devised to bring the advantages of the Internet to bear on the secondary markets. At one end of the spectrum are Internet-based "alternative trading systems"[100] that are roughly analogous to traditional exchanges in that they serve as a trading forum for various stocks. These systems implement proprietary matching or auction programs to connect buyers and sellers. For instance, in matching systems like Instinet participants enter firm, priced orders which the system executes automatically if there is another matching order in the system.[101] Crossing systems, by contrast, execute unpriced orders at a price typically acquired from a primary public market.[102] Finally, participants in single-price auction systems such as the Arizona Stock Exchange enter priced orders from which the system determines "the single price at which the largest volume of orders can be executed."[103] These alternative trading systems are closely related to traditional exchanges, aspiring to handle trades in various securities and improve on the efficiency of such exchanges.[104]
At the other end of the sophistication spectrum are alternative trading systems that consist merely of Internet bulletin boards maintained by the issuer of a stock upon which investors can post indications of interest to buy or sell stock of the issuer at a given price. Ideally, these bulletin board systems[105] provide "an inexpensive mechanism for shareholders [of a small issuer] to adjust their holdings."[106] These systems generally are not involved in facilitating the settlement of the trade; rather, the posted offers to buy or sell the issuer’s security would contain sufficient information for the participants to contact each other and effect the trade themselves.[107]
The more ambitious alternative trading systems that mirror traditional exchanges, such as the Arizona Stock Exchange, are still developing and at this time do not have the volume to make them a viable solution for liquidity.[108] Given their meager volume, it seems unlikely that sufficient traders are using the system to generate interest in, and provide a liquid market for, an obscure issuer’s securities. But since some of these systems are growing rapidly,[109] they may yet come to play a role in providing liquidity.
For the small business looking to make an offering, the simple, inexpensive bulletin board system is probably of at least some help in providing shareholder liquidity. As for regulatory worries, the SEC has provided assurances to various issuers that it will not take enforcement action if they operate such bulletin board trading systems without registration as a broker-dealer or as a national exchange.[110] Further, given that many of the investors in a small, relatively unknown issuer will likely be drawn to that company because of affinity, interest in a proprietary product, or as a customer, it makes sense that such investors would be amenable to a system which draws them together. They may have some sense that other like-minded investors, who appreciate the uniqueness or appeal of the company, will be there as potential buyers should they need to sell for liquidity.
Apart from these trading systems, the Internet may assist in developing liquidity for small issuer stocks through increasing the securities markets’ informational efficiency. As the Internet is used increasingly for collection and dissemination of information about securities, investor access to information and analysis about an increasing number of companies should be possible.[111] As investors become informed as to a wider range of issuers, small issuers should be drawn into the circle of companies about which investors have sufficient information to make informed investment choices. This is a product of the idea that "in an electronic environment, more informed investors can act with respect to a greater range of stocks."[112] The noteworthy result for our purposes is that since investors with access to useful information will be more willing to risk their money on small issuer stocks, the liquidity obstacle for small company stocks should be mitigated.
This section began with the question of whether the Internet could improve small business access to the equity markets. In one respect, the answer certainly seems to be yes. As discussed, the Internet offers a less expensive medium for accomplishing many of the tasks associated with a stock offering, such as printing and mail. However, most of these cost advantages are incremental; it seems unlikely that the ability to save on printing and mailing will open up equity financing to a whole new class of issuer. Disintermediation and other principal cost saving measures that are key to any hope of revolutionizing equity offerings are, at this time, beset by problems. In certain places, it seems likely that effective solutions may lie within the scope of the Internet as a medium and will be devised over time. The answers to other issues, such as developing the ability to duplicate the reputational function of underwriters, seem to lie beyond mere exploitation of the Internet’s potential.
It is not clear whether enough of these problems can be overcome to allow the Internet to have a significant impact on small business capital formation. There does not seem to be a clear consensus among issuers, investors, and commentators about whether the Internet will end up a serious force or a minor ripple in the way issuers offer securities.[113] In sum, while the Internet provides some advantages that improve the ability of small businesses to access equity markets, it seems unlikely that these improvements will instigate a sweeping revolution of the way small businesses raise capital in the near future.
V. The Internet and SEC Regulation
Because regulatory action by the SEC has the potential to stifle the development of the Internet as a capital-raising tool, it is worthwhile to look at the SEC’s treatment of Internet issues thus far and examine the philosophy underlying its pronouncements. Rather than survey and summarize the various SEC No-Action Letters and Interpretive Releases on point, this section seeks to uncover and discuss the underlying goals and concerns of the SEC as evidenced by the content of SEC actions and statements
