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BY MICHAEL B. SOHMER
SENIOR CONSULTANT, CONSULTANTS TO MANAGEMENT

Private Investment in Public Equity, or "PIPE," has been utilized as a capital source since investing in companies began. Back then, it didn’t have the fancy name or acronym, but investors typically invested directly into public companies.

PIPEs are often smaller deals compared to registered secondary offerings and usually more flexible. In a PIPE deal, a company will sell directly to qualified investors in a private transaction. PIPEs can take the form of debt, equity or both and are usually deeply discounted to prevailing market prices. Once completed, these shares are registered and equivalent to shares already held in the marketplace.

PIPEs became fashionable in the 1980s and lost steam in the late 1990s due to easily accessible capital. Now PIPEs are finding their way back into the market as an easy, efficient capital source in a time when capital is becoming increasingly harder to come by.

For companies seeking capital, PIPEs have their advantages when compared to the typical secondary offering.

Speed of Transaction — Usually, PIPE transactions can be completed in less than two months, compared to three or four months for secondary offerings. The speed of these transactions and the less complexity involved, frees company management to concentrate on managing the business instead of running from city to city performing a road show.

Lower Costs — Due to reduced complexity, fewer investors and quicker turnaround, PIPE transactions are less expensive and much more cost efficient compared to secondary offerings.

Certainty — In a PIPE transaction, the purchase price, amount and investors are all disclosed to the market after the closing of the deal. In a secondary offering, the stock price and the amount raised are unknown. Goals for both share price and total amount raised are set, but not always achieved. Until the secondary offering is completed, dilution and amount of capital raised are issues to existing shareholders.

The benefits of PIPEs may sound great, but there are also many pitfalls lurking. PIPEs have also been called "death spiral" or "toxic" financial instruments. Many companies in their haste to raise capital entered into PIPE transactions that included convertible bonds. These floating convertible bonds were not pegged to the amount of shares convertible, but to the dollar value of the shares. So, as the price decreases, the equity ownership of the bondholders increases. This scenario is particularly vulnerable to short sellers, who may also be the PIPE investors. Too much supply depresses the stock price, therefore increasing the equity ownership of the PIPE investors. These investors make money on the short sale and, through their PIPE transaction, increase their ownership levels in the company.

PIPEs are usually deeply discounted to the prevailing stock price. But to many companies, the options are limited to PIPEs or bankruptcy. To increase the likelihood of a successful transaction between the PIPE investors and the company, first, seek to align the investors’ interests with the company. Negotiate the conversion to a set number of shares, making stock appreciation the investor’s main goal. Management must do their homework by researching the investors and the terms of the PIPE instrument. This is where most companies lack the knowledge and don’t spend the time. Doing the proper due diligence can save the company money and its current existence. Finding the right investors is difficult, but those investors will align their interests with the other shareholders and may possibly provide business advice by becoming board members.

PIPEs can be a company’s best friend or its worst nightmare. With a thorough due diligence and the right advice, it can be a lifesaver.

Michael Sohmer is a senior consultant with Amper, Politziner & Mattia and a member of the firm’s Technology Group.