THE NEW AGE OF Capital Democracy.

These guys may look like new kids, but they've been around the block more than once. Now they're determined to put the public back in IPO - and they may just eat Wall Street's lunch while they're at it.

Meet company X.com. Two years after its launch, with the IPO market hopping, X.com's founders decided it was high time to go public. They opted to go out with Goldman Sachs, who wooed young X.com with promises of market expertise, analyst coverage, generous aftermarket support, and of course, the Goldman signature - all for the low, low price of the standard 7 percent fee. A few short phone calls were made at the shares - priced at a paltry $11 - were quickly sold to several institutional clients and a short list of valued private investors, none of whom had any personal attachment or affiliation with the company, but who saw dollar signs in the near term. By the time retail investors could lay hands on the stock, it was trading at $65 and they devoured it, sending the price to a whopping $90 by the end of the first day's trading.

The tab wasn't cheap and the money left on the table was almost enough to make X.com's board members weep, but they consoled themselves with thoughts of the indelible imprint they had left on the public eye. The second week out, however, two out of four of the institutional investors decided the stock was already high enough to turn a substantial profit, so they dumped their three million shares apiece, sending the stock plummeting - and it continued to free-fall as individual investors who bought high realized they picked yet another lemon and rushed to unload. The fact that X.com was a solid company with a sound strategy and a growing customer base never factored into the drama. But then, what's that got to do with an IPO anyway?

If that sounds extreme, it's not far off from the way things are. Or, more aptly, the way they were - if the Street's newest Net-based capital players have anything to say about it. Armed with fresh strategies and new models for raising equity, Wit Capital's co-CEOs Robert Lessin and Ronald Readmond, and W.R. Hambrecht's chief Bill Hambrecht are going after Wall Street's lunch. Their battle hymn? It's savvy individual investors, particularly those who believe in a company's mission and its product, who ought to be its primary initial investors - not faceless institutions, many of whom, truth be told, flip stock as shamelessly as the most fickle of daytraders. "[Institutions] essentially use a privileged position to generate a gain that I wouldn't be moralistic enough to say they have no right to, but they really added no value to," says David Schehr, senior research analyst, Gartner Group financial services. "They're simply constricting access and through that, getting an inordinate gain for relatively little risk."

Wit Capital's leaders hope to help break that trend. While Wit doesn't lead manage deals yet, the New York City-based firm, now in its third year - and a long way in Internet time from the day founder Andy Klein first saw the potential value in offering shares of a company's stock to its own best retail customers - co-manages deals with the big boys and reportedly gets as many as 500,000 shares of IPO deals. (Wit has gotten that high-end number mostly from deals led by Goldman Sachs, which owns a 13 percent stake in the firm, and has brought Wit in on 22 of its 69 lead-managed deals since April. Goldman declined to comment on the relationship.)

Wit then offers the stock to its retail customers on a first-come, first-served basis, and they are required to hold the stock for at least 60 days - or risk being booted to the end of the line for future allocations. The company boasts an 80 percent retention rate of stock among investors after the 60 days are up, according to Lessin. Why? "Much of it is targeted toward the community that is particularly relevant to the issuer," he says. "To the extent that you have interested shareholders, they're going to be less likely to flip the stock."

While the Wit model is not entirely new - more evolutionary with regard to distribution of IPO shares than revolutionary, to be sure - it aims to chip away at the share of market held by the Morgans and the Merrills from inside the traditional Street model, by slowly building brand recognition and investment research capabilities and by convincing IPO companies that Wit, as co-manager, can extend their retail distribution and offer expertise they simply can't do without.

San Francisco-based W.R. Hambrecht & Co., for its part, aims to scrap the current tradition altogether and replace it with OpenIPO, a Dutch auction method of IPO allocation. The process is simple: W.R. Hambrecht, as lead manager, offers the stock; potential investors bid (through accounts with either Hambrecht or other participating brokerages) for a specific number of shares and set the price they're willing to pay; the bidding continues until the highest price at which the entire lot of shares can be sold is reached. The result: the IPO company gets arguably the best price for its stock, leaves as little money on the table as possible, while paying a competitive 3 to 5 percent fee to W.R. Hambrecht, and investors can bid as high as they like and they can't overpay. Since the potential for a runaway run-up is slim to none, daytraders and flippers have little incentive to join in; i.e., only loyal investors who believe in the company's mission need apply.