Harkening back to the first section of this article, the SEC is aware that small businesses face hurdles in securing sufficient financing and that it plays a role in either solving or entrenching this problem. The SEC "has long recognized that a critical aspect in the continued viability of small businesses is access to capital above and beyond that which can be provided by banks."[114] The Commission further acknowledges that it has a part to play in guaranteeing that small businesses can gain such access, aware that if its regulations make raising capital in the domestic markets too difficult, small companies will try to find financing in foreign markets.[115] Rather than force small companies to look abroad for financing, the SEC wants to "ensure the continued pre-eminence of [domestic] securities markets."[116] In the past, the Commission has taken measures designed to relieve some of the regulatory compliance burden on small companies.[117] This desire to keep regulation friendly to the needs of small businesses coupled with a realization that the Internet may be a useful tool in small business capital-raising will likely steer the SEC toward measures designed to preserve and promote innovation in on-line offerings.
To this point in time, the Commission has indeed shown a willingness to be flexible in order to advance the use of the Internet in financing applications. For example, when considering guidelines for Internet-based offshore offerings, the SEC declined to adopt a blanket rule requiring registration for any Internet offering that U.S. residents could access.[118] It noted that "the adoption of such an approach by securities regulators could preclude some of the most promising Internet applications by investors, issuers, and financial service providers."[119] Likewise, the SEC has consciously avoided treating alternative trading systems[120] as exchanges and forcing them to register as such for fear that doing so would stifle their development.[121] It is this philosophy which indicates that the Commission will continue to regulate with an eye toward preserving enough "space" around the Internet to allow development of its potential.
The Commission’s proclamations are uniformly couched in language indicating that it wants to be viewed as a friend of new technology. In response to the first foray into Internet offerings, the SEC stated that it wanted "to encourage . . . modernization" and recognized that "innovation and creativity are the hallmark of our nation’s securities markets."[122] The Commission has also asserted that it is "mindful of the benefits of increasing use of new technologies for investors and the markets" and wants to encourage "experimentation and innovation by adopting flexible interpretations of the federal securities laws."[123]
While clearly supporting the exploitation of the Internet for securities purposes, the SEC is also cognizant of the fact that some of the same features that make the Internet a valuable tool also make it an effective weapon with which to perpetrate securities fraud.[124] Awareness of these problems may temper the enthusiasm of the SEC’s apparent support for unbridled cyber-exploration.
For instance, while the ability of the Internet to disseminate information to millions of people very quickly makes it useful in increasing the information available to investors, this same trait makes the Internet a potent means of manipulating the market. Investors ranging from individuals in their homes to multi-billion dollar mutual fund managers are studying the investment information posted on Internet bulletin boards and discussed in newsgroups.[125] The effect is that information posted on the Internet "can, within minutes of posting, influence the price of a stock or group of related stocks."[126] While this has the benefit of enabling the market to react quickly and efficiently with respect to information, such an ability can also be exploited by the unscrupulous to manipulate stock prices to their advantage. This danger of manipulation is especially pernicious since the technology can be used to give the author of such messages a false identity and the pretense of being an insider -- it is even possible to use the e-mail identity of a real person for the purposes of impersonation.[127] Another example grows out of the ability of almost anyone to cheaply and easily create an impressive Web page. While this enables even the smallest issuer to generate an outstanding site to generate interest in its securities, it also allows scam artists to easily achieve the impression of legitimacy by creating slick Web pages.
The SEC is aware of these problems and is thus far pleased with the results of enforcement efforts.[128] However, should such problems prove intractable, they may well chill the Commission’s current enthusiasm toward the Internet. Whereas developments in shaping the Internet for useful applications in securities offerings and trading have progressed unchecked and with the SEC’s blessing, if the Commission determines that close regulation of Internet offerings is needed, it would surely delay or prevent full utilization of this medium’s potential.
VI. Conclusion
The Internet is a potent new technology whose full promise, it seems fair to say, has not yet been explored. While other landmark technologies, such as the telegraph, telephone, and even the computer, have not significantly altered the methods by which companies raise capital, the Internet may. The Internet combines the communications abilities heralded by the telegraph with the computer’s ability to speedily process vast quantities of information. More importantly, it does these things in an engaging, user-friendly medium. Furthermore, the Internet is a very flexible, fluid technology; its protean nature makes it the most promising technological development yet for capital-raising applications. The speed at which the Internet continues to expand and be harnessed for new uses suggests that there remain undiscovered ways to apply it to securities offerings.
Such is conjecture. In its current form, the Internet does not represent a coming revolution in securities offerings. It does not portend a mighty wave of direct stock offerings, it should not send underwriters scrambling for alternative work. Nonetheless, there are ways in which the Internet streamlines portions of the offering process. Whether by partial disintermediation, virtual road shows, or enhanced liquidity through alternative trading systems, the Internet may reduce the cost of capital for small issuers. Though such cost reductions appear incremental rather than extensive at this point, even gradual reductions are encouraging and may bring the cost of a securities offering within the reach of many small companies. When this point is reached, it will signify a great step forward in the ability of small businesses to access the equity markets and thereby secure the financing they need to prosper.

