Terms of Endearment
The private investment in public equity market is booming. Hold out for the right terms and your business could be, too.
Not too long ago, PIPE was practically a dirty word, considered a last-ditch financing move for a public company on its last legs. But over the past few years, PIPE (or private investment in public equity) deals have edged steadily into the mainstream, thanks to a still sluggish market for secondary offerings and a scarcity of traditional forms of financing.
"There has been a ton of activity in the last year," reports Brian Overstreet, CEO of Sagient Research, a firm that tracks PIPE deals through its PlacementTracker database. According to Sagient, PIPEs raised $83 billion last year, eclipsing the 2006 record of $29 billion. Even without the megadeals that have become more mainstream, the core microcap market still grew about 30 percent last year over 2006, says Overstreet. The overall market slowed a bit recently--the $43 billion raised in the first quarter of 2008 was largely owed to mega-PIPEs--but Overstreet says it's already picking up speed again. "There's plenty of money out there," he says. "It's a real seller's market."
PIPEs allow public companies to quickly and quietly do a limited distribution of securities--in common stock or convertible debt--to accredited or institutional investors through a sort of hybrid public/private financing. The key to success with this higher-risk funding is to look past the dollar signs at the terms of the deal.
When they're desperate for dollars, entrepreneurs might agree to overly onerous terms, offering the stock at too deep a discount or allowing for rampant short selling. Worse still, they often agree to floating conversion rates. "That basically means that investors can convert into an infinite number of shares, and there is no incentive for them not to push the share price down to gain liquidity," says Dennis McLaughlin III, the 42-year-old CEO of Earth Biofuels, a Dallas producer of renewable fuels with a focus on biodiesel. A PIPE deal veteran, McLaughlin advises entrepreneurs to push back when offered less-than-friendly terms. "Everything is negotiable," he says.
In his most recent PIPE deal in July 2006 for $52 million, McLaughlin negotiated a fixed at-market conversion rate and a provision to reduce short-selling, but he says he would have done one thing differently: "There were too many investors in the PIPE, too many divergent interests." Reaching a consensus on any modifications to the terms of the deal was a challenge with as many as eight different investors. He decided he would now allow only three or four investors at most.
When considering a PIPE deal, do your due diligence on the investment firm and each investor. Look up the deals they've done in the past, the size of the deals and how the stock performed post-deal. Ask the firm for references, and call each one. "The company has to know who they're getting into bed with," says Corey Ribotsky, managing member of N.I.R. Group, a PIPE hedge fund that looks at more than 1,500 companies seeking PIPE financing each year. "You want someone who's going to be a financial partner as opposed to someone who's just looking for a trading play."
Even the best PIPE deals see their share of stock price upheaval in the months that follow, given the dilution. But good companies that carry out their business plans can rebound, says Gregory Sichenzia of securities law firm Sichenzia Ross Friedman Ference. "At the end of the day, it comes down to management," he says. "At first there'll be dilution, the stock will get beat up a little bit. But if management can take that money and build value, eventually the stock will respond."
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