"As long as you have preferential distribution, it's going to get distorted because an underwriter giving away guaranteed profit is going to give it to someone who can reciprocate in some way," says Hambrecht. And that, he adds, is not best for the company going public. But the question is, with only two deals under its belt (with one more scheduled at press time) can W.R. Hambrecht convince companies to let go of the traditional model and take a chance with their IPO on an entirely new and relatively untested method?

Clearly, though, whether or not OpenIPO survives and prospers, the age of new and different capital formation has arrived; Forrester Research predicts that by 2005, one in five IPO shares will be sold electronically to individual investors. The private equity side, too, is seeing the effects, with companies such as Wayne, PA-based Internet Capital Group allowing individuals to get in on the ground floor of venture level e-commerce startups. While ICG CEO Walter Buckley says the firm will not be a venture fund long term, but rather a business-to-business e-commerce holding company, it nevertheless is helping to sow the seeds of change in private capital.

"Keep in mind that the U.S. capital markets are really the envy of the world," says Michael Gazala, senior analyst with Forrester Research. "So we're not talking about something that doesn't work." But, as the following stories illustrate, these rule-breakers - who, incidentally, are not 20-something dot-com bandits, but rather veterans from the brick-and-mortar investment banking world - question whether the system works nearly as well as it could.

Fast Facts on Internet IPOs

* Over the six months ended July 31st, 1999, 181 companies offered shares to the public.

* Over that same period, only three Internet-oriented firms served as lead managers.

* Two of those did so only for their own IPOs, leaving W.R. Hambrecht as the one Internet-oriented firm acting as lead manager.

* Of the 181 deals, Web-based firms co-managed 18, or 10 percent.

* A firm acting as co-manager typically gets about 1 percent of the offering, which, for a 3 million share deal, translates to 30,000 shares. AT 100 shares per customer, this would allot enough for 300 customers.

* As of the end of second quarter 1999, E*Trade, Schwab, and DLJdirect had 1.2 million, 2.8 million, and 277,000 electronic brokerage accounts, respectively.

Source: Gomez Advisors, Inc.

The New Investment Bank

When it comes to Wit Capital's reason for being, Bob Lessin gets right to the point. "If you think Wit is about taking 22-year-old kids public, then you don't understand what we're all about," he says. "Wit is about the role of the individual in the capital raising process."

A challenging focus, given that once upon a time, there was no individual in the capital raising process - and one obviously powerful enough to entice the now 44-year-old Lessin to leave his post as vice chairman of Solomon Smith Barney, where he'd been since '93, and enough to woo Ron Readmond, 56, indefinitely out of retirement (he had previously been vice chairman of Charles Schwab and one of the leaders of its decisive shift toward electronic brokerage), and to hitch their wagons to the promise of a new breed of online investment bank.

And these two have plans that go well beyond co-managing IPOs in the U.S. (Lessin insists they have no plans to lead manage deals, although industry experts say they likely will). Specifically, the firm is busy gathering data on hundreds of potentially hot new dot-coms to position itself to offer fee-based advisory services to big physical-world media and retail conglomerates looking to build Web businesses. "We see every deal. We can tell you the next thousand IPOs coming in the next year. That's highly useful to corporations who want to know in whom to invest and with whom they should trade legitimacy for equity before the IPO happens," says Lessin. "And yes, we advise them but we'll also often be investing side by side with them." The firm is also working on establishing Wit Capital Japan, the country's first Internet investment bank, formed in July. In addition to offering Japanese individual investors IPO shares, the Far East firm will advise U.S.based companies seeking to create Japanese joint ventures.

