Death by finance
April 11, 2001

L. David Sikes was desperate. The CEO of Ramtron International (Nasdaq: RMTR) watched helplessly as the publicly traded chip maker lost $1 million a month during the height of the Asian financial crisis of 1998. Ramtron needed $17 million to stay in business, but couldn't turn to the traditional capital markets -- not with its balance sheet and its dependence on the Asian market. With nowhere else to turn, Mr. Sikes contacted a consortium of 12 individual investors and came up with the $17 million at terms that would make a credit card company green with envy. "It was," Mr. Sikes concedes, "a roll of the dice."

What Mr. Sikes did was take a "toxic convert," a financing measure of last resort that is becoming increasingly popular in the wake of the Nasdaq crash on April 14, 2000 -- and is coming under increasing scrutiny. In exchange for the $17 million, Mr. Sikes was required to turn over about $19 million's worth of Ramtron common stock. The catch: the investors were entitled to the $19 million in stock, regardless of the price per share.

And it was likely that Ramtron stock would drop enough so that the investors would eventually take control of the company on the basis of their $17 million infusion. In fact, when a company takes a deal like this, the odds are overwhelming that its stock will drop. Within six months, Ramtron's share price dropped from $5 to $0.25. Of the 220 such toxic convert deals that took place in 2000, only five companies wound up in better shape -- most of them tanked.

It happened to eToys. It happened to MicroStrategy (Nasdaq: MSTR). It happened to Quokka Sports (Nasdaq: QKKA). And it happened to hundreds of other startups on the verge of extinction. Still, hundreds more clamor for a similar deal. And for every company in need there is an organization willing to lend a hand -- for a stiff price: Promethean Asset Management, the Citadel Investment Group [Kenneth Griffin], Marshall Capital Management, and Angelo, Gordon & Company. There's a reason they aren't household names. "They like to stay under the radar," says Steve Bruce, an attorney who represents the Citadel Investment Group, explaining why his clients and their competitors would be unwilling to discuss their business.

Toxic converts are a form of private investment in public equity (PIPE) and are known in the industry as the grimmest of reapers. Companies accept the financing because it is fast -- typical deals close within a month -- and the sums are generally below the $30 million minimum for secondary offerings. A last-ditch infusion of capital tied to stock price is an entrepreneur's way of gambling on a long shot -- that the struggling company can quickly turn around. Far more frequently, however, it is merely an invitation to the short-sellers -- often the PIPE investors themselves -- and throws the company's stock into an irreversible death spiral.

Meanwhile, the investors get fat at the expense of long-term individual and institutional investors. Promethean Asset Management founder and president James O'Brien boasted in the pages of a conference agenda that his $140 million fund has returned 126 percent since 1996, when the financing mechanism was first unleashed. Six years ago, 36 death-spiral deals worth a combined $264 million were consummated, according to private equity tracker In 2000, death-spiral deals were taken by 220 companies and accounted for $2 billion of the $18 billion overall PIPE industry. This popularity comes despite the fact that the death-spiral investors, motivated by a seller's market, stack the odds higher and higher with increasingly onerous contract demands.

As the technique grows in popularity, so does the controversy surrounding the profiteering. And now some companies and long-term investors are fighting back. The State of Wisconsin Investment Board, which manages a $60 million portfolio, has threatened to sue any of its portfolio companies that get involved with PIPEs. Several other companies have sued or are suing their PIPE investors. The growing ranks of dissatisfied companies include Log On America (Nasdaq: LOAX), Ariad Pharmaceuticals (Nasdaq: ARIA), and Ramtron, where Mr. Sikes struggled to extricate his company from the deadly deal's tight grip. "That was the most miserable year of my life," he says.

Ramtron, based in Colorado Springs, Colorado, lives on today only because the deal went so horribly sour. The investors demanded more shares than the company had issued. Using that as leverage, Mr. Sikes engineered a five-for-one reverse stock split and paid the investors 50 cents on the dollar to settle several lawsuits. But Mr. Sikes, who retired last year, was one of the few lucky ones.

When Mr. Sikes signed his deal with the devil, he was able to explicitly ban his investors from short-selling the company's stock. It did little good. The company was hit hard by unidentified short-sellers who helped send the company's stock into a six-month nosedive. "Things can happen offshore that you can't prevent," he says.

