As cash reserves dwindle and secondary markets fizzle, public companies turn to Pipe financing. Jane Welch reports

America's stock exchanges are back in business. But the rhythm of capitalism is slow to rebound. As continued worries of a recession ripple through the economy and financial markets, we see glimmers of hope, excitement and opportunity shadowed by sadness and fear.

In business, we have been experiencing a focused return to fundamentals. Many deals that would have been funded by the public markets are no longer interesting to investment bankers. Companies are reevaluating their relationships, business strategies and methodologies for growth and profitability. In the public company arena a strong trend towards private investing under the banner of Pipe (private investment in public entities) has emerged.

According to PlacementTracker.com, a web site with information on the Pipe market, more than 654 transactions raised $8.6 bn during the first three quarters of this year. There were several notable Pipe transactions in August 2001, including Tower Automotive which raised $39 mn in common stock; Triangle Pharmaceuticals ($75 mn in common stock); and TiVo ($51.7 mn in convertible notes). One of the largest Pipe deals was in September, when Seattle-based InterNAP Network Services raised $101 mn through preferred stock, warrants and common stock.

Secondary sentiment

Traditionally, public companies that needed to raise money would make a secondary offering, handled much like an IPO. But dramatic changes in market sentiment have sharply decreased secondary offerings.

'After September 11, the capacity and interest of most investment banks to conduct secondary public offerings is virtually non-existent, especially for small and mid-cap public companies,' says Brian Overstreet, founder and CEO of San Diego investment bank DirectPlacement, which compiles the online database for PlacementTracker.com. 'Since public offerings are largely dependent on market whim and investor confidence, the market is very bleak for those now. Pipes are placed with sophisticated institutional investors who - as spooked as they might be by the general market today - are expressing that they are open for business and looking for quality Pipe product.'

PlacementTracker.com is a good place to go for information on the Pipe market.

It reveals who the investors are; who the placement agents are; and it provides details of how the stocks of past deals have performed after closing. Many executives going the Pipe route use sites like this as a resource to identify the most appropriate partners.

Many public companies are discovering that private placement financing for cash has certain advantages over a secondary public offering. Among the most important of these advantages is that the time and expense needed to complete a private placement is much less. But there is significant risk as well. Some inexperienced companies agree to such arduous terms that the financing can harm the company more than it can help. These are called 'toxic' or 'death-spiral' financings that could result in severe dilution of the value of existing shares and wound other shareholders.

'Making the decision to go the Pipe route takes serious planning. The key is to identify investors who show an appetite for a particular company,' says Tim Curtiss, COO of Wall Street Investor Relations, an IR consultancy. 'Many of these groups manage their own proprietary funds that invest, and also can conduct investment banking work to introduce the prospective issuer to their lists of investors. It's important for the issuer to work with a respected investment banker who has the right contacts in the private equity investment world.'

Structuring the deal

According to Instream Partners, a San Francisco-based investment banking firm, Pipe deals tend to come in two forms: traditional and structured. Traditional Pipes are fixed-price issues of common stock, convertible preferred stock and convertible debt. Structured deals include convertible floating (where the conversion price continually changes based on the future market price of the common stock); convertible/common stock reset (deals with repricing rights which change the terms at a later date to give investors more shares or reduce the conversion price); and structured equity lines (which require investors to purchase a predetermined amount of stock or debt over a specified period). Under Regulation D, the SEC allows public companies to issue securities without registration and without a prospectus.

'Pipe pricing can be less finite than a public secondary offering,' cautions Instream Partners' co-founder, Samantha Lincoln. 'In both a Pipe and a secondary, if no one likes the offering price, the company has to take a lower price or withdraw the offering. In a public deal, the market will clear at a certain fixed price. However, the most toxic Pipes are structured so that future stock prices continue to reset the price of the issue. In this case, the price is not fixed, and the company can have almost unlimited cost. That means - in the worst scenarios - the investors can end up owning virtually all of the company.'

Free trading dilemma

In a Pipe deal, the issuer typically prefers to hold off trading for somewhere between 90 and 180 days to keep from immediate, downward stock price pressure.

'If the stock becomes free trading when the market is doing well and when the company is achieving success, it's probably not too much of a problem,' says Michael Manahan, the co-founder and chief executive of Los Angeles-based communications firm Magnum Financial. 'But, if the stock becomes free trading when the market is depressed or if the company is not performing well, then the added overhang of that stock now coming into the market - and those people potentially going into the market and selling it - can push the price of the stock down. That's particularly true if the price at which the private placement sold was less than the current market price of the stock.'

'If you've completed a Pipe with appropriate pricing and terms, and investors and have made good use of the proceeds raised, you have absolutely nothing to fear,' counters Overstreet. 'The vast majority of Pipe investors in today's market are longer-term players who, while they require a registration to be filed post-closing, are not looking to exit the position unless the company has had exceptional problems post-closing.'

Investor relations professionals and investment bankers agree that any decision to go the Pipe route is highly dependent on the company, its industry sector, growth opportunities, trading volume, research coverage, level of business maturity and market value. A few words of caution: Read the fine print. A large number of new Pipe players are actively soliciting public companies. Some of these firms are trading the stock and realizing profits from short positions. 'Companies must be very diligent in exploring who their placement agent is and who their investors are,' concludes Overstreet.

Jane Welch is the co-founder & CEO of Welch Consulting, based in Pacific Palisades, California. Her e-mail address is Jane.Welch@Verizon.net


Case study
In January 1999 e-MedSoft.com approached Magnum Financial Group to handle its IR. The Amex-listed company had gone public through a reverse merger and wanted to do a secondary offering. To that end, one of the founders was flying back and forth to New York on his private jet every two weeks visiting all the major investment banking firms, trying to cut a deal for the secondary offering - with no luck.

'Many in the investment banking world feel that a company that goes public through a reverse merger is less likely to be as ready for the public market as one that goes through an investment banking firm,' says Magnum's Michael Manahan. 'We took a serious look at the company and the market and said, We don't think any of the major investment banks will be interested because they have already backed their e-health players - Healtheon, Trizetto, Care Insight, Web MD, etc. We had to go to a second or third-tier firm that had yet to back a player in this space.'

The approach worked. Magnum helped the company negotiate with investment banking firm Sutro & Company to raise some $67 mn. That included $7.1 mn in restricted shares of common stock and warrants for additional restricted shares with an exercise price of $4. On top of its fees, the private placement agent got warrants for 350,000 restricted shares of e-MedSoft at $5 per share and warrants for 1.3 mn restricted shares at one cent per share. Another $60 mn came when e-MedSoft sold 4 mn shares to some 50 accredited investors at $15 per share.

Unfortunately, even with this capital infusion, e-Medsoft.com had a tough time in the market. 'The medical community has been slow to adopt e-health solutions,' Manahan points out. 'All of these companies, including e-MedSoft.com, have been pressed to generate revenues and, as a consequence, they have seen their stock prices tumble. And they have had to go out and raise additional funds.' Notwithstanding these pressures, however, e-MedSoft's Pipe deals proved highly successful.