Cash-hungry tech companies get stuck in the PIPEs

With the secondary equity markets effectively closed, public companies are being forced to seek private investments in a public entity, or PIPEs. Is the money worth the price?

By Stephen Lucey
February 14, 2001

The real innovation these days in technology companies is happening in the finance department, not in the R&D labs. Thanks to a continued capital crunch, the real challenge for many companies today is locating alternative financing channels.

With the IPO pipeline and secondary markets all but sealed shut, many technology companies are scrambling to raise money to keep their doors open. Now public companies have nowhere to turn except the private markets, through financing vehicles known as PIPEs (private investments in a public entity).

In January alone, 54 PIPE offerings were completed for a total of $681 million, according to PlacementTracker.com , the market data division of DirectPlacement.com , an online PIPE market exchange. By way of contrast, just three IPOs and 12 follow-on offerings have been priced so far this year, down from 34 and 46, respectively, at this point in time last year, according to Thomson Financial Securities Data . And analysts say that these PIPE deals may be just the tip of the iceberg. The tenuous financial condition of many of the 351 companies that had IPOs last year -- 147 of which are trading at a 50 percent discount to their offering price -- suggests another public offering would be unlikely.

"It doesn't look like things are going to get better anytime soon," says Brian Overstreet, president and cofounder of DirectPlacement.com. "We've already seen a pretty active PIPE market this year, but it is going to pick up even more into the second quarter."

TIMES ARE TOUGH

While these deals have provided financing primarily for small and midsize companies, Mr. Overstreet expects large technology concerns to follow shortly. A desperate need for funding has forced companies to reinvent the relationship between the public and private capital markets. The same young companies that gladly rushed to the public markets not long ago are now returning to venture capital firms, institutional investors, and buyout firms.

Though the amount of money raised through PIPEs has risen in recent years -- $54 billion in 2000, compared to $22 billion in 1999 and just $12 billion in 1998 -- these deals are clearly not new, but simply one of the last alternatives in a slowing marketplace (see "Debt Reckoning").

The sale of private equity stakes to a selected group of institutions provides a quick channel to capital for companies. By targeting the offering to a limited number of investors, the process to complete the deal becomes much faster than completing a traditional secondary offering. Since any direct sale of capital stock of more than 20 percent requires shareholder approval, most PIPE deals amount to a sale of roughly a 10 percent stake in the company.

But the speed of the offering combined with the often-distressed nature of these companies allow issuers to extort a price for the financing. Among the recent PIPEs surveyed by Kent Penwell, a managing director in the equity capital markets group at Banc of America Securities, companies raising $50 million or more through common stock offerings accepted a discount of 10 percent to 12 percent below their stock price. According to Mr. Penwell, this was double the discount rate of companies completing traditional offerings in the secondary market last year.

PUBLIC HUMILIATION

The higher discount rates are in large part a function of the speed with which a PIPE can be completed. But Mr. Penwell says that since many of the companies completing these deals are smaller, potential volatility in the stock price must be factored into the terms of the deal. With nowhere else to turn, companies have little bargaining power. It's becoming a case of take it or leave it.

With the public markets in disarray and the startup community suffering from the weakness in the broader market, venture firms and institutional investors are glad to see these deals coming across their desks. Though investors at all levels are less inclined to part with their money than they were a year ago, there is still capital available in both the public and private markets to fund these cash infusions. And institutional investors and VCs are finding some bargains in the public market at the moment.

"The public market, in days like these, is a very attractive place to put your money to work," says Rick Kimball, a general partner at Technology Crossover Ventures, which invests in both private and public companies. "The valuations of some public companies are more attractive than a lot of those in the private markets. And at the end of the day, if you were wrong, you've got a better chance at liquidity than if you made a mistake on the private side."

Unlike the public markets, which open and close based on market sentiment, the PIPE market is always open. The only thing that really changes is the terms of a deal. And while the terms of an investment are the most important part of any deal, in crunch times like these, many companies are more concerned about a quick cash infusion than the terms of the PIPE. In other words, it's a buyer's market.

SURVIVAL AT ANY PRICE

In the case of the ailing Internet consulting firm Marchfirst (Nasdaq : MRCH ), the need for emergency access to cash forced it to give up 32 percent of the company and two seats on its board in exchange for a $150 million investment by Francisco Partners in December.

Having suffered along with the other Internet consulting firms following the dot-com fallout in April, Marchfirst drastically cut its staff and closed offices in the face of declining revenue and weak demand for Net consulting services. With such a dramatic shift in the market and its stock price falling 89 percent between September 1 and the time of the infusion in mid-December, Marchfirst had no chance of convincing public investors to bankroll a restructuring. In many ways, the PIPE deal was the company's last hope for financing.

This was an extreme case of a company on the ropes, but it does highlight the tradeoff that many firms are willing to accept to capture more capital. And while existing shareholders welcome the additional liquidity these deals afford, they are forced to contend with the dilutive effects of the placement. Nowhere is this more apparent than with the type of PIPEs dubbed "death spirals."

PINING FOR THE FJORDS

Death-spiral deals allow a company's PIPE investors to reprice the conversion rate in the face of a declining stock price and thereby acquire more shares. Although these deals already have received a large amount of negative publicity because of the impact on existing investors, Mr. Overstreet expects their volume to increase in 2001 as private investors look for downside protection against companies that are struggling to turn around their operations.

This was the case for Log On America (Nasdaq : LOAX ), a regional Internet provider and competitive local exchange carrier (CLEC), after completing a $15 million convertible preferred stock PIPE offering last February. Rather than marking the turning point for Log On America, the stock subsequently fell 89 percent from the negotiated investment price of $16.31 to close Monday at $1.66.

With the stock well below the conversion price of $24.615, Marshall Capital Management, HFTP Investments, Fisher Capital, and Wingate Capital were able to adjust the number of shares eligible for conversion. The initial stock price decline could be attributed to any number of company-specific problems, but Log On America management alleges the drop was due to market manipulation on the part of the investors in the deal. As such, the company filed suit last month against Credit Suisse First Boston, the parent of Marshall Capital Management, to seek recovery of $100 million in damages associated with the PIPE.

In general, the negative stigma attached to death-spiral offerings emanates from short-selling by investors that are aware of the dilutive effects of such a PIPE, according to Mr. Overstreet. The growing trend toward these alternatives highlights the perils that small public companies face when shopping for new funding. And for existing investors, the questionable history of such transactions shows the dangers of this last-resort financing.

As more companies encounter the capital crunch, the complexity and risk of PIPE deals will only escalate. While risk is associated with any investment, the downside risk may be deadly to investors.