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

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

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

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

ck buck. In fact, they do not necessarily care what a company does.
Rather, these deals are really a financial arbitrage, which can be
inherently profitable because certain requirements are met, such as trading
volume and market cap.

A PIPE can also pose problems. How? Well, this arrangement results in a
large amount of stock that can potentially be sold (called overhang). In
this scenario, it is not uncommon to see the stock tumble.

However, according to Steve Sadleir (partner for
Financial Resource Consultants), the
equity line of credit option is a good alternative for companies. “The
equity line puts control in the company’s hands,” says Sadleir. After all,
a fund is committed to the company for a year or more. Also, since there is
not much stock coming onto the market, there is less of a problem of

Yesterday, announced a
$40 million private equity financing. The details are sketchy, but it does
appear to be an equity line. In the press release, has “the
right (but not the obligation) to obtain” the financing. The CFO stated
that the deal provides for “adequate working capital while minimizing the
dilutive impact on currently outstanding shares.”

The company is a leading seller of software. However, it has refocused its
efforts away from the B2C marketplace and is now targeting corporate and
government customers. The $40 million commitment should give the company
breathing room.

Who is the Investor?

“Another thing to consider,” says Frank Marino, a partner at NetCap
Ventures, “is know thy investor. In other words, is the investor
strategic?” If the answer is yes, then there will probably be no financial

Let’s take a recent example. On June 27, Technology Crossover Ventures and
Microsoft invested $60 million in
Expedia , the online
travel site. The share price was $16.60. There were also warrants to
purchase 723,000 shares at the same price.

Yesterday, Expedia announced a strong quarterly report. Revenues surged
115% to $76 million, as net losses narrowed to $1.6 million. In fact, the
company had positive cash flow and there is $122 million in the bank.

So far, Expedia has been effectively diversifying its product line. For
example, it now has deals with more than 1,600 hotels worldwide. Other
notable milestones include: new mobile service; Expedia Travels Magazine
(in partnership with Ziff Davis); and complex travel planning services (from
an alliance with eGulliver).

Technology Crossover Ventures and Microsoft clearly have strong insight into
the inner workings of Expedia (Microsoft owns more than 70%). True, this is
no guarantee that Expedia will be a success, but at least the company will
have access to sufficient funds to execute its business model – which is currently not
the case for many companies.

Interestingly enough, on the quarterly announcement, Expedia surged 41%.
Yet, the stock price is still under the price paid by Technology Crossover
Ventures and Microsoft.

News Around the Web