Footnotes

[1] Throughout this article, a "small business" is defined as a business that has less than 500 employees. This definition is most widely used in the relevant literature. Unless otherwise noted, statistical information to which this article cites is based upon such a definition.

[2] See Small Business’ Access to Capital: Impediments and Options: Hearing Before the House Comm. on Small Bus., 104th Cong. 38 (1996) [hereinafter Hearing] (statement of Representative Jan Meyers).

[3] See id.

[4] JEFFREY L. SEGLIN, FINANCING YOUR SMALL BUSINESS 41 (1990).

[5] See Hearing, supra note 2, at 43 (testimony of William J. Dennis, Jr., Senior Research Fellow, National Federation of Independent Business).

[6] ARTHUR ANDERSEN ENTERPRISE GROUP, SURVEY OF SMALL AND MID-SIZED BUSINESSES - TRENDS FOR 1995 18 (1995), reprinted in Hearing, supra note 2, at 107.

[7] See Hearing, supra note 2, at 63 (testimony of The Small Business Legislative Council).

[8] See GEORGE W. FENN ET AL., THE ECONOMICS OF THE PRIVATE EQUITY MARKET 2 (Staff Study of the Board of Governors of the Federal Reserve System, November 1995).

[9] See ARTHUR ANDERSEN ENTERPRISE GROUP, supra note 6, at 106.

[10] See, e.g., Hearing, supra note 2, at 42 (testimony of William J. Dennis, Jr.).

[11] Indeed, it seems that some of the same problems have been discussed before Congress for the past forty years. Compare Hearings, supra note 2, at 38-82 with A.D.H. KAPLAN & PAUL H. BANNER, ADEQUACY OF SMALL-BUSINESS FINANCING: ONE VIEW, REPRINTED IN REPORT TO THE COMMS. ON BANKING AND CURRENCY AND THE SELECT COMMS. ON SMALL BUS. 85th Cong., 2d Sess. 108-10 (Apr. 11, 1958).

[12] See Hearing, supra note 2, at 43 (testimony of William J. Dennis, Jr.).

[13] See DELOITTE & TOUCHE, STRATEGIES FOR GOING PUBLIC 5 (1992).

[14] That is, they will be worried that if they decide to sell, and there is not an active market for the stock, selling will not be possible without doing so at a significant discount.

[15] See DELOITTE & TOUCHE, supra note 13, at 42. Although venture capital firms may be willing to take deals starting around $1 million, venture capital is simply not a viable option for many companies. This is because venture capital firms tend to focus only on certain sectors such as communications, electronics, medical products, and high-technology where they see high-growth and cashing-out within seven to ten years. See SEGLIN, supra note 4, at 75-76. The selectivity of venture capital firms results in only one to two percent of companies applying for venture capital assistance being approved. See id. at 75.