Today's PIPE deals don't prohibit short-selling by the investors. In fact, companies sign contracts that explicitly allow the investors to sell stocks short. "The companies resist the clause in the first four or five drafts of the contract," says securities lawyer Robert Friese. "But by the sixth draft, it's in there."

When it comes time to recoup their investments, death-spiral dealmakers garner enough stock in the companies to cover large short positions and have enough left over to take control.

Another benefit of short-selling for toxic-convert investors: as the stock drops in price, not only do they get a larger share of the company, but the company's valuation makes it an attractive takeover candidate -- enabling the investors to make money on both ends.

Judson Schmid, chief financial officer of health care content provider ProxyMed (Nasdaq: PILL), points out that for dot-coms that went public too soon, there often is little choice -- take the tainted money or turn off the lights. "When you get desperate, you're willing to overlook things," he says.

Ramtron's 1998 agreement called for it to repay the death-spiral investors with common stock discounted 7 percent from the prevailing market rate. Now, companies are consenting to repay the investors with stock discounts ranging from 10 percent all the way up to 30 percent.

In December 1999, ProxyMed raised $15 million in a death-spiral deal with several investors. Among other concessions, ProxyMed agreed to voluntarily delist from the Nasdaq in the event that the investors were owed more than 20 percent of the company and its long-term shareholders refused to allocate additional stock. At the time ProxyMed signed the deal, its stock traded at $10 a share.

When the investors came calling for repayment last year, the company's stock had collapsed to below $3 a share. By May, the company owed the investors close to 40 percent of all its common stock. Rather than delist, ProxyMed's shareholders agreed to a radical dilution of the company's stock. They doubled the company's stock allocation from 50 million to 100 million, in essence devaluing their investments by half to pay off the death-spiral deal. The company also needed additional funding in 2000, taking a $24.3 million investment that further diluted the company's ownership.

ProxyMed now trades at around $1 a share.

These deals are also referred to as "corporate loan-sharking," "payday advances," or "pawnshops for dot-coms." Mr. O'Brien, an industry pioneer, established Promethean in 1994 after serving as managing director of Fletcher Asset Management in New York. Last year, Promethean invested nearly $108 million in 11 companies. The stock of every one of those companies lost value after the investment. According to, the stocks of companies that Promethean has invested in since 1995 have dropped an average of 36.5 percent just six months after closing the deals and 17.3 percent after a year.

Last year, Promethean chipped in $25 million of the $100 million in death-spiral convertibles invested in eToys and $20 million of the $125 million invested in MicroStrategy. EToys stock plummeted from around $5 at the time of the deal to almost zero this year and at press time was facing bankruptcy and Nasdaq delisting. MicroStrategy stock traded at $38 when its deal was announced in June, almost four times what it was trading by February. Promethean's partners in those two deals were Citadel in Chicago and Angelo, Gordon in New York.

Citadel [Kenneth Griffin] is a $4.5 billion hedge fund that invested $141 million in seven companies last year, including $60 million in MicroStrategy and $30 million in eToys. Citadel's portfolio companies decline an average of 21 percent a year after closing its death-spiral deals, according to

Angelo, Gordon's portfolio companies fared somewhat better, dropping a mere 6 percent a year after closing its deals. But Angelo, Gordon doesn't do as many death-spiral deals as Citadel [Kenneth Griffin] and Promethean. Last year, Angelo, Gordon closed seven death-spiral deals for a combined $125.7 million, of which $90 million was divided equally between investments in eToys and MicroStrategy.

Clearly, companies signing up for such financing are generally poor performers and doomed for failure anyway -- with or without additional cash. The death-spiral deals themselves don't necessarily kill an already dying company. But they definitely hasten death.

The investors are assured automatic profits because they demand repayment in common stock, sold to them below the prevailing market price. They face little downside in shorting the stock, especially since the companies are usually in financial trouble and their stocks were destined to tumble anyway.

As more death-spiral deals go bad, some long-term investors and even the companies themselves are fighting back.

In banning its portfolio companies from taking toxic converts, the Wisconsin Board of Investment warned: "The investors have gone through great lengths to appear thorough and genuine in their interest in the companies. However, they may actually be assessing the odds of failure. Adding a toxic security to the financial structure increases the odds."

