Prakash DHEERIYA

Impact of Internet on
Firm’s Cost of Capital:
An Analysis
Prakash DHEERIYA
Chair and Professor of Finance
California State University-Dominguez Hills
1000 E Victoria St, Carson, CA 90747, USA
310-243-3350
[email protected]
Ted AZARMI
Assistant Professor of Finance
California State University-Long Beach
1250 Bellflower Blvd., Long Beach, CA 90840, USA
562-985-5725
[email protected]
Abstract
_______________________________________________
The use of entry of new technology such as satellite communications, fibre optic cables, high speed EFTs has significantly
changed the way companies raise capital. Geographical and
time constraints are not obstacles anymore. Participants in
financial markets react swiftly to latest data, regardless of its
geographical location.
Internet makes it possible for all business entities to tap potentially thousands of investors located all over the globe. Small
companies in tend to benefit the most since their access to
capital markets tend to be restricted. With Internet as one of
the viable avenues for raising capital, these companies have as
much access to financial markets as large companies.
In this paper, we investigate cases of companies that have successfully raised capital on the Internet and its impact on cost of
capital. We hypothesize that cost of capital should be lower for
companies using the internet to access capital. Transaction
costs, geographical spread of investors are some factors which
can explain the lower cost of capital. Results of this study are
useful to academicians, corporate officers, businessmen and
regulators.
Keywords:
Internet, Financing, Cost of Capital
The internet1 as a medium of raising capital has many backers.
It can provide an extremely valuable tool in public offerings as
Impact of Internet on Firm’s Cost of Capital: An Analysis
Prakash DHEERIYA and Ted AZARMI
well as private offerings exempt from registration with the
SEC under Securities Act of 1933. In the context of a public
securities offering, an internet user can find an issuer's website
containing a securities offering prospectus and can easily become a possible investor. An issuer, by offering securities on
the internet, can bypass the use of underwriters entirely. With
millions of internet users worldwide, the value of internet as a
means of access to capital in the context of a public offering of
securities is very obvious.
The nineties saw a tremendous growth in the use of cyberspace, internet, information highway or technology in ordinary
business activities. Internet based businesses dealing with investment banking, venture capital, financial marketing have
mushroomed. In the area of obtaining capital for "small cap"
firms, the internet has been valuable in bringing information
about capital needs very rapidly to potential investors. The
presence of such facilitating firms onto the Web can be attributed to three main factors: the emergence of the Internet as a
powerful marketing tool; the advent of on-line trading; and the
changes in SEC regulation to better facilitate the first financing
of smaller companies (Balling (1997)).
When federal securities laws were enacted half a century ago,
it was inconceivable for businesses to communicate in a paperless society2. Despite the unanticipated growth in electronic
communication, drafters of securities laws established a basic
set of objectives for securities disclosure that could be
achieved regardless of the type of communication used to distribute or offer those securities. A particular form of communication is also not required to meet the other objectives of securities laws, namely, preventing fraud in the securities markets,
maintaining fair and honest markets, and improving the
breadth of capital available to securities markets.3
The objective of this study is to investigate the growth of offerings of capital on the Internet; the simultaneous response and
changes brought about in securities laws and by regulators; and
the consequent impact on a potential issuer’s cost of capital.
The first section of this paper will discuss changes in current
securities laws in response to the use of changing technology
by market participants. Instances of companies raising capital
over the internet will be discussed next, followed by a discussion on cost of capital of such issuers. Finally, the future role
of the Internet, SEC, in the area of capital raising will be discussed and summarized. This paper will conclude with the
author's observations.
1. Introduction
Over past fifty years, the Securities and Exchange Commission
(SEC) has regulated the capital raising mechanism, be it face
to face communications or via telephone conversations. Instead of instituting or seeking fundamental changes in securities laws from Congress in response to changing uses of technology by market participants, the SEC has updated and revised its rules and regulations incrementally to address new
forms of communication and technologies. For example, since
1975, the SEC has generally overseen the development of the
structure of a "national market system for securities." The
SEC's role in this regard generally has been to serve as a facilitator of market participants' development and use of new technologies in the trading of securities, rather than to mandate a
specific market structure. Most recently, the SEC, under the
chairmanship of Arthur Levitt, amended Regulation A (of the
Securities Act of 1933) to exempt companies raising up to $ 5
million in a self-underwritten offering from full registration
(an expensive and time-consuming process for many start-ups)
in 1992. In addition, the 1992 amendment allowed for companies to "test the waters" to solicit indications of interest in their
securities from investors before undergoing the difficult process of going public. In 1995, the SEC ruled that company prospectuses could be delivered to investors electronically, leading to substantial savings in printing and postal costs associated with prospectus distribution (Balling (1997)). In the latter
half of 1999, there was discussion of NYSE & NASDAQ becoming a for-profit, publicly listed entity, and offering extended trading hours. Growth of Instinet, Datek’s and E-trade’s
extended trading hours, and development of similar electronic
commerce networks (ECNs) further testify to the growing
popularity and demand of internet-based trading systems, despite widespread concern by regulators of day trading.