This additional business could prove critical as Wit battles to solidify its brand and prove its legitimacy in a space dominated by giants that have never been above squeezing out the little guy. "It's going to take time to beat the established investment banks because there is so much money involved from the institutions," says Dan Burke, senior analyst, Gomez Advisors. "Fidelity as an account is worth a hell of a lot more to Merrill Lynch than I am. And that's just she way the system works."

But then again, Burke adds, time was, individual investors had little choice but to place trades through brokers for hefty commissions, until the E*Trades came along. "You'll see the same kind of scenario in the investment banking sphere once these online competitors get stronger. People will be asking, 'What am I getting for that 7 percent? Explain yourself.'"

And if they can't, say Lessin and Readmond, Wit most certainly will be there.

Bob Lessin On the Wit Global Vision

So Wit isn't just for domestic on-line IPOs anymore?

First of all, there's nothing uniquely domestic about Wit. Wit is a global concept. Every economy has to accommodate capital formation or they won't have an economy. So we go well beyond the domestic market. Second, Wit goes well beyond IPOs. If we had been the king of preferred stocks, we would have had two articles written about us. So it started with IPOs; that's the most glamorous aspect of capital raising. But Wit really has to do with the role of the individual in the process. And third, Wit is the advisor to a huge portion of the Fortune 100s right now, in helping them to define their Internet strategy.

So you've got a lot on your plate.

Yes. But you know, right now there's only so much we can do. We have to live with bandwidth constraints. When you're growing 1 percent or 2 percent a day, how do you manage that kind of hypergrowth? That's our single biggest issue. Obviously the more you can do virtually, the better off you are. But there are human beings around here and the question is, how do you manage it?

Do you have an interest in lead managing?

No. We have an interest in the individual playing an increasingly important role in the capital markets. And we will keep moving the bar on the lead manager until we're satisfied that the individual plays the same role in capital raising as they do in capital trading. But I'd rather work with Wall Street than against it.

What is the Goldman relationship about?

It's a superb relationship, but a nonexclusive relationship. We don't have to do deals with them and they don't have to do deals with us. It is intimate, but it doesn't cross the line. They understand they have only part of the equation, and that, where the world is going, they're going to need the other parts. The relationship is making a ton of sense from the IPO perspective.

So how do you gauge your own success - by the amount of money you make your clients?

I actually don't gauge it that way. Of course you've earned a lot of money; it's the Internet sector - how can you not have?

Instead I look at what is the quality of the companies we've gone with. Have any of them had problems? How good is our due diligence? How good is the process? With whom do we affiliate? How many deals do we walk away from? And it's a pretty damn good record. The lead underwriters of our deals are tier one. Maybe not every one is Goldman Sachs, but it's one notch down, which is pretty good.

What would stop a Morgan or Merrill from doing what you're doing?

Because they're in the business of wealth creation for themselves, of rewarding their two or three best customers with IPOs. They're not in the business of helping the users or the issuer. So there are things I worry about in life - because I've got to be worried, because I know one of these days I'm going to open up the paper and say "Oh, sh-t. I can't believe this just happened to me." But that's not one of the things I worry about. What used to keep me up at night was the fact that Wall Street would try to blackball us. So we went to the issuers and bit by bit, we've overcome that. We've created a brand.

Do you worry about E*Offering?

No. If that's the worst of my worries I'm in pretty good shape.

What about W.R. Hambrecht?.

Irrelevant. I don't understand his model, from two perspectives: I don't understand the idea of an auction of an IPO. I mean, IPOs are supposed to trade up, not flat. And I don't know how you can do anything without research. If you ask me what's unique about Wit, ultimately, it's our research. The greatest fear of a company going public is orphanage. So if you're Hambrecht, you'll be used when nobody else will take the company public. You'll do it with third- or fourth-class research and when this market tanks, guess what tanks first? Those companies.

One of the concerns about Wit is that it's never lived through a real bear market.

First, let's recognize that the company hasn't, but the individuals have. Whether it's 26 or 35 years on Wall Street, you've got a lot of history here. So I don't think any of us are going to be duped by that one.

