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Playing the PIPEs: The Benefits and Risks of Private Investments in Public Entities
Author(s): Mark Anson
Source: The Journal of Private Equity, Vol. 5, No. 1 (Winter 2001), pp. 66-73
Published by: Euromoney Institutional Investor PLC
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Playing the PIPEs:
The Benefits and Risks
of Private Investments
in Public Entities
Mark Anson

Mark Anson
Public companies agree to sell unregistered
is the senior investment
capitalists, and leveraged buyout securities, usually at a discount, to institutiona
officer for Global Equity at
firms are all pursuing a new form investors. Since the securities sold are not reg-
California Public Employ-
ees' Retirement System Hedge firms of capitalists, equity funds,of equiaretyalinlvestment
and investment
called a mutual pursuing leveraged funds, a new called venture buyout form a istered with the Securities and Exchange Com-
in Sacramento, CA. PIPE. PIPE stands for private investment in mission (SEC), the investors cannot resell them
mark@calp ers . ca . gov public entities. In a PIPE investment, an into the market until a registration statement
investor or group of investors bargains directly has been filed and declared effective by the
with a public company to acquire a private SEC. Typically, a condition of the PIPE trans
equity position. These are private placements action is that the issuer subsequently files
of the company's stock that are purchased by a Form S-3 registration statement with the
investors outside of the normal public arena. Securities and Exchange Commission. An
The PIPEs market began because many S-3 registration statement is a "short-form
small, newer companies have found it more registration statement that requires the leas
difficult to raise funds through a traditional amount of information and is the least costly,
stock offering. This is even more important but will nonetheless serve the purpose of reg-
given the compressed time frame for compa- istering the PIPE securities for public resale.
nies operating in the technology sector. PIPE transactions may be a private sale
This article examines the growth and of common stock, convertible notes, or con
structure of the PIPEs market. We consider the vertible preferred stock. Consider the follow-
benefits and risks of PIPE transactions both ing examples.
from an investor and issuer perspective. Last, On May 21, 2001, Restoration Hard-
we review how leveraged buyout funds have ware Inc. (ticker RSTO) raised $24.5 million
fared with this type of financing. by selling unregistered common stock to a
group of select investment firms including
HOW PIPEs WORK Capital Research and Management Company,
Fidelity Management and Research Company
and Baron Asset Management. The privat
In a typical situation, a start-up company
will take its stock public, for example, stock was priced at $5.43 per share, which
at $20
was 25%
dollars a share, only to see its share price slip below the closing price of $7.25 on
back to $5. The start-up company May By August 2001, Restoration Hard-
unable to find additional public marketware's
financ-stock price had declined to $4.80
ing with attractive terms. This is where a PIPE Hardware committed to filing a
transaction is most applicable. registration statement with the SEC in one to
two months. In the meantime, the investor
PIPEs are a form of private placement.

66 Playing the PIPEs: The Benefits and Risks of Private Investments in Public Entities Winter 2001

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Exhibit 1 iPIX's share price increased from $0.70 a share to $0.92
Term Sheet for the iPix PIPE Transaction a share (a gain of 31%). In July 2001, iPIX announced a
second-quarter loss of $4.9 million and an $1 1 million loss
for the first quarter. As a result, iPIXs stock price drifted
Financing Amount $ 1 0 million Tr
back down to $0.23 a share by the end of July.
Securities Tranche A: Convertible notes plus warrants PIPE transactions are often presented to institutional
Maturity = August 14, 2002
Tranche B: Series B convertible preferred investors in a term sheet. Exhibit 1 presents a term sheet
that reflects the deal points of the iPIX PIPE financing.
Interest Tranche A: 8% per year in cash or
preferred stock at investor's option.
To illustrate a situation of preferred shared issues
Payable at maturity of the note. through a PIPE, consider Net2000 Communications
Tranche B: 8% per year of the original
(ticker NTKK), a provider of broadband telecommuni-
Conversion Terms Tranche A: Convertible into common at cations services with operations in over 20 markets. On
$0.25 (for 52 million shares) and $0.50 (for
March 29, 2001, Net2000 entered into an agreement to
8 million shares).
Tranche B: Convertible into common at issue 65,000 of shares of series D convertible pay-in-kind
preferred stock for $65 million. The private stock was
issued to Boston Ventures, BancBoston Capital, The Car-