If a company in the portfolio succumbs to temptation, "We will sell the company or seek some kind of [legal] action," says board analyst Mark Traster. The investment board also threatened to pull its business from a large investment bank that is trying to get into the death-spiral business. With the growth of this financing technique -- and the drying up of traditional investment banking services -- prestigious investment banks are entering the market. For example, Credit Suisse First Boston now controls Marshall Capital Management, which specializes in death-spiral convertibles.

Meanwhile, several companies have sued their death-spiral investors, alleging fraud and market manipulation. Ariad sued Promethean in 1999, a year after Promethean invested $5 million in the company. The suit accused Promethean of shorting 2.5 million shares -- 10 percent of the company -- soon after closing the deal. This massive short-selling helped send Ariad's stock from $3 a share to just $0.59 in a few weeks, say executives at Ariad.

The companies settled last year. Ariad agreed to issue just under 1.1 million new common shares so Promethean could "cover [its] total outstanding short position," according to a document filed with the U.S. Securities and Exchange Commission. The company also agreed to pay Promethean $6.9 million.

Citing a nondisclosure agreement, lawyers for both sides declined to discuss the case. But Log On America, a small Rhode Island ISP, is using the Ariad settlement as a centerpiece for its own suit against Promethean, Citadel, and CSFB's Marshall Capital.

Log On America accuses the investors of stock fraud. The investors, Log On America alleges in its suit, funded the company simply "to launch an unlawful scheme to short-sell its stock in sufficient volume to drive down its price, knowing that they would be in a position to cover the short sales by converting their preferred stock at depressed market prices." The investors' alleged short-selling, according to the lawsuit, allowed them to reap millions of dollars in profits from short-selling while "simultaneously allowing them to reap tens of millions of dollars in profit and seize control of the company" as the ultimate result of the PIPE deal. Since Log On America entered into the deal in January 2000, its stock price has dropped from $17 to $2.50, and the company has lost about $120 million in market capitalization.

None of the investors returned telephone calls. But in court documents, they deny all of the accusations. In fact, every investor except Marshall Capital denies that they sold short a single share of Log On America stock. Besides, they say in court papers, even if they did sell short, they did nothing illegal.

Indeed, the contract explicitly allows the investors to sell short. Their bottom line: Log On America is trying to get out of "having to live up to its obligations under the agreement."

What the lawsuit doesn't fully explain is why Log On America entered into the deal in the first place. That's saved for a separate suit against CSFB, which served as Log On America's financial adviser and helped negotiate the death-spiral deal. The suit alleges, and Log On America CEO David Paolo asserts in a separate interview, that CSFB led them astray with bad advice and that the advice was given because CSFB was concerned primarily with sending business to its subsidiary, Marshall Capital.

Mr. Paolo says his company had $20 million in cash on hand and a burn rate of $4 million a year when CSFB persuaded Log On America to take the deal. "We should never have done that deal," Mr. Paolo says now. "We didn't need the money." At press time, the investors were attempting to have the suit thrown out.

Meanwhile, most of the companies that took these deals weren't like Log On America. They were young companies teetering on the brink of extinction. Death-spiral investors were the only places these companies could raise more capital. Some decided against taking a death-spiral deal and chose to shut off their lights instead. An investor, who asked not to be identified, asked rhetorically, "Who was better off, or eToys? EToys lasted longer and gave it a shot. didn't, and shareholders in both companies are now in the same position. Which is worse?"

Julie Wainwright, CEO of the now-departed, did, in fact, turn down offers from the toxic-convert crowd as the company sank into oblivion late last year. She apparently didn't want tossed into a vortex that would end with toxic-convert investors walking away with the company's carcass. Instead, Ms. Wainwright filed for bankruptcy under Chapter 7, choosing to liquidate and pay off the company's creditors and long-term investors as best she could. Ms. Wainwright apparently reasoned that the act of putting down without taking a toxic convert was a more dignified death.

But there's another benefit to avoiding the financial grim reaper. By not selling out the interests of long-term investors to Johnny-come-latelies, executives like Ms. Wainwright stand a chance of burning fewer bridges -- increasing their odds of staying in the game.


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