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Home > Financing Best Practice > Private Investments in Public Equity

Financing Best Practice

Private Investments in Public Equity

by William K. Sjostrom, Jr

Executive Summary

  • A private investment in public equity (PIPE) is a type of public company financing transaction that is prevalent in the United States.

  • In a typical PIPE transaction, a public company privately issues common stock or securities convertible into common stock to a small number of sophisticated investors in exchange for cash. The company then registers the resale of the common stock issued in the private placement, or issued on conversion of the convertible securities issued in the private placement (the PIPE shares), with the US Securities and Exchange Commission (SEC).

  • Generally, investors must hold securities issued in a private placement for at least six months. However, because the company registers the resale of the PIPE shares, investors are free to sell them into the market as soon as the SEC declares the resale registration statement effective (typically at most within a few months of the closing of the private placement).

  • In 2009, companies closed on 1,072 PIPE deals in the United States, raising approximately $36.7 billion in the aggregate.

  • While companies of all sizes have used PIPEs to raise money, PIPE deals have emerged as a vital source of financing for small public companies, with the overwhelming majority of deals being completed by companies with market capitalizations of $250 million or less. This is driven by the reality that PIPEs represent the only available financing option for many small public companies.

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Types of PIPE

PIPE transactions are highly negotiable; hence, there is a fair amount of variation from deal to deal with respect to the attributes of the PIPE securities. PIPE securities may consist of common stock or securities convertible into common stock, such as convertible preferred stock or convertible notes, and may be coupled with common stock warrants.

Regardless of the type of securities involved, PIPE deals are categorized as either traditional or structured. With a traditional PIPE, the PIPE shares are issued at a price fixed on the closing date of the private placement. This fixed price is typically set at a discount to the trailing average of the market price of the issuer’s common stock for some period of days prior to closing of the private placement. As mentioned above, securities regulations generally prohibit investors from selling PIPE shares prior to the SEC declaring the resale registration statement effective. Thus, because the deal price is fixed, investors in traditional PIPEs assume price risk, which is the risk of future declines in the market price of the issuer’s common stock during the pendency of the resale registration statement.

With a structured PIPE, the issuance price of the PIPE shares is not fixed on the closing date of the private placement. Instead, it adjusts (often, downward only) based on future price movements of the issuer’s common stock. For example, investors may be issued convertible debt or preferred stock that is convertible into common stock based on a floating or variable conversion price, i.e., the conversion price fluctuates with the market price of the issuer’s common stock. Hence, with a structured PIPE, investors do not assume price risk during the pendency of the resale registration statement. If the market price declines, so too does the conversion price, and therefore the PIPE securities will be convertible into a greater number of shares of common stock.

For example, say an investor purchases a $1,000,000 convertible note in a PIPE transaction, and the note provides that the principal amount is convertible at the holder’s option into the issuer’s common stock at a conversion rate of 90% of the per share market price of the stock on the date of conversion. Thus, if the market price of the issuer’s common stock is $10 per share, the note is convertible at $9.00 a share into 111,111 shares of common stock. If the market price drops to $8 per share, the note is then convertible at $7.20 per share into 138,889 shares of common stock. Regardless of how low the price drops, on conversion the investor will receive $1,000,000 of common stock based on the discounted market price of the stock on the day of conversion.

Some structured PIPEs do contain floors on how low the conversion price can adjust downward, or caps on how many shares can be issued on conversion. If a structured PIPE has neither a floor nor a cap, it can potentially become convertible into a controlling stake of the PIPE issuer. Continuing the example from above, if the market price dropped to $0.01, the note would then be convertible into more than 100 million shares, which would constitute a controlling stake unless the issuer had at least 200 million shares outstanding. Hence, structured PIPEs lacking floors or caps are pejoratively labeled “death spirals” or “toxic converts,” because investors in these deals may be tempted to push down the issuer’s stock price through short sales, circulating false negative rumors, etc., so that their structured PIPEs become convertible into a controlling stake of the issuer.

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Registration Requirement

The registration requirement of a PIPE transaction can be either concurrent or trailing. With a concurrent registration requirement, investors commit to buy a specified dollar amount of PIPE securities in the private placement, but their obligations to fund are conditional on the SEC indicating that it is prepared to declare the resale registration statement effective. If the SEC never gets to this point, the investors do not have to go forward with the deal. Thus, the issuer bears the registration risk; that is, the risk that the SEC will refuse to declare the resale registration statement effective.

