A Short Story
March 12, 2010
Let’s Talk Risks…
March 14, 2010

An Ode To The PIPE

Public Investments in Private Equities, also known as PIPEs are one of the most misunderstood and underappreciated tools that most small company investors have. The majority of small businesses don’t make it. They fail because they are undercapitalized. That is why companies go public in the first place—to access capital.

Let’s say a small company is growing quickly. They need money to expand, hire more employees and invest in infrastructure. They could use their profits for this, but entrepreneurs want to grow fast—opportunities often do not wait. They can go to the bank, but banks are always hesitant to lend to small businesses. Furthermore, it is dangerous to leverage up a small company. Their other option is to do a PIPE with investors and issue more shares.

Let’s say that a company is trading at $3.00.The company will often call a few large investors and see if they want to increase their positions. A deal will be struck, and the company will sell 2 million shares at $2.70. To sweeten the deal, they’ll throw in a half warrant struck at 3.50 that is good for two years. The company will get $5.4 million in additional capital to grow the company with. The cost to the company is the 2 million shares of dilution and an additional million shares of potential dilution. If these warrants are exercised, the company gets $3.5 million more cash. It’s like they were selling shares at $3.50 when the shares were trading at $3.00.

Clearly, this is good for the company. They get the cash they needed to grow. The investor also wins. For starters, the investor is getting new shares at a 10% discount to the current share price. There isn’t much free money in the world—this is as close as it gets. Even better, you have the chance to buy more shares at $3.50 if you are right about the company. You get 50% more upside with the same amount of downside. Even better, your cash is helping the company grow—which should improve the chance that you are right and there is more upside.

The only downside is that these are restricted shares. Every country has different rules, but generally, you need to hold the shares for a few months. If you’re a long term investor, this won’t matter. Finally, in order to get the shares in a free trading format, you need to fill out a document and get a few lawyers to sign off on it. If it costs you more than $500 in fees for this, you need to find a different law-firm. Depending on the rules where you are investing, sometimes these restriction periods are waived or shortened. Clearly, this isn’t as easy as pointing your mouse and buying shares—but when did someone ever hand you a 10% gain with a free warrant attached?

Over the years, PIPEs have been given a bad name. This is because the majority of PIPE transactions turn out to be losers. Think about this a minute. What sort of companies need money? Early stage biotechs. Mining companies. Oil Exploration plays. Venture capital companies. Unprofitable businesses and companies that need to pay off debt. No wonder most deals fail. These are all terrible investments. Most PIPE transactions are initiated by some banker who wants fees. He pretties things up, tells a story to gullible investors and collects a big fee. If he does a good job, that company will re-hire him in a year when they run out of money again. You almost NEVER want to invest in these PIPEs. You NEVER want to invest in a PIPE just to collect the 10% and a warrant. You only want to invest in a PIPE in a situation where you would buy the shares if the PIPE wasn’t available.

If you find a company that you like, call the CEO, ask him if he’s looking to raise money. Sometimes they will tell you that a raise is coming. Usually, he’ll tell you that nothing is pending. If that’s the case, tell him you are buying shares, but he should keep you in mind if he does raise money.

People think that PIPEs are only for big institutions. They aren’t. CEOs like to reward loyal shareholders, rather than selling to some fund that will sell the shares and keep the warrants. If you stay friendly with management, they’ll likely give you a call when they do raise money. Even if you own shares from a lower price, you can always sell those shares, buy the restricted shares at a discount and get a free warrant. No matter what—you win.

It’s rare that you get something for free. PIPEs should be a key component of your investing arsenal.

Categories: Investment Strategy
Positions Mentioned: none

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