Help Comes With a High Price
Distressed Firms Agree to Extraordinary Terms, Even at the Risk of Depressing Stock Prices

By Cynthia L. Webb
Washington Post Staff Writer
Monday, April 16, 2001; Page E01

In June 2000, MicroStrategy Inc. was in difficult straits. Its secondary stock offering had just fallen apart, it was being investigated by the Securities and Exchange Commission and it needed money.

The high-tech company embraced an overture from an investment group led by Promethean Asset Management LLC. The $125 million deal might have looked good to MicroStrategy's management at the time, but it would prove costly for MicroStrategy's shareholders, possibly causing extreme dilution of their shares and helping drive down MicroStrategy's stock price.

The MicroStrategy-Promethean deal was a harbinger. In the past year, a half-dozen local technology companies, struggling to survive, turned to private investors and hedge funds that demand stiff and often unpleasant concessions.

The deals take many forms, but a common thread is that the money is often tied to the firm's stock in such a way that it can put downward pressure on a stock price at the expense of existing shareholders.

In MicroStrategy's case, Promethean, Citadel Investment Group LLC and Angelo, Gordon & Co. bought $125 million in preferred stock that was convertible to common stock. The conversion price of the common stock was based on the weighted average of shares over a 17-day trading period following the close of the deal in June, or about $33 a share. On the one-year anniversary of the deal, the conversion rate could be reset based on the average price of the stock during a 10-day period starting in June.

The more MicroStrategy's common stock price fell below what it was in June 2000, the more stock Promethean and the other investors were entitled to. The price sank so low that the conversion threatened to severely dilute the holdings of Vienna-based MicroStrategy's other shareholders.

As of Thursday, MicroStrategy's stock was trading at $2.48 a share. With the June conversion date approaching, it became clear to MicroStrategy and the Promethean group that the conversion would severely dilute existing shareholders' investments in MicroStrategy. This month, they renegotiated the deal.

"In an effort to avoid that kind of ticking time bomb, the company restructured the financing," said David Hillal, an analyst with Friedman, Billings, Ramsey Group Inc. The Arlington firm has served as one of MicroStrategy's investment bankers.

The new deal gives MicroStrategy a combination that includes common stock, cash and fixed-rate securities instead of a variable security, and results in less dilution for shareholders.

Overall, it's a "much better deal for shareholders," Hillal said.

"At the time of the original Series A preferred stock agreement in June 2000, we felt the terms were favorable to our overall business," MicroStrategy spokesman Aaron C. Radelet said in a statement. But the capital markets have changed considerably since then, he said, citing both the U.S. economy's slowdown and the decline in the Nasdaq composite index.

"So we refinanced the agreement under different terms that were favorable to our shareholders and the long-term success of our company," Radelet said. "Our other common stock shareholders benefit because it eliminates the risk of potential dilution, which could have been significant under the original terms of the agreement."

MicroStrategy's dance with New York-based Promethean illustrates the kind of difficult choices faced by companies as the stock market turns against them. Teligent Inc., E.spire Communications Inc., Inc., CyberCash Inc. and FastComm Communications Corp. are among the local telecommunications and technology companies that have turned to nontraditional financing to get through the downturn.

The deals are often different from traditional private placements of capital, in which investors get stock for cash, sometimes at a slight discount from the market price. But when a company is distressed and the risk for investors is high, institutional investors can demand a variety of painful terms.

They might ask for a combination of warrants, which entitle holders to buy shares at a specified priced for a certain period; added board seats; or stock at steeply discounted prices. They may engineer a way to gain more equity in the company as its stock slides.

Critics contend the deals can become "death spirals," since a company's stock price often drops after taking on this financing. As the stock drops, a company has to issue more common stock to meet terms of its original deal. Meanwhile, a lending company might convert its preferred stock into common stock at a discounted rate and then use the converted common stock to pay back a short-selling contract. In a short contract, a company borrows stock, then sells it, promising to pay back the stock at a certain time. When the price falls, it pockets the difference between the borrowed price and the lower market price at the end of the contract.

It can lead to a downward spiral of the stock, as other investors see a plunging price and continue to sell their shares.

Investors who are involved in distressed financing deals counter that they often invest for the long-term and want the stock to go up, not down. They also argue that they have to set stiff conditions if they hope to recover their investments, since they are taking a higher risk by investing in the company in the first place. It's a principle of risk reward -- the higher the risk of the investment, the higher the return should be for the investor.

"The idea of the company issuing more shares the lower the stock price goes is actually a concession on our part to these companies," said James F. O'Brien Jr., managing member of Promethean, a hybrid hedge fund and private equity investor. In "traditional public convert deals, if the stock doesn't perform, the company is required to pay in cash. We do an option [for companies] to pay in cash or stock."

O'Brien said his company doesn't look at its investments as "distressed" companies; it believes they are growth companies that are undervalued when it invests in them.

Promethean has been accused of short-selling by some of the companies in which it has invested. It is named in a lawsuit filed last August by Internet service provider Log On America Inc. of Providence, R.I. O'Brien said the claims were "outrageous." Ken Cornell, Log On America's chief financial officer, refused to comment.

Promethean settled a similar suit in January with Ariad Pharmaceuticals Inc. of Cambridge, Mass.

O'Brien said it is a misconception that his firm contributes to downward spirals, noting that in every deal, his firm caps the amount of equity stake it can take in a firm to either 4.9 percent or 9.9 percent of the company's outstanding shares.

"There's no question that [in] every investment we make, including MicroStrategy, we want not only emotionally but economically for these stocks to go up. We win when we go up; we lose when we go down," O'Brien said.

Still, as technology companies in particular continue to stumble, financial experts indicate that high-risk financing deals, often described as distressed investments because the companies are in dire situations, are likely to increase in number.