2. How do Companies Raise Capital
on the Internet?
Potential investors can obtain information related to small-cap
offerings by issuing companies can access their potential investors at IPO-related Web sites4. Some sites (IPOnet, INVbank, and WitCapital) are trying to offer "full service" in one
location by building a network of broker/dealers to participate
collectively in buying/selling and market-making of securities
offered on their sites. Since secondary market for Internet IPOs
is very small, these sites are trying to increase their securities'
liquidity (Balling (1997)).
There hasn't been a single case where an issuing company
managed to raise 100 % of its capital needs through an Internet
IPO. Only "40% of Spring Street's IPO, [now famous as the
first Internet-based IPO] was financed over the internet, while
remainder of the capital was found off-line. Internet IPOs can
lower an issuer's cost of capital by eliminating underwriters'
and bankers' fees, which can run upto 6 % of the proceeds.
Most common types of public offering found on the Internet
are small-cap, self-underwritten offerings: SCOR's (Small
Corporate Offering Registrations, up to $1 million), "SB-2's"
(nicknamed after the actual form filed with the SEC up to no
limit on the offering amount) and Regulation A's (named after
the 1992 Amendment to Regulation A of the Securities Act, up
to $5 mil)5. SCOR offerings were designed by SEC to enable
smaller companies to raise capital by making registration process easier and cheaper, by using a shortened prospectus for
registered offerings upto $ 1 million.
On the internet, private placements and regulation S offerings
are self-underwritten and exempt from registration with the
SEC. In such placements, moneys can be raised from "Accredited Investors"6 only and there is no limit on the amount of
money that can be raised.. There have been no studies which
have dealt with the issue of internet related offerings, their
success in raising capital for its issuers and impact on issuer’s
cost of capital. A study by Osteryoung et al. did not explicitly
investigate internet-based offerings, but concentrated on a
narrow field of initial public offering called SCOR offerings.
They found that neither geographical regions nor amount of
equity offered in SCOR significantly affected the success of
SCOR offerings7.
3. Current SEC Rules & Regulation S
Impact of Internet on Firm’s Cost of Capital: An Analysis
Prakash DHEERIYA and Ted AZARMI
Pertaining to Internet Offerings
Laws governing internet offerings are same as the ones for
those done in the traditional manner. For example, only users
who have registered with the Web site as Accredited Investors
can read the private placement memorandums on password-protected pages. Similarly, in accordance with state
"blue-sky" laws, announcement of public and private offerings
on IPO Web sites have notices alerting potential investors as to
which state residents may purchase the securities offered. Certain offerings that are exempt from registration at the federal
level may be subject to the securities laws of individual states.
Many states have followed the lead of the SEC and the State of
Pennsylvania, and have amended their Blue Sky Laws to permit the use of an electronic prospectus. The exemption, first
adopted by Pennsylvania, exempts securities offered on the
internet from registration, so long as offers are not directed at
residents of the state. This leads to a potential problem for the
broker if he and his firm, and the securities themselves, are not
registered in all 50 states. The posting of a preliminary prospectus, or other information regarding an internet offering
could be deemed a solicitation in that state. Without registration, or an exemption, a broker, brokerage firm, and even an
issuer, could find itself the subject of an administrative proceeding for violation of state securities laws.
The SEC has the power to enter an order temporarily suspending a Regulation A exemption for at least seven reasons under
Regulation A, Rule 258. An important reason, insofar as internet offerings are concerned, is under Rule 258 (3) of Regulation A, which allows the SEC to order suspension when "the
offering is being made or would be made in violation of section 17 of the Securities Act."8 In addition, the SEC requires
posting of warnings that show the SEC does not formally endorse Regulation A securities as it commonly does with a registered security9.
Issuer of an exempt security typically files with a particular
state in which it seeks to sell exempt securities. Every state has
its own securities regulations (known as "Blue Sky Laws"). As
long as full and honest disclosure are made, the SEC has little
power to review the substantive merits of a proposed offering.
Most state blue sky laws, however, do not follow the "disclosure only" approach and instead allow the state securities administrator to prohibit an offering if the administrator believes
that the issue is substantially undesirable. This can have a
chilling effect on internet IPOs since the issuers will have to
file in each state in which they intend to sell their securities.
