In a volatile or difficult public market environment, many public companies engage in Private Investment in Public Equity (PIPE) transactions to raise capital. Whether to finance existing operations or acquisitions, to refinance existing debt, or to build a cushion of available cash in periods of uncertainty, a PIPE transaction can offer public companies an attractive financing source.
In a PIPE transaction, a public company sells equity or equity-linked securities to a limited group of accredited investors in a private transaction. This is pursuant to Regulation D (Reg D) under the Securities Act of 1933 (the Act). The company then registers those shares for resale into the public markets by the investors. If a convertible security is sold, the underlying common stock is registered for resale.
Companies needing capital and investors looking to put funds to work, may be attracted to PIPE transactions because they can be done quickly and discretely without disclosure to the market until a deal is signed. PIPEs allow parties to tailor investment terms to their commercial goals and, particularly for the company, signal to the market that it is worthy of investment by sophisticated investors. For private equity firms, also known as sponsors, and other investors, PIPEs are a way to continue to invest in the markets when buyouts and other investment strategies are too challenging or uncertain. PIPEs also present investors with an opportunity to take a meaningful position in a company at a price that is typically at a discount to the prevailing public market price.
PIPE transactions generally occur in two steps. Step one is an initial private offering to a limited number of institutional or otherwise accredited investors that is not subject to SEC review and clearance. Since the capital raising segment (the first step) can be accomplished without the delay of SEC review, the timing of the capital raise can be predetermined and needed funds can be quickly raised. Then, in the second step, a registration statement is promptly filed on behalf of the investors with the SEC after the closing. This allows the resale of the securities purchased in step one. In order to protect their expectation of relative immediate liquidity, however, investors will negotiate for penalty provisions requiring the company to make payments in the event that the registration statement is not filed or does not become effective within the agreed upon time frame (typically, 30 days for filing and 90-120 for effectiveness).
Usually, a placement agent will act as an intermediary between the investors and the company in the sale of the securities. A PIPE transaction can take only a few days to close, or many weeks, and the timing usually depends on the way the placement agent markets the deal. Some placement agents approach the transaction as they would a registered public offering. They work with the company to prepare a private placement memorandum, and they require a placement agent agreement, accountant comfort letters, and a legal opinion. Other placement agents use a more informal approach, placing the securities with investors by using the company’s existing SEC filings and reports and sometimes “wrapping” them with a short document summarizing the company and the offering (a quasi private placement memorandum). In still many other cases, PIPE transactions are based upon term sheets offered by the investors themselves following a limited road show focused on the company itself and not any specific deal terms.
PIPE transactions are almost invariably marked by the use of a formal purchase agreement, a registration rights agreement, and if the transaction involves a preferred or convertible debt security, then also instruments setting forth the terms of such security (i.e, a certificate of designations or an indenture).
Types and Terms of PIPE Securities
There are several common types of securities involved in PIPE transactions. These types of securities include:
- Common stock (fixed price or variable)
- Preferred stock
- Convertible debt (fixed or variable)
- Any combination of these securities
Similarly, the terms governing the securities issued to investors vary as well and they include:
- Dividends/Coupons. The securities issued in PIPE transactions often bear a dividend or coupon, and this can be payable in cash or payable-in-kind on a cashless basis. Depending on the security issued, an investor may receive certain protective features if dividends are not paid for a defined period of time. These may include an expanded board, rights to a board seat, appointment rights, or increased governance rights.
Registration Rights. As discussed above, generally investors in PIPE transactions require registration of their investment securities to enable them to resell and obtain liquidity in the public markets. Typically, such rights include demand rights and/or piggyback rights. Demand rights require a company to file a registration statement on the investors’ behalf for the resale of their securities. Piggyback rights require the company to include a certain amount of the investor’s securities in any separate registered offering the company wishes to engage in.
Lock-up. Furthermore, investors in PIPE transactions may agree to a restriction on their ability to sell all or a portion of their purchased securities for a certain time period after making the initial investment.
- Conversion & Redemption. The securities issued in PIPE transactions (e.g., convertible preferred stock) may have a wide range of conversion and redemption features, whether on a mandatory basis or at the company’s or investor’s option.
Conversion. Events that may trigger a conversion include the passage of a certain period of time or the company’s common stock price reaching a specific threshold. In the case of a mandatory conversion, a change in tthe control of the company can also prompt a conversion. PIPE transactions may also include a “make-whole” feature in favor of the investor upon a change of control of the company or upon a notice of redemption.
