"PIPE" FINANCING EXPLAINED

What is a PIPE? The acronym stands for "Private Investment/Public Equity." Here's how it works: An institutional investor agrees to purchase the capital stock (convertible preferred, convertible notes, or common stock) of a public company, usually a relatively small public company, in a "private placement." Securities issued in a "private placement" cannot be resold for at least a year, unless those securities are registered with the SEC. In a PIPE, the company immediately registers the securities, so that the PIPE investor can liquidate its investment when the stock price rises to a level that gives the investor the return it seeks.

There are two kinds of PIPEs: pure PIPEs and standard PIPEs. In the pure PIPE, the deal doesn't close until the SEC declares the registration statement for resale of the shares effective. In the standard PIPE, the company and the investor close the deal, and the company agrees to immediately file a registration statement covering resale of the otherwise "restricted securities." There are usually penalties imposed if this filing is not made timely, and effectiveness with the SEC secured within a specified period of time.

What are the advantages for the institutional investor? The investment fund receives a security that it can almost immediately trade, timing its exit strategy to suit its convenience. For the company, the primary advantage is speed and flexibility: it can raise money quickly - a private placement of securities can be accomplished literally in days, whereas registering the shares before the transaction is begun can take several months.

PIPE transactions have assumed certain standard structures. If common stock is being sold, it is usually sold at a 5-15 percent discount from the current market price. If convertible preferred stock or convertible notes are issued, the conversion price (the divisor used to determine the number of common shares issued upon a "conversion" of the instrument) usually is also pegged at a discount to the current market price.

Invariably, to sweeten the deal, the investor receives warrants to purchase additional shares, either at the "conversion price" of the primary instrument, or at a discount or premium relatives to that price. This is a highly negotiated term of the deal. Warrant "coverage" ranges from 30 percent to 100 percent of the deal size (e.g., at 100 percent, the number of warrant shares equals the primary deal size divided by the warrant exercise price).

If not properly structured, a PIPE transaction can create a "death spiral" -the price is discounted so much, with such a built-in gain for the investor on the closing date, that the investor begins liquidating its position immediately, causing the stock price to plummet. This often triggers additional stock issuances under the original PIPE transaction, which creates even further downward price.

Death spirals aside, the PIPE transaction is probably the best way for small public companies to raise capital quickly and relatively inexpensively.