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. We re supposed to give  em $2 million, right? Yes. That s about four million shares at today s prices, isn t it? askedthe boss. Yes, replied the lieutenant,  and we sold at an average price of73 cents. Call Jerry in Canada and have him short it more, ordered the boss. Okay, agreed the lieutenant.The foregoing true vignette (names changed to protect the guilty)highlights the risks (to the issuer) inherent in PIPE financing forsmaller-cap stocks.Large companies with an active market can absorbsome degree of short selling without the price dropping much, if at all.PIPE investors may be individuals, hedge funds, or other finan-cial institutions.You won t often see the Goldman Sachses of theworld or other gilt-edged Wall Street fi rms investing directly in thePIPEs of small companies, but they may well back the hedge fundsthat do invest.The best of the PIPE investors will be content to do a  fund andregister transaction at a fixed price.This means that the company agreesto issue to the investor x shares, representing y percent of the companyas unregistered shares (also sometimes called lettered stock), often onthe condition that the company becomes publicly reporting, if it is notalready, (by filing a Form 10 with the SEC) and that it agrees to:" Register the shares by filing a registration statement with the SECwithin z days of funding (typically 120 days), registering the sharesbought for resale." Use commercially reasonable efforts to have the registrationdeclared effective within some number of days (typically 60) or elsecompensate the investor for the delay by paying additional sharesfor each day or week of delay.The company may also be asked to commit to working with asponsoring broker-dealer so that a market for the securities is allowedto develop (i.e., that it trades).Before rushing to agree to such a proposal,PIPEs 79companies must ensure that securities counsel and auditors havebought into the time frames.An example of a company that wasfunded this way but came to grief was Smart Online, a fraud we profilein Chapter 31.PIPE investing just got even easier.In an effort to encourage honestplayers to participate, recent changes in the securities laws have reducedthe holding period for PIPE investors to six months in many circum-stances; so often, if the company is already public, there is no longer aneed to file a registration statement at all the company merely signsa contract, gets its money, and then files the details of the transactionwith the SEC on Form 8-K.This change was done by relaxing the requirements of Rule 144 to:" Permit nonaffiliates of an SEC-reporting company to resellrestricted securities without regard to Rule 144 volume, reporting,or manner of sale limitations after a period of six months." Permit nonaffiliates of an SEC-reporting company to resellrestricted securities without regard to any Rule 144 requirements,including the current information requirement, after a period ofone year.(In the event that the company existed as a shell for aperiod of time, then the holding period for nonaffiliates for unreg-istered stock is one year.)When the Share Price Is Not FirmIt is not easy to get an investor to agree to a share price that is fixednow but then hold on until the shares are eligible for resale at anessentially unknown future date at least six months into the future.Toprotect themselves, investors ask for floating discounts.For example, theinvestor agrees to invest $1 million by buying 1,000 shares of SeriesA preferred shares with a face value of $1,000 per share, bearing inter-est at 10 percent annually with each preferred share convertible intocommon shares at the rate of 70 percent of the average closing bidprice for the common stock for the three days preceding conversion,times 1,000.So, if the common shares were originally valued at $1, thenthe 1,000 Series A 10 percent preferred shares issued would have aface value of $1 million.80 hi s t or y of gr e e dIf the average bid price per share dropped to 50 cents on theconversion date (based on the closing price for the three previousdays), then 2,850 shares would be issuable for each preferred shareconverted.Savvy investors would typically employ a  sell and convertstrategy, whereby they would sell the shares all day, and then at theclose of business, send a conversion notice covering the shares actuallysold, essentially locking in their 30 percent profit.The SEC has been frowning on these types of open-ended conver-sions, which were known in the trade as  death spiral preferreds or floorless conversions because the more the price falls, the moreshares are owed, so that the owner of the preferred shares has areally unfair advantage over common shareholders.Such death spiralpreferreds are deemed toxic, and wise investors avoid any companythat has issued them.(Mark Cuban s decision to dump his stock in acompany planning to enter into a PIPE is what precipitated his fightwith the SEC.)The SEC prefers a fl oor price so that there is a clearly determin-able maximum number of shares that can possibly be issuable from aconversion, and it wants this number to be disclosed.If funders agreeto a fl oor, they usually also demand a ceiling (a maximum conver-sion price, no matter how high the share price rises).So heads, theinvestor wins; tails, the company loses.Clever minds have come upwith many legal circumventions of the ban on floorless conversions.While the terms for a reporting company, at least, must be promptlydisclosed in detail, along with a copy of the  material agreementcontract in a Form 8-K, which needs to be filed within two days,the language is often sufficiently arcane so that its implications cannotpossibly be fathomed by the average shareholder (and often not by thecompany, either).How a Company Can Be Hurt by PIPE InvestorsWhile there is no shortage of examples, consider ICOA Corporation,a provider of wireless Internet services for public spaces such as hotels,airports, restaurants, and marinas (see www.icoacorp.com).As thisbook went to press, the common stock of ICOA was trading on thePink Sheets at $0.0002 per share (down from as much as $0.125 inPIPEs 81the past), which is 1/625 of its value a few years ago.What happenedin the meantime? The company s sales grew several-fold, its lossesdropped substantially, and it managed to acquire several smaller competi-tors with cash raised from a PIPE.However, it had accepted the PIPEinvestment from an aggressive PIPE writer who has been investigatedby the SEC for illegal short selling.ICOA is now among the walkingdead.At $0.0002 per share it can t raise money by selling equity, andthe unconverted debt from the PIPE constitutes a priority lien, so itcan t sell debt, either.HedgingExcept for regulated SBICs, hedging transactions are often carried outby a funding investor in PIPEs or someone close to that investor tomitigate risk and increase profi ts, legally or otherwise.By selling short(ideally prior to funding and continuing on afterward), the investor haslocked in the higher price.If the stock price then falls as a result ofthe selling pressure from the hedge, the investor is entitled to moreshares.The investor closes out the short sale, profiting from the fall inthe price, but then profi ts a second time because the fall in the pricerequires the company to issue him additional shares [ Pobierz całość w formacie PDF ]