[16] See JOE PEEK & ERIC S. ROSENGREN, BANKS AND THE AVAILABILITY OF SMALL BUSINESS LOANS 2-3 (Federal Reserve Bank of Boston Working Paper No. 95-1, 1995). This study also noted evidence indicating that "the reductions in lending may have seriously harmed businesses" in the subject region. See id. at 28.

[17] One study has found that such a relationship may increase the availability of credit and may result in the lender being less likely to require full collateralization. See id. at 4.

[18] See JOE PEEK & ERIC S. ROSENGREN, SMALL BUSINESS CREDIT AVAILABILITY: HOW IMPORTANT IS THE SIZE OF A LENDER? 16 (Federal Reserve Bank of Boston Working Paper No. 95-5, 1995).

[19] See H. Onno Ruding, The Positive Side of Bank Mergers, Address Before the University of Rochester Simon School of Business (Mar. 11, 1997).

[20] See PEEK & ROSENGREN, supra note 18, at 22. The authors of that study concluded that "as small banks with a small business loan emphasis are absorbed into larger, more diversified lenders, which tend to focus much less on small business lending, credit availability to bank-dependent small business borrowers should be a major public-policy concern." Id. at i.

[21] Although this solution may offer some hope for the future, there is not much current lending to small businesses by non-bank sources. A recent study of New England businesses found that less than thirteen percent of the smallest firms (those with annual sales between ten and forty-nine million dollars) get any of their credit from non-bank sources. Peek & Rosengren, supra note 16, at 28-29.

[22] See, e.g., DELOITTE & TOUCHE, supra note 13, at 12; ROBERT R. OWEN ET AL., ARTHUR YOUNG GUIDE TO FINANCING FOR GROWTH 9 (1986).

[23] There are, of course, some advantages of debt over equity. First, the interest on debt is deductible for tax purposes. Second, since debt only gives the holder a fixed claim, if the company becomes extremely successful the owner is able to keep the entire upside in excess of the agreed upon fixed repayment amount. Third, the owner of the company does not see his interest in the company diluted. See generally OWEN, supra note 22, at 90.

[24] See PHILIP W. TAGGART & ROY ALEXANDER, TAKING YOUR COMPANY PUBLIC -- RED LIGHTS & GREEN LIGHTS FOR A GO/NO-GO DECISION 5 (1991).

[25] See Jonathan A. Koff & Michael C. Lee, The Initial Public Offering Process, in 1 UNDERSTANDING THE SECURITIES LAWS 113, 113 (PLI Corporate Law and Practice Course Handbook Series, 1997).

[26] See DELOITTE & TOUCHE, supra note 13, at 18. High growth companies may have somewhat lower requirements. See id.

[27] The editor of a magazine devoted to touting technology companies stated that "[i]nvestors are still troubled by the excesses of 1996, when too many overvalued Internet companies went public with too little justification." Jason Pontin, Whatever Happened to the Technology IPO?, THE RED HERRING, Apr. 1998, at 152.

[28] See DELOITTE & TOUCHE, supra note 13, at 13.

[29] See OWEN, supra note 22, at 14.

[30] See DELOITTE & TOUCHE, supra note 13, at 13.

[31] See Jeffrey A. Timmons & Dale A. Sander, Everything You (Don’t) Want to Know About Raising Capital, reprinted in FINANCE FOR CORPORATE GROWTH 91, 91 (Harvard Business Review Paperback ed. 1991).

[32] See KOFF & LEE, supra note 25, at 3-4.

[33] See WILLIAM A. KLEIN & JOHN C. COFFEE, JR., BUSINESS ORGANIZATION AND FINANCE -- LEGAL AND ECONOMIC PRINCIPLES 206 (6th ed. 1996).

[34] But see TAGGART & ALEXANDER, supra note 24, at 17 (downplaying this possibility on the ground that public stockholders are usually passive with regard to company affairs). Further, shares can be issued with limited voting rights to ensure the present owners retain control; however, such shares would likely be discounted in the market to reflect such a limitation.

