Financing under Extreme Risk:

Contract Terms and Returns to Private Investments in Public Equity*

Susan Chaplinskya and David Haushalterb

aDarden Graduate School of Business, University of Virginia, Charlottesville, VA 22906 bSmeal College of Business, The Pennsylvania State University, University Park, PA 16802

Abstract

This paper studies financial contracting using a large sample of transactions from the market for private investments in public equity (PIPEs). Our tests show that the use of terms that are contingent on an issuer’s future performance increases with issuer risk. Among issuers with poorer stock performance, higher cash burn rates, and more uncertain investment prospects, purchase discount-only contracts are uncommon and contracts with contingent terms, such as warrants and price resets, are frequently used. Our evidence also shows that terms that can transfer control to investors are most commonly used by issuers in the weakest financial condition, which suggests that as financing alternatives grow more limited their bargaining power with investors erodes.

JEL classification: G24 Keywords: PIPEs, private placements, financial distress, contracting costs Draft: September 15, 2009

*We thank an anonymous referee, Tom Bates, Audra Boone, Paul Fischer, Randall Heron, Mike Hertzel, Sandy Klasa, Laura Lindsey, Antonio Mello, David McLean, Toby Moskowitz (the editor), Bob Parrino, Gordon Phillips, Lei Zhou, and the seminar participants at the University of Wisconsin, Ohio University, West Virginia University, Miami of Ohio, SUNY Buffalo, and participants from the 2003 FMA, 2006 NAEFA and 2006 WFA meetings for helpful comments. We thank the Batten Institute at the Darden Graduate School of Business and individuals at Placementtracker, especially Robert Kyle, Bobbie Sue Richardson, and Tassanee Sukramule for technical and financial assistance in obtaining the PIPE data. Kulwant Rai provided excellent research assistance on the project. a. Susan Chaplinsky (corresponding), Darden Graduate School of Business, University of Virginia, Charlottesville, VA 22906, Tel: (434) 924-4810, email: chaplinskys@virginia.edu b. David Haushalter, Smeal College of Business, The Pennsylvania State University, University Park, PA 16802, Tel: (814) 863-7969, email: dhaushalter@psu.edu

Financing under Extreme Risk:

Contract Terms and Returns to Private Investments in Public Equity

Abstract

This paper studies financial contracting using a large sample of transactions from the market for private

investments in public equity (PIPEs). Our tests show that the use of terms that are contingent on an

issuer’s future performance increases with issuer risk. Among issuers with poorer stock performance,

higher cash burn rates, and more uncertain investment prospects, purchase discount-only contracts are

uncommon and contracts with contingent terms, such as warrants and price resets, are frequently used.

Our evidence also shows that terms that can transfer control to investors are most commonly used by

issuers in the weakest financial condition, which suggests that as financing alternatives grow more limited

their bargaining power with investors erodes.

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Financing under Extreme Risk:

Contract Terms and Returns to Private Investments in Public Equity

1. Introduction

We examine an increasingly common form of equity-linked financing, private investments in

public equity, generally referred to as PIPEs. PIPEs are negotiated sales of securities by listed firms to

private investors that usually convert to publicly traded common stock. These privately issued

instruments can take the form of Floating Rate Convertible Debt or Preferred Stock, Convertible Resets,

Common Stock Resets, Structured Equity Lines, or Common Stock that is often packaged with warrants.

From 1995-2000, 1,466 firms issued 2,626 PIPEs that raised more than $29 billion, which amounts to

about 25% of the public equity companies raised during this period. Since then, the PIPE market

continues to grow with proceeds annually exceeding $15 billion.

There are several important distinctions between the PIPE market and more established markets

for financing. The first is the distressed nature of the companies using the PIPE market. By almost any

standard, PIPE issuers are poorly performing firms. In the year prior to issue, more than 84% of PIPE

issuers have negative operating cash flow and more than 50% of the issuers have falling stock prices.

Moreover, a majority of the companies will be out of cash within a year. These characteristics leave

PIPE issuers with a smaller universe of financing options than companies able to access public debt or

equity as a means of fund raising. 1 In addition PIPEs are generally unregistered securities when the

shares are issued and often represent a sizeable percentage of the issuers’ outstanding equity. Therefore

these investments are less liquid compared to seasoned equity offerings.

A second important feature of the PIPE market is the use of complex contracting terms. Of the

PIPE contracts we analyze, only 32% include just a purchase discount to the market price. The majority

of contracts also include warrants, resets, or a combination of these terms along with floors, caps, 1 By comparison, companies making follow-on public equity offerings, generally exhibit superior performance both in terms of operations and stock returns in the months leading up to the issue. For example, see Heron and Lie (2004), Loughran and Ritter (1997), Korajczyk, Lucas and McDonald (1990), Asquith and Mullins (1986), Masulis and Korwar (1986), and Mikkelson and Partch (1986).

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dividends, and other terms. More traditional private placements that have been the focus of much of the

empirical work in this area generally only include a purchase discount. 2

The primary purpose of our study is to provide empirical evidence on the choice of PIPE

contracting terms and its implications for financial contracting. This analysis is motivated by the fact that

the need for such complex contracting terms in PIPE contracts is not initially obvious. In a perfect market

setting, the use of contingent claims – such as warrants and price resets – should provide no special

advantage over issuing shares at a discount. Theories for including contingent claims by Aghion and

Bolton (1992), Dewatripont and Tirole (1994), Schultz (1993), and others assume the existence of

contracting costs, such as agency costs, moral hazard, and/or asymmetric information, between managers

and outside investors.

The general idea of these theories is that purchase discounts alone cannot resolve contracting

problems. Investors who choose to manage risk by simply increasing the purchase discount subject

themselves to adverse selection problems similar to those described by Stiglitz and Weiss (1981).

Further, discounts do not necessarily deter managers from using a firm’s remaining capital to pursue

failing projects in lieu of returning it to investors. Terms contingent on performance, however, can allow

investors to manage these risks. For example, warrants provide additional capital to managers in positive

states, increasing the resources managers control when firms perform well. In contrast, resets payoff in

negative states and transfer additional control to investors when firms perform poorly.

The PIPE market is well suited to empirically examine the implications of financial contracting

theories, both because of the variation in the financial condition of the issuers and the variation in the use

of contracting terms.3 Although agency costs, moral hazard, and asymmetric information are present with

any equity issue, the characteristics of PIPE issuers exacerbate these concerns. Many issuers are currently

2 Prior empirical studies of discount only private placements include, among others, Wruck, (1989), Hertzel and Smith (1993), Barclay, Holderness, and Sheehan (2003) and Krishnamurthy, Spindt, Subramaniam, and Woidtke (2005) and Wruck and Wu (2006). Other studies of PIPEs, as opposed to discount only private placements, include Hillion and Vermaelen (2004) that focuses on reset contracts and Brophy, Ouimet, and Sialm (2009) that investigates the role of investor identity in this market. 3 See Roberts and Sufi (2009) for a survey of the empirical literature on financial contracting theories.

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distressed and will likely run out of cash within a few months if additional capital is not raised. These

conditions heighten concerns regarding whether the firm has profitable investment opportunities and

whether managers will terminate failing projects given that they appear to have few alternatives other

than liquidation. For firms near distress, the pursuit of failing projects often occurs with little margin for

error before encountering bankruptcy or delisting, which can increase agency conflicts due to risk

shifting. The urgency with which capital is needed by issuers allows us to examine the importance of

bargaining power on the choice of contract terms. In addition, PIPE investors’ ability to manage their

exposure to these risks can be limited. In particular, companies issuing PIPEs are often illiquid, have

shares that are difficult to borrow to short, and rarely have listed options. Therefore, the contracting terms

used in PIPEs are a principal means by which investors can attempt to mitigate the risks of issuers.

If contingent terms help manage the risks of contracting problems, there should be a relation

between proxies for issuer risk and the choice of contracting terms. We find that purchase discount-only

contracts are common among the lowest risk issuers but are uncommon among issuers for which the risks

of financial distress and uncertainty about investment opportunities are greatest. The findings support

arguments, like those of Stiglitz and Weiss (1981), that the risks of adverse selection and agency

problems are difficult to manage using just purchase discounts. Although an increase in purchase

discount increases an investor’s cushion for bearing the costs of contracting problems, discounts alone

also have the potential to exacerbate these problems.

We also find that issuers of contingent claim contracts – warrants and price resets – commonly

have high cash burn rates (i.e., little time before running out of cash), few assets, high levels of intangible

assets, and poor stock returns leading up the offering, characteristics which suggest a greater degree of

risk compared to purchase-discount only issuers. The results support contracting theories of Aghion and

Bolton (1992), Dewatripoint and Tirole (1994), and Schultz (1993) and others that by making the extent

of the manager’s control and access to capital largely contingent on performance, contracting terms can

help manage increasing concerns for agency and information problems that increase with issuer risk.

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Combined with results for discount-only contracts, the findings indicate that as the risk of the issuer

increases, the ability to manage these problems through discounts alone becomes increasingly limited.

Therefore, by introducing contingent contracting terms, financing for high risk issuers becomes more

generally available.

Further, we show that although contracting problems can arise from concerns over the issuer’s

financial condition or uncertainty regarding the value of its investment opportunities, the choice of

contingent terms varies with the type of issuer risk. Issuers of warrant-only contracts are in better

financial condition than issuers of resets. What stands out about issuers of warrant-only contracts is that

they have the most volatile stock returns before the offering, indicating a high level of uncertainty about

valuation, but a less urgent need for financing. In fact, their financial condition, though less strong, is

more similar to that of discount-only contracts.

In contrast, resets are used by issuers with the weakest financial condition: they have the highest

cash burn rates and the worst stock returns leading up to the offering. There is, however, little evidence

that the volatility of returns around the offering in itself is important for the use of resets. The findings

for the choice of contingent terms support bargaining power arguments, similar to those in Aghion and

Bolton (1992), Dewatripont and Tirole (1994), Lerner, Shane, and Tsai (2003), and Roberts and Sufi

(2008). Firms in the weakest financial condition with likely the fewest alternatives for financing are the

most willing use of resets that can potentially lead to a greater transfer of control to investors.

Collectively, the findings indicate that although uncertainty about valuation and the risk of

financial distress can both lead to contracting problems, they result in a different choice of contracting

terms. Theoretical predictions in the contracting literature for the extent of contracting problems,

however, do not clearly distinguish between risks that might be limited to uncertainty about valuation and

those of financial distress. Our results, however, indicate their importance suggesting that PIPE investors

draw a distinction between these types of risks.

Finally, in addition to providing evidence on the ex-ante choice of contracting terms, we

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investigate the ex-post returns to PIPE issuers and PIPE investors. Issuer returns and rates of delisting

vary across contracting terms. The poorest performance and highest rate of delisting are for issuers of

resets, which significantly underperform market benchmarks. In the main, issuer returns for discount-

only contracts and warrant-only contracts are comparable to market benchmarks. In contrast, investor

returns that incorporate the net effect of issuer returns and contracting terms exceed or are comparable to

market benchmarks across all contract types. The results indicate that the contract terms are effective in

mitigating the sizeable contracting problems posed by PIPE issuers. Therefore, our results help explain

both the use and choice of contracting terms and the importance of these terms to the returns realized by

investors.

The paper is organized as follows. Section 2 provides institutional background on the practices of

the PIPE market. In Section 3, we develop hypotheses that motivate the use and the choice of contracting

terms. In Section 4, we describe the sample of PIPEs, their contract terms, and our measures of issuer

risk. In Section 5, we test the hypotheses developed in Section 3 regarding issuer risk and the use of

contingent contracting terms. In Section 6, we analyze investor returns. Section 7 provides our

conclusions.

