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Gaffe mars Artistdirect's public offering

The online music provider offers to repurchase all stock options issued to artists and managers who shouldn't have received equity in the newly public company.

Taking a company public evokes images of mansion-dwelling executives and Porsche-driving administrative assistants. But there are exceptions.

Not only do many IPOs start to slide as soon as they hit the Nasdaq, but young companies often are ill-prepared to deal with myriad regulations and reporting requirements.

For Net music company Artistdirect, which went public this week, investors and company executives have had to contend not only with sinking shares, but also with a potentially costly violation of Securities and Exchange Commission regulations.

Artistdirect helps bands from classic rock group Pink Floyd to alternative favorite Limp Bizkit set up Web sites that dispense information and sell merchandise. The company raised $60 million this week by selling 5 million shares for $12 each. The shares have since lost about one-third of their value, currently trading around $8.

In addition, Artistdirect could end up paying back nearly half of the $60 million it raised because of violations of SEC regulations.

"To also have a stock out there with this kind of a problem--I've never seen this happen before," said David Menlow, president of IPO Financial Network.

Artistdirect has admitted to issuing more options before its IPO than it should have, a violation of federal securities law and a potential embarrassment to the company and its underwriters.

According to a document filed with the SEC late Monday, the company intends to make a so-called rescission offer to certain investors later this year. If it follows through on the offer, these investors could ask the company to repurchase their shares.

Many shareholders may not take the company up on its offer. But if the shares continue to slide, such a buyback could look attractive. In the worst case, Artistdirect says the buyback could cost up to $27 million, plus interest.

Company executives, who did not want to be quoted directly, explained to CNET News.com that the rescission offer was merely meant to comply with SEC guidelines on who can receive equity in a new company.

At the heart of the problem is how companies classify "consultants." SEC regulations permit consultants to receive equity stakes in companies that are planning to go public. But not just anyone can be labeled as a consultant.

In Artistdirect's case, executives were attempting to create a broad community of owners, ranging from directors and employees to musicians and their managers. As a result, it liberally considered such people consultants.

Artistdirect builds Web sites about musicians--including everything from biographical information to concert dates and new recordings--for an audience composed mainly of the musicians' fans. The company hosts sites of more than 100 different artists and controls Downloadsdirect, a digital music hub.

The company gave participating artists and their managers options for 7.3 million shares in exchange for agreements to sell merchandise.

But SEC guidelines enacted late last year dramatically restrict the number and types of people who can be considered consultants for the purposes of issuing equity stakes, Artistdirect executives said.

To comply with the new guidelines, Artistdirect in September issued a rescission order, alerting potential investors that too many people had been categorized as consultants and that the company might offer to buy back the shares. Monday's filing updated the SEC and investors on the consultant issue in advance of this week's IPO.

According to the SEC filing, Artistdirect will offer to buy back shares from these consultants at the purchase or exercise price, plus interest at the rate of 10 percent per year.

The company also will offer to repurchase all unexercised options under a complicated formula outlined in the SEC filing.

Company executives said yesterday that Artistdirect will continue trading on the Nasdaq Stock Market. They do not expect a major management shakeup because of the incident, which one executive characterized as "minor."

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