Redemption. Like conversion features, there are a number of triggering events that may permit or require the redemption by the company of the securities issued in a PIPE transaction, and redemption prices may include make-whole or rate of return based features.
- Anti-Dilution & Preemptive Rights.
Anti-Dilution. Investors in PIPE transactions receiving securities convertible into common stock typically receive anti-dilution protection in the event the company engages in a stock split, reclassification, or other similar act. In addition, in the event of a future issuance of securities at a lower price, PIPE investors often negotiate for broad-based weighted average anti-dilution protection, which takes into account the weighted average dilutive effect of such lower priced future equity sale based on the size of that sale and such lower price.
Preemptive Rights. In addition, PIPE investors often negotiate for preemptive rights to participate in future equity sales by the company, either by including an express preemptive right or by obtaining a consent right over future equity sales.
Magnitude and Pricing
The appropriate size and pricing of a PIPE transaction should also be considered in conjunction with the governing standards on which the company’s shares are listed, and on whether the PIPE transaction’s magnitude and pricing may require shareholder approval.
- 20% Rule. Although there is no legal limit on the amount of capital that a company can raise through a PIPE transaction, the exchanges and Nasdaq have rules that generally restrict a company from selling 20% or more of its outstanding common stock (whether directly or through convertible or derivative instruments), unless the company sells the shares at the greater of fair market value or book value, or the company obtains prior stockholder approval of the deal.
- Change in Control. Companies should also be mindful that transactions that would result in a change of control (generally, where a single investor or group of investors acquires 20% or more of a company’s common stock or voting power), involve an acquisition, or involve the sale of stock by officers, directors or substantial stockholders, may also require stockholder approval under exchange or Nasdaq rules. Accordingly, depending on the size, purpose of, and parties to a PIPE transaction, these provisions may need to be evaluated as well. It is recommended that a company consult its exchange or Nasdaq representative in advance of a transaction to address any issues that the proposed structure may raise.
Before beginning any PIPE transaction, a company should complete an internal assessment of certain matters to determine whether it is in a position to engage in that transaction, including:
- Obtaining any required consents (such as from lenders, in the case of a dividend paying preferred stock), or waivers of existing registration or preemptive rights
- Confirming that the company has sufficient authorized capital stock to accommodate the PIPE
- Evaluating the potential dilutive effect to existing stockholders
- Evaluating whether anti-dilution adjustments under existing convertible instruments will be triggered
- Considering the possible integration of the PIPE transaction with other recent or planned offerings in a manner that would violate the securities laws or that would violate the shareholder voting rules of the exchanges or Nasdaq
- Exploring any unusual tax consequences to the company or the investors. For example, investors may want to purchase a preferred stock that accrues but does not pay dividends in an effort to avoid ordinary income taxation on the dividends.
The agents in a PIPE transaction (e.g., the placement agent, accountants, and other participants in the PIPE process) owe a duty of trust or confidence to the company. Inasmuch as the company does not share any information with potential investors that (i) has not already been included in its filings or reports made to the SEC, (ii) would qualify as public information, or (iii) otherwise does not constitute material non-public information, the mere fact that the company is contemplating a PIPE transaction may by itself constitute material non-public information. The company will not want to be forced to make a premature disclosure regarding a financing. Therefore, in compliance with Regulation FD (Reg FD) under the Securities Exchange Act of 1934, as amended, the company should ensure that before the placement agent reveals the company’s name, the placement agent obtains an oral or written agreement from each potential purchaser that shared information will be kept confidential. Besides a confidentiality provision, the agreement should prohibit potential purchasers from trading in the company’s stock, otherwise the company may be in a position where it must publicly announce the potential transaction under its Reg FD obligations.
There are several accounting issues that companies need to be cognizant of when considering a PIPE transaction. They include:
- Transactions with a beneficial conversion feature (e.g., the sale of securities with a below fair market value conversion price) may produce a non-cash charge to earnings
- In unit transactions, where warrants are issued, a portion of the purchase price needs to be allocated to the warrants
- In the case of preferred stock, if it can be redeemed by the holders, or if it has a fixed redemption date, it generally will not be treated as equity. This issue can have important consequences for companies seeking to comply with existing borrowing ratios, regulatory requirements or the listing standards of the exchanges or Nasdaq.