2. The PIPE Issue Process

PIPE offerings are made in compliance with private placements issued under Regulation D of

Rule 144. Regulation D enables a public company to issue equity securities to a group of private

accredited investors without registering the shares, subject to investors holding the shares for a year or

longer following the purchase. PIPEs differ from traditional private placements because a registration

statement is filed soon after signing of the purchase agreement (within ten days). Investors in a PIPE

commit to buy shares at a fixed price in a traditional PIPE or at a variable/reset price in a structured

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PIPE.4 Typically the terms of a PIPE require the issuer to file a registration statement with the U.S.

Securities and Exchange Commission (SEC) within 60 days of signing of the purchase agreement. The

registration statement in a structured PIPE will typically cover the original shares and any additional

shares that arise as a result of the conversion process. The registration statement, upon being declared

effective, allows for the resale of shares sold to PIPE investors. However, because the price is fixed

earlier when the purchase agreement is signed, investors in a traditional PIPE are subject to price risk

until the registration is declared effective (less so for reset investors because of the variable conversion

price). Thus, a PIPE differs from a typical private placement because the shares investors receive are

liquid after approximately 90 days.

A significant advantage of a PIPE compared to follow-on equity offering is the speed with which

it can be arranged – typically about a month from initiation to closing. The documentation for a PIPE

financing is limited in scope – consisting typically of an offering circular summarizing the terms of the

financing, a business description, a purchase agreement, registration rights, and other legal agreements.

PIPEs are frequently marketed with the aid of a placement agent that prepares the offering circular and

facilitates the identification of potential buyers of the securities for a fee. Structured PIPEs typically

involve more negotiation over the terms than traditional PIPEs. Further, because structured PIPEs are

associated with more distress they frequently contain more debt-like covenants (e.g., require the payment

of interest, prohibit future financing) which can take longer to negotiate.

Before agreeing to purchase securities, a potential investor has the opportunity to conduct due

diligence on the issuer. This due diligence usually consists of a review of public filings and may involve

discussions with management. Although these activities should not result in the investors obtaining non-

public information, such activities can potentially enable investors to overcome some of the informational

4 A traditional PIPE is a PIPE whose terms do not change following issuance (e.g., common stock sold at a discount). A structured PIPE involves the issue of “future priced” securities or securities whose terms can change following issuance (e.g., floating rate convertibles or convertible resets). For further information on the legal structure of PIPEs see Dresner and Kim (2003).

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asymmetries associated with these firms. 5 If the company and investors reach agreement on the terms,

the company will issue a press release (and typically also an 8K) describing the PIPE transaction at

closing. The press release is often quite general, but when the company files subsequently for registration

it provides a more detailed description of the terms and a list of the investors participating in the deal. It

is only at the point of the press release (or 8K filing) that the market learns of the PIPE and the investors

participating in the deal are released from confidentiality agreements.

3. Theory and Hypotheses related to the Choice of Contract Terms

The extant work on why public companies place equity privately has often focused on explaining

the discount that private investors pay for shares relative to public investors. For example, Hertzel and

Smith (1993) argue that the discount compensates private investors for the costs of due diligence and

other activities needed to overcome some of the informational asymmetries associated with the issuers.

Wruck (1989) focuses on the discount as investor compensation for expected monitoring services.

Since the time of these studies, however, the contracting terms of private equity issues have

become increasingly complex. For example, only 17 of the 128 private equity placements Wruck (1989)

examines include warrants. PIPEs, by contrast, frequently include warrants as well as price reset

provisions, floors, caps, and other contract terms. Our main focus is to understand how the use of these

terms fits with contracting theories.

In this section we draw on financial contracting theory to examine the terms used in PIPEs. The

choice of contracting terms in this literature depends on the extent of contracting problems, such as

agency costs, moral hazard, and/or asymmetric information, between managers and outside investors.

Based on these arguments we develop hypotheses related to the choice of contract terms in PIPEs.

5 Because PIPEs involve issues by public companies, the offerings are subject to concerns about materiality and Regulation Fair Disclosure (FD). Typically the issuer should not share information beyond that disclosed in other regulatory filings.

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3.1.1 PIPEs and contracting problems

The greater range of contract terms used in PIPEs compared to common shares arises from the

nature of these investments. Private equity placements result in investors taking on relatively large,

usually initially unregistered, stakes in the issuer. Although the ability to publicly trade shares issued via

a PIPE is much shorter compared to traditional Rule 144 private placements, PIPE investors typically face

substantial challenges divesting their stakes. For example, the number of shares issued via a PIPE is an

average of 36 times the issuer’s daily trading volume and a median of almost 18 times daily trading

volume. Given the illiquid nature of their holdings, PIPE investors are essentially “locked in” and

exposed to risks from contracting problems to a greater extent than those experienced by public investors.

A risk of primary concern is managers taking on negative NPV projects. For example, Schultz

(1993) examines a development stage company that requires funding for R&D and production facilities,

although the production facilities should be built only if the R&D first proves valuable. Under value

maximization, managers who learn through R&D that the project is unsuccessful should stop investing,

liquidate the firm, and return the remaining capital to investors. As Schultz (1993) discusses, agency

problems can intercede and, even if a firm’s investment opportunities consist only of negative NPV

projects, managers will continue to invest in hopes that the projects will pan out rather than liquidate the

firm and give up their jobs. Dewatripoint and Tirole (1994) and Aghion and Bolton (1992) provide

similar arguments and contend that managers have both private and monetary incentives to continue with

failing projects.

This type of agency problem is illustrated by DeAngelo, DeAngelo, and Wruck (2002) who

describe how LA Gear’s management used the liquidity of its assets to continue to fund operations as its

business deteriorated. Management continued on this path of liquidating assets to fund losses (but not to

return capital to investors) for more than six years until the company was finally forced to declare

bankruptcy. Although DeAngelo, et. al (2002) acknowledge that liquid assets can be useful in allowing

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managers time to implement a turnaround, the more telling aspect of LA Gear’s behavior is the difficulty

of getting managers to cease operations rather than continuing to subsidize losing operations.

Financial distress can increase agency problems by raising concerns about the quality of a firm’s

investment opportunities and the willingness of managers to terminate failing projects given that the

likely alternative is liquidation. Similarly, informational asymmetries can compound these problems by

reducing the precision of the investor’s ex-ante estimates of the probability of a project success and the

potential losses from continuing to fund failing projects. Even in the absence of agency problems,

asymmetric information increases investor risk by increasing the difficulties of measuring the true quality

of a company’s projects.

3.1.2 Purchase discounts

One way investors can manage risk from contracting problems is to demand larger purchase

discounts. This approach, however, can exacerbate the contracting costs investors face rather than resolve

them. In a model of credit rationing, Stiglitz and Weiss (1981) show that a bank will not set the interest

rate on loans high enough to supply all borrowers because the rate itself can increase contracting costs. 6

For example, an increase in the interest rate can have the adverse effect of drawing primarily poor quality

borrowers into the loan pool. Although banks face the risk of poor quality borrowers at any interest rate,

as rates increase poor quality firms become a larger proportion of the loan pool and concerns for adverse

selection increase. Similarly, an increase in interest rates can increase moral hazard problems in which

managers attempt to generate returns that exceed the higher rates by taking on riskier projects with a

lower probability of success but higher payoffs when successful. PIPE investors can face similar costs if

they set a high purchase discount on the contract. The high discount has the potential to attract firms that

know their equity is over-valued by more than the discount.

6 We thank the referee for suggesting the applicability of their model.

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3.1.3 The use of contingent terms

Investors can also manage risks from contracting problems by using terms that are contingent on

a firm’s performance. For example, Schultz (1993) focuses on staging financing through warrants.

Partially funding a project upfront and including warrants that will only be exercised if the project proves

successful can limit both a firm’s ability to pursue value decreasing projects and an investor’s exposure to

such projects. Also, by specifying the exercise price in advance, warrants can give the firm incentives to

use the funds to reveal information about project quality. The incentive effect of warrants to curtail over-

investment can be further reinforced if it is difficult for the firm to raise funds from alternative sources.7

In addition to limiting a firm’s access to capital, contingent terms can manage the allocation of

control between a firm and investors. In particular, terms that increase an investor’s ability to gain

control and terminate failing projects will reduce an investor’s exposure to contracting problems. Aghion

and Bolton (1992) and Dewatripont and Tirole (1994), for example, both focus on control rights and a

firm’s desire to avoid outside interference. In Aghion and Bolton (1992) contingent control rights allow

entrepreneurs to retain the private benefits of control in successful states (high profitability) but give

investors control in failed states (low profitability). Similarly, in Dewatripont and Tirole (1994),

managerial incentives are such that outside investors only interfere with managers when it is likely that

managers have engaged in suboptimal actions. Poor performance is thus followed by a high probability

of external interference by outside investors (e.g., the loss of control) and good performance is rewarded

by a low probability of interference by outside investors. Therefore, contingent control rights can reduce

the incentives of managers to take suboptimal actions while also increasing the ability of investors to

curtail these actions. In PIPEs contingent control rights are gained through resets that payoff in negative

states by transferring additional control to investors as a firm performs poorly. 7 PIPE contracts typically employ a right of first refusal and anti-dilution terms. Depending on how the right of first refusal is structured it can limit the potential for other capital providers to emerge or lower the price at which providers are willing to offer additional capital. If the issuer’s value declines after the issue, subsequent financing will take place at a lower price than the current financing, triggering anti-dilution. Anti-dilution terms lower the warrant exercise price or increase the number of shares a warrant is entitled to purchase if new equity is raised. As Schultz (1993) discusses for unit IPOs, anti-dilution terms in PIPEs can also make it difficult for managers to raise additional equity through a seasoned equity offer or another PIPE.

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Although contingent terms do not eliminate contracting problems, they help investors manage

these risks. The foregoing arguments lead to Hypothesis 1: Discount-only contracts are less likely and

contingent terms more likely to be used as issuer risk increases.

3.1.4 The choice of contingent terms

Because either contingent control rights or warrants can help reduce contracting costs, it raises

the question why resets or warrants would be used. Preferences for the type of contingent contracting

terms used can differ between managers and investors. Based on the idea that managers want to pursue

projects with minimal outside interference, warrants provide a more attractive form of contingent

contracting than resets.8 The protection of an investor’s interests, however, is greatest with the contingent

control rights provided through resets because they reduce investor exposure to issuer losses and increase

investor control if issuer’s take suboptimal actions. Since renegotiation is more difficult in an equity

contract, an important feature of resets is that they are “self-executing” and do not depend on institutional

enforcement (Anderson (1999)).These terms also allow investors to exert control prior to delisting (or

bankruptcy) when it is most beneficial to them.9

Because the preferences for contracting terms differ between managers and investors, the choice

of contingent claims depends on which party has the greater negotiating power. As discussed by Aghion

and Bolton (1992), Aghion and Tirole (1994), Lerner, Shane, and Tsai (2003), and Roberts and Sufi

8 Aghion and Bolton (1992) discuss how the exercise of warrants in good states increases the stake or control of outsiders but managers prefer this because the managers control a larger resource base and can continue to consume private benefits in this state compared to the potential loss of these benefits with poor performance. 9 The importance of the control right provision is illustrated in the example of eToys, Inc. In June 2000, eToys entered into a $100 million floating rate convertible preferred stock issue when its stock price was $6.58. The contract required the company to convert or redeem 10% of the principal beginning in August for the first five months. However, if the price fell below $3.00 for 15 consecutive days or $2.30 for three consecutive days, investors had the right to accelerate conversion of the remaining portion of the security. As eToy’s stock price declined in subsequent months there were on-going discussions between management and the investors over the pace of the disposal of their remaining shares. By November 2000, investors had recovered 70% of their principal. eToys declared bankruptcy in March 2001. Note this commonly found feature of resets which increases investor control as delisting or bankruptcy becomes more imminent, is most often directed at controlling the pace of share liquidation rather than turning the company around. See “EToys is Given Reprieve on Timing of Stock Conversion,” Wall Street Journal, November 17, 2000 and placementtracker.com.

