Tom Taulli is the publisher of the Taulli Report, an online investment site.  You can reach him at tom@taulli.com

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Last week, Wit Capital announced the formation of an ambitious online investment bank, through which individual investors can purchase IPOs at the offering price. Wit Capital's first IPO is Radcom (which I will analyze in next week's column).

Over the past year, I have been studying and to some extent, participating in the market for Internet IPOs. In this article, I will give you my experiences, as well as impressions of this emerging market.

In the Beginning

It was during the Christmas party of 1992 that Andrew Klein resigned from his job as a securities attorney for Cravath, Swaine & Moore. He wanted to do what his clients were doing - that is, create his own business.

He started a microbrewery called Spring Street. But as with any business, he needed capital. So he drafted a private placement memorandum, raising about $500,000.

A private placement is not an IPO; rather, it is a common financing vehicle for start-up companies. The heart of a private placement is Regulation D, which the Securities and Exchange Commission promulgated in April 15, 1982. A Regulation D offering is exempted from the SEC Act of 1933, which requires onerous reporting requirements (such as a lengthy prospectus).

Despite the reduced paperwork, you still need a lawyer to understand how a Regulation D offering works. There is Rule 501, which defines the terms for a Regulation D offering. The most critical definition is "accredited investor." This is an investor who is not a beginner, and could be a bank, broker-dealer, insurance company, and so on. As for individuals, an accredited investor must be relatively wealthy.

Why the accredited investor requirement? Well, start-up companies are extremely risky. An accredited investor is presumed to be a sophisticated investor; moreover, he or she will likely not go broke if the deal collapses.

Then there is Rule 502, which contains the general requirements and limitations for Rule 504, 505 and 506. For example, Rule 504 limits sales up to $1 million; Rule 505 ranges from $1 million to $5 million; and Rule 506 is for offerings over $5 million.

The Next Stage

Yes, $500,000 sounds like a lot of money. But just like a growing kid, a young company eats money at an incredible rate. And Spring Street was no exception.

Klein started to talk to venture capitalists. A venture capitalist is a private firm - usually a partnership - which finances a company after it is beyond the start-up phase, but before the IPO phase. However, venture capitalists are very selective. They have a fiduciary responsibility to their investors to pick quality investments.

A variety of venture capitalists expressed interest in Spring Street. Unfortunately, they were not acting fast enough. Klein needed money immediately.

It was then that he decided to bypass the venture capitalists and do his own IPO. But doing a traditional IPO can be expensive; the fees range from $500,000 to $1,000,000 for a small company.

He found an arcane exemption to the 1933 SEC Act called a Regulation A offering. First of all, Klein would not have to draft a prospectus, but instead an offering statement, which is typically less comprehensive. What's more, the offering statement need not be filed with SEC headquarters in Washington, D.C., but at a regional office (and the filing fee is much lower; Klein's was only $500). In fact, there is no requirement for an audit of the company's books. As for investors, they do not have to be accredited. But a company is limited to raising a maximum of $5 million (although this is usually enough for a small company).

The most enticing element of a Regulation A offering is that the issuer can "test the waters." This means that a company can use advertising and publicity to see if there are any interested investors. If so, then the company can draw-up the offering statement.

Throughout 1995, Klein used traditional advertising to raise money for his Regulation A offering. But a new technology was sweeping the globe: the Internet. He thought this would be a superb vehicle for promoting his offering. Why not put the prospectus on the Web? So he did.

He raised $1.6 million.

Only The Beginning

A key to financial markets is liquidity. That is, if you own 100 shares of IBM, you know that you can readily find a buyer for your stock - without suffering a huge reduction in price.

But what if you buy stock in a small brewery? Will there be anybody around to buy it from you? And if so, will you get a good price?

Understanding the importance of liquidity, Klein created an online service in March 1996, called Wit-Trade. Here, investors could buy and sell Spring Street shares. It was the first virtual stock market.

But the SEC was quick to respond. Steven Wallman, an SEC Commissioner, called Klein (it is usually only a SEC staffer that makes these calls). Wallman expressed grave concerns about Wit-Trade. Without hesitation, Klein suspended trading.

But what shocked Wall Street was that the SEC - within several weeks - said it is OK for a company to trade its own stock on its Web site so long as certain conditions are met: There must be a licensed agent that handles shareholder funds; next, there must be notices that such online stock may be illiquid.

I Had an Idea

During this time, I was in law school and bored (learning about the Rules of Perpetuities, the parole evidence rule, imputed contributory negligence, and so on, is not very fun).

A year before, I had started a small business selling educational software. I got very lucky and signed a contract to develop software for West Publishing to help students prepare for the bar exam.

But, when I started to read about Andrew Klein, I wanted to start my own online investment bank. I started talking to some of my friends. Robert George, a fellow law student, was interested. Another friend, Don Jones (who developed software for the printing industry), also wanted to do it. And my business partner for my educational software company, Mike Patchen, wanted to do it.

The first step was finding a cool name. We spent several weeks on this and came up with WebIPO. We quickly registered the name with Internic (these were the early days when you could actually get the domain name you wanted).

The next step was to develop a Web site. It had to look sharp. After all, if you are selling shares online, the Web site is the focus of the business. We subcontracted with a graphic designer, who created an excellent logo (click to see a screen shot).

We also decided that the site needed lots of content. IPOs are not easy to understand. The site would be a source of education.

I was once a stockbroker and had written several hundred pages of information on stocks, bonds and other financial subjects for my clients. We posted this stuff on the site (you can see this content on the www.directipo.com site). I also wrote a series of articles on the IPO process. Furthermore, I began writing a weekly column on IPOs (the genesis of this column).