I actually am a big believer in the valuations and I think there's something more fundamental than the whims of the market behind all of this. I mean, I respect Alan Greenspan, but he doesn't see 200 deals a week. But having said that, what makes Wit unique is the seasoning of the chain. It's not just 22-year-old kids who never even knew there wasn't an SEC.

Wit's own share price hasn't been exactly stellar. Are you concerned?

I don't even think about it. I don't have the slightest interest where my stock trades on a day-to-day basis. What I'm paid to do by the board is produce results, not to watch the share price. The quarters that we have filed have been pretty impressive in terms of meeting Wall Street estimates. I can't comment on where we're going but I do have a smile on my face.

Ron Readmond On the Future

So how do you see U.S. capital markets shaping up in four or five years' time?

Retail participation in capital markets will be predominantly through the electronic channels rather than through the visible broker and bricks and mortar. The Internet will be expanded in terms of the way information is provided to individuals and institutional investors interactively. The Internet does two things. It disintermediates traditional physical processes, and we've only begun to do that with the retail side of the business. But it will penetrate every aspect of our business in that three-to-five year period of time. And because it is disintermediating and takes costs out of the process, it also tends to be somewhat deflationary.

Wit will be a major player in the capital formation part of the financial services business. The world doesn't need another E-Trade; it doesn't need another Schwab; it doesn't need another Goldman. But it needs somebody to facilitate the economic restructuring and providing of capital for the economic restructuring that's taking place today, as a participant rather than an observer.

What happens if we hit a bear market and the IPO window snaps shut?

That's the incredible part of this model to me. Sources of capital dry up. So sometimes the IPO window is open, and it's open today. Other times it closes and closes fairly abruptly. But our relationship is with literally thousands of private companies that are in various states of development and have different needs for capital. If the IPO market dries up, those companies are still going to need money.

So what about the concern that retail investors are more "emotional" and more apt to panic and flip during a correction?

The institutions are the flippers. And they make a lot of money. And there's something wrong with that. Because the money they've made is at the expense of the company because they paid too little when they paid $9 a share, and at the expense of the retail public that didn't have access to the IPO. The institutional ownership in our stock today is less than 20 percent.

You had retired from a long career on Wall Street. What drew you out?

Very seldom does one get an opportunity to not just participate in, but drive, a paradigm shift in a business where they've spent a whole career. Generally the paradigm shift is executed by somebody who follows you, rather than by you or somebody who preceded you. So it's the fun of the whole thing.

Hambrecht Goes Dutch

Hot-to-trot day traders would scoff at Bill Hambrecht's Dutch auction IPO system. If supply matches demand, and shares are sold for precisely what the market will bear, and there is, therefore, very little chance of a run-up, where on earth is the Las Vegas-style excitement?

"I guess the question is, is the purpose of an IPO to allow somebody to flip a stock in four hours and make a bundle," asks Gartner Group's Schehr, "or is the purpose of the IPO to allow investors their first opportunity to be a public investor in a company with potential?"

No question which one Bill Hambrecht chooses. "Ultimately, when people look back, very few have done really well in the IPO market because they don't typically get in at the offering price and they get drawn into an emotional aftermath that's destructive," says Hambrecht, CEO and founder of W.R. Hambrecht.

Since traditional investment banks make it nearly impossible to change the system - and Hambrecht is all too familiar with this code, having been at Hambrecht & Quist since 1968 - his solution is to step outside the model and create a new one.

As of press time, of the two companies W.R. Hambrecht had taken to market, one, Ravenswood.com, was trading fairly flat, and the other, Salon.com, was down from a high of 15 to around 5. (Hambrecht urges critics to take the long view, out five years or so, where he is convinced Salon.com will come into its own.) Undaunted by what might be regarded as setbacks, W.R. Hambrecht, together with Advest and DLJdirect, will take out Andover.net, which provides content to the Linux operating system user community.

So far, W.R. Hambrecht has yet to get a really big-name deal, something it needs to lend credibility to the model. In that, this little company has perhaps its greatest challenge, says Burke, "because if you're going public and you're getting wooed by Goldman Sachs and W.R. Hambrecht, Goldman Sachs makes a pretty compelling case why you should do the deal with them."