[35] Securities Act of 1933, 15 U.S.C. § 77a et seq. (1994).

[36] During the several months that are necessary to complete an IPO market conditions can change appreciably, leaving the issuer with a market less receptive to the offering than the market that was assessed when the decision to go public was made.

[37] An issuer should be aware that although exempt from SEC registration, registration under state blue sky laws may still be required. See Regulation D, Preliminary Note 2. Likewise, the anti-fraud provisions of the securities laws still apply, obliging the issuer to provide investors with enough complete and accurate information about the company to make a well-informed investment decision. See Regulation D, Preliminary Note 1.

[38] Securities Act §3(b). The exemption under Regulation A as well as those under Rules 504 and 505 of Regulation D are based on this rationale. Securities Act rules 251, 504, 505, 17 C.F.R. §§ 230.251, 230.504, 230.505.

[39] Securities Act § 4(2). The exemption under Rule 506 of Regulation D is such an exempt transaction. Securities Act rule 506, 17 C.F.R. § 230.506.

[40] Rule 504 under Regulation D allows the issuer to sell up to one million dollars in securities in 12 months, Securities Act rule 504, 17 C.F.R. § 230.504(b)(2), while Rule 505 and Regulation A both have a limit of five million dollars, Securities Act rules 251, 505, 17 C.F.R. §§ 230.251(b), 230.505(b)(2)(i).

[41] Rule 505 under Regulation D allows sales to an unlimited number of "accredited investors" with an allowance for sales to a maximum of 35 nonaccredited investors. Securities Act rules 501, 505, 17 C.F.R. §§ 230.501(e)(1)(iv), 203.505(b)(2)(ii); see also Securities Act rule 501, 17 C.F.R. § 230.501(a) (defining "accredited investor"). Likewise, Rule 506 restricts sales to accredited purchasers, but with an allowance only for sales to 35 "sophisticated" purchasers. Securities Act rule 506, 17 C.F.R. § 230.506(b)(2).

[42] Securities Act rules 502, 505, 506, 17 C.F.R. §§ 230.502(c), 230.505(b)(1), 230.506(b)(1).

[43] Securities Act rules 502, 505, 506, 17 C.F.R. §§ 230.502(d), 230.505(b)(1), 230.506(b)(1).

[44] Securities Act rule 254, 17 C.F.R. § 230.254.

[45] See supra Part II.

[46] See generally Robert A. Weaver, Jr., Equity Financing for the Small Firm, 34 HARV. BUS. REV. 91, 92 (1956) (discussing reasons why small businessmen have avoided public equity financing).

[47] Here I am referring to trades entered on-line by investors but which are still executed by brokers on traditional exchanges such as the NYSE.

[48] See Christina K. McGlosson, Who Needs Wall Street? The Dilemma of Regulating Securities Trading in Cyberspace, 5 COMMLAW CONSPECTUS 305, 312 (1997).

[49] See generally Donald C. Langevoort, Information Technology and the Structure of Securities Regulation, 98 Harv. L. Rev. 747, 755-78 (1985).

[50] See Owen, supra note 22, at 15.

[51] See Paul G. Mahoney, Technology, Property Rights in Information, and Securities Regulation, 75 WASH. U. L.Q. 815, 823 (1997).

[52] See, e.g., Donald C. Langevoort, Toward More Effective Risk Disclosure for Technology-Enhanced Investing, 75 WASH. U. L.Q. 753, 756-57 (1997); Mahoney, supra note 51, at 823.

[53] See Langevoort, supra note 52, at 756; DELOITTE & TOUCHE, supra note 13, at 35 (stating that investors "will have greater confidence in your stock if a highly regarded investment banking firm is named . . . as the managing underwriter. . . . Reputation also affects the managing underwriter’s ability to organize a strong syndicate of other underwriters to assist in selling and distributing the stock.")

[54] See DELOITTE & TOUCHE, supra note 13, at 36.

[55] See Constance E. Bagley & Robert J. Tomkinson, Internet Is Seeing Its Share of Securities Offerings, NAT’L L.J., Feb. 2, 1998, at C3.

