Alternative Financing Mechanisms

With the markets down, it's time to explore alternatives to straight equity deals for public companies: PIPEs, equity lines of credit, convertible debt, and "toxic preferred" securities.

Q&A on Alternative Financing Mechanisms

Question: Nasdaq's down 60%. If things stay this way, and a public company needs to raise money quickly, what are the alternative financing mechanisms that are available?

Answer: The investment banking industry offers a variety of nostrums for financial malaise, which include straightforward treatments promising immediate relief and no lingering side effects; less conventional approaches that take advantage of the body's ability to heal itself; and experimental therapies which may cure or kill the patient. Private placements of public equity/common stock (PIPEs), equity lines of credit, and convertible preferred stock are three vehicles which depict these three different approaches to financial relief.

A PIPE involves the placement of common stock by an underwriter to selected institutional buyers at a negotiated discount (10-20%) to the stock price of the issuer. For an issuer caught in a temporary down-draft of the market as a whole, the PIPE offers the opportunity to compute the "average" price over the preceding 30-45 day period, a sale price more reflective of the true underlying value of the company.

The PIPE is consummated before public announcement of the transaction so that third parties cannot sell short in anticipation of the transaction. The company then commits to register the securities within 30-60 days of the closing (on a short-form S-3 registration statement, which is normally not reviewed by the SEC). Alternatively, the securities could have been previously registered as part of a shelf registration, which permits issuers to then take down and sell tranches of registered stock on an almost immediate basis (although arguably a shelf registration may defeat one of the key advantages of a PIPE, namely the ability to consummate the deal before hedge funds can take short term profits as a result of anticipating the transaction in advance).

Along with the discount, the buyers may also ask for a mild deal sweetener, namely the issuance of warrants to purchase additional common stock of the issuer at a premium to the current purchase price of the stock (i.e., the exercise price is meant to reflect the true, long-term value of the common). This "warrant coverage" provides for the issuance of warrants typically worth 10%-20% of the value of the deal. Although the warrants are dilutive, they do not create a serious overhang issue, since they normally contain a provision for mandatory exercise by the buyer once the issuer's stock price hits a target level after the closing of the PIPE: for example, the buyers must exercise the warrants once the issuer's price hits twice the price of the stock offered in the PIPE.

The beauty of PIPE transactions is that they can be completed in a few days time, quite unlike the 60-90 days needed for completion of a secondary public offering. Although the amount of money raised is usually about half (e.g., $50-75 million) of the normal secondary offering, the deal can be timed so that it occurs during an advantageous market window. And since the security sold is common stock, it does not contain any of the additional rights typically attached to preferred stock, namely preferential financial return or intrusive governance provisions.

If an issuer's stock is undervalued but it expects positive news flow to increase the price and trading volume of the stock over an extended period (i.e., 1-2 years), it can establish an equity line of credit with a financial institution, like Acqua Wellington or Kingsbridge. The equity line permits the issuer to sell blocks of common stock to the institution in installments during the period that the line is in effect, at a price equal to a discount of the "average" current price computed over a pre-agreed timeframe. The percentage discount decreases as the issuer's price rises, rewarding the issuer for the effect of the positive news on its price or a general improvement in market conditions.

The method by which the average price is determined is a subject of negotiation. Unlike in the case of a PIPE, the issuer prefers the average price to be determined over as short a time period as possible, so that it can time each drawdown to the transitory financial market glow produced by the positive news announcement. In response, the provider of the line will at least require that the price be determined on a "weighted average volume basis", so that if the price is computed over a relatively short time period, at least it will be reflective of the days on which volume is greatest and arguably a "true" price is produced rather than a temporary bump up immediately following the issuance of a press release. So that the issuer does not take undue advantage of a one-time pop in its price on account of a single announcement, typically the amount of the drawdowns in a given month is limited to a pro ratapercentage of the line.

In consideration for the risk assumed by the provider of the equity line, it will require either a warrant sweetener or a transaction fee (normally no more than 5%) on each drawdown. More typically, lenders get warrants which are a bit more advantageous to their recipient than PIPE-related warrants, providing for exercise over an extended time period (e.g., 5 years) and usually having an exercise price set at a smaller premium over the market price at the time of the corresponding drawdown (e.g., 10-15%). Still, the warrants only vest as the issuer accesses the line through drawdowns, so that the dilution is controlled by the issuer.

