PIPE Primer for Venture Investors

Private investment in public equity (PIPE) transactions have attracted a great deal of attention lately. A PIPE generally involves a private placement of securities by an emerging public company to investors at a discount to the market price of the securities, paired with an undertaking by the issuer to register the securities for public resale. PIPEs permit issuers to obtain capital quickly, while offering investors both the opportunity to purchase discounted securities and near term liquidity.

Hedge funds and sovereign wealth funds dominated the PIPE market from 2006 through 2008, accounting for almost 65% of all PIPEs based on transaction volume and capital invested, according to a November 2008 report by DealFlow Media. Traditional PIPE investors have been attracted by short-term gains realized from the purchase of securities at a discount followed by a registered resale of the securities at market prices.

Venture capital and private equity investors have not invested heavily in PIPEs primarily because PIPE investments have not met their investment criteria. VC and PE investors accounted for only 15% of PIPEs during 2007 and 2008 based on transaction volume and capital invested, according to DealFlow Media.

With the $2.5 trillion hedge fund market in disarray, PIPEs by hedge funds have slowed or stopped entirely. Diminished investments by traditional PIPE investors have prompted emerging public companies to look to VC and PE investors.

Large private equity investors now are doing PIPEs. Eighty-seven “mega-PIPEs” of $1 billion or more were completed last year by private equity funds, sovereign wealth funds and others who collectively invested $165.12 billion, according to Sagient Research Systems. These larger PIPEs were often structured using preferred stock with private equity-style features.

Investors in these large PIPEs, which historically might have used a traditional private equity structure, have recognized the potential benefits of a PIPE. Less noticed is the increasing number of smaller PIPEs by VC and PE investors.

The opportunity

Emerging companies (public and private) requiring capital face reduced availability of equity investments and collapsing capital markets for underwritten public offerings. Many private companies are curtailing operations and capital expenditures, reducing the number of viable private investment opportunities.

Uncertain exit strategies also are contributing to fewer VC and PE investments. Last year marked the first time since 2003 when annual venture investments declined, according to the MoneyTree Report by PricewaterhouseCoopers and the National Venture Capital Association. Venture-backed exits also collapsed last year, with only six venture-backed IPOs and 37 venture-backed M&A transactions, according to the NVCA and Thomson Reuters (publisher of VCJ).

PIPEs of under $100 million by traditional PIPE investors likewise fell 21% from $15.34 billion in 2007 to $12.71 billion in 2008, according to Sagient Research Systems.

PIPEs 2.0

The evolution of PIPEs greatly expands investment opportunities for venture capital and private equity investors and affords both emerging public companies and private company investors mutual benefits.

For issuers, the entry into the PIPE market by venture capital and private equity investors offers new sources of growth capital. Additionally, the attributes of PIPEs differentiate an emerging public company from private companies that are competing for capital by offering greater liquidity and transparency than in private transactions.

For venture capital and private equity investors, a PIPE offers favorable economics and venture capital-style control mechanisms with the added benefit of a liquid security. A venture capital or private equity investor can capitalize on historically low stock prices of emerging public companies, enhanced liquidity and the benefits of reporting transparency while preserving rights usually accompanying a private company financing.

Key issues

Type of security. While common stock has historically been sold in PIPEs, convertible preferred stock and convertible debt securities are becoming more common in PIPEs.

Investment amount. Like venture capital and private equity investments, PIPEs range from under $10 million to hundreds of millions of dollars. Securities sold in a PIPE are often priced at a 5% to 25% discount to the trading price of the issuer’s common stock.

For venture capital and private equity investors, a PIPE offers favorable economics and venture capital-style control mechanisms with the added benefit of a liquid security.

Investment percentage. PIPE investors usually limit their maximum ownership percentage to 9.9% in order to avoid disclosure obligations under federal securities laws. Larger stakes will subject the investor to Exchange Act reporting. If more than 20% of the issuer’s outstanding float is purchased, a stockholder vote is required by exchange rules.

Anti-dilution protection. Anti-dilution protection is rare if common stock is being issued in the PIPE. A “negative clawback” (i.e., an obligation to issue additional common stock to the investor if the issuer sells securities at a price lower than the investor’s purchase price) can provide an investor with the equivalent of anti-dilution protection. If convertible preferred securities are sold in the PIPE, investors can receive anti-dilution protection as with venture capital and private equity deals.