With a trailing registration rights requirement, the parties close on the private placement and then the issuer files a registration statement. Consequently, the investors bear the registration risk. If the issuer never files, or the SEC never declares the registration statement effective, the investors will not be able to sell their PIPE shares into the market for at least six months. As a result, PIPE deals that include such trailing registration requirements typically obligate the issuer to file the registration statement within 30 days of the private placement closing date and require that it be declared effective within 90 to 120 days of such date. If these deadlines are not met, the issuer is obligated to pay the investors a penalty of 1% to 2% of the deal proceeds per month until filing or effectiveness.

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PIPE Issuers

As mentioned above, companies of all sizes have used PIPEs to raise money. Larger companies pursue PIPEs as a quicker and cheaper route to funding than a registered public offering. The vast majority of PIPE deals, however, are undertaken by small public companies. These companies generally pursue PIPEs not because they offer advantages over other financing alternatives, but because the companies have no other financing alternatives. By and large, PIPE issuers are not only small in terms of market capitalization but have weak cash flow and poorly performing stocks. Thus, traditional forms of financing are simply not an option. Few, if any, investment banking firms are willing to underwrite follow-on offerings for small, distressed public companies. Further, these companies lack the collateral and financial performance to qualify for bank loans and the upside potential to attract traditional private equity financing.

Given the distressed status of PIPE issuers, PIPE financing can, of course, be very expensive. Not only does the company typically issue common stock or common stock equivalents at a discount to market price, but PIPE deals often involve other cash flow rights such as dividends or interest (typically paid in kind not cash) and warrants. For example, in August of 2007, Callisto Pharmaceuticals, Inc., a biopharmaceutical company located in New York, raised $11.2 million in a PIPE financing consisting of 1,124,550 shares of Series B Convertible Preferred Stock, and 22,491,000 warrants. The conversion price of the Series B Preferred Stock was set at a 23% discount to Callisto’s market price on the day prior to the deal. This compares to a typical discount of 4% for a traditional seasoned equity public offering.

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Investors in PIPEs

Hedge funds constitute a large percentage of the investors in micro-cap PIPEs. Hedge funds invest for the obvious reason: their returns from PIPE investments meet or beat market benchmarks. Hedge funds are able to obtain market-beating returns notwithstanding the poor performance of PIPE issuers through a relatively straightforward trading strategy. They sell short the issuer’s common stock promptly after the PIPE deal is publicly disclosed. To execute a short sale, a fund borrows stock of the PIPE issuer from a broker–dealer and sells this borrowed stock into the market. The fund then closes out or covers the short sale at a later date by buying shares in the open market and delivering them to the lender. By shorting stock against the PIPE shares, the fund locks in the PIPE deal purchase discount. With a traditional PIPE, if the market price of the issuer’s common stock drops below the discounted price following a PIPE transaction, the fund will take a loss on the PIPE shares, but this loss will be exceeded by gains realized when it closes out its short position because it will be able to buy shares in the market to cover the position at a lower price than it earlier sold the borrowed shares. If the market price of the issuer’s common stock rises after the PIPE transaction, the fund will take a loss when closing out the short position, because it will have to buy shares to cover the position at a higher price than it earlier sold the borrowed shares. This loss, however, will be exceeded by an increase in the value of the PIPE shares since they were purchased at a discount to the pre-rise market price.

In addition to short selling, many hedge funds retain up-side potential by negotiating for warrants as part of a PIPE transaction. Hedge funds typically hold on to these warrants even after unwinding their PIPE shares positions so that they can profit further in the event the issuer’s stock happens to rise above the warrant exercise price. In sum, hedge funds are able to garner superior returns through PIPE investments because they purchase the PIPE shares at a substantial discount to market, manage their downside risk through short sales and floating conversion prices, retain up-side potential through warrants, and liquidate their positions a relatively short time after closing on the private placement.

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Making It Happen

  • Explore other financing options first; PIPE financing is often very expensive, especially for smaller public companies.

  • Retain experienced PIPE counsel (see the league tables at www.sagientresearch.com PIPE agents).

  • Retain a PIPE agent to advise on deal structure and locate investors (see the league tables mentioned above.

  • If pursuing a structured PIPE deal, insist on a floor on how low the conversion price can adjust downward, or a cap on how many shares can be issued on conversion.

  • Consider restricting investors’ ability to engage in short selling.

  • Consider the amount of dilution existing investors will suffer as a result of the PIPE financing and how to address their complaints.

  • Make sure you consult your accountant because, depending on structure, the deal may produce a noncash charge to earnings.

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Further reading

Book:

  • Dresner, Steven, with E. Kurt Kim (eds). PIPES: A Guide to Private Investments in Public Equity. Revised and updated ed. New York: Bloomberg Press, 2006.

Article:

  • Sjostrom, William K., Jr. “PIPEs.” Entrepreneurial Business Law Journal 2:1 (2007): 381–413. Online at: tinyurl.com/32m83e5 [PDF].

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