Floating or None
Adjustable Conversion lyle Group, PNC Equity Management, and Nortel Net-
Warrants Tranche A: 250,000 warrants to purchase works. The preferred stock is convertible into 22 million
Series B preferred stock at prices of $20 shares of Net2000 common stock based on a conversion

Registration The company will file a registration price of $2.955. On March 29, 2001, this represented a
statement with the SEC within 20 days of
slight discount from the closing price of $3.00.
In July 2001, despite improving gross margins (35%,
up from 28% in the first quarter of 2001), Net2000
could not reported a second-quarter
sell their loss of $21.2 million. sha
Its share
As an example
price declined from $3.0625 at the end of ofMarch 2001 P
consider to $0.84 by August
the case 2001. of In
IPIX), a As these three examples demonstrate, the most
based attractive feature of a PIPE transaction from
imaging an investor s
and entertainment. iPIX allows Internet users to receive point of view is the ability to buy the equity of a com-
a 360-degree view of a building site, a home, or a device pany at a discounted price. The less liquid the PIPE, the
listed on a web page. steeper the discount. The investor must bear the liquid-
iPIX had previously received $200 million of ven- ity risk until the PIPE securities are either registered or
ture and public financing. The company went public in converted.

August 1999 at $7.00 a share. Unfortunately, the company However, not all PIPE transactions are priced at a
reported a loss of $17.1 million for the first quarter, and discount. Consider Breakaway Solutions Inc., a Boston-
its share price declined from a post-IPO high of $45.00 based provider of consulting services for small companies.
to $0.40 in April 2001. Breakaway is the only publicly traded company that
In May 2001, iPIX entered into a PIPE transaction focuses exclusively on companies that have market capi-
with Paradigm Capital Partners and the Memphis Angels, talizations below $500 million even though this segment
two investment groups best known for early-stage ven- of the market accounts for 53% of industry-wide expen-
ture financing. The two groups provided iPIX with $10ditures on consulting services. As a result, Breakaway
million in exchange for convertible notes that may be exer-does not face a competitive bid on 60% of its contracts,
cised for up to 60 million shares of common stock atand a it is one of the fastest-growing companies in the e-
price of $0.25 (for 52 million shares) and $0.50 (for the services industry.
remaining 8 million shares). This financing was part of a In May 2000, Breakaway s dominant position in the
two-tranche plan, with an additional $20 million of con- e-services industry made it an attractive investment even
vertible preferred stock to be issued later with a conver- though the company had just gone public a scant eight
sion price of $0.25 for common shares. months prior. Nonetheless, Putnam Investments approached
After the announcement of the PIPE financing, Breakaway for a PIPE transaction. Putnam paid $26 a share

