📈 The Insiders Guide to Investing in PIPEs

The public stock market has never been this “unhealthy” for retail investors looking to invest in exciting growth opportunities.

Here’s why…

In 1997, there were 7,414 public companies listed on national exchanges. Today – even after a record 1,000 IPOs in 2021 – there’s barely half that number.

Why? In today’s public markets, it’s hard to survive as a “small cap” stock; The game is “rigged” in favor of the largest companies.

If we don’t do something to fix the dying “Small IPO” market, research suggests that not only do we miss out on the opportunity to produce new companies that generate the largest number of new jobs…

Every day investors are locked out of the early-stage growth companies they used to have access to in public markets; as of June 30, 2022, small exchange-listed companies make up a shockingly tiny .4% of total market capitalization.

How do we solve this problem?

Our un-shocking answer: expand retail participation in private market offerings normally reserved for institutional investors.

Our previous two issues have been dedicated to a little-known strategy called private investment in public equities (PIPE)…

In part one, we discussed some of the new challenges companies face when raising capital in public markets (as well as some discussion around Warrant Coverage).

In part two, we talked about some of the problematic – and potentially predatory – PIPE financing terms companies sometimes agree to in PIPEs.

But a few of our readers asked for some more detail on how PIPEs are actually structured from an investment product standpoint, so that’s what we’re talking about today.

-Jake Hoffberg

A Brief History of Securities Regulation in America

Historically, buying investment products (called “Securities”) was limited to only the wealthy. It was believed that because of their wealth, they could handle the high risk – and the high potential for loss of principal and even fraud – that came along with investing.

However, as the importance of the stock market grew, it became a larger influence on the overall economy.

Eventually, as people started earning higher disposable income, more people could afford to purchase securities and otherwise invest.

In theory, these investors were protected by something called “Blue Sky Laws” – a term said to have originated in the early 1900s, gaining widespread use when a Kansas Supreme Court justice declared his desire to protect investors from speculative ventures that had “no more basis than so many feet of ‘blue sky.’”

But without any real regulatory oversight, Blue Sky Laws did little to protect investors from companies that issued securities (called “Issuers”), promoted real estate opportunities, and other investment schemes, while making lofty, unsubstantiated promises of greater profits to come.

By the 1920s, the economy was “roaring” along, and people were desperate to get their hands on anything to do with the stock market.

Then, on Oct 29th, 1929, “Black Tuesday” – one of the largest one-day drops in stock market history – sent the country spiraling into the Great Depression.

It is estimated that one-half of the $50 billion in new securities offered during this period became worthless, yet restoring investor faith in the capital markets was essential to economic recovery.

Eventually, this led Congress to pass the Securities Act of 1933 (the “Securities Act”), the Securities Exchange Act of 1934 (the “Exchange Act”), and later, the Investment Company Act of 1940 (the “40 Act”).

These three Acts provide the framework for the oversight and regulation of the securities markets through disclosure, recourse, enforcement, and suitability/fiduciary requirements.

As part of this new regime, all Issuers seeking to sell new securities in the public markets would now be required to disclose important financial information through the registration of those securities with the SEC.

Said another way, in order to raise capital, Issuers had to undergo an initial public offering (IPO) or follow on public offering (FPO) – most commonly by filing SEC Form S-1 – and assuming all the costs that come with being a publicly listed company.

However, Congress also recognized that there is no practical need for registration in certain situations, where the public benefits from registration are too remote.

For this reason, the SEC allows businesses to raise capital in the private markets, using different exemptions; as the name suggests, this frees or exempts the issuer from the registration requirement.

The 2012 JOBS Act updated and expanded the frameworks for today’s most commonly used Exempt Offerings

• Regulation D (Reg D): Under this framework, the issuer must have something called a Private Placement Memorandum (or PPM). The PPM is not filed with the SEC.

Regulation D includes two SEC rules – Rules 504 and 506(b)/506(c) – that issuers often rely on to sell securities in unregistered offerings.