Thus, under the current economic and market conditions, PIPE transactions may represent an attractive alternative for a company in need of additional and immediate funding. However, a company contemplating a PIPE transaction should, very early on in its examination, include in its assessment its short and long term capital needs, corporate constitution, tax implications of the transaction and any potential conflicts of interest that may exist, against not only the few topics discussed in this memorandum, but also against the backdrop of market and shareholder perceptions, expectations, and sentiment.
This memorandum is a summary of the topics discussed above and does not purport to provide legal advice. No legal or business action should be based upon the above summary. Questions concerning the topics or issues addressed in this memorandum should be directed to:
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 Banks may have tightened their lending practices and policies, while the market for underwritten registered offerings may be undesirable for any number of reasons. Even when a public offering is an option, the delay that may occur makes that alternative more risky for companies in immediate need of capital.
 While PIPEs represent an attractive means for a company to quickly raise new capital, there are several issues for companies to consider as they evaluate the appropriateness of this technique, as discussed in greater detail below.
 By a PIPE transaction’s very structure, the shares initially sold to the investors in the step one private offering are restricted securities under the Act and cannot be resold (in order for the investors to monetize their purchase) unless those shares are either registered or an exemption for resale is applicable (e.g., under Rule 144 of the Act).
 See also the discussion under the heading “Regulation FD” below.
 PIPE transactions typically fall into the two following general categories: the traditional PIPE and the trailing PIPE. While they are both similar in many regards, one of the important differences between them is that in a traditional PIPE transaction, funding/closing does not occur until after the attendant registration statement relating to their shares sold has been deemed effective by the SEC. In contract, funding for a trailing PIPE transaction occurs at the time of the initial private sale of the securities with an attached obligation to have a registration statement filed and made effective within a specific amount of time after the closing. Because trailing PIPE transactions are often the most common, they are the focus of this discussion.
 These penalty payments usually range from 1% to 2% of the aggregate proceeds received by the company in step one and are due upon the failure to meet the stated deadline and on each 30 day anniversary afterwards (or any pro rata portion thereof) until such time as the filing is made or the registration statement becomes effective.
 Typically, a placement agent in a PIPE transaction will not purchase the shares for its own account and then immediately resell them as such an intermediary would do in a firm commitment underwriting or a 144A offering.
 In addition, it is not uncommon for investors to receive similar rights merely by virtue of the percentage of shares they hold and/or by the deal terms of the transaction. For example, board oversight appointees or other governance rights may be negotiated for by investors for the length of their investment of the company (subject to certain prescribed minimum thresholds of ownership).
 In addition, a lock-up may contain limitations on the size of the block an investor can sell to a future transferees as well as the identity of that transferee.
 Fair market value for this purpose typically means the closing bid price on the date that the purchase price is established and purchase commitments made, but it can be measured over the five day trading period up to and including the date of pricing.
 See NASD Rule 4350(i)(1)(D), NYSE Rule 312.03(c), and AMEX Rule 713(a). This requirement can be waived by the Nasdaq in the event of a company’s financial distress, but in order to rely on this exception the company must, at least 10 days prior to the issuance of the securities, mail to all shareholders a letter alerting them to its failure to seek shareholder approval and indicating that its audit committee has expressly approved reliance its on the exception. See NASD Rule 4350(i)(2).
 For shareholder approval requirements in connection with a change of control, see NASD Rule 4350(i)(1)(B) and NYSE Rule 312.03(d). For shareholder approval requirements in connection with transactions involving an acquisition, see NASD Rule 4350(i)(1(C) and AMEX Rule 712. For shareholder approval requirements in connection with transactions that involve insiders, see NASD Rule 4350(i)(1)(A), NYSE Rule 312.03(b) and AMEX Rule 711.
 See Rule 152 under the Act.
 See Treas. Reg. sec. 1.301-1(b), which provides that a distribution made by a corporation to its shareholders shall be included in their gross income when the cash or other property is unqualifiedly made subject to their demands.
 It is important to note that this list is not exhaustive, nor applicable to all PIPE transactions. Each transaction may have its own unique features and professional tax advice should be sought out at the beginning contemplation stages of considering a PIPE.
Note: This memorandum discusses PIPE transactions only and not equity lines of credit transactions. Equity lines of credit are not PIPE transactions. Although these two financings share some common attributes, they are very different in market and deal terms, structure, process, and execution.