The most likely targets for distressed investments in the Washington region are telecommunications companies because of their large capital needs. But those companies are having a hard time accessing the marketplace for new cash infusions, said Ned Armstrong, an analyst at Friedman, Billings, Ramsey.

"In this particular environment, finding people who are willing to [invest] capital takes longer," said Doug Poretz, whose McLean-based firm Qorvis Communications LLC offers public relations and investor relations services for firms. According to Poretz, many companies are facing two options: get the money whatever the stakes, or go broke.

Poretz said his clients often worry about the stigma of taking the money, but he tells them that with market conditions worsening by the day, "don't worry about the terms. Get the money. "We are telling clients that money at 'X' rate is better than no money at 'X' rate. Your first goal is to survive," Poretz said.

Many area companies are trying to do just that., a Germantown-based Internet telephone service provider, last month secured a $2 million bridge loan from an unidentified "high net worth individual investor." The loan is a lifeline of sorts, giving the company 90 days to try and secure additional cash. But in exchange for the loan the investor can convert the debt to equity at his option for $1 per share. The investor also gets 500,000 warrants at the firm's market price of the stock when the deal closed, about 50 cents a share. For waiving any interest and financing fees, the investor also picked up a license to ZeroPlus's intellectual property and technology.

Officials for the firm declined to comment through spokesman Bill Brobst. ZeroPlus is still looking for new financing, Brobst said.

Poretz, who handles the firm's investor relations, said the deal's potential for diluting the pool of stock is typical. "There will be dilution. There will always be dilution with every company in distress."

Another local company, CyberCash Inc. of Reston, took on high-stakes financing in early 1999. Investors Rose Glen Capital Management LP and Palladin Group LP invested a combined $15 million in the company in exchange for stock in the form of warrants. The way the deals were structured, if the company's stock fell, the investors were in line to get a proportionally greater number of shares.

The stock did just that. As the stock dropped to 88 cents a share from $9.77, shares entitled to Palladin and Rose Glen rose to nearly 15.6 million from 1.4 million. CyberCash's founder and chairman, William N. Melton, resigned in protest in January. Melton said he quit to persuade the two main investors to renegotiate the deal, saying the original deal would significantly dilute the value of the electronic credit card processing company. The company and its investors reached an agreement several days later under which the investors agreed to exercise only a portion of their warrants to avoid extreme dilution of the stock.

CyberCash has since filed for Chapter 11 bankruptcy protection and is selling its assets and operations to pay its debts. A California company, VeriSign Inc., last week submitted a winning bid of $20 million for CyberCash's services, pending the approval of a bankruptcy court judge. (Story, Page E5.)

CyberCash's chief financial officer, John Karnes, did not respond to calls for comment on the original financing deal.

Another company, Teligent Inc. of Vienna, is on a desperate quest for cash. In December, it secured a commitment for $250 million from Rose Glen, the same firm that invested in CyberCash. The equity financing would allow Teligent to sell stock to Rose Glen at a 5 percent discount over 18 months. But Teligent has not been able to tap into the money because the stock price hasn't reached the required minimum of $2 a share, said Kerry Watterson, Teligent's vice president of investor relations. Teligent's shares have been trading under $1. The firm is shopping for another investor, Watterson said. Rose Glen refused to comment for this article.

Other companies that have struck deals for financing with more terms than traditional financing would dictate include the telecommunications firm E.spire Communications of Reston, which took on $125 million in equity financing in September but filed for Chapter 11 bankruptcy protection last month.

Dulles-based FastComm Communications, a maker of equipment for network communication systems, accepted $850,000 in February in a deal brokered by Zanett Securities Corp., a New York investment banking firm that had previously committed $3.5 million in the firm.

Zanett doesn't characterize it as a distressed deal. Zanett received prepaid warrants that can be converted into equity at $2.50 per share, higher than the market price for the stock when the deal was struck, said Augie LaTorre, a Zanett associate. If the stock price drops, Zanett can't convert its shares for more than 4.9 percent of the company's total outstanding stock.

"It's so the company doesn't have to worry that we are just going to take over the company. We did this for the company. We are actually quite benign investors," LaTorre said.

He said while the deal may "look a little stiff" on paper, Zanett puts in place anti-hedging clauses and does not short the stock.

"In this market, you have to take the money where you can get it. The thing is, do you pay a little bit more to get a good quality investor that is after the interest of the company or do you just take any money?" LaTorre said, adding that his firm typically holds an investment for two to three years.

According to industry figures, companies are biting on private placement deals, regardless of the requirements. During the first quarter, $2.2 billion was committed to public companies through 167 private investment in public entity deals, according to Inc., a San Diego investment banking firm that runs a Web site that provides data on such deals.

Ten percent to 15 percent of those deals were structured equity deals, most of them with floating or reset convertible preferred stock in exchange for cash, said Brian M. Overstreet, president of

Area investors are getting in on the act as well.

In Baltimore, T. Rowe Price runs a $100 million fund dedicated to distressed investments. Meanwhile, John M. Collard, who heads the Annapolis-based turnaround management firm Strategic Management Partners Inc., said he wants to start a $50 million fund to invest in "underperforming companies," or join a group of local distressed investors.

In February, W. Russell Ramsey of Friedman, Billings, Ramsey said he was leaving his role of co-chief executive of the investment banking firm by year-end to start an investment fund that plans to make debt and equity investments in undervalued public companies in the Washington region.

Despite negative attention the deals might bring, Overstreet said there is a silver lining.

"They are investing in companies that would otherwise not get the capital and it's as simple as that," Overstreet said. "They provide a service. They exact a price for it, but they provide a service."

© 2001 The Washington Post Company