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Death Spirals and Toxic Convertibles: The Future for Dot-coms?

George Bernard Shaw once said, "The lack of money is the root of all evil." The same can be said about many public Internet companies nowadays.

When the equity markets were humming, it was no problem to raise money. In some cases, companies were able to raise in excess of a billion dollars in a secondary offering.

But of course, secondary offerings are a rare thing now. Unfortunately, many Internet companies are still burning cash. True, these companies are reducing their expenditures. But this will likely mean less revenues, as marketing expenditures fall.

Consequently, over the next few quarters, expect to see much creativity in dealing with the cash crunch. Actually, some of the key players will likely be venture capitalists (VCs); that is, these firms will reinvest in current public companies. In a way, the VCs will become quasi mutual funds. And, hey, there are huge sums of money to do this. In the first six months of 2000, VCs raised $30 billion.

Yes, VCs originally pumped money into Internet companies to get them public. Now, the same VCs will use their cash to keep these companies from being delisted!

Now, there are different types of investment vehicles to choose from. Let's take a look:

PIPEs: Simply put, this is when a fund buys common stock at a discount to the current market value. But it takes about three months to get the money, since a registration statement needs to be filed with the SEC. For some dot-com companies - which are running out of money quickly - time is of the essence.

Drips (also known as an equity line of credit): An investor makes a commitment to purchase a certain amount of stock of a company typically over a two to three year period. Example: XYZ company gets a Drip for $24 million for a two year period. In this arrangement, XYZ is allowed to sell $1 million in common stock to the investors every month (the stock is "put" to the investors or dripped to them). If XYZ does not need the money or the stock price is very low, then there is no requirement to sell the stock. But what if a company needs more than $1 million for the month? In many cases, there is a clause that allows for bigger amounts, so long as there is a 21 day notice.

Unlike a bank line of credit, there is no interest due on a Drip. But there are hurdles. Before a put can be made, a company must file a registration statement with the SEC.

Convertibles: Here, an investor gets a security that can be converted into common stock. This security may be a preferred stock, which gets higher priority than common stockholders if there is a liquidation. Or, the security may be a debenture or note; that is, a debt instrument that has a higher priority than preferred stock.

The conversion price of the convertible - the price that an investor can swap it for common stock - is at a premium to the market price. This can range from 5% to 20%.

Some convertibles have reset provision. In other words, the conversion price falls as the stock price falls. This can set the stage for a death spiral. For example, the investor can short the stock, as the reset price falls, and then swap the convertibles at the reduced price. This can be extremely lucrative. Unfortunately, the stock price will get pummeled. It is for this reason that convertibles are often referred to as "toxic convertibles."

True, some convertible deals have "no-short" provisions. But this is little comfort. You see, it is easy to set up offshore funds to handle the short-sales. It is virtually impossible to track.

Some Advice Before Jumping In

Over the next year, there will be more and more examples of private financings of public companies. So which ones should you focus on? As a general rule, it is a good idea to be skeptical of convertible deals. In many cases, these are financings that involve hedge funds, which are seeking a qui