Winter 2001 The Journal of Private Equity 67

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for 1 .5 million of private stock in Breakaway, well above the usually takes several weeks to complete while a public
closing price of $22.50 at the time the deal was announced.1 offering may take several months. The difference in this
After the PIPE financing Breakaway s stock price timing can be crucial for a company that is burning
increased to almost $42, but it has declined significantly through cash quickly or needs the money in the near term
since then. In 2001, Breakaway announced its intention for an acquisition or other time-intensive project.
to take a $200 million write-down of intangible assets. Last, the market for initial and secondary public
Additionally, Breakaway recorded a net loss of $389.85 offerings has cooled quite a bit from early 2000. For
million for 2000. Its share price dropped to $0.08 by example, in the first quarter of 2000 there were 185 IPOs
August 2001. of new stock, while in the first quarter of 2001 there were
only 17 IPOs. Clearly, the market for public offerings has
WHY COMPANIES ARE WILLING dried up considerably.
TO ISSUE PIPEs For these reasons, it is advantageous for a new com-
pany to find a long-term equity partner - an investor
PIPEs are often offered at steep discountswho
to is willing to hold on to the company's stock as the
ing market prices for a company's stock. Companies asserts itself in the marketplace. This
willing to distribute their stock at below-market prices for may be willing to purchase the stock of
several reasons. the company in a private transaction. The trade-off for
First, new public companies generally have only a the company is that it may have to sell its stock at a dis-
small percentage of outstanding public stock (the "float"). count to the market price.
Insiders, venture capitalists, and other investors may retain
a large portion of convertible preferred shares or restricted THE SIZE OF THE PIPEs MARKET
stock that has yet to be publicly registered. Consequently,
the outstanding float may be in the range of 5% to 30%. It is not surprising that with a slowing econom
With such a small percentage of stock outstanding, PIPE transactions have declined in 2001. In the first qua
issuing new public shares will further dilute the public ter of 2001, $2.5 billion was invested in 184 PIPE tr
stock price of the company. Of the 1,262 companies that actions with public companies. This amount was a sh
went public between 1998 and 2000, 152 of them (12%) decline from $8.4 billion invested with 385 PIPE tran
are trading below $1. Under these circumstances, a pri- actions in the first quarter of 2000. Still, the numbe
vate placement of public equity can ensure that the addi- PIPE transactions in the first quarter of 2001 excee
tional stock stays out of the public market until the those of IPOs (17) and secondary offerings of pu
company has a better chance to implement its business stock (65). 4
strategy. PIPEs fall into two broad categories: traditio
Second, Wall Street analysts can be merciless when PIPEs and structured PIPEs. Traditional PIPEs are straig
a new technology company fails to achieve its sales or profit forward private purchases of common equity and prefer
targets. When this happens, the public stock of a new stock with a fixed conversion ratio into common shares.

company can be hammered. PIPEs can provide a form of Structured PIPEs include the more exotic investments such
financing that will not react violently to performance as floating convertibles, reset convertibles, common stock
numbers that fail to live up to analyst forecasts. with resets, and convertible preferred stock with resets.
Third, the new company decides to whom it will Exhibit 2 presents the growth in traditional PIPE
sell its shares. This is in contrast to a public offering, transactions since 1995. As can be seen, the market for
where the company does not have any control over to PIPEs has grown significantly over the past six years. Not
whom its shares are distributed. surprisingly, the issuance of traditional PIPEs peaked in
Fourth, public offerings of stocks are expensive. They 2000. As noted above, the pace of PIPE transactions in
require expensive banking fees as well as a road show for the first quarter of 2001 has declined significantly from
investors. McDonough3 documents that the average cost the first quarter of 2000.
for an IPO is 11% of the proceeds, while the average cost Exhibit 3 presents the growth in structured PIPE
for a secondary offering is 7.1% of the total proceeds. transactions. Similar to traditional PIPEs, structured PIPE
Additionally, private placements can occur much transactions peaked in 2000 but have declined in 2001.
more quickly than a public offering. A private placement

