Ready for hyper risk? Ground-floor deals raise online concerns

Talk about risky business.

How about pouring tens of thousands of dollars — or ten times that much — into a company so early in its development that most venture capital firms are afraid to touch it?

Private placements are one of the most highly distilled investments, a concoction so heady that only well-connected bankers, the super rich and large monied institutions have traditionally had the stomach for them.

But a new breed of online financial matchmaker is vying to give the merely upscale a taste of the action. And, while the risks can bite like cheap whiskey, the payoffs can be downright intoxicating.

The new-found availability of private placement deals on the Internet, however, is raising questions about their quality. And it’s giving some advisers pause over the wisdom of exposing midrange investors to bets that are more in line with casino gambling.

Companies like OffRoad Capital in San Francisco and Garage.com, co-founded two years ago by Apple guru Guy Kawasaki in nearby Palo Alto, are in the forefront of the trend, and they are counting on financial advisers to usher wealthy investors up to the bar.

OffRoad, founded in June, took a leap forward this month when it signed a deal with Charles Schwab Corp., offering Schwab investors free access to its private stock deals.

But buyer beware. Only one in 30 venture-backed companies ever goes public, the Holy Grail of a start-up, according to industry estimates.

Of the 2,498 companies that were receiving venture financing this year, 121 have gone public, according to Venture Economics, a research firm in Newark, N.J.

Typically, it takes as long as ten years for a firm to go from start up to exit strategy, which can include its sale or a public offering.

“These are venture deals, which means they are risky deals,” says Geoff Baum, co-founder of Garage. com. “Not only are they venture deals, but they are early-stage venture deals, which means they are even riskier.”

Also unclear is the quality of the companies being pushed by firms like OffRoad and Garage.com. Both just started doing deals this year.

At a time when top-notch venture capital firms are flush with cash and can’t find enough firms to finance, why would an emerging business — especially one with hot prospects — go through relative newcomers on the Internet?

“I would guess it’s because they have not had any success with the traditional venture capital firms,” says Nancy Dorman, a general partner with venture firm New England Associates.

But that hasn’t deterred investors from lining up to roll the dice.

Schwab signed the OffRoad deal because it wanted a new product to offer high-end investors as it tries to extend its reach upmarket. You’ll need to have $1 million invested with the San Francisco discount brokerage to get in the door, but a well-placed investment in an emerging business can yield a windfall return.

In one example of a big payoff, Baltimore-based New England Associates invested $2 million in UUNet Technologies Inc. in 1993, and reaped more than $400 million after UUNet went public and was acquired three years later.

Richard Dreskin, a financial planner in Roseland, N.J., recently set up a limited liability company through which clients can pool their money and invest in start-ups.

The LLC, called Eagle Rock, has three partners — including Mr. Dreskin — and has invested about $125,000 in two companies offered by OffRoad.

In return, Mr. Dreskin’s firm, Dreskin Gillman & Granet, collects a 2% annual management fee — plus up to 20% of Eagle Rock’s yearly profits, which is considered typical.

“We love it because we are getting directly into the companies, and we are getting in at a good price,” says Mr. Dreskin, who is encouraging all of his wealthy clients to consider investing up to 5% of their assets in private equity ventures. “We think it’s the future.”

But what’s considered atypical is the fact that neither OffRoad nor Garage. com have much — if any — exposure in their deals. Garage.com, for example, contributes 5% of the money raised in a private offering. So far, OffRoad has contributed nothing.

“I want to see a substantial portion of their own money going into these deals,” says Lou Stanasolovich, an adviser at Legend Financial Advisors Inc. in Pittsburgh. “Otherwise, they’re saying it’s nothing but a crapshoot.”

For their part, Garage.com and OffRoad say their deals are anything but. Both say they spend a lot of time and resources picking companies that stand a chance of becoming the next Amazon.com or Netscape.

Garage.com, which specializes in finding money for early-stage technology and medical device companies, works with only one in every 200 companies it reviews, the firm says. It has raised $85 million for 27 companies since doing its first deal earlier this year.

OffRoad, which focuses on businesses that are close to going public or being acquired, says it accepts one in 40 companies it considers. It has raised and invested $10 million in two companies, Plexus Net Broadcasting Corp. and Quantum 3D.

Plexus Net creates virtual trade shows on the web and Quantum develops simulation hardware. So far, neither has plans to go public.

OffRoad says it requires all candidates to show revenues, existing banking relationships and at least one prior round of financing. Firms must also file quarterly and annual reports.

“The companies we do business with can’t be just an idea,” says OffRoad’s chief economist Susan Woodward, who has served in that capacity with the Securities and Exchange Commission. “We look for the things that most investment banks look for.”

OffRoad makes money by collecting 3% to 10% of the amount it helps place with a company. It also collects warrants, which are essentially long-term options on stock. Garage.com collects 5% of the money raised.

Both companies only deal with “accredited” investors, which means they have $1 million in investible assets, or $200,000 in annual income ($300,000 for couples), according to SEC guidelines.

Both OffRoad and Garage.com declined to reveal how many investors have signed up with them.

With increased exposure to private equity deals for financial planners via the Internet comes an increased risk of fraud. It won’t be long, say industry experts, before someone starts pitching a ground-floor deal that is too good to be true.

“We don’t think we have any copycats out there, at least not yet,” says OffRoad’s Ms. Woodward. “But we will. And some of them will be sleazy.”