4. Regulation S and Global Equity
Offerings via Internet
Any offering of capital over the internet can be considered
global since any investor can access the issuer's site and subscribe to its offering. Regulation S under the Securities Act
provides that offers and sales of securities outside the U.S. are
not subject to the registration requirements of the Securities
Act. This regulation was adopted in April 1990 and it was
considered necessary since there was no exemption in the Securities Act itself for offerings outside the U.S. that make use
in any way of U.S. means of communication. The exemption
provided by Regulation S relates only to the registration requirements of the Securities Act, and not to the various provisions relating to misstatements or omissions in offering materials.
Having outlined the key provisions of the relevant U.S. laws
and regulations, we now discuss their effect on the mechanics
of a global equity offering and on cost of capital. In a standard
internet equity offering, underwriting arrangements will be
absent, since the objective is to bypass middlemen and go directly to investors. Registration requirements of the Securities
Act, including prohibition on offers before a registration
statement is filed, limitation of written offers thereafter to the
preliminary prospectus included in the registration statement,
the requirements that no sale be made until registration statement is declared effective and that a copy of the final prospectus be delivered to each purchaser at or prior to the confirmation of sale, and the associated restrictions on publicity (as well
as restrictions on publicity imposed by Rule 10b-6) will, of
course, apply to any public offering in the U.S. They will not,
however, apply to the international offering so long as it is
made outside the U.S. in accordance with Regulation
S.(Braverman (1993)).
There have been issuers who have pioneered the use of internet
in raising capital. Notably among those are Spring Street
Brewing Company, Wit-Capital, and Real Goods Trading
Company. The financing subsidiary of General Motors has
used the internet, in addition to the traditional means of raising
capital, in its offering of debt securities.
A company’s cost of capital is the required rate of return that a
firm must achieve in order to cover the cost of acquiring funds
in the marketplace. Based on an assessment of riskiness of
each firm, investors will supply new funds to a firm only if it
pays them the required rate of return to compensate them for
taking the risk of investing in that firm’s stocks and bonds.
Cost of capital is composed of cost of debt and of equity. If the
risk is high, as is true in most companies offering securities
over the internet, the return investors demand to invest in them
is high too. In internet offerings, there is also the uncertainty of
existence of a secondary market, in addition to the traditional
uncertainty and risk of time. The longer the funds are invested,
the higher the cost of capital due to time-related risks of loss of
principal through failure and default.
Capital market conditions, government policies, tax structure,
and other factors can cause significant changes in relative cost
of acquiring funds, and therefore, the weighted average cost of
capital (WACC). The supply curve available to a firm tends to
flatten, given the large amounts of funds available through the
internet. Consequently, one can argue that cost of capital to a
firm falls, as the supply of funds increases dramatically. This is
illustrated in the following diagram in Figure 1:
Impact of Internet on Firm’s Cost of Capital: An Analysis
Prakash DHEERIYA and Ted AZARMI
S”
D
Cost of Capital
S
C”
S’
C
C’
Supply of capital
Figure 1: Cost of Capital and internet
San Francisco lists two Internet based offering stocks -- Real
The supply curve (S’), in the presence of increased capital
Goods Trading, a Ukiah, California, catalog company that
availability through the internet, shifts to the right and is flatoffers alternative-energy products, and Mendocino Brewing of
ter. The shift to the right is caused by increased availability
Hopland, California in its SCOR Marketplace. The exchange
and use of internet. The lowering of costs of raising funds is
discussed with state regulators and the American Bar Associapossible due to savings in floatation costs, underwriting extion on designing the market in Internet based stocks, but so
penses, postage and other middlemen-related costs (C’).
far volume in the two listed stocks is only a "couple hundred"
a day. The exchange has a vested interest in development of
It is possible that the increased uncertainty and riskiness of a
this market because it believes that such companies, if and
firm unknown to the capital market may shift the WACC back
when successful, would continue to be listed on that exchange.
to the same level (C), as if the firm did not avail of the internet
Infrastructural problems on building of the secondary market
medium. One can argue that WACC to a small firm is the same
have prevented its growth.
(C), regardless of the avenue taken for raising capital. In addition, costs incurred to advertise the web site where prospectus
Another proposal by a professor of finance for an Internet
and other capital-raising documents are located, may be as
trading system had to be shelved. Dan Weaver, at Marquette
great as the cost of raising capital through traditional means.
