No Escape From the Orphanage: The Problem with PIPEs Financing For Small Cap Companies:
Pity the public, say, biotech company resident in the "orphanage." It went public on the basis of promising therapeutics in Phase II trials . a Wall Street darling, at least for a time. The drug discoveries still look promising but the landscape has changed. Mid- to small-cap biotechs are out of favor. Stock trading under $5; delisted from The NASDAQ National Market System; Market cap under $75,000,000; cash running short; no analytical coverage anymore (the underwriter's analysts are walled out); and stock trading by appointment, at prices well under management's estimate of fair value.
Go private and then raise capital from the VCs? Given the historical attitude (hostile) of the SEC to going private transactions, frictional costs of up to $1,000,000 are entailed, on top of whatever capital is needed to fund the transaction.
An underwritten secondary? Too small for Wall Street. The remaining alternative is a PIPE, and there is trouble on that front as well.
Thus, consider the implications of the SEC staff's response (not yet published but widely circulated) to a no-action request involving the re-sale of securities used in a PIPE if the issuer is one of the 10,000 registrants which are S-3 eligible for, and only for, secondary offerings:
" . given the nature and size of the transaction, we are unable to agree with your analysis that the transaction being registered is appropriately characterized as a transaction that is eligible to be made on a continuous or delayed basis under Rule 415(a)(1)(i). Because the offering of the common stock may not be done on a delayed or continuous basis wider Rule 415(a)(1)(x), you may not file a resale registration statement before the time that the selling shareholders convert or exercise the outstanding securities and acquire the common stock. At that time, you may register the transaction on the form on which you are eligible to register the transaction as a primary offering; identify the investors as selling shareholders and underwriters in the registration statement and include the price at which the underwriters will sell the securities."
The issue was first identified, to this corner at least, by Joe Smith of Feldman & Weinstein. Joe and his firm are major players in the PIPEs marketplace:
Again, courtesy of Joe Smith, the substance of Lynn's Guidance is summarized as follows:
For added guidance, please feel free to contact Joe Smith (firstname.lastname@example.org).
Given the cold hard fact that the IPO window in the U.S. is more or less closed for flotations by issuers with market capitalizations lower than, say, $600 million, a number of private equity funds are looking urgently for liquidity events in addition to trade sale. In a number of cases, Fund III managers, say, are undertaking to market Fund IV and a liquidity event or two in the existing portfolio would prove to be an enormous boost to what has become a "long hard slog" in front of funds . even some of the best of breed . seeking to raise capital in today's market. There is a lot of money around but very nervous investors, none of whom want to be the next "Bozo." As a consequence, some pretty fancy funds are looking at exit events for their portfolios, by reverse merging the same into a public shell or a SPAC (special purpose acquisition company) which has gone public for the express purpose of merging with a private company within 18 months. (However, in a paper published some years ago, a student of mine and I did a survey on reverse mergers, which we are updating as Book 20 in The Encyclopedia of Private Equity and Venture Capital, with after-the-merger data on both SPACs and Shells. (For a copy of our existing materials, see Sections 8.15 and 8.15.1 of The Encyclopedia.) the post closing numbers and the SPAC exit remains a question mark; shortly VC Experts will be posting Book 20 to The Encyclopedia of Private Equity and Venture Capital. One section of that material will track the performance of SPAC shares based on that handful of SPACs which have completed an acquisition in the required 18 month period. Based on preliminary readings, and throwing out the one transaction with the word "China" in its name, the results may not prove to be, let me put it this way, entirely satisfactory.
There is a variation on the SPAC/Shell theme, however, which may well hold considerable promise. As reported to me, a venture fund specializing in early stage opportunities ran up against the typical problem . a sticky portfolio company or two as the fund reached the end of its term. The portfolio companies were, for the most part, solid . but too small to try and lift the IPO window open; and, for one reason or another, the trade sale route did not seem to reflect the true value, in the opinion of the venture managers, of the companies concerned. What the managers did was, I think, highly creative: They took a look at the seven thousand or so public companies in the "orphanage" . not shells but genuine operating companies. The "orphanage" is home to those companies which are too small to attract much in the way of analytical following, firms handicapped by the fact that the stock is selling off, trading by appointment at prices which do not reflect the valuations which management believes the stock should command. Given the jihad in the U.S. against sell side analysts these days, small companies with limited trading volume are not going to attract many if any, interested analysts; there is no currency sufficient to intrigue the analytical community. One man's problem is, however, another's opportunity.