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(2008), the bargaining power between managers and investors varies with the firm’s financial condition

and with the availability of alternative sources of financing. 10 In general, as firms face greater challenges

raising needed capital, bargaining power shifts to the investors providing capital. In our setting, this leads

to the prediction that as a firm’s financing alternatives grow more limited, the use of contingent control

rights will increase. Hypothesis 2: Resets will be used more frequently relative to warrants when

financing needs are most urgent.

4. Risk and Contract Terms

4.1 Sample description

Our analysis of contracting terms begins with a sample of 2,626 PIPEs that are issued over 1995 –

2000 from Sagient Research, Inc.’s Placementtracker database. The Placementtracker database is to the

best of our knowledge an exhaustive list of all PIPEs issued since 1995. Relative to the private

placements available in Security Data Corporation’s New Issues database, it includes many more issues

and has a greater number of contract specific items available for analysis. We use Placementtracker data

to identify the type of PIPE issued, the terms of the contract, and the closing date of the agreement.

Our initial sample includes five types of PIPE securities: common stock PIPEs, floating rate

convertibles, convertible resets, structured equity lines, and common stock resets. From the initial sample

of 2,626 PIPEs we exclude 475 PIPEs in which the issuing firm is not available on CRSP and 200 PIPEs

in which there are insufficient or incorrect terms in Placementtracker or the terms indicate the PIPE was

issued at a premium.11 We also exclude the 182 structured equity lines and common stock resets because

10 For example, Lerner, et. al (2003) show that biotech firms with little recourse to public equity market financing and therefore little bargaining power appear to grant investors “excessive” control rights (at least relative to the unattainable first best outcome.) p. 416. Roberts and Sufi (2008) discuss how certain contract terms in credit agreements build in an incentive for borrowers to renegotiate as credit quality deteriorates, thereby increasing the bargaining power of lenders to improve terms in this state. 11 The PIPEs excluded from the sample include issues where the proceeds the company receives from investors exceeds the estimated value of the PIPE. The purchase premium may be due to incorrect data in Placementtracker or because the investor is receiving additional benefits not included in the terms of the PIPE (e.g., strategic benefits or control.) Results from our analysis are qualitatively similar if these firms are kept in the sample.

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the contracting terms of these contracts make them difficult to classify for the purposes of our study.12

Our final sample consists of 1,769 PIPEs. These PIPEs are issued by 871 unique firms, roughly 90

percent of which are traded on NASDAQ.

Common stock PIPES allow investors to purchase the company’s stock at a discount to the

current market price or at some average of the prices in a short interval before the issue. Some portion of

common stock PIPEs also include warrants that enable investors to purchase additional shares of the

issuer’s stock at a predetermined price.

Floating rate convertible preferred stock or debt and convertible resets include price resets and are

treated as one group and referred to as “resets.” 13 Some, but not all, of these contracts also include

warrants. The reset group provides investors with contingent control rights. The rights are in the form of

a price reset (or a repricing right) that enables investors to receive additional shares upon conversion of

the preferred security into common stock if the price of the issuer’s shares falls following issuance. If the

stock price of the issuer rises, the conversion usually takes place at an agreed upon contract price (most

often the stock price at closing). The reset term therefore allows investors to maintain the value of their

principal in the case of adverse movements in the issuer’s stock price following the offering, while

preserving the investors’ ability to benefit from favorable post-issue stock performance. The downside

protection offered by resets is limited by the degree of liquidity in the stock and can cease to exist as the

issuer’s stock price approaches zero in the event of distress or delisting.14 Because the payoff on resets

12 For example, common stock resets typically allow the terms to be adjusted for only a 60 to 90 day period following closing and thus the length of downside protection is much shorter compared to floating rate convertibles and resets which typically have maturities ranging from two to five years. Results of our study are similar if we include common stock resets and structured equity contracts in our sample, regardless of how they are classified. 13 Relative to fixed rate convertibles which typically have a single conversion price above the current stock price that is maintained for the duration of the contract, the conversion price on a floating rate convertible changes on a daily basis with movements in the issuer’s stock price. Reset convertibles allow for a discrete number of changes of the conversion price at specified intervals (e.g., six months, one year, and two years from closing). Prior to the reset points, the security is convertible only at the last fixed conversion price. 14 In theory, if the stock price is delisted or the company declares bankruptcy before the PIPE investor has converted any of the position, the investor could lose his or her entire investment. In practice, this is unlikely to occur as investors begin to sell shares soon after the registration takes effects.

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results from the ability to liquidate the stock, the creditworthiness of the issuer can be of lesser

importance to investors than the liquidity of the stock.

4.2 Descriptive statistics of PIPE contracts

4.2.1 Issue volume

In Table 1 we show a yearly breakdown of PIPEs sorted into groups based on their primary

contacting terms. All PIPEs in our sample include a purchase discount so that the groups are categorized

based on the presence of additional contracting terms beyond the purchase discount. The three groups

are: Common Stock PIPEs with Purchase Discounts only (PD); common stock PIPEs with warrants

(PDWT); and Resets (RESET).

The total proceeds raised in the PIPE market increase substantially during the sample period from

$658 million in 1995 to almost $11 billion in 2000. In addition to the regulatory changes discussed

above, the growth in the PIPE market is partially demand driven. For example, Fink, Fink, Grullon, and

Weston (2005) and Fama and French (2004) document that since 1990 firms go public at an earlier age,

resulting in more public firms with less consistent profitability and lower survival rates. The age of PIPE

issuers and other characteristics we discuss later are consistent with the deteriorating quality of “new

lists.” For example, for our sample of PIPE issuers, the average time from their founding date to IPO date

is less than seven years and the median time is four years.15 These young, usually unprofitable, public

firms with heavy demands for capital differ substantially from the firms that generally use seasoned

equity offerings (SEOs) and other forms of public financing.

In terms of the total proceeds raised by PIPEs, the PD group accounts for the largest percentage

(57%) of the funds raised. A sizeable portion, however, of the remaining funds raised (43%) involve

some form of contingent contract term. Eleven percent is raised by common stock PIPEs that include

warrants and 32% is raised by reset contracts. Of the contract with resets, slightly less than half of these

15 We thank Laura Field and Jay Ritter for data on founding dates. The remaining data are gathered from EDGAR.

15

contracts (391 of 864) also include warrants (untabulated). We treat resets with and without warrants as

one group in subsequent analyses for several reasons. First, an extensive empirical investigation of resets

with and without warrants reveals few discernable differences between the two contracts.16 Second,

although theory has not explicitly dealt with contracts that include both resets and warrants, when

incentive conflicts are large, contracts with debt-like features often emerge as an optimal contract design

(Roberts and Sufi (2009)). This suggests that resets, whether combined with warrants or not, are more

likely to be used when investors see the potential for large costs being associated with deviations from

optimal behavior.

Between 1995 and 2000, a total of $23 billion was raised in the PIPE market which compares to

$112.6 billion that Gomes and Phillips (2007) report companies raised in public equity over the same

period. Consequently, PIPEs constitute upwards of 20% of the funds raised via public equity and are an

increasingly important source of funding. The two types of common stock PIPEs – those with and

without warrants – generally increase from year to year, whereas resets increase from 32 in 1995 to 232 in

1997, but then trail off to 122 in 2000. The reduced issuance of resets has been attributed to adverse

publicity about the controversial nature of the securities (e.g., “death spirals,” “toxic converts”) and an

NASD ruling that introduced certain contract terms which effectively limited the downside protection

provided to investors.17 Although these events have reduced the use of resets, they continue to be

issued.18

16 This analysis was included in a previous version of the paper and is available from the authors by request. 17 The National Association of Securities Dealers (NASD) views structured equity lines and floating rate convertibles and resets as “future priced securities.” Certain NASDAQ listing rules regarding future priced securities are codified in NASD Rule 4350 which was approved in March 2002. Under this rule, the issuance of certain PIPEs can require a vote by shareholders. To eliminate the need for shareholder approval, an issuer can limit the number of shares that can be issued upon conversion to 20% of the common stock before the issuance of the PIPE or place a floor on the conversion price to that effect. See the Federal Register, Vol. 67, Number 45, March 7, 2002. 18 Although their proportion of total PIPE funding remains substantially lower than in our sample period, after reaching a low in 2003, Floating Rate Convertibles and Convertible Resets grew to 117 issues and 0.487 billion in 2005, and 158 issues and $1.0 billion in 2006.

16

4.2.2 Contracting terms The contracting terms used by the different types of PIPEs are shown in Table 2. The PIPEs

included in Table 2 and in subsequent analyses are required to have Compustat data available, thereby

reducing the sample to 1,179. Of note is the relative lack of variation in the purchase discounts across the

types of PIPEs. The median purchase discount is 14% for issuers of common stock PIPEs with warrants

(PDWT) and 15% for issuers of purchase discount-only (PD) and reset (RESET) contracts. There is

greater variation however in the use of other contracting terms. By definition, PD issuers do not include

warrants but the use of warrants is extensive in the other groups. On average, the proportion of warrants

to shares issued is 63.4% (median 50.0%) for PDWTs and is 43.9% (median 28.0%) for RESETs. The

ratio of proceeds from warrants to current proceeds, labeled warrant ratio, is 90.6% on average (median

62.7%) for PDWTs and 57.4% (median 37.6%) for RESETs.

The repricing rights contained in reset contracts can include floors and caps. A floor puts a lower

bound on the price at which conversion can take place. A cap puts an upper bound on the conversion

price. Almost 22% of RESETs have a floor that is on average 43% below the market price at the time of

offering. For the remaining contracts no floor exists, suggesting that for upwards of 75% of RESETs

investors have downside protection to the point of delisting. The conversion price is capped at an average

of 9.3% (median 2%) for RESETs, suggesting that investors obtain relatively unlimited upside.

To summarize the value of the different PIPE contracting terms, we compute an “all-in net

discount.” As described in the Appendix, the all-in net discount incorporates the estimated value of the

purchase discount and any warrants, resets, caps, floors, and interest or dividend payments included in the

contract. The all-in net discount is the ratio of the proceeds received by the issuer divided by the sum of

the estimated value of the contract terms received by the investors minus one.

In contrast to the consistency of the purchase discount, the all-in net discount varies to a much

greater extent across the groups. The median all-in net discounts range from a low of 15% for PDs to a

17

high of 30% for both RESETs and PDWTs. The two-fold increase in all-in net discount between PDs and

the other contracts highlights the importance contracting terms beyond the purchase discount to investors.

Finally we examine the size of the offering several ways. Although this is not a contract term, it is

a characteristic of the contract. Total proceeds ranges from $10 million for the median issuer of PDs to

$4.5 million for PDWTs. Compared to a median offer size of $65 million for SEOs, PIPE offerings are

small.19 The offering, however, can represent a relatively large fraction of the issuer’s market value and

trading volume. The median proceeds as a fraction of market value is 12.6% for PDs, 12.2% for PDWTs,

and 9.5% for RESETs. The offering in terms of shares is equivalent to several weeks or even months of

average of daily trading volume. Based on the medians of the issuer’s average daily trading volume, it

would take a PIPE investor from 15.1 days (RESET) to 20.2 days (PDWT) to liquidate their position.