[56] WIT CAPITAL -- COMPANY BACKGROUND (visited Feb. 16, 1998) <http://www.witcapital.com/press/backgrnd.html>.

[57] WIT CAPITAL -- OUR SERVICES -- INITIAL PUBLIC OFFERINGS (visited Feb. 16, 1998) <http://www.witcapital.com/welcome/services.html#digital>. The company has instituted an anti-flipping policy whereby investors who demonstrate a propensity for flipping will lose priority in getting allocations in future offerings. See id.

[58] See id.

[59] See WIT CAPITAL -- OUR SERVICES -- PRIVATE PLACEMENTS (visited Feb. 16, 1998) <http://www.witcapital.com/welcome/services.html#digital>. The company currently boasts a membership that contains over 3000 accredited investors. See WIT CAPITAL -- RAISING CAPITAL (visited Feb. 16, 1998) <http://www.witcapital.com/ibs/capital/raise.html#private>.

[60] See Bagley & Tomkinson, supra note 55. Examples of such combinations include Donaldson, Lufkin & Jenrette’s ownership of DLJ Direct and BancAmerica Robertson Stephens’ alliance with E*Trade. See id. at n.37.

[61] DIRECT STOCK MARKET -- DSM HAS BANNER YEAR IN 1997 (visited Feb. 20, 1998) <http://www.dsm.com/DSMExt/Press>. The company’s mission is "to be the most efficient Internet equity market that connects small cap companies to capital and facilitates investors to trade their stocks." Id. Direct Stock Market lists both underwritten and direct offerings.

[62] See id.

[63] DIRECT STOCK MARKET -- DIRECT STOCK MARKET INC. LISTED COMPANIES (visited Feb. 20, 1998) <http://www.dsm.com/DSMExt/CFront>.

[64] See Jon Bigness, Net to Link Investors and Startups, CHI. TRIB., Mar. 19, 1998, at N3.

[65] Angel investors are discussed supra Part II.C.

[66] Angel Capital Electronic Network, SEC No-Action Letter, [1997 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 77,305 at 77,516 (Oct. 25, 1996).

[67] See Bigness, supra note 64.

[68] See JAMES E. GRAND & GARY LLOYD, INTERNET IPO’S -- A POTENTIAL OASIS FOR SMALL COMPANIES, INTERNET FINANCIAL CONSULTANTS, LTD. (visited Feb. 20, 1998) <http://www.ipoexchange.com/ipo_art.htm>.

[69] Based on the examples given, <pgatour.com> and <winespectator.com> would be representative web sites. A listing on one of these sites could generate significant exposure: in its first three weeks of existence, Wine Spectator On-Line received over two million "hits" from an estimated 135,000 "visits." See Marvin R. Shanken, Two Legends Explore Cyberspace, WINE SPECTATOR, Dec. 15, 1996, at 9.

[70] For example, for a company trying to raise 2 million dollars in its offering, only 4000 investors would be needed if the average purchaser invested 500 dollars.

[71] At this point, however, it is not clear how much work the Internet is really doing. Although perhaps slightly more expensive, it seems similar access to affinity investors could be achieved in more traditional ways. For instance, the issuer could raise awareness by publishing in a print source or even by including information on wine labels, presumably allowed under Rule 135. As usual, the advantage to using the Internet may be cost savings.

[72] See U.S. SECURITIES AND EXCHANGE COMMISSION, REPORT TO THE CONGRESS: THE IMPACT OF RECENT TECHNOLOGICAL ADVANCES ON THE SECURITIES MARKETS, Part IV.C.7 (1997) [hereinafter Report to Congress] (visited Apr. 16, 1998) <http://www.sec.gov/news/studies/techrp97.htm>. This report cited a survey which found that while only 26% of all investors use on-line sources to assist in their investment activities, 45% of young investors (age 18 to 34) do so. While this means the investors currently on-line are likely inexperienced and of modest means, it also bespeaks a bright future for the Internet offerings as these young investors mature and accumulate more wealth for investing.