The creative fund managers targeted companies listed on a NASDAQ Small Cap Market, the American Stock Exchange and the Over-The-Counter Bulletin Board, the shares of which are selling under, say, $5 per share. 'Going private' is technically a solution of sorts; but the SEC staff's hostility to going private has established transaction costs ranging from $500,000 to $1 million in fees and expenses . even for the smallest companies.
The fund managers' solution was and is to sift through and classify, with the help of some relatively uncomplicated algorithms, the matrix of "orphanage" residents and then identify, vis- -vis each of the fund's portfolio companies, a set of, say, 10 or 15 candidates which might constitute a match with the portfolio company involved. Thus, assume the process spots a public company in the orphanage, its stock trading at, say, $1.00 a share . too low for an escape from the orphanage. The VC fund's proposition is a merger with a portfolio company in a complementary line of business with the orphan . doubling, say, the revenues and assets of the orphanage resident. Assume a fifty-fifty split between the portfolio company and the orphan, the math is simple. If the stock price goes to $3 from $1, everybody has made money. If the two businesses can operate more efficiently and productively . and generate, say, additional revenues which support trading at $4 or $5 a share, the transaction produces the kind of multiples any venture fund would be proud of. If this method of operation catches on, it could solve a couple of problems. First, a significant boost to the IRRs in funds reaching the end of their term, now dampened by the sticky illiquidity caused by the IPO closed window. Secondly, it can boost companies out of the orphanage, where no one makes much money . the stockholders, the managers, the U.S. economy.
 The situation was summed up in the August 1, 2006 PIPEs Report as follows:
. the SEC is declaring that the offerings [resales of PIPEs securities] are primary offerings and are preventing companies from availing themselves of Rule 415(a)(1). The solution to that finding would require the companies to file S-3 registration statements or conduct "best efforts" offerings, in which they simply sell shares into the market at a fixed price.
That raises a couple problems, says Greg Siehenzia, a securities attorney with Siehenzia Ross Friedman Ference, which represents roughly 75 small publicly traded firms: First of all, these issuers are nowhere near eligible for S-3 filings, which among others stipulations, require a company to have a market float of $75 million. And the best efforts offering? Unlike PIPEs, it hardly guarantees that investors will buy a company's shares, and it certainly won't raise money in a timely fashion, he says.
"If small companies can't use 415(a)(1) anymore, it will be devastating." Sichenzia says. "The guys that need funding most will suffer the most."
Indeed, companies with market caps of $10 million or less have issued 188 PIPEs through the end of July this year, according to PrivateRaise, which tracks PIPEs of more than $1 million. Those 188 transactions were about 127% of the entire PIPE market. Forty-five of those PIPEs were variable price convertible debt deals, and on average, companies raised 11% of their market cap in the transaction. .
But issuers of variable price convertible debt PIPEs aren't the only companies at risk: Very small issuers of fixed price convertible debentures looking to raise an amount equal to their market cap will run into the same problem, explains Sichenzia. "This affects companies with low market caps regardless of what kind of deal it is," he says.
Gose, "SEC Curveball, Commission's Comments on Rule 415 Put Micro PIPEs in Flux," IV The PIPEs Report, No. 14 (Aug. 1, 2006).
See Private Equity Issues Under the Radar, June 2006.
 Bartlett and Kunz, The Journal of Private Equity, Winter 1998, "Reverse Mergers and Shells: A Preliminary Analysis."
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
McCarter & English, LLP
McCarter & English, LLP is a firm of over 400 lawyers with offices in Boston, Hartford, Stamford, New York City, Newark, Philadelphia and Wilmington. In continuous business for more than 160 years, we are among the oldest and largest law firms in America.
Clients come first at McCarter & English. Their goals and priorities are what count. Our job is to listen to our clients, stay on top of the frequent changes that can affect their goals, and implement the strategies that will lead to success. Applying this approach effectively and consistently requires dedication and constant attention to many details. This client-centered philosophy has served our clients well and is responsible for our success and stability.
We are honored to be the chosen law firm of clients ranging from Fortune 100 companies to mid-market and emerging growth companies to individual people. When our clients do great things, we are pleased to get the assist.