The average values are considerably higher (29.3 to 52.2 days). Therefore although PIPE investors have

the right to divest their stake soon after an offering, they can face market challenges in doing so.

4.3 Characteristics of issuers

Our hypotheses predict that the use of contingent claims increases with the severity of contracting

problems. Of primary concern is a firm’s continued pursuit of failing projects rather than returning

capital to investors. This risk is related to both the issuer’s financial condition and the uncertainty

regarding the value of its projects, particularly the probability of project success and the potential losses

associated with failed projects. Theoretical predictions in the contracting literature for the extent of

contracting problems do not clearly distinguish between risks that might be limited to uncertainty (i.e., the

value of an investment opportunity) from those of financial distress.20 Either form of risk can increase

contracting problems. However, as noted previously, these risks can be distinguished because they can 19 The offering size is based on 2,594 seasoned equity offerings (SEOs) made during 1995-2000 we use to compare to PIPEs. The sample of SEOs is gathered from the Securities Data Corporation database. 20 An example of this can be seen in Aghion and Bolton (1992). In a model describing financial structure and the optimal allocation of control rights between entrepreneurs and investors, they describe “it is always best to start with entrepreneurial control if that is feasible. If however, entrepreneurial control does not sufficiently protect the investor’s claims, one should go for contingent control. Finally if that is still not enough to protect the investor’s interest, one wants to give full control to the investor (p. 491-492).”

18

affect an issuer’s alternatives for financing. For example, a financial distressed issuer that is close to

running out of cash likely has more limited alternatives for financing than one with high uncertainty but is

otherwise financially sound. As a result, financially distressed issuers will have less bargaining power

with investors and allow investors to gain greater control rights.

4.3.1 Measures of financial condition

Table 3 reports issuer characteristics related to financial condition and investment uncertainty.

The results show that the financial condition of PIPE issuers can best be characterized as distressed.

Twenty-two percent of the issuers have sales less than $1 million. Return on assets (ROA) is -39% on

average and -26% for the median issuer. Eight-four percent of the issuers have negative operating

income. Among these firms, more than half have less than a year until they will burn through their

existing cash. The median issuer is small with total assets of $18 million and a market cap of $51 million;

a quarter has total assets less than $8 million and a market cap less than $22 million. Further, the book to

market ratio would place these firms in the lowest decile of firms on the NYSE, indicating that they are

valued in the highest growth category.21 Stock returns leading up to the PIPE issues also tend to be poor.

The median issuer has abnormal returns in the 12 months leading up the offering of -19%; a quarter of the

issuers have abnormal returns of -56% or less.

The distressed condition of the issuers increases contracting problems several ways. First, the

fact that projects are not profitable or falling short of expectations (as indicated by stock returns) raises

questions about whether current or future projects will be successful. Given that managers appear to have

few alternatives other than liquidation, they have little incentive to curtail investment and may favor high

risk projects with little chance for success. Issuers, however, have limited capacity to bear losses from

failing projects without realizing delisting or bankruptcy and a loss of most – if not all – equity. Second,

relatedly, the extent of financial distress also increases the uncertainty about an issuer’s future

21 For example, see Ken French’s data library http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html#Benchmarks

19

performance. Griffin and Lemmon (2002) find that the stocks of distressed firms, as measured by low

book-to-market ratios, subsequently realize abnormally poor stock returns. They argue that investors

underestimate the importance of current firm fundamentals and overestimate the pay-offs on growth

opportunities and suggest these problems are particularly acute for low book-to-market firms.

In addition to increasing contracting problems, financial distress is important for an issuer’s

ability to negotiate contracting terms. As shown by Heron and Lie (2004) and others, most forms of

equity financing cater to companies that have realized positive stock returns and operating performance

leading up to an offering. 22 Therefore, as distress increases, a firm’s financing alternatives can be

expected to decline, while the importance of obtaining financing for survival becomes more critical. The

characteristics of PIPE issuers point to reduced bargaining power with investors.

4.3.2 Uncertainty around investment opportunities

Apart from financial condition, uncertainty regarding future investment opportunities can also

lead to contracting costs. 23 These costs increase as the potential outcomes of a firm’s investments vary

widely and larger losses are associated with unsuccessful projects. The characteristics of PIPE issuers

indicate that is difficult to assess the potential returns associated with future investment opportunities.

Issuers are often young and at a developmental stage. For example, 25% of the issuers are less than seven

years old at the time of the PIPE.

The asset composition of the issuers can also contribute to uncertainty about firm value. In

particular, PIPE issuers are often from industries such as biotech and technology for which patents and

22 For a sample of SEOs offered during 1995-2000, the median CAR(-12, -1) exceeds 40%. In the year prior to the issue the median assets of SEO issuers is $128 million compared to $18 million for PIPE issuers and the median return on assets is 12.7% for SEO issuers compared to -26% for PIPE. For brevity’s sake, we do not report the SEO comparisons. 23In theory a firm’s financial condition and uncertainty over investment opportunities can separately give rise to contracting costs. Although the financial condition of a company might be strong, uncertainties regarding its investment opportunities can still lead to contracting problems. For example, a firm could have high variance investment projects whose failure might lead to a loss of value but not to distress. Similarly, contracting problems can exist for firms in poor financial condition even when uncertainties regarding investment opportunities are low.

20

other types of intellectual capital are particularly important.24 Studies by Barth, Kasnik, and McNichols

(1999), Barron, Byard, Kile and Riedl (2002), Lev (2005) and others argue that intangible assets increase

informational asymmetries between managers and investors over firm value. For example, the dispersion

of forecasts by analysts is greater for firms with relatively high intangible assets suggesting less

consensus about the usefulness of current earnings in predicting future firm value.

We measure intangible assets of PIPE issuers using the ratio of intangible assets to total assets

and the ratio of research and development expenditures to operating expenses. The average of intangible

assets as a fraction of assets is 9% and the average ratio of R&D expenditures to operating expenses is

30%. These compare to similarly constructed variables of 6.3% and 6.6%, respectively reported in

Barron, et. al (2002) using a broader sample of Compustat firms. Moreover, because PIPE issuers are not

widely covered by analysts, an alternative means by which the market can learn about the value of

intangible assets is largely unavailable for these firms.

Finally we examine investment uncertainty using the volatility of stock returns. The annualized

standard deviation of stock returns leading up to the offering averages 106% and has a median of 94%.

By comparison, Lowery, Officer, and Schwert (2008) report a standard deviation for NASDAQ stocks of

roughly 55% during our sample period.25 Although this is the volatility for returns leading up to – rather

than following – the offering, Figlewski (1997) and others show that there is autocorrelation in

volatility.26 Therefore, it is reasonable to expect continued uncertainty regarding issuer value following

the offering.

Although no one variable captures the ex-ante issuer risk PIPE investors face, collectively the

characteristics PIPE issuers show that they are distressed, young, volatile firms with substantial growth

opportunities – all of which can make it difficult for investors to predict how the issuers will perform.

24 The high level of intangible assets is consistent with the industry patterns of PIPE issuers. Using Fama-French industry classifications, we find PIPEs occur in 30 different industries with the largest concentration in Health, Services, and Computer Equipment. 25 Data are available from http://schwert.ssb.rochester.edu/IPOVolatilityData.xls. 26 Studies also document that implied volatility of options listed on a firm are predictive of future volatility. Very few of our sample companies have listed options, so we rely on historical volatility.

21

These difficulties heighten concerns for informational asymmetries and agency issues that increase

contracting problems for private investors. Having highlighted the substantial risk associated with PIPE

issuers, the remainder of our analysis focuses primarily on the variation in these characteristics, which we

refer to as “issuer risk,” and the choice of contracting terms.

5. Contracting Terms and Issuer Characteristics

5.1 Issuer risk and contracting terms

5.1.1 Purchase discount versus contingent contracting terms

In Table 4 we relate our previously described hypotheses to issuer risk characteristics and the

choice of contracting terms. The main focus of panel A is whether the use of contingent claims is

associated with greater issuer risk. The characteristics of issuers using contingent contracting terms (CC)

differ from issuers of Purchase Discount-only contracts (PD) across the board. CC issuers are more

distressed than PD issuers – they have significantly lower raw and abnormal stock returns leading up to

the PIPE, are burning through cash at a faster rate, have a lower ROA, and are more likely to have

negative operating income. CC issuers are also significantly smaller in terms of assets and market cap,

have a greater portion of intangible assets, and a greater standard deviation of returns than PD issuers.

One result that seems to run counter to CC issuers having more uncertainty about investment

opportunities is that PD issuers have greater research and development (R&D) expenditures than CC

issuers. Although higher R&D can indicate greater informational asymmetries, a more likely explanation

for this result is that CC issuers face constraints that limit their ability to fund R&D. 27

The trading characteristics of issuers show that investors in CC contracts face greater challenges

shorting the issuer’s shares. The “Short Constrained” variable is similar to that described by Asquith,

Pathak, and Ritter (2005) and is set equal to 1 if a firm’s short interest divided by shares outstanding is 27 Consistent with financial constraint, in unreported results we find a positive relation between operating income and R&D expenditures, suggesting firms with more income invest more in R&D and a negative relation between cash burn and R&D expenditures. Also there is a strong correlation between proceeds and R&D expenditures, suggesting the money raised may further these activities. Balance sheet intangibles are likely less affected by financial constraint because they represent past expenditures that could have occurred in periods of less constraint.

22

greater than its institutional ownership divided by shares outstanding over a three month period prior to

issue. Because institutions are the largest suppliers of stock in the equity lending market, the costs of

borrowing shares are expected to be higher if short interest exceeds the holdings by institutions.28

Sixteen percent of CC issuers are classified as short constrained compared to just 3% of PD issues. The

greater difficulty of shorting suggests investors will value contract terms that help mitigate the risk of

downward price movements in the issuer’s shares. Overall, the results in panel A of Table 4 support

arguments that greater issuer risk is associated with the use of CC contracts.

5.1.2 The choice of contingent contracting terms

The focus in panel B of Table 4 is on the issue of whether RESETs – and contingent control

rights – occur in circumstances where the issuer is in more urgent need of financing and has less

bargaining power. The findings in panel B point to resets being used when issuers face higher levels of

distress. Compared to issuers of PDWTs, the issuers of RESETs experience lower raw and abnormal pre-

issue stock returns, have less time left before running out of cash, and more leverage. The median

leverage ratio of RESETs of 0.14 is not high by conventional standards, but then the required payment of

any interest is likely problematic for these firms. Although there is evidence that both groups are

distressed, reset issuers clearly have a more urgent need for funds than PDWT issuers as best exemplified

by the differences in BURN between the groups. In comparison to PDs, the mean cash burn rate for

PDWTs is not significantly different, suggesting they have a comparable amount of time on average to

PDs before new financing is needed.

Differences between issuers of RESETs and PDWTs with respect to the proxies for investment

uncertainty are less clear. Issuers of PDWTs have a higher median standard deviation of returns and

higher R&D expenditures than issuers of RESETs, but lower levels of intangible assets. For example, for

28 The median institutional ownership as a fraction of outstanding shares for all PIPE issuers is 2.2% compared to about 15% reported by Asquith, Pathak, and Ritter (2005) for NASDAQ firms over 1995-2000. The median short interest as a percent of shares outstanding is less than 1% for the sample of PIPE issuers.

23

RESETs the median issuer has a standard deviation of returns of 93% which is much closer to 92% for

PD than 102% for PDWT. The findings indicate that although the use resets is increasing with the extent

of financial distress, greater uncertainty often leads to the use of warrant-only terms.