As with PIPEs, the provider of the line receives registered common stock, which is accomplished via a short-form filing with the SEC that is not normally reviewed. It is perhaps best to think of an equity line as providing the issuer with the assurance that it can accomplish a series of PIPEs over an extended time frame, while still giving the issuer the discretion as to the precise timing of each issuance. The cost of this assurance is potentially more expensive warrant coverage or a transaction fee.

If the price of the issuer's common stock is significantly undervalued—say by 50% or more—relative to its presumed fair value and the timing of its return to an appropriate level is difficult to estimate, then a company might try to sell either convertible debt or convertible preferred stock. By doing so, the issuer incurs less dilution than if its common stock were to be issued at a bargain price, since these convertible instruments are exchangeable for common stock at a significant premium to the currently undervalued price of the common. In exchange for taking the risk that the issuer's common may never return to its historic price level, the investor receives downside protection against a doomsday scenario through the ability to recover its money on a priority basis through repayment or exercise of a liquidation preference.

Although conversion to common stock at a fixed exchange ratio is most common in convertible deals, occasionally investors will offer a conversion ratio that floats as a percentage of the market price of the common stock. Optimistic managers may see such a floating conversion ratio as attractive (betting that their stock price will increase in the future), but since stocks fall as well as rise, so does the conversion ratio. This can prompt short selling and thus a vicious downward cycle in the issuer's stock price.

For this reason, such instruments have come to be known as "toxic preferred" and are best avoided unless a floor can be negotiated on downward adjustments to the conversion ratio. Other, more indirect protections against the downward spiral effect which can be negotiated include prohibitions against conversion for a minimum period of time (so that the company can get its act together in a time of crisis), and redemption rights which permit the issuer to force conversion if the price of the common stock reaches a threshold level or if the securities have not been converted after a specified period of time.

Even with a conversion ratio that is not tied to fluctuations in the market price of the issuer's common stock, holders of convertible securities in public companies are, like venture capitalists in a private deal, protected against subsequent issuances of common stock by the company at a lower price, typically through "weighted average" price antidilution protection. The convertible securities also come with registration rights, permitting the investor to require registration of the common stock underlying the security upon conversion. But since the convertible securities are not registered upon issuance, the legal process is even faster and cheaper than PIPEs and equity lines, since no SEC filing is required (until conversion of the securities into common stock).

There are numerous variations among convertible securities, with the boundaries set only by the creativity of the investment banking community. For example, companies with approved or late-stage products have begun to issue convertible debt instruments that offer both interest and a royalty participation in product sales.

In short, a depressed public market doesn't foreclose the possibility of reasonable financings by public companies. The only caveat is that it is difficult to ride two horses at once: once a company has filed a registration statement for a follow-on public offering, the SEC will not permit it to market a private placement of the same security unless the registration statement is withdrawn and following a short cooling off period.

This rule does not apply to efforts to market a different security, so a registration statement for a secondary offering of common stock could be left pending until market conditions improve. During this time, the issuer could do a convertible debt or preferred offering to qualified institutional buyers. The advantage of maintaining on file a pending registration or a shelf registration is that it permits quick action when the market turns up and, thanks to the crowd of companies looking to take advantage, review times at the SEC begin to lengthen. The issuer's only obligation regarding a pending registration statement is that the company must update the financial statements when they become more than 135 days old and describe material interim developments affecting the issuer.

In the current investment gloom, there is at least this bright light: the financing alternatives available today are far more readily taken advantage of than ever before in our industry's history. The investor base for biotechnology has broadened dramatically over the past few years. Each of the above financing vehicles has its own investor constituency; thus while it's important to choose the right investor for the right vehicle, there are many more such investors in each category than there used to be even a few years ago.

Michael Lytton is a General Partner at Oxford Bioscience Partners and formerly head of the life sciences legal practice at Palmer & Dodge. If you have any questions you'd like addressed in this column, or if you have comments, e-mail directly to[email protected]