[73] See Julia B. Strickland & Shanda D. Wedlock, Information Practices: The Nits and Grits Versus the Net: Differing Disclosure Standards for "Retail" Versus "Professional" Investors, in HOW TO PREPARE AN INITIAL PUBLIC OFFERING 940, 948 (PLI Corporate Law and Practice Course Handbook Series, 1997).

[74] Not everyone interested in investing reads the Wall Street Journal or gets analysts’ reports.

[75] That the new issues of small companies are likely to be significantly more risky than those of more mature companies is, however, cause for concern since these investors probably have little investment experience and may lack the sophistication to appreciate this risk.

[76] See Strickland & Wedlock, supra note 73, at 949.

[77] See OWEN, supra note 22, at 53.

[78] See id.

[79] This is similar to the "affinity" investor concept discussed supra Part IV.B..

[80] See Report to Congress, supra note 72, at Part I.C.1.

[81] An example of such an investor would be someone with sentiments parallel to those expressed by Warren Buffet, who has stated that he does not buy stock of Internet companies because he "doesn’t understand them." Moneyline (CNN television broadcast, May 4, 1998).

[82] Testing the waters is authorized by Securities Act Rule 254. 17 C.F.R. §230.254(a).

[83] See id. The provision allows the potential issuer to do this without fear of violating section 5 of the Securities Act.

[84] While Rule 254 only authorized use of a "written document" or "scripted radio or television broadcasts" in testing the waters, the SEC has approved on-line posting of testing the waters materials. See Angel Capital Electronic Network, SEC No-Action Letter, supra note 66.

[85] Langevoort, supra note 52, at 756.

[86] See Richard Raysman & Peter Brown, Securities Offerings Over the Internet, N. Y. L.J., L.J. EXTRA! (visited Apr. 16, 1998) <http://www.ljx.com/practice/securities/0610irsec.html>.

[87] This idea is discussed more fully supra Part IV.B.

[88] The issuer would not know, however, whether the lack of response was due to failure of investors to notice the materials or due to lack of investor enthusiasm in the actual offering. Perhaps a traditional solicitation under Rule 254 could follow the Internet effort to see which was the cause. If the issuer received a lukewarm response to the second solicitation, it could surmise that investors were skeptical as to the value of the offering itself. If, on the other hand, the second solicitation garnered a vigorous response, the issuer would realize that the offering itself was sound and the problem was with investors failing to notice the on-line materials. Presumably, such an investor would then proceed with a traditionally-executed offering.

[89] See generally Stephen J. Schulte, IPO Road Shows Today: A Primer for the Practitioner, in HOW TO PREPARE AN INITIAL PUBLIC OFFERING 491, 491-93 (PLI Corporate Law and Practice Course Handbook Series, 1997).

[90] Net Roadshow Inc. is located on the Internet at <http://www.netroadshow.com>. The SEC has approved Net Roadshow’s transmitting of road shows over the Internet. See Net Roadshow, Inc., SEC No-Action Letter, [1997 Transfer Binder] FED. SEC. L. REP. (CCH) ¶ 77,367, at 77,849 (July 23, 1997).

[91] See id.

[92] Preventing unbridled access to these materials was one of the Commission’s main concerns with virtual road shows. See id.

[93] See id.

[94] See Bagley & Tomkinson, supra note 55.

[95] Presumably, a small company is thinner in its management than is a large company, thus making it more important to prevent their extended distraction.

[96] DELOITTE & TOUCHE, supra note 13, at 75.

[97] See Net Roadshow, Inc., SEC No-Action Letter, supra note 90.

[98] See Bagley & Tomkinson, supra note 55.

[99] For a discussion of disintermediation, see supra Part IV.A.

[100] The SEC uses this term to refer to automated systems that centralize, match, cross, or otherwise execute trading interest, but that are not registered as national securities exchanges or operated by a registered securities association. Regulation of Exchanges, Exchange Act Release No. 38,672, [1997 Transfer Binder] FED. SEC. L. REP. (CCH) ¶ 85,942, at 89,633 n.1 (May 23, 1997).

[101] See Report to the Congress, supra note 72, at Part IV.C.4. n.291.

[102] See id. Because prices in the crossing systems are derived from a primary public market, such systems may not be workable for the smallest issues which are not traded on any other market and therefore do not have an established price.

