The PIPE – Can a PIPE transaction offer advantages?
I love the smell of a good pipe… The aroma is something found outside of the normal smell of foods or nature that we are accustomed to. Every evening for a period of many years in my neighborhood of Scottsdale, AZ an elderly neighbor would walk his dog around the block of our community smoking his pipe. I enjoyed the smell so much, I went to my favorite cigar shop (Ambassador Fine Cigars) and decided to jump in and try one—and I now contribute to that fine aroma on an occasional evening in beautiful Arizona.
I also love the aroma of another kind of pipe, the Private Investment in Public Equity. A PIPE refers to a transaction in which an already-public company issues private securities to a select group of accredited investors. A majority of PIPE transactions are issued by small companies who are looking to raise capital without having to go through lengthy process of registering a secondary offering of public shares. PIPEs can be traditional or structured. In traditional PIPE, the investor agrees to buy the security at a fixed price or fixed conversation ratio. In a structured PIPE, typically a convertible security is used and the conversion price is adjusted based on a formula usually tied to the market price of the underlying common stock during a period prior to conversion. Let’s take a look at an example of a traditional PIPE:
Company XYZ needs an additional $6 million in capital to support the research and development of a new medical device. The company’s common stock is currently trading at $7 on the over-the-counter market. Company XYZ approach a group of investors and offers them one million privately-held shares at $6 per share. To sweeten the deal, the company also offers the investors 500,000 in warrants at a price of $9 per share. The investors are required to hold the private securities for a minimum of six month before then can exit the investment via the company’s publicly traded stock. The company issues the warrants to entice the investors to keep their investment for the long-haul. 12 months later, the company stock is trading at $9 per share, and the investors have decided to keep their holdings with the company. Their six million in which they invested is now worth nine million. They bought and additional 500,000 shares when the stock hit $9, which increased their ownership position in the company. In total the company received $10.5 million in additional capital.
A PIPE transaction can offer several advantages to both the Issuer and the Investors. The main advantage for investors include, receiving a discount to the current market price for their willingness to accept an illiquidity premium (initial resale restrictions).
A PIPE transaction offers several advantages to the issuer, including:
- increasing the number of accredited and institutional investors
- for fixed price transactions, investors will be less likely to hedge their private stock by shorting the issuers common stock.
- its a private transaction which will be disclosed to the public only after the investors have fully committed to purchasing the private securities.
- a transaction can close in seven to ten days of receiving the investors commitments.
Now, to be fair, there are some disadvantages to PIPE transactions in which issuers should be aware, including:
- Investors will require a significant discount to the current market purchase price, including warrants.
- Issuers must be careful to offer PIPE securities only to accredited investors.
- an issuer cannot sell more than 20% of its outstanding stock at a discount without receiving prior stockholder approval.
As mentioned before, structured PIPEs include a floating conversion price. A floating price, which can change depending upon the price of the publicly traded common stock, can lead to a situation that is potentially toxic to the issuers financial health. A toxic PIPE works as follows:
- A company goes public before it has a chance to establish its target market.
- The company burns through its IPO cash and desperately needs additional capital to continue its operations.
- Without a history of producing cash flow, traditional methods of financing are not an option.
- The company approach a group of private investors who agree to provide more capital in return for PIPEs that can be converted into common stock at a floating conversation rate. In addition, the investors are purchasing the securities at a discount to the current common stock price.
- The investors realize they can manipulate the company’s stock price by shorting the company stock.
- The downward pressure on the company’s common stock price causes the conversation ratio to increase for the PIPE investors resulting in greater dilution of common stock of the company.
- The company is forced to reduce the conversion ratio for the PIPEs into common stock at lower prices which drive down the common stock of the company, resulting in an even lower conversion price.The investors profit from selling the company short, sell their converted shares or take control of the company.
Given the choice, I highly recommend that small/ micro/ or nano-cap companies seeking to raise capital through PIPEs, do so through the traditional format. Private equity firms and hedge funds recognize the abnormal profits that can be attained through investing in PIPE transactions; while making money for their investors is their goal, it’s important that companies protect themselves from entering into a toxic deal. Traditional PIPEs place the issuer and the investor on the same side of the table.
If you would like to learn more about PIPE deals that are offered to our Partners, or are interested in syndication participation, please fill out the following link: https://interlinked.com/syndicate-participation-request-form/