5.2 Distress versus investment uncertainty

The results to this point provide evidence that the choice of contracting terms is associated with

an issuer’s financial condition and is less clear about the role of investment uncertainty. In principal, these

two factors are distinct, warranting further investigation. A prediction from Hypothesis 2, which focuses

on the bargaining power of investors, is that although the use of contingent terms is associated with issuer

risk, the issuer’s financial condition is the primary factor determining the choice of terms. Issuers in the

poorest condition with the most urgent need for funds are more likely to agree to resets that provide

investors with contingent control rights. Issuers for which investment uncertainties are high but who

otherwise are in less urgent need of funds will use warrants.

To examine the importance of these factors on the choice of contract terms, in Table 5 we

perform a two way sort using measures related to the probability of financial distress and the uncertainty

of investment outcomes. The issuer’s cash burn rate (BURN) is used as a proxy for distress and the

standard deviation of its returns leading up the offering (SDRET) is used as a proxy for uncertainty.

Results are qualitatively similar, however, when we consider combinations of alternative measures for

these characteristics, e.g., return on assets (ROA) and the ratio of intangible assets (INTANG).

To construct the quartiles in Table 5, we sort each firm based on whether its cash burn rate is

above or below the sample median. We also sort each firm based on whether the standard deviation of its

returns is above or below the sample median. We then assign issuers to one of four quartiles. The

quartiles are defined as: Q1, issuers with below median BURN and below median SDRET. Q2 are

issuers with below median BURN and above median SDRET. Issuers in Q3 have above median BURN

24

and below median SDRET. Issuers in Q4 are those with above median BURN and SDRET. The

following schematic is helpful in interpreting the results:

Q1: LOW BURN RATE/LOW SDRET Q3: HIGH BURN RATE/LOW SDRET

Q2: LOW BURN RATE/HIGH SDRET Q4: HIGH BURN RATE/HIGH SDRET

These sorts allow for the individual effects of distress and uncertainty to be examined and also

importantly their combined effects. Issuers in Q1 can be considered those with the lowest risk and issuers

in Q4 those with the highest risk.

The results for ALL PIPEs in panel A of Table 5 indicate that the observations are not uniformly

distributed across the quartiles. Although there is some tendency for firms with the lowest cash burn rates

to have the lowest standard deviations (Q1 has 302 observations) and vice versa (Q4 with the highest cash

burn rates and standard deviations has 305 observations), there remains a sizeable number of observations

with low burn rates and high standard deviations (Q2 has 267 observations) and high burn rates and low

standard deviations (Q3 has 266 observations). The non-uniform distribution suggests that BURN and

SDRET do not necessarily proxy for the same risk.

The results for ALL PIPEs also highlight the variation in risk within the sample. Although by

design we seek to construct differences in issuer risk across the groups, the differences between quartiles

are substantial nonetheless. For example, for issuers with high SDRET in Q2 and Q4, the standard

deviation of returns for the median firm is 124% and 127%, more than 50% greater than the standard

deviation of issuers in Q1 (77%) and Q3 (80%). There are also large differences in cash burn rates

between the high and low categories. Translating BURN into the time left before running out of cash, for

issuers in Q3 and Q4 with high BURN, the median firm in each quartile has less than six months before

running out of cash compared to the issuers in Q1 and Q2 with low BURN that have more than two years

before running out of cash.

25

After assigning the issuers to quartiles, we sort them again based on the choice of contracting

terms. The issue of primary interest for our analysis is whether there are differences in the use of

contracting terms across the quartiles. The hypotheses provide two predictions. The first is that purchase

discount-only contracts (PD) will be used primarily by firms with less risk (i.e., low BURN, and low

SDRET). The second is that use of RESETs will increase with the cash burn rate. In other words, the

less time an issuer has before running out of cash, the more likely a RESET will be used.

The results for PD contracts (panel B) indicate that as issuer risk increases, investors are less

likely to use contracts that rely only on purchase discounts. The largest number of PD contracts (120)

occurs in Q1, the lowest risk category. PD contracts are least used by issuers in Q4 (70), the highest risk

group. The differential use of PD contracts is particularly apparent when we compare the number of

issuers with above median BURN (sum of Q3 and Q4 observations) to the number of issuers with below

median BURN (sum of Q1 and Q2 observations). Of the 368 issuers of PD contracts, only 139 (38%)

have a cash burn rate above the sample median, a proportion that is significantly less than that for cash

burn rates below the sample median (Z-stat = 4.69). The standard deviation of returns appears to be less

important. For PD issuers, 178 have a standard deviation above the sample median and 190 have a

standard deviation below the sample median, a frequency of occurrence that is not significantly different.

Therefore purchase discount-only (PD) contracts are used primarily by issuers in the best financial

condition.

A different frequency of contract usage emerges when we focus on the use of PDWT contracts in

panel C. The majority of PDWT contracts are used by issuers with SDRET above the sample median.

Among the 226 PDWT issuers, 132 (58%) are from the high SDRET groups, a proportion that is

significantly greater than that from the low SDRET group (Z-stat = -2.53). The use of PDWT contracts,

however, does not vary significantly with the cash burn rate. The use of PDWT is split almost equally

between issuers above (115) and below (101) the median cash burn rate. The results indicate that

warrants are not primarily used to address concerns of financial distress but rather investment uncertainty.

26

The results for issuers of RESETs are almost the antithesis of PD contracts. Of the 547 contracts

that include resets, 317 (58%) are made by issuers with a cash burn rate above the median. The use of

resets does not vary significantly with the standard deviation of returns. There are 263 issuers of resets

with standard deviation above the median and 284 with standard deviation below the median. The

findings indicate that resets are used by issuers facing greater financial distress and investment

uncertainty, as measured by the standard deviation of returns, does not appear to be an important

determinant for the choice of resets. In other words, firms in poor financial condition and running out of

cash are more likely to use resets regardless of the extent of investment uncertainty.

The findings in Table 5 show that issuer risk matters for the choice of contracting terms. The

findings support theories that suggest contingent contracting terms help investors manage risks beyond

purchase discounts alone. The findings also support theories that the choice of contingent terms varies

with an issuer’s financial condition. The users of warrants, although facing high uncertainty about firm

value, are in a somewhat more comparable financial condition to issuers of PD contracts. In contrast,

firms that are in poorest financial condition, and likely have little bargaining power with investors, most

often end up using resets.

5.3 Multivariate analysis of the choice of contracting terms

In Table 6, we regress contracting terms on proxies for issuer risk. The first column examines

differences between purchase discount-only contracts and contracts with contingent contracting terms. In

this model, the dependent variable is 1 if the PIPE includes a contingent claim (CC) and is 0 if it is a

purchase discount-only (PD) PIPE.

The results in the first column support the notion that the use of contingent claims is increasing in

the risk of the issuer. The use of contingent contracting terms is more likely among issuers with smaller

market capitalizations, relatively more intangible assets, and issuers that are poorly performing – both in

terms of pre-issue abnormal stock returns and in the rate they are burning through cash. The results also

27

show that CC issues are associated with significantly fewer days to liquidate. One interpretation of this

result is that, when other factors are held constant, investors are less willing to make large illiquid

investments in companies facing risks that result in the use of contingent claims. It is also consistent with

earlier evidence that investors take smaller stakes in CC issuers.29

In the second model in Table 6 we examine the choice of contingent terms. The dependent

variable in this regression is 1 if the PIPE includes a RESET and is 0 if the contract is PDWT. The

regression results indicate that differences in the use of these contracts are primarily related to concerns

about financial distress. Companies with lower pre-issue abnormal stock returns and higher BURN are

significantly more likely to use RESETs than PDWTs. The choice of terms also depends on the standard

deviation of issuer returns. Consistent with the results in Table 5, among issuers using contingent terms,

firms with more volatile returns are more likely to use PDWT. The coefficient on Days to Liquidate is

again significantly negative, most likely suggesting investors take smaller stakes in resets.

The results in Table 6 are consistent with findings in Tables 4 and 5. The use of contingent

claims is more likely to occur when issuer risk is greater. The choice of contingent control rights is more

dependent on the issuer’s financial condition than investment uncertainty. Resets are more likely to be

associated with poor performance, a more urgent need for funds, and lower uncertainty than PDWTs, for

which the opposite is true.

5.4 The distribution of realized returns and contracting terms

Our analysis has focused on issuer characteristics leading up to an offering. Although these

characteristics are likely correlated with issuer’s ex-ante risk, they are likely to only capture a portion of

the risk that investors’ face. For instance, Guo, Lev, and Zhou (2005) describes the importance of non-

financial data related to development activities, such as the number and stage of products under

29Due to the construction of the variable, ADTV is similar across the types of PIPEs suggesting that the differences in Days to Liquidate could be driven more by the numerator – the number of shares investors’ receive. We also examine Amihud’s (2002) measure of illiquidity but it was not a significant driver of contract choice.

28

development and the legal protection of intellectual property, to the valuation of initial public offerings of

biotech companies. They find product development information affects valuation beyond fundamentals

such as cash flow or single input measures of intangibles, such as R&D expenditures. Similarly, Tetlock,

Saar-Tsechansky, and Macskassy (2007) find that qualitative information – particularly the language used

in news stories about a company – explains hard-to-quantify information about a firm’s fundamentals,

especially when accounting and analyst information are incomplete. Given the developmental nature of

the companies issuing PIPEs, these non-financial characteristics can be particularly important sources of

risk for investors.

With these concerns in mind we consider alternative measures of risk using an issuer’s ex-post

performance. This approach follows Christensen and Prabhala (1998) and other studies that indicate that

implied volatilities – a forward looking measure of investor uncertainty at the time of the offering – are

related to future realized volatility. In our case, however, the interest is in the opposite direction. We use

the distribution of ex-post realized returns as an additional measure of issuer risk at the time of the

offering to potentially capture sources of risk beyond those captured by firm fundamentals.

In this section we examine the realized returns to (non-PIPE) shareholders in PIPE issuers to

determine how shareholders fare with respect to the type of contract issued. We relate the use of

contracting terms to two measures of the issuer’s ex-post performance: the variability of returns following

the PIPE issue and the frequency of delisting. Based on the hypotheses, we investigate whether contracts

that include contingent claims are associated with a higher variability of returns and a greater frequency

of delisting than purchase discount-only contracts.

A caveat to this analysis is that we do not observe what outcome would have occurred if

alternative contracting terms had been used. For example, a finding of a higher rate of delisting for reset

issuers with contingent control rights might be viewed as surprising given that the terms provide investors

with greater ability to steer the company. On the other hand, the rate of delisting might have been even

29

greater if alternative contracting terms were used. Therefore, although these findings can help provide a

sense of issuer risk ex-ante, they can also reflect the effect of contracting terms ex-post.

We estimate buy and hold returns and the rate of delisting of issuers for 6, 12, and 24 month

intervals following the issue. Buy-and-hold returns (BHAR) are computed using the following approach:

Ri,T = ⎥⎦

⎤⎢⎣

⎡−+∏

T

ttiR

0

1)1( ,

RRi,t is the monthly return for the sample firm or a benchmark portfolio for month t. Abnormal

returns for the window between t0 and T are the returns on the sample firm minus the return on a

benchmark portfolio. Abnormal are computed using a benchmark portfolio that controls for size and

book-to-market ratios (CAR); see Brav and Gompers (1997) and Chalmers, Dann, and Harford (2002).30

In untabulated analysis, we find similar results when abnormal returns constructed using alternative

benchmarks, including NASDAQ decile 1 firms and NASDAQ firms with less than $2 million of market

capitalization (Cochrane (2005)). We also find similar results when we use alternative methodologies, for

example using calendar-time abnormal returns, including co-skewness factors, focusing on first time PIPE

issues, and computing returns for other time intervals.