[103] Id.

[104] The Arizona Stock Exchange is actually an "exchange" as far as the SEC is concerned, and only avoids registration as such pursuant to a limited volume exemption. See id. at Part IV.C.4. n.292.

[105] An Internet-based bulletin board, known as a "BBS" in Web-parlance, operates just like a traditional bulletin board, except the messages are posted in cyberspace rather than on a corkboard.

[106] See Report to the Congress, supra note 72, at Part IV.D.2.e.

[107] See David M. Bartholomew & Dena L. Murphy, The Internet and Securities Regulation: What’s Next? 25 SEC. REG. L.J. 177, 187 (1997) (describing the system proposed by Real Goods Trading Corporation in its request for an SEC No-Action Letter).

[108] See Bagley & Tomkinson, supra note 55.

[109] See id.

[110] See The Flamemaster Corp., SEC No-Action Letter (Oct. 29, 1996), available in WESTLAW, 1996 WL 762990 (S.E.C.) at *5; PerfectData Corp., SEC No-Action Letter (Aug. 5, 1996), available in WESTLAW, 1996 WL 480429 (S.E.C.) at *5; Real Goods Trading Corp., SEC No-Action Letter, [1996-1997 Transfer Binder] FED. SEC. L. REP. (CCH) ¶ 77,226, at 77,134 (June 24, 1996).

[111] See Langevoort, supra note 52, at 758.

[112] Id. at 758 n.12.

[113] Compare Michelle V. Rafter, Online IPOs Falling Short of Expectations, L.A. TIMES, May 26, 1997, at D1 (stating that successful Internet offerings are rare and likely to remain so) with Anne Brockhoff, Clear Off Internet Runway for Wave of IPO Launches, 16 KANSAS CITY BUS. J. 26 (Dec. 15, 1997) (predicting continued growth for Internet offerings).

[114] ALLAN B. AFTERMAN, SEC REGULATION OF PUBLIC COMPANIES 106 (1995).

[115] See id. at 107.

[116] STATEMENT OF CHAIRMAN ARTHUR LEVITT, UNITED STATES SECURITIES AND EXCHANGE COMMISSION OPEN MEETING (May 23, 1997) (transcript available at <http://www.sec.gov/news/speeches/spch161.txt>).

[117] For example, in 1992 the SEC announced a package of initiatives designed to aid small businesses. Small Business Initiatives, Securities Act Release No. 6924, [1991-1992 Transfer Binder] FED. SEC. L. REP. (CCH) ¶ 84,931, at 82,481 (Mar. 11, 1992).

[118] Statement of the Commission Regarding Use of Internet Web Sites To Offer Securities, Solicit Securities Transactions, or Advertise Investment Services Offshore, Securities Act Release No. 7516 (Mar. 23, 1998), available in WESTLAW, 1998 WL 128173 (S.E.C.) at *4.

[119] Id. at *4.

[120] For a discussion of alternative trading systems, see supra Part IV.E.

[121] See Report to the Congress, supra note 72, at Part IV.C.4.

[122] Spring Street Brewing Co., SEC No-Action Letter, [1996-1997 Transfer Binder] FED. SEC. L. REP. (CCH) ¶ 77,201, at 77,001 (Apr. 17, 1996).

[123] Report to the Congress, supra note 72, at Executive Summary.

[124] See generally Joseph F. Cella III & John Reed Stark, SEC Enforcement and the Internet: Meeting the Challenge of the Next Millennium - A Program for the Eagle and the Internet, 52 BUS. LAW. 815 (1997); INTERNATIONAL ORGANISATION OF SECURITIES COMMISSIONS TECHINCAL COMMITTEE, REPORT ON ENFORCEMENT ISSUES RAISED BY THE INCREASING USE OF ELECTRONIC NETWORKS IN THE SECURITIES AND FUTURES FIELD (Press Release Sept. 22, 1997), available at <http://www.iosco.org/docs-public/1997-report_on_enforcement_issues-document01.html>.

[125] See Cella & Stark, supra note 124, at 825.

[126] Id.

[127] See id. at 826.

[128] See generally id.