Convertible securities usually have a “reset” feature that reduces the conversion price if the issuer’s common stock trades below the issuance price for a certain period. Unlike the “death spiral” reset provisions seen in legacy PIPEs, issuers now negotiate a floor below which no further adjustments are made or limit the number of conversion price resets.

Make-good provisions. Where a limited number of individuals both operate a company and hold a majority interest, PIPE investors can negotiate a “make good” agreement requiring the majority stockholders to escrow a percentage of their stock (usually on a one-for-one basis with the number of shares issued in the PIPE) in support of the company’s future performance.

If the company fails to achieve certain financial results during a defined period, the escrowed shares are transferred to the PIPE investors. If the financial milestones are achieved, the escrowed shares are returned to the majority stockholder(s). “Make good” provisions can result in non-cash charges under U.S. GAAP and must be carefully crafted to avoid adverse accounting treatment.

Time to closing. A PIPE usually can be closed within a month after a term sheet is finalized, and sometimes within a week. Due diligence is usually more streamlined than in private company financings because the issuer’s SEC reports are readily available. There are generally no regulatory barriers or other major hurdles to close a PIPE, and valuation negotiations are faster because a public company’s trading price establishes a baseline valuation.

Registration rights. As in VC and PE deals, an issuer in a PIPE financing is obligated to register the securities issued to the investors. Since the issuer in PIPE financing is already public, the resale registration statement can be filed almost immediately after closing and can be declared effective shortly thereafter. Usually, only common stock must be registered for resale during a preordained period.

If convertible securities are sold, the common stock underlying the convertible securities is ordinarily registered. Liquidated damages are commonly imposed if the issuer fails to meet its registration obligations. The penalty is typically 1% per month (based on the total amount of capital raised) capped at 10 percent.

Liquidation preferences. VC and PE investors typically negotiate for a preferential payment upon a liquidity event. Liquidation preference payments are atypical in PIPE financings when common stock is issued. A growing trend in PIPEs is to issue senior convertible securities with liquidation preferences.

Preferred dividend rights. Mandatory dividend rights are rare in PIPEs involving common stock, but more typical if preferred stock is issued.

Stockholder veto rights. Venture and private equity deals usually afford VC and PE investors veto rights over significant corporate actions (e.g., payment of dividends, incurrence of debt, liquidity events, sale of senior securities and redemptions). Where common stock is issued, veto rights are rarely granted to PIPE investors.

Stockholder veto rights can be granted in PIPEs where preferred stock is issued or may be contractually established. Veto rights must be structured properly so as not to expose a PIPE investor to controlling stockholder liability or place undue operating burdens on the issuer.

Board representation. PE and VC investors often negotiate for board representation as a condition to investment and may do so in a PIPE. Given today’s litigious environment and the demands of Sarbanes-Oxley, investors are less inclined to serve as public company board members. Mechanisms exist, however, that can mitigate a public company board member’s exposure to liability.

Due diligence. Due diligence for a PIPE often is faster and less expensive than in a VC or PE transaction due to publicly available SEC reports. Many PIPEs also involve investment banks which conduct their own due diligence, a level of protection often not available in private company transactions.

Legal documents. Where common stock is being issued in a PIPE without any special rights, PIPE documents include a Securities Purchase Agreement and a Registration Rights Agreement. If the PIPE financing involves preferred stock or convertible debt with special rights, then additional, very familiar documents are required.

Louis A. Bevilacqua, Robert B. Robbins and Joseph R. Tiano, Jr., are partners in the law firm of Pillsbury Winthrop Shaw Pittman LLP. Bevilacqua and Tiano are members of Pillsbury’s China practice team and advise U.S., European and Asian clients in the life sciences, software, energy and other industries on a wide range of legal and investment matters. Robbins leads Pillsbury’s global Corporate & Securities Practice. Bevilacqua may be reached at louis.bevilacqua@pillsburylaw.com, Robbins at robert.robbins@pillsburylaw.com and Tiano at joseph.tiano@pillsburylaw.com.