By late June, 1996, we were done. Now we needed to generate traffic. We wrote a press release and sent it to PR Newswire - which, for a fee, will sent it to a myriad of news organizations.

Unfortunately, for several weeks, the traffic was dismal. We had about 150 hits - most of which were from us.

But in early July, Michael Brush, a writer for Money Magazine Online, contacted me. He wanted to write a story on WebIPO. That morning, he interviewed me for about an hour (see the story). I went to school that day and when I came back, I looked at the hit counter on our Web site. It had increased by 650 hits. I then checked my email: "You have 111 message(s)." I refreshed the hit counter again and again. Another 20 hits. Another 15 hits. Another 35 hits. Oh my God. It was going crazy.

I read the emails:

· "How do I invest?" · "Attached is a business plan for my company." · "How much does it cost to do an IPO?" · "Can you send me more information?"

And on and on.

But we had a huge problem: How the hell do we do an IPO?

WebIPO In Wonderland

We received an email from a newly formed investment bank in San Diego. They were interested in a potential partnership agreement. This was exactly what we needed. WebIPO would do the online marketing and content and the investment banking firm would handle the IPO. A perfect match.

We had several meetings and signed an agreement, in which we would hand over investor and company leads (for a fee) and the investment banking firm would use its "best efforts" to execute.

But within several months, we decided to cancel the agreement. First of all, the investors we gave them were not high-net worth individuals. Also, the quality of companies was low. We realized that, in a sense, we were a financing option of last resort. We were getting business plans of companies that had been rejected by venture capitalists, angels (wealthy, private investors who put money into start-ups) and investment banks.

We also learned that an online offering was not likely to be a cost-effective alternative to VC financing or a traditional IPO, because of:

In fact, the handful of successful Internet IPOs were companies that had affinity investors. For example, Spring Street went directly to its customer base to sell its offering. However, many start-up companies do not have this luxury (because young companies usually do not have customers).

There is a famous saying on Wall Street: "Stocks are not bought, they're sold." Look at all the stockbrokers that Merrill Lynch has. They are there to convince millions of people to fork over their money into risky investments.

Many of the companies that did do direct offerings quickly found out that they had to talk endlessly with investors - reassuring them that this was the right decision.

Crisis Mode

As a few months passed, our traffic started to decline. The investors and companies were beginning to wonder what was happening with WebIPO.

There was also infighting. Don Jones was the first to leave. He then set-up his own online IPO firm, called PrestigeIPO (www.prestigeipo.com). Then Robert George left.

We had to do something ASAP. We knew the site design was good and that there was lots of valuable content on our site. Perhaps another firm would be interested.

We called DirectIPO, which was only several miles from us (in Marina del Rey, California). It took about three days, but we had an agreement to sell WebIPO to them. Out of the deal, we got stock and cash (because of my conract, I cannot disclose the details of the agreement, nor can I disclose my experiences at DirectIPO).

Wit Capital Goes Online

During this time, Klein was able to raise $9 million to create his own online investment bank.

His firm is now a fully registered broker-dealer (which allows a company to handle investor funds) and a member of the National Association of Securities Dealers (a self-regulating organization for the securities industry) and the Securities Investor Protection Corporation (which provides insurance for investor accounts).

Like a discount broker, Wit Capital does not pay its brokers a commission. In other words, you will not get pesky cold calls.

Wit Capital provides the following services:

Interestingly enough, Wit Capital plans to create a Digital Stock Market (in about mid-1998). You will be able to buy and sell shares of various NASDAQ companies directly with other investors. This will avoid the spread, which is the difference between the bid price and the ask price of a stock. That's where brokerage firms get lots of their money.

Some Competition

On May Day 1975, the Justice Department eliminated the regime of fixed commissions. The result was increased access to Wall Street for individual investors, as discount brokers offered greatly reduced fees.

With the Internet, the individual investor has not only enjoyed institutional-level commissions, but also access to instant information and research. For less than $10,000, you can basically have your own institutional trading desk.

One of the last areas of Wall Street to be opened to individual investors is the opportunity to buy IPOs at the offering price.

But Wit Capital is not the only firm giving individual investors a shot at IPOs. Earlier this month, E*Trade announced an alliance with the investment bank Robertson, Stephens & Co (which is owned by Bank of America) to sell IPOs over the Net. What's more, this group will provide research reports that have been formerly available only to institutional investors. There will even be online road shows (again, traditionally, individual investors have not been invited to these events; and yes, Wit Capital will have online road shows, too).

On the same day, Schwab announced a major deal with First Boston, JP Morgan and Hambrecht & Quist to offer IPOs to individual investors.

This is great. There is no reason to deny individual investors a chance at an IPO.

Then again, this does not mean that all individual investors should invest in IPOs. Despite the boom, IPOs are still high-risk. You must do lots of research. If you do not have the time, then a mutual fund is probably a better option. Never buy an IPO blind.

Unfortunately, there is a psychology that IPOs are the key to riches. But, as J.P. Morgan once said, "Markets fluctuate." Over the past 15 years, the markets have been surging. And, perhaps, they may surge for another 15 years. Then again, the markets could plunge.

Klein has started a revolution. Where it goes is anyone's guess. What is likely to happen is that there will be many more offerings. This is great news for companies that are begging for capital. But Wall Street has a tendency to go to extremes. Competition for fees is fierce. And Wall Street is not afraid to go for the fences.

So be careful. IPOs are not guaranteed like Treasury bills. Buyer beware.

For comments/questions, contact Tom Taulli at tom@taulli.com.