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Saturday, October 18, 2003

There's a fascinating thread on Slashdot discussing whether Baystar Capital's $50 million infusion to SCO was in fact a PIPE bought by Microsoft.

I have to admit that this is a cool possibility - when I looked at their site yesterday, I didn't notice that all they seem to do is PIPEs. Nice catch by the poster that noticed it.

I don't think it's possible that they may have done a PIPE deal in the traditional sense. Here's why:

PIPEs are financial instruments that allow firms to invest in other public firms, but do so privately. Most of the time, the instruments used to structure the PIPEs are custom-made convertible securities, which can have some nasty features.

They're mostly used in risky situations. They let capital get raised fast - but there's often a price. The fact that a firm has to resort to PIPEs means that other (primary and secondary) markets for it's debt and equity have dried up. So it has to sell a stake now, at a discount, and often, with a further embedded discount. The embedded discount takes the form of the convertible security, which often has provisions to maintain it's value nonlinearly with regards to the company prior debt and equity - so investors in the convert are ok, but investors in other securities aren't, if the firm begins to tank.

Here's an old Herring article explaining more about one kind of PIPE from a few years back:

"They work like this: investors buy heavily discounted preferred convertible bonds from the company. On the surface, there's nothing untoward about that. But with a toxic convertible, the investor includes a "reset" clause in the contract. Bonds then convert into shares based on a dollar amount instead of converting to a fixed number of shares. Thus, the lower a stock goes, the larger the percentage of the company that ends up in the PIPE investor's hands".

What they mean is this:

"The conversion price in a structured PIPE, however, is either variable or contains a re-set mechanism that automatically adjusts the conversion price downwards (i.e., allows the investor to acquire more shares) if the market price of the company�s common stock falls below the conversion or re-set price fixed at the time of issuance".

Now, SCO is currently trading at around $20. It's trend has gone nowhere but up for the last few months. So I don't think they need to resort to the PIPEs market for cash. The stock price and trend alone tell us that the market doen't want to provide SCO cash at a discount (PIPEs) but have in fact bid up the opportunity to provide it cash. So SCO should be able to go to try private placements of debt and equity first, try the regular old debt and equity markets second, the converts market third, before it needs to resort to structured PIPEs.

The only kind of 'PIPE' SCO would go for would be a vanilla convert, with no embedded contorl clauses or differential payoff.

Update: It looks like I may have been right. Here are the terms of the deal:

"The SCO investors receive nonvoting Series A preferred shares, convertible into common stock at a fixed conversion rate of $16.93 a share. That was the average closing bid price for the company's common stock for the five previous trading days prior to closing the deal".

So if it is Microsoft, it's certainly an expensive way to hold a private placement, because it costs the same as a PIPEs deal, but has none of the advantages. Why not just use the beancounters at your local friendly i-bank?

-- umair // 4:50 PM //

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