To compute the rate of delisting, we use the delisting information from CRSP. In computing the

delisting rate, we exclude delistings with codes from 200 to 390 (delistings due mergers or exchanges)

because the outcome for investors from these events may not be related to distress. Results are, however,

similar when these events are included in the delisting rate.

In Table 7 we report the distribution of realized returns for PD and CC contracts in panel A and

for PDWT and RESET contracts in panel B. In panel A, the main finding of note is the difference in the

30 Companies are assigned to one of twenty-five benchmark portfolios in the year prior to the PIPE offering using the market value of equity and the ratio of book value to market value. The benchmark portfolios are constructed on an annual basis by first taking the companies both appearing in CRSP and COMPUSTAT and separating them into quintiles according to the market value of assets as of June of the previous year. Then, each of these quintiles is separated into quintiles based upon the ratio of the book value to the market value of assets in June of the previous year. If a company is delisted within the 12 month window following the PIPE issue, the delisting return (if available) is used as the return for the month of the delisting. The returns for the remaining months are set equal to 0 percent. These returns are then adjusted by the returns on the benchmark portfolio to calculate abnormal returns.

30

level of realized returns between PD and CC contracts. For PD contracts, outside of the extremes of six

months and 24 months, the realized raw and abnormal returns to PD issuers are insignificantly different

from zero. In contrast, the mean and median realized returns for CC issuers are generally negative and

significantly different from zero. For the most part the differences in returns are large and significant

between the groups. For example, the average abnormal through 12 months (CAR(0,+12)) for PD issuers

is -5% compared to -23% for CC issuers and -27% versus -42% through 24 months (CAR(0,+24)).

The distribution of 12 month abnormal returns for PD and CC issuers is also shown in Figure 1.

The figure highlights the mass of negative returns among PIPE issues but also shows the extremely large

returns generated by a handful of the issuers. Approximately 69% of PD issuers and 79% of the CC

issuers realize negative abnormal returns. However, 3% of PD issuers and 2.5% of CC issuers realize

returns of 300% or more.

In panel B of Table 7, there are similarly large differences in realized returns between PDWT and

RESET contracts. Through 12 months, average abnormal returns are -12% for PDWTs and -27% for

RESETs. Through 24 months, average abnormal returns are -23% for PDWTs and -50% for RESETs.

The median returns for both groups are negative for all intervals and also significantly worse for RESETs

and PDWTs.

Although there are many indications of poor financial condition leading up to the offering, the

realized returns indicate that issuers – especially issuers of resets – deteriorate to a greater extent than at

least public investors had anticipated. The finding of poor post-issue performance is consistent with

Hertzel, Lemmon, Linck, and Rees (2002)’s study of private placements. They offer a behavioral

explanation for the performance in which public investors’ underweight current operating performance

and overweight investment opportunities. Their explanation is similar to Griffin and Lemon (2002)’s

argument for why distressed firms are difficult to value. Hertzel, et. al (2002) argue that the terms of a

private placement (purchase discounts in their study) can reflect the private investors’ estimate of the

31

issuer’s true (lower) value. We investigate this issue further in the next section when we examine the

returns to PIPE investors.

To examine our hypotheses, we first focus on the variability of returns as a measure of issuer risk.

There is little difference in the dispersion of returns between PDs and CCs. This is consistent with the

earlier results that showed the measures of investment uncertainty were not the principal drivers of the use

of contingent claims. Uncertainty does play a role, however, in the choice of contingent claims. As

shown in Panel B of Table 7, the standard deviation of returns is consistently greater for PDWTs

compared to RESETs. Standard deviation of abnormal returns for PDWTs compared to RESETs is 99%

to 85% through 6 months, 110% to 100% through 12 months, and 149% to 118% through 24 months.

The results are consistent with the previous findings that uncertainty is particularly important for the use

of warrants.

The fraction of issuers delisted is shown in Table 8. Issuers using contingent claims are delisted

at a rate that is almost twice that of issuers using purchase discounts. For example, 4% of PD issuers are

delisted within 12 months of the offering compared to 11% of CC issuers. Through 24 months the rate of

delisting increases to 15% for PDs and 26% for CCs. The findings are consistent with Hypothesis 2 that

the use of contingent claims increases with issuer risk, particularly the risk of financial distress.

When we focus on the choice of contract, the rate of delisting for RESET issuers is two times or

more that of PDWT issuers. For RESET issuers, 14% are delisted within 12 months and 29% are delisted

within 24 months. By comparison, “only” 4% of PDWT issuers are delisted within 12 months and 19%

within 24 months. The rates of delisting do not differ significantly between PDs and PDWTs. The

results are consistent with resets being used by issuers in the poorest financial condition when bargaining

power with investors is lowest. The poor post-issue performance of reset issuers is consistent with the

findings in Hillion and Vermaelen (2004) and Brophy, et. al (2009). Although a reset does not

necessarily fully protect an investor’s capital if the issuer is delisted, it allows investor to reduce their

exposure to price declines to the point of delisting. Additionally, the reset can provide investors a way to

32

increase control as performance deteriorates and take steps that might reduce the probability of delisting

or the consequences of it to them.

6. Returns to PIPE Investors

In this section we shift our focus to the importance of these contracting terms for the returns

realized by PIPE investors. The analysis is aimed at understanding the extent to which these terms help

investors manage issuer risk. The tests focus on the returns to PIPE investors compared to market

benchmarks.

Our estimates of returns to PIPE investors take into account the size of the discount or premium

on the purchase of shares, reset features, dividends or interest paid on the security, and whether any

warrants included in the deal would have been “in-the-money” at the end of the respective six to twenty-

four month windows. In computing these returns, we assume that PIPE investors do not convert any

shares, sell any of their equity stake, or short shares of the issuer between the time of the PIPE issue and

the end of the test window. For these reasons, our estimates of investor returns are likely to be

conservative. The Appendix details our estimation procedures. These estimated returns are adjusted by

the size and book-to-market benchmark portfolio used to compute shareholder abnormal returns, although

the results are similar if NASDAQ decile 1 firms or NASDAQ firms with less than $2 million in market

capitalization are used as the benchmark portfolio (Cochrane (2005)).

Estimates of returns to PIPE investors are shown in Table 9. For all categories of PIPEs, average

investor abnormal returns through 6 and 12 months are significantly greater than zero. Through 12

months, average returns are 22% for PDs, 42% for PDWTs and 19% for RESETs. Through 24 months,

average returns are negative for RESETs, but are not significantly different from zero for PDs and

PDWTs. Consistent with positive skewness in the returns, medians returns are generally negative for 12

and 24 months. Overall, the results indicate that contracting terms are such that, on average, PIPE

investors perform on par or better than market benchmarks. When compared to shareholder returns in

33

Table 7, the findings are consistent with the arguments of Hertzel, et. al (2002) that contracting terms can

provide information about an issuer’s true (lower) value.

The skewness in returns can also be seen in the distribution of investor returns to PD and CC

contracts shown in Figure 2. In comparison to the shareholder returns in Figure 1, there is a distinct

rightward shift in the distribution of investor returns − accentuating the importance of the contracting

terms for PIPE investors.

The contracting terms also reduce the differences in returns between the groups. For example,

earlier results show that shareholders of CC issuers substantially underperform PD issuers. The returns to

PIPE investors, however, are similar between these groups. Through 12 months average investor returns

are 22% for PD contracts and 26% for CC contracts. Similarly, earlier results show that shareholders of

issuers of RESETs consistently underperform issuers of PDWT. When we compare the returns to PIPE

investors between these groups, average returns are not significantly different through 12 months, and

median returns are comparable through 6 and 24 months. The findings support the idea that investors

choose contract terms in a manner consistent with their expectations of the issuer’s return.

7. Conclusions

This article uses detailed data on 1,179 Private Investments in Public Equity (PIPEs) to study

financial contracting. We show that the choice of contracting terms varies widely and is associated with

issuer risk. Contracts that only include purchase discounts are often used by the lowest risk issuers and

are rarely used by the highest risk issuers. The use of contracting terms that makes funding or control

contingent on an issuer’s post-issue performance increases with the risk of issuer. Finally, the choice of

contingent contracting terms varies with the type of issuer risk. In particular, terms that can transfer

control to investors are most commonly used by companies that are in the poorest financial condition and

the closest to running out of cash. In contrast, warrants are used by issuers with a greater variability of

returns but have a relatively less urgent need for financing.

34

The findings have several implications for contracting theories and security design. First, the

ability to manage risk purely through the use of purchase discounts appears limited. Although increasing

purchase discounts can address concerns for agency costs and asymmetric information by increasing an

investor’s cushion for error, they do not necessarily reduce these problems. Similar to arguments of

Stiglitz and Weiss (1981), greater purchase discounts can lead to a related set of problems in which both

the quality of the pool of issuers and managerial incentives to control risk taking are reduced. We

conclude that the use of discounts alone can curtail the equity financing available to high risk firms.

Second, both the extent of contracting problems and issuer concerns about investor interference

are associated with the use of contingent terms. Highlighting the importance of contingent terms for

managing contracting problems, we show that contingent terms are common among issuers at higher risk

for contracting problems as measured by proxies for uncertainty of valuation and distress. The fact,

however, that the use of contingent terms is largely limited to this group underscores the preferences of

issuers to fund projects with minimal investor interference. These findings indicate that firms generally

do not use contingent terms unless they have limited alternatives for funding.

Third, our results show an association between the type of issuer risk and the choice of contingent

contracting terms. Although theory provides guidance for when contingent terms will be used, it is less

clear in its predictions for the choice of contingent terms. Theory perceives risk as a continuum and the

point at which concerns related to uncertainty about valuation give way to more extreme concerns for

distress are not clearly defined. We show that the extent of investment uncertainty (i.e., the volatility of

returns around an offering) increases the likelihood of warrants being used. Investment uncertainty,

however, is not associated with the use of resets, which can lead to a greater transfer of control to

investors than warrants. Instead, the use of resets is associated with the financial distress of the issuer.

Resets are most often used by issuers with the most immediate need for capital and consequently those

issuers with the weakest bargaining power. Therefore, although the use contingent contracting terms

35

depends on issuer risk, the choice of which contingent contracting term to use ultimately comes down to

which party has the greater say in the decision.

36

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39

Appendix

Estimating the All-in Net Discount and Returns to PIPE Investors

“All-in Net Discount” to Investors

The all-in net discount to the PIPE investor is an inclusive measure of the value of the equity and

other contract features and embedded options PIPE investors receive in exchange for the funds they

provide to the issuer at the time of the transaction. In general, the net discount is estimated as (I / V0) -1,

where V0 is the sum of the underlying market value of equity investors receive in the company (plus the

value of other securities or payments they potentially receive) and I is the proceeds the issuer receives

from PIPE investors.31

Purchase Discount

For common stock PIPEs, V0 is the sum of the market value of equity and the value of warrants,

if any, granted to the PIPE investors. The market value of equity is the product of the stock price one day

prior to the closing of the transaction times the number of shares issued to the PIPE investor. The number

of shares issued to the PIPE investor incorporates any purchase price discount to the current market price.

For example, in the absence of warrants, a common stock PIPE with a 20% purchase discount to a closing

market price of $10 per share allows an investor to receive 125,000 shares ($1 million/$8 per share) in

return for a $1 million investment. The all-in net discount, (I /V0) –1, in this case is simply [($1 million /

(125,000 shares × $10 per share) – 1] or –20%.

