fyi:Basic Intro to 'PIPE' funding
(note that the increase of PIPE financings began around 2004)
THESE PIPE ARE SMOKING
April 23 2004
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.
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