68 Playing the PIPEs: The Benefits and Risks of Private Investments in Public Entities Winter 2001

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Exhibit 2
Traditional PIPEs

Exhibit 3
Structured PIPEs

Winter 2001 The Journal of Private Equity 69

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EQUITY LINES OF CREDIT in massive dilution, driving a company's stock price down
even further into a "death spiral."
A variation on a PIPE transaction is an equity line These structured PIPE transactions have been
of credit (ELC). Consider the recent example of Igenreferred to as "toxic" PIPEs because they are potentially
International (ticker IGEN), a biotechnology company. poisonous to a company's financial health. Unscrupulous
Igen was within a few months or running out of cash and investors can take advantage of a company through a
was involved in an expensive lawsuit with another phar-structured PIPE deal. A toxic PIPE works as follows:
maceutical company. Furthermore, with a depressed mar-
ket for biotechnology stocks, a secondary public offering 1. A neophyte company goes public before it has a
was not a viable option. chance to establish its business strategy.
Instead, Igen turned to a New York investment 2. The company quickly burns through its IPO cash
fund called Acqua Wellington. Acqua Wellington was and needs more capital to survive.
established about two years ago by a group of former 3. With no profitability in sight, the public markets are
bankers to offer equity lines of credit to new companies closed to the new company.
in return for discounted shares of a company's stock. 4. Private equity investors agree to provide more cash
Acqua Wellington has invested about $1.6 billion in 32 in return for private securities that can be converted
companies with plans to invest an additional $1.3 billion.5 to common stock at a floating conversion rate, and
Acqua agreed to purchase up to $60 million of at a steep discount to the company's current stock
Igen s stock in a private investment. In February 2001, Igen price.
received $9.5 million in exchange for 789,075 shares of 5. The private investors short the stock of the company,
its common stock, about $12.04 per share. Compared to driving its price downward.
an average share price of $14.27 in February, this was a 6. The downward pressure on the company's out-
15.6% discount. In addition, Igen has the option of draw- standing stock triggers larger and larger conversion
ing on another $50.5 million from Acqua Wellington ratios resulting in greater and greater dilution of
over a 28-month period in exchange for further common the company's stock.
shares. In August 2001, Igen shares were trading near $30 7. The company must convert the private investors' pri-
per share. vate securities into common stock at a high con-
ELCs are popular for several reasons. First, the issu- version ratio and at a discount to the current market
ing company holds the option on when to tap into the price. This dilution drives the company's public
line of credit to issue more shares. Granted, it must issue stock price down even further.
the shares below market price, but it can do so quickly 8. The private investors cover their shorts with the
and inexpensively. Second, like a traditional PIPE, an newly issued common stock and reap a bonanza.
equity line of credit does not dilute the share price of the Alternatively, the private investors hold on to their
company's outstanding stock. Last, repayment of the line stock, having converted enough so that they have
of credit does not deplete the company's cash reserves gained control of the company.
because it is repaid with new shares.
Sound improbable? At least one company has sued
TOXIC PIPEs: THE RISKS INVOLVED its investors claiming that they hatched just such a scheme.
Log On America Inc., a provider of high-speed Internet
Despite the popularity of PIPEs, they have been
access, accused three firms of manipulating its stock price
severely criticized by the media.6 Many PIPE transactions
through short sales in an attempt to seize control of the
are structured with a "floating" conversion rate company.
so that the
amount of common shares that an investor will receive In a lawsuit filed in the U.S. District Court in New
increases as the stock price of the company declines. As York City in August 2000, Log On alleged that three
a result, critics contend that PIPE transactions can become investment firms drove down its stock price so that they
"death spirals" since a company's stock price often drops could convert preferred shares they held into more com-
after a PIPE financing. As the stock price drops, the com- mon shares. The lawsuit contends that the firms planned
pany must commit to issue more and more equity to to acquire enough shares to take control of the company.
keep up with the floating conversion rate. This can result In February 2000, Log On had issued $15 million

