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Home > Financing Best Practice > Private Investments in Public Equity

Financing Best Practice

Private Investments in Public Equity

by William K. Sjostrom, Jr

Executive Summary

  • A private investment in public equity (PIPE) is a type of public company financing transaction that is prevalent in the United States.

  • In a typical PIPE transaction, a public company privately issues common stock or securities convertible into common stock to a small number of sophisticated investors in exchange for cash. The company then registers the resale of the common stock issued in the private placement, or issued on conversion of the convertible securities issued in the private placement (the PIPE shares), with the US Securities and Exchange Commission (SEC).

  • Generally, investors must hold securities issued in a private placement for at least six months. However, because the company registers the resale of the PIPE shares, investors are free to sell them into the market as soon as the SEC declares the resale registration statement effective (typically at most within a few months of the closing of the private placement).

  • In 2009, companies closed on 1,072 PIPE deals in the United States, raising approximately $36.7 billion in the aggregate.

  • While companies of all sizes have used PIPEs to raise money, PIPE deals have emerged as a vital source of financing for small public companies, with the overwhelming majority of deals being completed by companies with market capitalizations of $250 million or less. This is driven by the reality that PIPEs represent the only available financing option for many small public companies.

Types of PIPE

PIPE transactions are highly negotiable; hence, there is a fair amount of variation from deal to deal with respect to the attributes of the PIPE securities. PIPE securities may consist of common stock or securities convertible into common stock, such as convertible preferred stock or convertible notes, and may be coupled with common stock warrants.

Regardless of the type of securities involved, PIPE deals are categorized as either traditional or structured. With a traditional PIPE, the PIPE shares are issued at a price fixed on the closing date of the private placement. This fixed price is typically set at a discount to the trailing average of the market price of the issuer’s common stock for some period of days prior to closing of the private placement. As mentioned above, securities regulations generally prohibit investors from selling PIPE shares prior to the SEC declaring the resale registration statement effective. Thus, because the deal price is fixed, investors in traditional PIPEs assume price risk, which is the risk of future declines in the market price of the issuer’s common stock during the pendency of the resale registration statement.

With a structured PIPE, the issuance price of the PIPE shares is not fixed on the closing date of the private placement. Instead, it adjusts (often, downward only) based on future price movements of the issuer’s common stock. For example, investors may be issued convertible debt or preferred stock that is convertible into common stock based on a floating or variable conversion price, i.e., the conversion price fluctuates with the market price of the issuer’s common stock. Hence, with a structured PIPE, investors do not assume price risk during the pendency of the resale registration statement. If the market price declines, so too does the conversion price, and therefore the PIPE securities will be convertible into a greater number of shares of common stock.

For example, say an investor purchases a $1,000,000 convertible note in a PIPE transaction, and the note provides that the principal amount is convertible at the holder’s option into the issuer’s common stock at a conversion rate of 90% of the per share market price of the stock on the date of conversion. Thus, if the market price of the issuer’s common stock is $10 per share, the note is convertible at $9.00 a share into 111,111 shares of common stock. If the market price drops to $8 per share, the note is then convertible at $7.20 per share into 138,889 shares of common stock. Regardless of how low the price drops, on conversion the investor will receive $1,000,000 of common stock based on the discounted market price of the stock on the day of conversion.

Some structured PIPEs do contain floors on how low the conversion price can adjust downward, or caps on how many shares can be issued on conversion. If a structured PIPE has neither a floor nor a cap, it can potentially become convertible into a controlling stake of the PIPE issuer. Continuing the example from above, if the market price dropped to $0.01, the note would then be convertible into more than 100 million shares, which would constitute a controlling stake unless the issuer had at least 200 million shares outstanding. Hence, structured PIPEs lacking floors or caps are pejoratively labeled “death spirals” or “toxic converts,” because investors in these deals may be tempted to push down the issuer’s stock price through short sales, circulating false negative rumors, etc., so that their structured PIPEs become convertible into a controlling stake of the issuer.

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Further reading

Book:

  • Dresner, Steven, with E. Kurt Kim (eds). PIPES: A Guide to Private Investments in Public Equity. Revised and updated ed. New York: Bloomberg Press, 2006.

Article:

  • Sjostrom, William K., Jr. “PIPEs.” Entrepreneurial Business Law Journal 2:1 (2007): 381–413. Online at: tinyurl.com/32m83e5 [PDF].

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