Warrants

For a common stock PIPE issued with warrants, the value of warrants investors receive is added

to the market value of equity to obtain V0. The warrants are valued using the Black-Scholes model

adjusted for the dilution of the warrants (see McDonald (2003)). This value is calculated using the

historical volatility of the stock for a 90 day window ending 10 days before the closing of the PIPE, the

31 The appendix in an earlier version of the paper detailed the estimation process for common stock resets and structured equity lines. Because these contracts are excluded from the main analysis in the current version of the paper, they are omitted from the appendix but are available from the authors.

40

stock price on the day prior to closing, and the yield on six month Treasury bills. As data are not widely

available regarding the expected life of the warrants, we calculate the warrants’ value for maturities

ranging from six months to two years but report the results for an expected life of 1.5 years. For the

issues for which we have data on the warrants’ maturity, the average maturity is 47 months so that the

reported results for 1.5 years are conservative. Based on the statistical properties of the returns around

these offerings, it is unlikely that the assumptions the Black- Scholes model are fully met but we unaware

of any bias this imparts to our results.

Resets

To the best of our knowledge there is no widely accepted model for valuing floating rate

convertibles or convertible resets. Therefore we value these instruments using a building block approach.

For floating rate convertible PIPEs with warrants, V0 is the sum of the market value of the equity that the

bond (or preferred stock) can convert into, the value of any warrants issued to investors, interest or

dividends payments, and the value of the floating rate features on the bond (or preferred stock). The

market value of equity and the value of the warrants are calculated using the same approach described

above. The value of interest or dividend payments is calculated as the product of the interest rate (or

dividend yield) times the proceeds from the investor, I.

We consider several floating rate features. The first floating rate feature is a reduction in

conversion price if the value of the underlying stock decreases after the issue (as the price decreases the

number of shares issued increases.) The payoff structure of this position is similar to having a long put

position to accompany the long stock position. However, as the stock price approaches zero, the value of

this price reset provision dissipates. For example if the company goes bankrupt, the security will also

likely be worthless. Moreover, as the company approaches the point of bankruptcy, uncertainties arise

regarding whether the conversion provision will be fully honored and an investor’s ability to liquidate his

or her shares if the provision is honored. To account for the fact that this reset provision will likely have

no value if the company approaches bankruptcy, we value this floating rate feature as an exotic option

41

referred to as a down-and-out put. With this approach the PIPE investor is assumed to be long a put with a

strike price equal to the market price at the time of issue that will be worthless or “knocked-out” if the

price of the stock drops below a barrier price. In our calculations we use a barrier price of $0.50. This is

roughly the average price at which stocks in our sample are delisted from CRSP either because the issue

was liquidated or dropped from a major exchange. We value this option using an expected life of 0.5, 1,

1.5 and 2 years but report the results only for 1.5 years.

If a security has a “floor” that designates the lowest price at which the stock can be converted, the

investor is considered to be short a put at this floor price. The size of the short position is set equal to the

size of the investor’s long put position. The result is a position similar to a put spread in which the value

of the price protection is capped by the difference between the closing market price and the floor price.

The second floating rate feature is a cap that limits the increase in the conversion price if the

value of the underlying stock increases after issuance (the number of shares issued does not change if the

stock price increases). For example a cap allows the conversion price of the bond to increase up to 20%

above the market price of the stock at closing. In this case, if the market price of the stock at the time of

issue is $5, the conversion price of the bond will increase as the stock price increases, but will not exceed

$6. We view this provision as a call spread in which the investor is long a call with a strike price equal to

the cap, and short a call at the closing market price.

We value these floating rate features using a Black-Scholes model or variations of this model

(See Hull (2003) or McDonald (2003)) for a description of the valuation of the down-and-out put.) In

making these calculations we use the previously described historic stock price volatility, stock price one

day prior to closing, six month yield on Treasury Bills and an expected life of 0.5, 1, 1.5 or 2 years.

Our estimates of the discount are not highly sensitive to alternative assumptions regarding the

expected life of the embedded options, warrants or the barrier price (i.e., the price at which the protection

provided by the floating rate feature loses its value). The data we have for the contracts and our estimates

cannot fully capture the dynamics or adjustments investors make in the management of their positions.

42

Absent detailed knowledge of investors’ positions in these securities, we believe our estimates provide a

reasonable indication of the value of these securities based on the available public information.

Estimates of the Realized Returns to PIPE Investors

We estimate the returns realized by PIPE investors at the end of holding periods ranging from

three to 24 months following issue assuming that investors have not liquidated any of their position or

taken offsetting positions (i.e., shorted shares to hedge the PIPE). The return to the PIPE investors is

calculated as: (Ve / I) –1. I represents the original investment made in the PIPE issuer. Ve is the sum of

the value of the underlying shares and the intrinsic value of warrants investors hold at the end of 3, 6, 12,

18, or 24 month holding periods, and any interest (or dividends) they receive over the same interval.

The value of the underlying shares is the number of shares held by the investor at the end of a

holding period (henceforth Se) times the share price at the end of the same holding period (henceforth Pe).

With respect to Se, there is no adjustment necessary to the initial number of shares received by investors

for common stock PIPEs. However, for floating rate convertibles and convertible resets the number of

shares initially granted to PIPE investors can change after the offering. For floating rate convertibles and

convertible resets, we calculate Se as I, the initial investment, divided by the lesser of Pe × (1- discount %

(if any)) or the maximum conversion price.32 For example, assume I = $1 million, a purchase discount of

10%, and a maximum conversion price of $10. If Pe = $12, the investor will receive 100,000 shares ($1

million / $10), because $10 is less than $12×(1–10%) = $10.8. Alternatively, if Pe=$8.89, the investor will

receive 125,000 shares ($1 million / ($8.89×(1-10%)). This methodology assumes that the repricing

provisions affect the number of shares issued rather than the other terms of the PIPE. This assumption is

based on the details of the PIPE contracts and conversations with technical analysts at Placementtracker.

32 The maximum conversion price is calculated using the variable labeled as “fixed conversion price” or “ceiling” in Placementtracker. Discount is calculated using what is referred to as the “variable conversion price” or “floating conversion price” in Placementtracker.

43

To the ending value of equity, we add the intrinsic value of the warrants. The intrinsic value of

the warrants is calculated as Pe minus the strike price of the warrants (less applicable discounts) times the

number of warrants held by investors. Finally, we add the appropriate interest (or dividend) payments

received by investors over the respective holding period to complete the calculation of Ve.

Finally, if the stock is delisted or is trading below $0.50 at the end of the period, we assume that

contracting terms of the PIPE contract will not be honored and no longer have value at this point. In these

cases, we ignore the terms of the PIPE contract and set the return to PIPE investors equal to the return

earned by existing shareholders. For delisted firms, these returns are calculated using CRSP’s delisting

return in the month of delisting and a zero percent return in the remaining months of the sample period.

An exception to this approach is if the PIPE issuer is delisted due to merger or acquisition. In these cases,

we assume the PIPE contract will be honored at the time of the acquisition and calculate PIPE returns

through the acquisition date based the stock price at the time of the acquisition. We then assume zero

percent returns on the PIPE contract for the remaining months of the sample period and adjust these by

the returns on the benchmark portfolio. Results are similar, although slightly greater, if we use different

assumptions for returns if issuers are delisted or if we relax the $0.50 threshold assumption.

44

Table 1

Private Placements of Public Equity 1995 – 2000

The table reports the number of issues and the amount raised ($ million) by Common Stock PIPEs, Floating Rate Convertibles, and Convertible Resets between 1995 and 2000. PIPEs are sorted into categories based on their underlying contract terms. As all contacts contain a purchase discount the categories are based on the terms added. Common Stock PIPEs with only a purchase discount are denoted “PD” and Common Stock PIPEs that also include warrants are denoted “PDWT.” Floating Rate Convertibles and Convertible Resets, both with or without warrants, are denoted as “RESET.”

1995 1996 1997 1998 1999 2000 1995-2000

Contract Terms

N Amount N Amount N Amount N Amount N Amount N Amount N TOTAL PCT

Purchase Discount-only (PD)

35 $341 62 $1,243 75 $1,056 61 $489 137 $1,888 197 $8,132 567 $13,149 57%

Discount & Warrants (PDWT)

18 $68 30 $132 31 $221 41 $270 102 $740 120 $1,107 342 $2,535 11%

Resets (RESET)

30 $230 156 $1,468 232 $1,859 194 $1,114 126 $954 122 $1,708 860 $7,333 32%

TOTAL 83 $639 248 $2,843 338 $3,136 296 $1,873 365 $3,582 439 $10,947 1,769 $23,020 100%

45

Table 2 Contract Terms of PIPEs

Contract features are shown for the categories of PIPEs and the sample described in Table 1, with an additional condition that the issuer has data on Compustat. Median values are below the average values. Purchase Discount is the ratio of the purchase price or conversion price to the market price minus one. Interest /Dividend Rate is the yield stated in the PIPE contract. Payment can often be in kind. Warrant Coverage is the number of warrants issued scaled by the number of shares purchased or by the number of shares the PIPE would convert into. Warrant Premium or Discount is only computed for PIPEs with warrants. Warrant Ratio is the proceeds the issuer will receive if all warrants issued with the PIPE are converted scaled by the offer proceeds. Warrant coverage, premium, and ratio are computed only for PIPEs with Warrants. Percent with Floors is the percent of issues that include a minimum conversion price. Floor Discount is the minimum price as percent of market price at time of the offering and is computed only for PIPEs with floors. Cap is the maximum conversion price as a percent of the market price at time of the offering. All-in Net Discount values the purchase discount, warrants, repricing rights, floors, and caps. See the Appendix for the estimation procedure. Total Proceeds ($MM) are the proceeds from the PIPE offering, excluding any proceeds if warrants are exercised. Proceeds to Market Value is the ratio of total proceeds to the market value of equity. Days to Liquidate is the ratio of the number of shares issued (excluding warrants) to average daily trading volume. For convertible securities it is the number of shares the security can convert into at the market price at closing. Values are winsorized at the 1% and 99% levels.

Contract Type PD PDWT RESET

Purchase Discount -18.7% -15.0%

-17.3% -14.0%

-13.2% -15.0%

Interest / Dividend Rate 0 0 5.5% 6.0%

Percent with Payment of Interest 0 0 84.8% Percent with Warrants 0 100% 45.5% Warrant Coverage 63.4%

50.0% 43.9% 28.0%

Warrant Premium or Discount 14.8% 9.0%

17.5% 17.0%

Warrant Ratio 90.6% 62.7%

57.4% 37.6%

Percent with Floors 21.7%

Floor Discount -43.0% -43.0%

Cap 9.4% 2.0%

All-in Net Discount -18.7% -15.0%

-32.3% -30.2%

-29.9% -30.2%

Total Proceeds ($MM) 20.2 10.0

8.3 4.5

8.5 5.0

Proceeds to Market Value 20.7% 12.6%

19.1% 12.2%

16.2% 9.5%

Days to Liquidate 37.2 17.6

52.1 20.2

29.4 15.1

N 382 235 559

46

Table 3

Pre-Issue Characteristics of PIPE Issuers

The table shows summary statistics for sample of PIPE issuers. Unless otherwise noted, data are for year –1 relative to the PIPE offering. RR(–12,–1) is the cumulative raw stock returns from month –12 to month –1. CAR(–12,–1) is the cumulative abnormal stock return from month –12 to month –1 adjusted by a market benchmark based on size and book-to-market. Return on Assets is cash flow from operations (Computstat Data #308) ÷ total assets. %Negative Operating Income is the fraction of firms with cash flow from operations less than $0. % No_Sales is the fraction of firms with sales less than $1 million. Years of Cash is computed as the absolute value of cash and cash equivalents ÷ cash flow from operations. This is only computed for companies with negative cash flow from operations. The variable indicates the length of time in years the company can continue funding operations using current cash. Debt to Assets is long term debt plus the debt in current liabilities ÷ total assets. Total Assets ($MM) is the book value of assets. Market Capitalization ($MM) is the market value of equity. Book to Market is the book value equity plus deferred taxes minus the liquidating value of preferred stock ÷ market value of equity. SDRET is the annualized standard deviation of stock returns based on returns from day –260 to –10. Intangible Assets are the balance sheet intangible assets ÷ total assets. R&D Expenditures is R&D Expenditures ÷ Operating Expenses. Age is the time (in years) from founding to the year of the PIPE issue. Values are winsorized at the 1% and 99% levels.