But, says Hambrecht, that's just because it's the way things have always been done. "The opportunity is there. I didn't realize this when I was at H&Q, but there's enough resentment against the current system that there's a lot of people who would like to use this if it works." To support the firm's theories, Hambrecht is currently conducting academic studies at Berkeley and Tel Aviv University to try to get a read on historical price moves in the IPO market.

Meantime, Hambrecht isn't looking to bite off more than his firm can chew. As far as research, he believes individuals can understand more than investment banks give them credit for, if you make the hard numbers accessible to them. He plans to offer statistical information on overall markets from independent research firms such as Giga Information Group, but will primarily focus on specialties in niche markets, such as the Linux operating system, where the company can offer expertise.

It's an uphill battle, to be sure, but this father of five is no stranger to a tough ride (for his birthday, he recently rode his age, 64 miles, on his bicycle in one day, a long standing tradition), and he has no interest in retiring now. "I think you've seen my last startup," he says, chuckling. "But, then again," he adds eyes twinkling mischievously, "you never know."

Bill Hambrecht On Playing Outside the Box

One of the criticisms of your model is that, while it takes some of the risk out, it also takes out the excitement.

That is the essence of our problem. The volatility created by an IPO is really very dangerous because it creates a lot of emotional excitement about the stock that tends to drive it up to a point where people rush in to buy and then generally it drops back. So the company ends up with a group of shareholders who bought it at the top and aren't happy and a bunch of employees who have option plans and are unhappy. So it's very exciting, but the aftermath is not very positive for most companies. I know it's a hard sell, but ultimately, we have to prove we can underwrite good companies and we think we will.

How will you address the research question?

In terms of research, getting another bunch of big-name analysts and doing it the same old way, I just don't think that's gonna work. You have to have a different model. Wit has got its established names and they're trying to do it in the conventional Street-model kind of system.

Right now Wit has an easier sale because what they're saying is, you don't have to change the process, you can keep your traditional underwriter; just give me a little piece. But my problem with that strategy is I don't think they'll ever give you much of a piece. [Lessin]'s been on a lot of covers but he doesn't have much revenue because - how much of the offering do you get? Usually 2 percent to 5 percent. For every deal we manage, it's equal to 20 deals he has in terms of revenue.

But with the Goldmans and Morgans offering full IPO services, how do you get these really choice companies to listen to you?

We've found the bigger and better known the company, the easier the sell. Because they've correctly figured out they don't really need that. If they're a well-known leading player in an area, all the analysts are going to cover them anyway. So if anything, you're losing [by going with a traditional investment bank] because you pick one and the other guys are mad at you.

It's the smaller, more fragile ones who say, "Are you going to support me as well as Goldman or Morgan Stanley would?" And I'll be the first to admit we can't cover as many industries as a Goldman or Morgan, but I think we know more about Linux than either one of those firms.

Do you have any big ones in the works?

We've come dangerously close to some very interesting companies. We had one that would have been the breakthrough deal for us, but finally at the board level, they said, that's a big gamble to take. There are a lot of people who would like to go second or third. So we just have to keep slugging away.

Do you think these guys are really going to lower their fees because of your model?

Oh, sure. They're going to have to, ultimately. There's no reason in the world why a company going through an IPO should pay 7 percent - particularly if the underwriter is discounting the price and selling it to his best customers. That's an enormously profitable thing for him because he's getting all this reciprocal business back. The 7 percent thing was set up 50 years ago, when you had salesmen out there selling each 100-share lot, to incentivize the salesmen to do it. When you discount the price, you don't sell it; you allocate. So why should there be a commission?

Your deals go up on the boards of on-line brokerages, such as Fidelity. How do you keep those accounts from being typical online flippers?

First of all they have to bid the number of shares and what they're willing to pay for them and they're told: no guaranteed profit, so make an investment decision. Buy it if you want the company. Don't put in the bid if you're expecting a jump. It's the Peter Lynch theory of investing. That's one of the reasons Fidelity was so good. It was, buy what you understand, buy the companies you believe in. It's not quite as sexy. It's like trying to be the straight guy at a New Year's Eve party. But New Year's Eve parties don't last the whole year.

