For the past several years, since the tech bubble burst, companies
have struggled to find sources of financing. Initial public offerings
virtually disappeared from the scene, frustrating private companies that
hoped to solve their financial needs by becoming public. But being
public is no panacea, and public companies have found funding equally
elusive.
That could be changing. Private investors, who have spent recent
years sitting on the sidelines waiting for a sign that the economic tide
has turned, have decided to open the spigot on their pipeline of funds.
Make that PIPEline, since much of the latest funding is being packaged
as PIPES, private investments in public companies.
PIPES provide almost instant access to funds, for those companies
willing to pay the price, which can be considerable. Still, companies
must be prepared to hand over a significant block of stock in exchange
for the financing, and what flows through these PIPES can prove murky
indeed. The structure of the PIPE may well spell problems down the road
for a company struggling to obtain credibility and pave the way for
future, more substantial funding.
According to a recent report from PlacementTracker, a division of
Sagient Research (itself an OTC Bulletin Board company trading under the
symbol PCSR) 209 PIPE transactions, involving $2.7 billion in proceeds
to public companies, concluded during the first two months of 2004.
This represented a 200% increase in transactions, and a 150% increase in
proceeds from the same period a year earlier. The numbers may be even
more striking - the PlacementTracker report excluded equity based
financings under $1 million and transactions placed by non-U.S. issuers.
Perhaps it is a sign of the revived economy, or of restless private
investors who have been waiting on the sidelines for the right
opportunity and environment. In any event, PIPES share a common
rationale with other forms of financing; the individuals providing the
funding see an opportunity to profit. While that does not mean that the
public company cannot also benefit from the PIPE, that benefit must be
carefully weighed against the price to be paid, in stock, cash or
reputation.
PIPES often provide a short term solution for the company, while
resulting in a handsome profit for the financiers. In a sense that
seems fair. After all, the people funding the PIPES are theoretically
putting their money at risk. In reality, however, those risks are
carefully calculated, and in many cases, merely theoretical.
Consider how PIPES generally work. One or more investors - often
including offshore companies - agree to buy unregistered shares of a
public company, at a substantial discount from their market price. The
investors may also receive warrants entitling them to purchase
additional shares at a fixed below-market price.
The shares are issued at a discount because, in theory at least, the
PIPE financiers will have their funds at risk until their stock has been
registered. Those risks appear to be particularly acute when the PIPE
is made available to a smaller public company, as is often the case. In
fact, so-called emerging growth companies traded on the OTC Bulletin
Board, and that would include many up and coming biotech firms, have
proven to be particularly receptive to the calling of the PIPES. They
need cash, whether for working capital or research and development, and
are willing to part with shares - lots of them - to become more liquid.
And, unlike more established companies with institutional shareholders,
they are less uneasy with the concept of dilution, and therefore far
more likely to continue printing shares to feed those PIPES.
PIPE investors recognize that these undercapitalized companies are
hungry for capital, and consequently prepared to issue even more shares,
at a greater discount. Even then, the investors find ways to reduce
their potential risk. In some cases, they insist that the public
company file a Registration Statement for their shares before any of the
funding is delivered. In that scenario of equity-based financing, the
company notifies the investor that it wishes to draw down funds from a
financing, and files a registration statement for the corresponding
shares that it is obligated to deliver. Once the Registration Statement
is declared effective, the investor exchanges the funds for the
registered shares.
The investor's risk is limited because he can immediately sell the
stock- at a profit since it was issued at a discount to the market.
Particularly shrewd investors can hedge their bets even further by
shorting the company's shares before the funds are delivered, then using
the money received from selling short to fulfill the financing
commitment, delivering the newly registered stock to cover the short
position, and pocketing any difference.
Even more dangerous are PIPES that involve "death spiral" financing.
In this scenario the number of shares issued to the investor is keyed
to the market price of shares, and increases as the market price
descends. Unfortunately, that means the PIPE investor stands to profit
from lower stock prices. Consequently, the investor has an incentive to
short shares, thereby depressing prices, and guaranteeing the receipt
of more shares.
Consider a PIPE investor who provides $1 million in financing in
exchange for a debenture that is convertible into $1 million worth of
stock. The number of shares to be issued is based upon the price of the
stock on the date of conversion. Say the investor begins to sell the
company's shares short when the stock is trading at $5, eventually sells
1 million shares, receiving $5 million and successfully depressing the
share price to $1. He then converts the debenture into common stock at a
rate of $1 a share and receives 1 million shares which he delivers to
cover the short position. He has earned a $ million profit in exchange
for $1 million in short term financing.
Death spirals are, however, the worst case scenario, and one to be
avoided even if it means foregoing a PIPE. That does not mean that PIPE
investors are willing to allow their shares to remain unregistered.
Most insist upon speedy registration following the delivery of funds.
In some instances, the investors will not receive common stock, but in
=stead are issued a debenture or interest bearing preferred shares, ach
of which can be converted into common stock once the underlying common
shares have been registered. That way the PIPE investors receive
interest while awaiting the day when they can convert and sell their
shares- again at a discount to the market.
PIPES have one other attractive feature; they provide speedy access
to cash without regulatory scrutiny. In a public financing the company
would be required to file registration documents with the Securities and
Exchange Commission, disclosing material details about the identity and
nature of the investors. PIPES remain private - and so do the people
who fund them. On the positive side that allows the public company to
move quickly. On the flip side, it means investors and regulators are
deprived of meaningful information about those investors, many of which
may simply be offshore companies with nominee directors and officers.
PIPES provide an appealing mechanism, provided they are utilized
judiciously. On the other hand, when companies issue PIPES repeatedly
they leave shareholders diluted and disgruntled, and create a public
float that may cause them to drown in their own shares.
Money is flowing again, but the individuals who are providing it are
sophisticated, shrewd, and dedicated to profit. In order to be treated
fairly in these transactions, public companies should be equally focused
on their goals and set reasonable limits on the price they are willing
to pay for an infusion of capital.
Put that one in your PIPE and smoke it.
Hartley Bernstein and StockPatrol.com have been featured in The New York Times, The Wall Street Journal, Forbes, Barrons, Crain’s New York Business, Details Magazine, Chief Security Officer Magazine, and Investment Dealers Digest.