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of convertible preferred shares to Promethean Asset Man- Inc. (NASD), through its Nasdaq subsidiary, has pro
agement LLC of New York, Citadel Limited Partnership an interpretive release regarding PIPE transactions.
of Chicago, and Marshall Capital Management Inc., a unit Specifically, the Nasdaq has proposed the adop
of Credit Suisse First Boston. The securities were struc-
of interpretive material relating to what it calls "f
tured so that they were convertible into more shares of
price securities." These are structured PIPE transac
common stock if the price of Log On s common stock where the conversion price for the common shar
declined. According to the lawsuit, the decline in Log On sadjusted as the stock price declines. The NASD state
stock was sufficient to result in the conversion of the pre-
companies issuing structured PIPE securities must con
ferred stock into 8 million shares of common stock, equal the following rules:
to roughly 50% of the company's equity. The lawsuit is
still outstanding. • The shareholder approval rules
Not all structured PIPE deals result in the death of • The voting rights rules
the company. As an example of a PIPE workout, consider • The bid price requirement
the example of MicroStrategy, Inc. In June 2000, its sec- • The listing of additional shares rule
ondary stock offering had fallen apart and it was looking • The change-in-control rules
for another avenue of financing. A $125 million PIPE • Nasdaq's discretionary authority rules
transaction was put together by Promethean Asset Man-
agement LLC, Citadel Investment Group LLC, and Failure to abide by these rules may lead to the
Angelo, Gordon and Co.7 listing of an issuer's stock by the NASD from the Nas
The three investment groups purchased Micro-
Strategy Series A preferred stock that was convertible Shareholder approval rule . This is the most im
into common shares. The conversion price of the com- tant of the NASD rules. According to NASD R
mon stock was based on the weighted average of shares 4310(c)(25)(H)(i), shareholder approval is required
over a 17-day trading period following the close of the to the issuance of securities in a private offering equ
deal in June 2000, about $33 a share. However, on the 20% or more of the common stock or 20% or more of
one-year anniversary of the PIPE transaction, the con- the voting power outstanding for less than the greater of
version rate could be reset based on the average price ofbook or market value of the stock.
the stock during a 10-day period in June 2001. Typically, if there is no floor to the conversion price,
The more MicroStrategy s stock price fell, the more a structured PIPE transaction can result in the issuance of

stock the three investment groups would receive. By stock that will exceed the 20% limit established by the
April 3, 2001, MicroStrategy s stock price was trading at NASD. In fact, the NASD takes the position that a struc-
$1.75 a share and the conversion rate threatened to severely tured PIPE transaction will always exceed the 20% limit.
dilute existing shareholders' stake in the company. In Therefore, shareholder approval must be obtained prior to
order to avoid this dilution meltdown, MicroStrategy the issuance of a structured PIPE transaction.
and the three investors restructured the PIPE deal to pro- Voting rights . NASD rules prohibit the reduction of
vide the company with a combination of common stock, voting rights of existing shareholders of publicly traded
cash, and a fixed-conversion rate senior security. The common stock. Under the voting rights rules, an issuer
workout strategy appeared to work. MicroStrategy s share cannot create a new class of security that votes at a higher
price rebounded to $3.50 by August 2001. rate than an existing class of securities or take any other
action that has the effect of restricting or reducing the vot-
REGULATORY REVIEW ing rights of an existing class of securities. If structured
OF PIPE TRANSACTIONS PIPE securities can vote on an as-converted basis, their
voting power may be disproportionate to the amount of
As the discussion above indicates, PIPE transactions
capital they have contributed to the issuing company. If
are most applicable for small, emerging companies.
the votingThese
power of the PIPE securities or the amount of
companies, as a general rule, list their stock on the of Directors representation received is dispropor-
over-the-counter stock market because of the strenuous
tionate list-
to the company's overall book or market value at
the timeCon-
ing requirements for the New York Stock Exchange. of issuance of the PIPE securities, a violation will
exist because
sequently, the National Association of Securities Dealers,a new class of securities will have been cre-

