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Running in Circles

If you're counting on the Internet as a shortcut to the capital markets, better think again.

1Jun

Three years ago, the financial press began to predict the end of Wall Street as we know it. Prompting such predictions was the news that the founder of New York's Spring Street Brewery had taken the company public over the Internet. Here, went the thinking, was a ready means of cutting out investment bankers, or at least those whose underwriting talents weren't worth the typical 7 percent markup on traditional securities offerings.


But if the Internet represents a revolution in corporate finance, Spring Street's initial public offering seems to have been a false start. To be sure, the brewery's founder went on to start Wit Capital Group Inc., an investment bank devoted to raising capital over the Internet. Its services have since been used by some 50 companies for IPOs and secondary offerings. And despite some initial hesitation, federal regulators have adapted the regulatory requirements for sending offering materials to investors electronically.


But most of Wit's underwriting has been for small parts of traditional deals, in which the technology has helped coordinate the distribution of shares among individual investors. "Wit Capital seems to be focusing on distributing slices of Street deals through the Internet to retail investors and third-party brokers, and trying to be a manager of third-party distribution syndicates," says Stephen Pelletier, chairman and CEO of OffRoad Capital Corp., a San Francisco company that provides an Internet service linking individual investors and private companies. (Wit declined an interview for this article, because it was in the process of doing its own IPO.) That's left most companies depending on investment bankers to manage the process, including time-consuming, expensive road shows for institutional investors.



Lack of Capacity

There are signs, to be sure, of more ambitious underwriting over the Net. Last February, the underwriting firm of W.R. Hambrecht, of San Francisco, unveiled OpenIPO, an electronic, auction-based method of conducting IPOs. Investors with accounts at certain brokerages are given the opportunity to place bids for the number of shares wanted, and shares go to the highest bidders, not to preferred investors, as in conventional IPOs. That would clearly benefit issuers, so long as the fees charged on such deals aren't higher than on traditional offerings and brokers' own capital isn't required to help finance the deals. Hambrecht says it will charge only 3 to 5 percent.


Some visionaries see this as the true beginning of a new era in the capital markets. "As the Internet becomes more of a brutally efficient marketplace, it will switch the power from the sell side to the buy side," says Bob Gold, president of Transaction Information Systems Inc., a consulting firm based in New York. "The CFO could put out an offering with one Internet ad saying, 'Here is what I'm trying to accomplish. How many bidders do I have?'"


In Hambrecht's first deal in April, however, Ravenswood Winery, in Sonoma, California, raised only $10.5 million in this fashion--about 30 percent less than some bankers expected. At a minimum, that suggests that expectations for the most far-reaching use of the Internet--where a deal is done without the support of bankers-- exceed what's currently possible.


One reason is that the capacity to handle large transactions isn't available yet. Ed Johnson, CFO of Mortgage.com, a Plantation, Florida-based private company that provides online mortgage banking services and technology, notes that the level of sophistication that companies like his own provide to customers shopping for mortgages isn't available yet for those buying stock in new companies over the Internet. "That capability is not available on the investment side," says Johnson.


But some finance executives believe that a lack of capacity isn't to blame for the Net's failure to live up to expectations as an investment- banking alternative. "Major institutions are always going to require the equivalent of a road show and more direct contact with management," says Rick Vanzura, president of Ann Arbor, Michigan-based Borders Online Inc., and formerly its senior vice president of Internet and fulfillment. "There's a difference in [what Internet investors want and] what, for example, a Fidelity is going to want in terms of information, presentation, and access to management."



No Obstacle Here

For Web companies, however, the Internet's limitations don't seem to be an obstacle. Consider one of Wit's latest customers. Marketwatch.com, which used Wit to help raise $50 million in an IPO last January, enables retail investors to get online access to financial information and breaking news. Its CFO contends the Net holds special appeal to his company's shareholders. "For .com companies, the Internet really speaks to your users," says J. Peter Bardwick. "Retail investors make up a very large component of Internet stock holdings," he notes.


That, more than technological limitations, explains why Internet IPOs have been limited to small parts of traditional deals. By selling few shares over the Net, issuers have been able to exploit demand among their own customers to send the IPO price skyrocketing. That, in turn, has either induced institutions to jump on the bandwagon, sending the stock even higher, or enabled investors that got in on the deal early to cash out at huge profits as the price peaked.


A couple of months before Marketwatch.com's IPO, for example, Earthweb, a $3.3 million (in revenues) Internet business- to-business intermediary, went public with a $29.4 million offering. Earthweb was attracted by Wit's ability to create a program that allowed its site users to buy into the IPO. Yet the portion of the deal offered over the Internet was a minuscule 63,000 shares out of a total of 2.1 million. Nevertheless, Irene Math, Earthweb's senior vice president of finance, suggests that the buzz surrounding the Internet slice of the deal helped sell the rest of it. "Online brokerage companies like Etrade give retail investors a power they never had before," says Math.


But that power may be limited to investors in Web companies. After all, their customers are already heavy users of the Internet, and are thus more likely to buy stocks over it. That explains why most of Wit's customers have been Internet-related companies. And whether their customers' zeal for their stocks would survive a major market downturn is anyone's guess, since most Internet investors have never experienced one.


In any case, this kind of hype-based game may work only in the public markets. William Rosenzweig, managing partner of Venture Strategy Partners LLC, a venture capital firm in San Francisco, says his company's Web site is inundated with "people sending us things who are not really good at conveying their ideas." Ultimately, Rosenzweig concedes the Internet accelerates sharing knowledge and connecting people to opportunities, "but I find it as much a hindrance as a help. In venture capital, especially the early stage, relationships are paramount. The Internet does not create personal relationships."


That isn't to say that issuers aren't taking advantage of the Net to attract sophisticated investors. Last April, for example, Ziff-Davis, a New York high-tech publisher with $1.1 billion in revenues, used an Internet-based service run by Morgan Stanley and Loan Pricing Corp. to arrange a credit facility of $1.35 billion. Instead of getting information via E-mail or facsimile, institutional investors could assess the details electronically. Yet Tim O'Brien, Ziff's CFO, is hard-pressed to cite any tangible benefit from using the Net for a loan syndication. While O'Brien asserts that "we are happy with the results," he can't point to any cost savings.



Lower Risk?

Perhaps they are merely difficult to quantify. San Francisco­ based Bank of America, for example, contends that far less time and paperwork is necessary as a result of an electronic service offered with the help of IntraLinks Inc., of New York. Like the service offered by Morgan Stanley and Loan Pricing, IntraLinks enables investors to examine offering documents via the Net. And IntraLinks's service encompasses private placements, asset-backed securities, and mergers and acquisitions, as well as loan syndication.


But while Bank of America has done roughly 50 deals using IntraLinks, all but a few have required both hard copy and Internet versions of offering memoranda. Even so, "the Internet shortens the cycle time for investors to get information," says Mike Rushmore, a managing director at Bank of America and head of its syndicated finance research unit. "It lowers risk because there is better communication." Lower risk, to be sure, should translate into a lower cost of capital. But Rushmore concedes that evidence for the claim won't become more apparent until Internet dissemination comes to replace--instead of merely augment--hard-copy dissemination.


At this point, no one is willing to predict when that will happen, or just how significant the benefit will become. Much will depend on the extent to which banks dominate the medium by offering Internet capabilities as an adjunct of their own.


Goldman, Sachs & Co., for instance, recently purchased a 22 percent stake in Wit Capital. If other investment firms follow suit and CFOs don't counter by using the Net on their own, they may be left hoping competition forces Wall Street to pass along at least some of its savings.

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