PPMs are legal disclosure documents that (should) provide full and transparent disclosure regarding the terms of the investment offering, information about the company, its operations and management, the use of the proceeds, while also describing the risks factors inherent in the business and industry.

The majority of PIPE transactions happen through the Regulation D pathways – specifically, Rule 506 – and are restricted to accredited investors and institutions.

• Regulation Crowdfunding (Reg CF): Under this framework, the Issuer files a Form-C with the SEC via the regulator’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) online filing system. Issuers can raise up to $5m in a rolling 12-month period from both accredited and non-accredited investors.

Reporting public companies cannot use Reg CF to raise capital. However, as long as they qualify as an Emerging Growth Company, small public companies can use…

• Regulation A (Reg A+): Under this framework, the Issuer files a Form 1-A with the SEC via EDGAR. Issuers can raise up to $75m in a rolling 12-month period, from both accredited and non-accredited investors.

For those following along at home, Regulation A+ is the backbone of what we refer to as the Retail PIPE, as it dramatically expands the investor universe the Issuer has access to (more on this in just a moment).

Regardless of what exempt offering framework the Issuer chooses to use, the security is typically structured in one of the following formats.

• Traditional PIPE: This refers to a private placement of common or preferred securities made by a public company. These are often sold at a discount to the current market price. Traditional PIPEs are the most common type.
• Structured PIPE (aka Private Convertible Preferred): These are complex transactions, where investors purchase preferred shares that are convertible into common stock, often at a discount. The terms of the conversion, including the conversion price and rate, may be structured in various ways.
• Private Placement with Delayed Resale Registration Rights: This is similar to a traditional PIPE, but investors are granted the right to sell their shares on the open market after a certain period, typically once the securities are registered with the SEC.
• Venture-Style or Change-of-Control Private Placement: This typically refers to a larger transaction that might lead to a change in control of the company. It can be akin to a private equity buyout but executed through a PIPE transaction.
• Private Equity Line or Equity Shelf Program: In this type of agreement, an investor commits to purchase shares of the public company over a certain period, providing the company with an “equity line” of funding.

If you want to get way deep in the weeds on the nuts and bolts of how these work, go here for a 45-page slide deck from law firm Morrison Foerster.

Done correctly, a PIPE offers tremendous advantages to an Issuer, and can be an efficient and cost-effective way to raise money.

But as I often say, for investors, the devil is always in the details when participating in private offerings.

One of our core investment tenets is “as early-stage investors who own common stock, our biggest risk is being subordinated by another round of financing.”

As a reminder, PIPEs do have risks that can be exploited at the Issuer’s peril – and by extension, the common stockholders – if not properly structured.

This means if the original reason the Issuer is seeking PIPE financing is that their stock is thinly traded and highly volatile…

If we are entering the deal via a Retail PIPE, we must first ensure the core capital raising issue – trading volume – is resolved, and the Issuer can get access to better costs of capital to minimize dilution (and subordination) in future fundraisings.

For this, we have to unpack the biggest problem facing small public companies…

The Small Cap Death Zone

A quick recap from our previous issues on PIPEs…

Unlike in the private markets where investors are willing to buy shares that can’t easily be traded…

Once a company goes public, its fundraising efforts are almost entirely dependent on both the current stock price… and how many shares trade per day (known as “trading volume”).

Why? In order to exit your position, someone has to buy your shares at the price you’re selling, in the quantity you wish to sell, and in the timeframe in which you wish to sell them.

This is called the Bid-Ask Spread.

Stocks that have low trading volume (aka “Thinly Traded Stocks”) tend to have wider bid-ask spreads than stocks with higher trading volume.

The wider the spread, the more expensive the transaction costs become when trying to enter – and later exit – a trade… especially for larger sized investments.

Researchers have found that this illiquidity of small company public stocks – sometimes called penny stocks – has driven large investment funds away from them since the late 1990s.

Small public companies typically need to continue raising capital. However, if they don’t have enough trading volume, they likely won’t be able to raise capital on attractive terms.

And this, in a nutshell, is what creates the Small Cap Death Zone.

This brings us to one of the most important questions public companies will likely have to face…

How do Issuers not only build their business… but also build a stock that people want to own and trade?