What do you consider this company's best measure of success?

Well, to be candid with you, I'm not very financially motivated anymore. That's not what it's all about for me. So first, if we can honestly see the auction process improve the system as it exists today so that companies do have easier access to capital and there's less volatility and less damage to the investment community. In other words, if the system rationalizes so that the people who really want to own the stock buy it and the company gets the right price - to me that would be a great success, if we can pull that off. And then, more parochially, if we build a firm that doesn't feel it ever has to sell out. That's my ultimate dream.

ICG: GE of E-B2B

In many ways it's easy to confuse Internet Capital Group with a publicly traded venture fund. The Wayne, PA-based outfit has spent most of its young life hunting for diamonds in the rough, investing in business-to-business e-commerce startups that show some promise of one day becoming serious contenders in their vertical markets. ICG now owns stakes in a collaborative network of some 35 companies in various stages of development. Its own stock is trading at somewhere between an $11 billion and $12 billion market cap.

Not bad for a venture fund that isn't a venture fund. "We do compete with individual venture firms on an acquisition by acquisition basis. But nobody is going in to try to have their companies participate in the top 50 markets," says Walter Buckley III, CEO of ICG. "What happens at Kleiner Perkins? They're going to invest in some great B2B e-commerce companies but over time they're going to liquidate their position."

Not so ICG. Buckley, the 39-year-old former VP of acquisitions for Safeguard Scientifics, says his firm is really a holding company with more ambitious plans than capital investment - well, that is, if you call striving to be the GE of the Internet ambitious. "Our goal is to be in the top 50 B2B e-commerce markets," says Buckley. "When we say we want to look like GE when we grow up, we don't want to exactly mirror GE. The structures of traditional holding companies range in terms of flexibility and structure. We're very flat, but what we do have that mirrors a GE is functional departments - our IT group, recruiting group, finance group, marketing group - and their primary goal in life is serve our partner companies."

ICG's partner companies fit primarily into one of two categories: "market makers," which bring buyers and sellers together through tile creation of Internet-based markets and facilitate exchange of goods and services; and infrastructure service providers, which sell software and services to e-commerce businesses, particularly ICG's market makers. Its most well-known and so far only public company is VerticalNet, a market maker that aggregates buyers and sellers in more than 47 industries or vertical markets. Its stock, not surprisingly somewhat volatile, has swung between $74 and $30; at press time it was hovering around $55.

Ultimately, ICG's goal is to see each of its fledgling companies rise to stardom as leaders in industries such as chemicals, plastics, paper, telecommunications, auto parts and healthcare, and key partnerships with physical world players will be an integral piece of that. "What we're doing is becoming a complement for them, a new channel, maybe the best channel they've seen because it's low cost and global in reach," says Buckley.

Opening Private Equity to All

With this new trend of ICGs and CMGIs and other publicly traded venture funds - combined with the much increased accessibility of the stock market by the individual investor - just about anyone can get in on the ground floor of a group of hot startups. "Whereas before you'd have 80 people in a deal, a private placement, you had to be called by a broker, you had to be sold really. It was an inefficient market," says Rob DiVenere, CEO of Newbury Capital. "What the internet has done is it's created the ability of an individual to invest in a startup." And it's those individuals, Buckley hopes, who will believe in ICG's companies and who will likely continue to support them going forward. "Obviously, we hope the investors are investing because of our vision of being the aggregator and consolidator of this marketplace, not just the arbitrage between private valuation and public currency."

But ICG's next challenge may be not only to dispel the myth that they're trying to compete with Kleiner, Perkins but to set themselves apart from a growing number of similar networks of small companies, publicly traded venture funds. "Publicly traded blind pools of venture capital are becoming more prominent because of the Internet and people are going to invest but they don't really know what they're getting necessarily," says DiVenere. "With an ICG, the argument is, yeah, you're paying a premium, but we've got 30 companies already in the portfolio and a lot of them are going to go public. We think they're going to be worth more than $11 billion. So it's all risk and reward."