Financing Puts North Greenbush, N.Y.-Based Banking Software Firm at Risk
(19-Jun-2001 11:00 EST)

Jun 18, 2001 (Times Union - Knight Ridder/Tribune Business News via COMTEX) -- In July 1999, North Greenbush banking-software publisher IFS International Holdings Inc. relied on an arcane tool to borrow $1 million from a group of three investors.

The arrangement, known as a "floating convertible" or "floorless convertible," has picked up a not-so-endearing sobriquet in corporate- finance circles: death spiral loan.

That's because some companies relying on the last-resort financing find they wake up with share prices in the toilet, and their lenders holding on to a big part of the company's ownership.

Some financiers say the tools are getting a bad rap, with too much attention paid to the companies eviscerated by the deals and not enough given to those that would not have lived to see another day if not for the loans.

"Without these types of financings, these companies would go out of business," said Martin Weisberg, a New York City attorney with Jenkens & Gilchrist, Parker, Chapin LLP speaking on behalf of two of IFS' lenders, investment firms Manchester Asset Management Ltd. and Gilston Corp. Ltd. "They're not going to get money from Fleet Bank; they're not going to get money from Goldman Sachs."

Regardless, despite a funding market that had been loose as a steel trap until the past couple of months, companies are steering clear of floorless convertibles -- a device that, apparently, has its roots in the Capital Region. One French academic's study of the convertibles pins their first use, in 1995, to CAI Wireless Systems Inc. That Albany company, which specialized in wireless communication, was bought by MCI WorldCom for more than $400 million in 1999.

IFS' former chief executive, David Hodge, did not return a message asking why the company relied on the risky financing. And current CEO Simon Theobald can't say for sure that the deal is what caused his company's shares to tank, plummeting to as low as 51 cents from an all- time high of $7.62 in 2000.

The stock (Nasdaq: IFSH) closed Friday at 84 cents, unchanged.

But IFS' experience after it took the $1 million matches the outcome at many other companies -- mostly cash-hungry dot- coms -- after they did the same.

Here's what can happen: In exchange for a loan, companies promise to repay the lenders in stock. But the number of shares the investor gets depends on share price. So the lower the price goes, the more shares of the company the lender gets in return. This can lead to severe dilution of the stock.

Sometimes, the lenders turn around and sell the shares, pushing the share price down further. And, sometimes, short-sellers take advantage of the situation, taking bets that the share prices will drop. As word about death spirals picked up, professional short- sellers often got in on the action, making them a self-fulfilling prophecy.

In IFS' case, short-selling started in earnest at about the same time the company registered the shares earmarked for the lenders. The shorts peaked at 200,000 shares in April 2000, from next to nothing the month before the shares were registered.

Whether the lenders are responsible for that is nearly impossible to determine. Theobald is not trying to figure out who sold the company short and plans no lawsuits; selling short is not illegal anyway. And Weisberg denied that his clients, the investment houses that loaned to IFS, sold shares short, the catalyst for many death- spiral avalanches.

IFS paid off the remainder of its convertible last week. That does not mean the company will snap back to life. Besides Theobald's unbounded optimism -- and recent news releases predicting a 2001 profit of $750,000 and touting sales of banking-industry software to institutions in various countries -- the company still lost $4.3 million in its third quarter, which ended Jan. 31.

And IFS is waiting to learn whether it will be delisted from the Nasdaq trading market, a sentence it faces as a result of its stock dipping beneath $1 a share.

Losses in share price is a common side-effect of the loans. One study by a professor at Insead, a French business school, shows that 85 percent of companies that issue "toxic convertibles" lose share price in the year after the deal is announced.

That's why Theobald said he made it a priority to pay off the loan. "I realized during the summer of last year that this was a problem," said Theobald, who became IFS' chief executive in December, replacing Hodge, who sat atop the company when the arrangement was reached. "It came to my attention during research I was doing on the company."

Few floorless deals are being done any longer, despite assurances from one financier that it's not the convertibles that are bad -- and, in fact, the companies themselves might end up digging their own holes.

Statistics from DirectPlacement.com, an online exchange for private security placements, show that of 925 floorless convertibles issued since 1995, share prices dropped approximately 9 percent, on average, in the six months following the deals. "How that correlates to the term death spiral is obviously a little bit of a mystery to me," said Brian Overstreet, president of the California company.

Still, Dow Jones Newswires reported June 8 that PlacementTracker.com, an offshoot of Overstreet's company, reported that just 29 companies issued floorless notes from November to May, off from 83 in the six months before that.

"They contain a great deal of risk, and probably on both sides," said Robert Lowry, a former U.S. Securities and Exchange Commission worker and now a private consultant who has testified in death-spiral cases.

Overstreet gets frustrated that the same spoiled deals, with companies such as failed online kiddie-store eToys Inc. and Rhode Island telecommunications company Log On America Inc., get played over and over again in the press. Lawsuits some companies have filed against their investors also have been widely covered.

Overstreet maintains those stories are at least partly responsible for scaring companies away from the deals.

Recently, DirectPlacement.com managed a $17.8 million offering for Cambridge, Mass.- based SatCon Technology Corp., a company partly backed by Mechanical Technology Inc. of Albany. Overstreet said that offering was a first-of-its-kind vehicle drawn up partly because so many investors were afraid to get into a floorless convertible.

Sean Moran, SatCon's chief financial officer, said he was approached by investors trying to palm off floating convertibles on him before settling on the mini-secondary. Despite Overstreet's support, Moran never considered a convertible.

"It's always been my opinion that's not a good thing," Moran said. He can understand the advantages for the lender; for him, though, "I would think that there isn't any (advantage). It's only if you can't get any other financing. I see a lot of downside."

Indeed, IFS was well aware of the problems floorless convertibles posed. In a prophetic filing with the SEC, all the woes that eventually befell the company -- diluted shares, prices driven down -- were spelled out in a statement detailing the risks of the financing.

Theobald, for his part, would not answer why previous management felt compelled to enter the deal. "It's hard for me to comment on what the thoughts of previous management before December the fifth were," he said. "They clearly believed this was the right avenue at the time."

Now, though, IFS has joined the pack of companies steering clear. IFS' recent financing was more straightforward, with a company buying shares at a prearranged price. "Quite clearly, there were and are other avenues for the company to do financing, should we need to," Theobald said.

IFS went through a management shake-up at the end of last year. Hodge left his post as president and CEO, though he remains as a director, and the company's chairman resigned as well.

By Kenneth Aaron To see more of the Times Union, or to subscribe to the newspaper, go to http://www.timesunion.com