University, sought to create an Interbourse, a Web-based sysSuccess of issuing capital is not guaranteed if done through the
tem to buy and sell stocks using credit cards for payment.
internet. The track record of companies raising capital through
Under the plan, if an investor bought a stock, then the price
the internet indicates that none of the companies ever reached
was charged to his credit card. If an investor sold a stock, then
full subscription. In that respect, the true supply curve (S”) of
a credit was applied to his account. His inability to find a credit
external funds of an unknown firm may be completely inelascard company which would go along with his proposal resulted
tic, or may compose entirely of owner-supplied funds. There is
in the plan's demise.
almost no evidence of a firm successfully lowering its WACC
by using the internet. Prices of other commodities (air-fares,
Internet-based IPOs are not a serious threat to Wall Street curbooks, to name a few) have been lowered where internet has
rently because they are too small to be economical. Value of
been used, but we find no evidence of that in case of capital.
internet in the context of private securities offering lies in the
speed of access to capital, significant savings of legal costs
The internet provides convenience of searching for resources,
related to organization and administration of the private offerrather than increasing availability of cheap resources. Access
ing, and savings of costs of printing, binding and postage into information by potential investors increases in the presence
herent in the private offering process.10
of internet-based issues, but competition for good, quality,
highly rated capital issues has not seemed to have lowered a
5. Future of Internet as a Medium of
firm’s WACC. Companies have often exploited their brand
name and recognition in offering low cost debt issues (e.g.
raising Capital
Walt Disney’s very long term debt issues), but we have yet to
see that in the cyber world. It is yet to be seen if the use of
Of the Internet IPO's filed after Netscape Communications
internet will lower a firm’s WACC..
Corp's IPO in August 1995, 79 percent failed to rise above
their offering price. Many analysts are skeptical of internet as a
Although Internet offerings provide businesses with fresh capiway of raising capital. According to David Menlow of IPO
tal for expansion at less than half the cost of a traditional Initial
Financial Network, "The Internet is not a viable market, and
Public Offering (IPO), there is virtually no secondary market
it's being used for companies that should not be going public in
for shareholders. That is a very serious disadvantage of such
the first place. Participating in an IPO outside of normal chanInternet based IPOs. Despite the presence of an active secnels is taking on an inordinately high level of risk." (Chrein
ondary market, issuers are trying to establish a skeleton
(1996)) Other IPO analysts are more cautionary when advocatmarket for their Internet based issues. The Pacific Exchange in
ing any Internet-based offering. According to Manish Shah,
Impact of Internet on Firm’s Cost of Capital: An Analysis
Prakash DHEERIYA and Ted AZARMI
publisher of the IPO Maven and producer of the INVESTools
Web site, "the risk involved with these stocks is very high, and
the volatility is also very high." Companies that are brought
public by smaller underwriters don't undergo the same amount
of public scrutiny as those backed by the big houses. Such
companies do not receive good analyst coverage, have undergone minor scrutiny thereby making it difficult to judge their
worth. (Chrein (1996)). More research is needed to determine
if internet as a highway to capital is open to small firms, and is
successful in lowering a firm’s WACC.
Company
Number of
Pric
Offering ($)
Shares
e per
shar
e ($)
Adeptus
400,000
2.5
1,000,000
Gempro International
HVR Water Purification
AB
Interactive Holdings
Interactive Multimedia
Network
Interactive Products & Services
Ives Health Company (Pvt
Offering)
Linear Energy (Australia's
1st IPO)
Mendocino Brewing Company
Millenium Interactive
Technologies
Mr CDROM
500,000
6.25
3,125,000
5,400,000
324 m SEK
200,000
SEK
60
10
625,000
8
5,000,000
1,000,000
5
5,000,000
5,000,000
0.5
2,500,000
10,000,000
A$ 2 million
600,000
A$
0.2
6
625,000
1.6
1,000,000
3,000,000
4
12,000,000
675,000
6
4,050,000
1,000,000
5
5,000,000
2,000,000
3,600,000
Amour Fiber Core
300,000
6
1,800,000
Annie's Homegrown Inc
600,000
6
3,600,000
Biomoda
600,000
5
3,000,000
BrainTainment Resources
250,000
2
500,000
Computer Eye Wear
200,000
5
1,000,000
Pyromid Inc
833,325
6
4,999,950
Continuum
200,000
5
1,000,000
Red Pheasant Gold Club
12,000
250
3,000,000
3,850,000
6.25
24,062,000
Spring Street Brewing
1,200,000
2.75
3,300,000
650,000
3
1,950,000
2,000,000
2.5
5,000,000
1,666,670
3
5,000,010
tel IT Communications
(Canada's 1st Ipo)
US Abalone
400,000
5
2,000,000
Eagle Brewing Company
200,000
5
1,000,000
Zap Power Systems
500,000
5.25
2,625,000
Ecology Communications
2,500,000
2
5,000,000
166,666
6
999,996
1,425,000
3.5
4,987,500
Dechtar Direct
Desserts by David Glass
Directional Robotics
ExpressAir Messenger
Gaming World
Table 1: Capital Raised over the Internet (1996-97)
National Specialty Networks
PeopleNet
Impact of Internet on Firm’s Cost of Capital: An Analysis
Prakash DHEERIYA and Ted AZARMI
tion (forthcoming)
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