One answer is simple: get more analyst coverage.

In fact, the necessity to attract analyst coverage has traditionally been one of the key hurdles for private companies considering a move to the public markets.

Less coverage means a smaller pool of investors will even consider the stock, both in the lead-up to the IPO, and once the company is public.

Research shows that 60% of the 1,171 companies with market capitalization below $100 million listed on major U.S. exchanges receive no analyst coverage!

It also suggests that a lack of coverage corresponds to lower stock liquidity…

Which, in turn, continues to put pressure on small public companies looking for financing.

The problem only gets worse for companies NOT listed on a major U.S. exchange (like the Nasdaq and NYSE), and instead, trading Over The Counter (OTC). This is true for several reasons:

1. ​​Lower Visibility: OTC-listed companies typically do not have the same level of visibility or recognition as those listed on more prominent exchanges, (again, such as the New York Stock Exchange or the Nasdaq).
2. Lack of Financial Information: OTC-listed companies are often not required to disclose as much financial information as companies listed on larger exchanges. This makes it more difficult for analysts to conduct in-depth financial analyses and forecasting.
3. Lower Trading Volumes: Many OTC-listed companies have lower trading volumes, which can make their stock prices more volatile and potentially riskier to invest in. This can deter analysts, who typically focus on companies with very broad investor bases.
4. Size of the Company: Many OTC-listed companies are often quite small, may not have reached profitability, and thus, may not generate the same level of interest as larger, exchange-listed companies.
   Analysts, particularly those at larger firms, often focus on larger companies with more significant market capitalizations.
5. Regulatory Oversight: Companies listed on major exchanges are subject to strict regulatory oversight, which can provide analysts and investors with more confidence in their financial reports. OTC-listed companies do not face the same level of scrutiny, which can deter analyst coverage.

6. Limited Institutional Interest: Given the above factors, many institutional investors, such as mutual funds and pension funds, often avoid investing in OTC-listed companies. As a result, analysts, whose work often caters to these institutional investors, may be less likely to cover these companies.

It’s important to note that while OTC-listed companies can face these challenges, it doesn’t mean they’re not worthwhile investments – simply that they might be more difficult to analyze, and could carry additional risks.

However, let’s come back to the core issue we want to see solved as part of a successful PIPE financing – increasing trading volume and liquidity.

For this, I’m going to quote from Adam Epstein’s 2012 book “The Perfect Corporate Board: A Handbook for Mastering the Unique Challenges of Small-Cap Companies”

Here, the issue here of “ownership” is one that is difficult to solve for small public companies without coverage.

By and large, the vast majority of mid- and large-cap companies are owned by mutual funds and hedge funds, with retail investors occupying the minority position.

In contrast, small public companies could have ZERO institutional ownership. Why?

• Some institutions have, as part of their investment policy statement, a mandate that prevents them from investing in OTC-traded companies
• Others can’t invest unless a company has at least a $5 or $10 stock price or a $250 million market capitalization;
• Additionally, even if the company meets the market cap and stock price requirements, might not have sufficient trading volume – a large investment would likely force the stock price higher causing “slippage” both entering and exiting the trade.

For this reason, our logic behind a Retail PIPE of an OTC-listed company is to not only help the Issuer raise sufficient funding to drive its business objectives…

But to help the company build analyst coverage that, in turn, helps build a more liquid stock and attracts institutional buyers.

Final Thoughts

Generally speaking, when looking at private equity deals, I’m interested in companies that are looking to go public within 1-3 years.

With this in mind, it is my opinion that a Retail PIPE – even though the company is publicly traded – still has many of the same business risks as a privately held company of the same size.

Furthermore, if the stock is trading over-the-counter, due to all the reasons we’ve already discussed – namely the stock price and trading volume – it can be challenging for small investors to get shares deposited into brokerage.

And even if you can get them deposited, the question still remains…

Who is going to buy the shares from you?

For this reason, we see Retail PIPEs as part of a broader uplisting strategy, and a way to build liquidity in the stock for early investors (and not a short-term trade).