Winter 2001 The Journal of Private Equity 71

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ated that has greater voting power than that of existing deems it nece
shareholders. tive acts and
Bid price requirement . The bid price requirement ciples of tra
states that for a company to be listed on the Nasdaq interest. In s
National Market, it must maintain a bid price for its otherwise me
common shares of $5. Similarly, to maintain a listing on Nasdaq mark
the Nasdaq Stock Market, a minimum bid price is $1. lous investor
Structured PIPEs can, through massive dilution, lead to by way of a
a stock price less than these two thresholds, resulting in
the company's de-listing from the Nasdaq. CONCLUSION
Listing of additional shares . Companies issuing com-
mon stock must file a Nasdaq-designated form no later PIPEs have become an extremely popular for
than 15 days prior to the issuance of the additional shares. equity financing for new and existing companies
The NASD takes the position that any security convert- ever, while the benefits are many for the company, th
ible into common shares falls under the notice provisions can be extreme. Despite the publicity of toxic PIP
of this rule, which applies to both structured and non- great majority of PIPE transactions are not struc
structured PIPE transactions. They are straightforward private investments in
Change in control. As the Log On America caseamount of public equity. Furthermore, the publicity
demonstrates, a change in control can occur through arounding toxic PIPEs and death spirals has resulted i
structured PIPE transaction. Under the NASD rules, if asafeguards in the PIPE industry.
change in control occurs through the conversion of the First, many PIPEs are now issued with a fixed
PIPE securities, the issuer of the PIPE securities must qual- version ratio, instead of a floating ratio. Second, for
ify under the NASD initial inclusion standards for listing PIPE transactions that contain a floating conversion
on the Nasdaq. In other words, if a change in control a floor provision is usually included. This provision re
occurs as a result of a structured PIPE transaction, the issu-the investor from converting into common share
ing company will be treated as a new company by the a certain price or above a certain conversion ratio
NASD with all the requisite listing standards for initial more PIPE transactions are restricting investors
inclusion in the Nasdaq. shorting the issuing company's public stock. The
Nasdaq's discretionary authority. The Nasdaq has the ity to short prevents investors from placing downwar
authority to preserve and strengthen the quality of andsure on the company's outstanding stock pric
public confidence in its market. As a result, the Nasdaqinitiating a death spiral.
may deny inclusion, or apply additional or more stringent In addition to these safeguards, the Nasdaq has p
criteria for the initial or continued inclusion, of particu- posed an interpretive release that will force compani
lar securities. Further, it may suspend or terminate theconsider the impact a structured PIPE transactio
inclusion of an otherwise qualified security if the Nasdaqhave on its Nasdaq National Market listing status. In
Breakaway Solutions has received a letter from th
Exhibit 4 daq indicating that the company does not currently
ply with the shareholder approval, voting rights, an
LBO Firms Investing in PIPEs
price listing requirements of the Nasdaq National Ma
LBO Firm In summary, PIPEs are an alternative invest
strategy for private equity investors. Many larg
Hicks, Muse & Tate ICG

Bain/T.H. Lee
firms invested significantly in PIPE transactions in
KKR With LBO deals becoming harder to find and mor
Texas Pacific Convergent $150 million
petitors in the industry than ever before (about 850 f
T.H. Lee private equity firms have turned to PIPEs as a new s
T.H. Lee of return.

Exhibit 4 provides a list of LBO firms that

CS First Boston


Silver Lake invested in PIPE transactions.8 It is expected th

trend will continue as buyout firms, venture capitalis

72 Playing the PIPEs: The Benefits and Risks of Private Investments in Public Entities Winter 2001

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hedge funds face pressure to put their billions of investor
capital to work.


Unfortunately, by the end of the year, Breakaway's

stock price had declined to less than $1.00.
2See Britt Tunick, "Equity Credit Lines Offer Cash for
Companies in Need," BuyOuts , May 7, 2001.
3Michael McDonough, "Death in One Act: The Case for
Company Registration," Pepperdine Law Review , 24 (1997),
pp. 563-647.
4"PIPE Market Outpaces IPO and Secondary Markets in
First Quarter; PIPEs Continue as the Primary Source of Equity
Financing for Public Companies," Business Wire , April 4, 2001.
5See Tunick, "Equity Credit Lines Offer Cash for Com-
panies in Need."
6See Steve Bergsman, "Toxic Cash-Burn Solutions,"
CFO, December 2000; Andrew Pollack, "A Lifeline, with
Conditions," New York Times , May 10, 2001; Cynthia L.
Webb, "Help Comes With a High Price; Distressed Firms
Agree to Extraordinary Terms, Even at the Risk of Depress-
ing Stock Prices," The Washington Post , April 16, 2001.
7See Webb, "Help Comes With a High Price."
8See Debra Sparks, "It May Not Be the Glory Years, but
Buyout Shops Are Back, Raising Billions - and Heading into
Uncharted Waters," Business Week , October 16, 2000.

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Winter 2001 The Journal of Private Equity 73

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