N Mean Median Standard

Deviation 25th

Percentile 75th

Percentile RR(–12,–1) 914 0.45 -0.02 1.43 -0.41 0.73

CAR(–12,–1) 914 0.20 -0.19 1.38 -0.56 0.44

Return on Assets 1,141 -0.39 -0.26 0.50 -0.57 -0.07

%Negative Operating Income 1,141 0.84 - 0.36 - -

% No_Sales 1,176 0.22 - 0.42 - -

Years of Cash 962 1.61 0.84 2.39 0.30 1.78

Debt to Assets 1,150 0.19 0.10 0.22 0.01 0.30

Total Assets ($MM) 1,153 $54.11 $18.21 $133.24 $8.06 $44.94

Market Capitalization ($MM) 1,130 $150.47 $50.48 $350.10 $21.70 $121.40

Book to Market 1,127 0.25 0.17 0.34 0.06 0.34

SDRET 1,175 1.06 0.94 0.49 0.78 1.25

Intangible Assets 979 0.09 0.00 0.15 0.00 0.11

R&D Expenditures 878 0.30 0.21 0.28 0.08 0.48

Age 1,028 12.74 10.00 10.82 7.00 15.00

47

Table 4

The Use and Choice of Contingent Contract Terms

Mean and median values are shown for characteristics of the issuers. BURN is as the value of cash and cash equivalents ÷ cash flow from operations. More negative values indicate less time before running out of cash. Short Constrained is a dummy variable equal to 1 if a firm’s Short Interest ÷ Shares Outstanding is greater than its %Institutional ownership. Other variables are defined in Tables 2 and 3. Panel A shows PIPEs that only include a Purchase Discount (PD) and PIPEs with Contingent Claims (CC). Panel B separates the PIPEs by the type of contingent claim used. PDWT are contracts that include a purchase discount and warrants and RESET are contracts that include a purchase discount and repricing rights. Significant tests are reported for the differences in mean and medians between the groups. The *, **, *** indicates the difference between groups is significant at the 10%, 5%, and 1% levels respectively. Values are winsorized at the 1% and 99% levels.

Panel A: Use of Contingent Claims PD Only CC Tests of Differences

PD vs CC Mean Median Mean Median Mean Median RR(–12,–1) 0.83 0.24 0.27 -0.11 5.06*** 6.35*** CAR(–12,–1) 0.51 -0.00 0.05 -0.28 4.27*** 4.62*** Return on Assets -0.34 -0.17 -0.42 -0.29 2.47** 3.69*** %Negative Operating Income 0.78 - 0.87 - -3.60*** - % No_Sales 0.21 - 0.23 - -0.42 - BURN -2.44 -0.61 -6.23 -1.10 4.16*** 6.90*** Debt to Assets 0.17 0.07 0.19 0.11 -1.67* -2.05** Total Assets ($MM) $84.40 $22.67 $39.45 $16.47 4.24*** 4.55*** Market Capitalization ($MM) $230.97 $77.12 $112.06 $43.34 4.37*** 5.32*** Book to Market 0.27 0.18 0.23 0.16 1.86* 2.08** SDRET 1.03 0.92 1.08 0.95 -1.37 -1.58* Intangible Assets 0.07 0.00 0.09 0.01 -2.60** -3.29*** R&D Expenditures 0.37 0.28 0.27 0.20 4.50*** 4.34*** Age 12.77 10.00 12.73 11.00 0.05 -0.03 Short Constrained 0.03 - 0.16 - -5.74*** - N 382 794

48

Table 4 (continued)

Panel B: Choice of Contingent Claim PDWT RESET Tests of Differences

PDWT vs. RESET Mean Median Mean Median Mean Median

RR(–12,–1) 0.46 -0.08 0.19 -0.13 2.27** 2.15** CAR(–12,–1) 0.19 -0.19 -0.01 -0.29 1.79* 1.65* Return on Assets -0.44 -0.33 -0.41 -0.29 -0.85 -0.63 %Negative Operating Income 0.86 - 0.88 - -0.70 - % No_Sales 0.26 - 0.21 - 1.27 - BURN -3.37 -0.89 -7.41 -1.19 3.39*** 2.24** Debt to Assets 0.17 0.06 0.21 0.14 -2.50** -3.32*** Total Assets ($MM) $33.68 $12.85 $41.83 $17.71 -1.22 -2.81*** Market Capitalization ($MM) $94.69 $37.76 $119.21 $47.38 -1.42 -2.70*** Book to Market 0.26 0.16 0.22 0.16 1.09 1.10 SDRET 1.10 1.02 1.07 0.93 0.88 2.11** Intangible Assets 0.08 0.00 0.10 0.01 -1.24 -2.04** R&D Expenditures 0.31 0.23 0.26 0.19 1.98** 2.19** Age 13.20 10.00 12.50 11.00 0.72 0.08 Short Constrained 0.12 - 0.17 - -1.41 - N 235 559

49

Table 5 Contract Terms Sorted by Issuer Risk

This table shows the use of contracting terms sorted by proxies for financial condition and investment uncertainty. Each issuer is assigned to a quartile using a two way sort on whether cash burn rate (BURN) or the standard deviation of stock returns (SDRET) is above (high) or below (low) the median of all issuers.

Q1: LOW BURN RATE / LOW SDRET Q3: HIGH BURN RATE/LOW SDRET Q2: LOW BURN RATE / HIGH SDRET Q4: HIGH BURN RATE/HIGH SDRET

BURN is a proxy for financial condition. High (low) BURN rate indicates the company has less (more) time until it runs out of cash. SDRET is a proxy for investment uncertainty. High (low) values of SDRET indicate that the company’s stock returns leading up to the offering are more (less) volatile. A binomial distribution statistic tests whether the frequency of observations (N) is equally distributed with respect to BURN and SDRET. The *, **, *** indicates significance at the 10%, 5%, and 1% levels respectively.

BURN

SDRET Low

Rate High Rate

N

Z-stat for N SDRET,

low = high Panel A: ALL PIPEs

BURN SDRET

Low

N

-0.23 0.77 302

-2.24 0.80 266

568 BURN SDRET

High

N

-0.32 1.24 267

-2.79 1.27 305

572

-0.12

N 569 571 Z-stat for N BURN, low=high -0.06

Panel B: PD Only BURN SDRET

Low

N

-0.17 0.74 120

-1.63 0.62 70

190 BURN SDRET

High

N

-0.32 1.22 109

-2.24 1.33 69

178

0.63

N 229 139 Z-stat for N BURN, low=high 4.69***

Panel C: PDWT BURN SDRET

Low

N

-0.38 0.80 45

-1.82 0.55 49

94 BURN SDRET

High

N

-0.27 1.26 66

-2.80 1.24 66

132

-2.53***

N 111 115 Z-stat for N BURN, low=high -0.27

Panel D: RESET BURN SDRET

Low

N

-0.36 0.77 137

-2.43 0.78 147

284 BURN SDRET

High

N

-0.36 1.27 92

-3.39 1.27 170

263

0.94

N 230 317 Z-stat for N low=high, BURN -3.77***

50

Table 6

Multivariate Analysis of the Choice of Contracting Terms

The table shows the results of logistic regressions. The independent variables are the measures of issuer risk described in Tables 4 and 5. The dependent variable in the first model is set equal to 1 if the contract includes contingent claims (CC =1) and to 0 if it only includes a Purchase Discount (PD). The dependent variable in the second model is set equal to 1 if the contract includes a reset (RESET) and to 0 if it only includes a Warrant (PDWT). RESET includes contracts with and without warrants. The second model excludes PD contracts. BURN dummy is set equal to 1 if cash burn rate is above sample median and to 0 if it is below the median. SDRET dummy is set equal to 1 if standard deviation of returns is above sample median and to 0 if it is below the median. Other variables are defined in Tables 3 and 4 and winsorized at the 1% and 99% level. P-values are reported in parenthesis. ***, **, * indicates values are significantly different from zero at the 1%, 5%, and 10% level, respectively.

Dependent Variable

CC=1, PD=0

RESET=1, PDWT=0

Intercept 3.13***

(<0.01) 0.94*

(0.06) CAR(–12,–1) -0.27***

(<0.01) -0.15* (0.07)

BURN dummy 0.49** (0.02)

0.48** (0.04)

Return on Assets -0.11 (0.63)

0.26 (0.28)

Intangible Assets 2.81*** (0.01)

0.65 (0.39)

Log Market Capitalization -0.39*** (0.01)

0.15 (0.11)

Book to Market -0.33 (0.23)

-0.09 (0.75)

SDRET dummy -0.13 (0.47)

-0.50** (0.02)

Log Days to Liquidate -0.25*** (0.01)

-0.23*** (0.01)

Pseudo R2 0.09 0.05 N (1/0) 501/242 343/158

51

Table 7

Distribution of Post-Issue Returns to Non-PIPE Shareholders

The table shows the distribution of returns to non-PIPE shareholders of issuers following a PIPE offering. Returns are equally weighted buy-and-hold from the month of the announcement of the PIPE offering (month zero) through 6, 12, and 24 months following the announcement. RR indicates raw returns. CAR indicates abnormal stock returns that are computed as the difference in returns between the sample firm and a portfolio matched on size and book-to-market. Companies that are delisted during the sample period are assigned CRSP’s delisting return in the month of the delisting and a 0% return in the remaining months of the sample period. SDRET is the standard deviation of returns across issuers. p-values are shown in parentheses. ***, **, * indicates differences between groups are significant at the 1%, 5%, and 10% level, respectively. Panel A: Use of Contingent Claims

  RR(0,+6) RR(0,+12) RR(0,+24) CAR(0,+6) CAR(0,+12) CAR(0,+24)

Purchase Discount-only (PD)  Mean 0.11 0.04 -0.10 0.05 -0.05 -0.27 (0.04) (0.54) (0.18) (0.28) (0.35) (0.01) Median -0.12 -0.33 -0.56 -0.16 -0.36 -0.63 (0.01) (0.01) (0.01) (0.01) (0.01) (0.01) SDRET 0.95 1.16 1.34 0.88 1.12 1.30 25th Pct -0.45 -0.68 -0.87 -0.51 -0.74 -1.01 75th Pct 0.33 0.27 0.03 0.26 0.18 -0.06 N 353 351 346 353 351 346 Contingent Claims (CC) Mean -0.04** -0.14** -0.19 -0.08** -0.23** -0.42* (0.24) (0.01) (0.01) (0.02) (0.01) (0.01) Median -0.29*** -0.46*** -0.64** -0.28*** -0.46*** -0.76*** (0.01) (0.01) (0.01) (0.01) (0.01) (0.01) SDRET 0.98 1.07* 1.30 0.90 1.03* 1.28 25th Pct -0.57 -0.74 -0.89 -0.57 -0.78 -1.09 75th Pct 0.08 0 -0.13 0.04 -0.08 -0.27 N 706 703 690 706 703 690

52

Table 7 (continued) Panel B: Choice of Contingent Claim

  RR(0,+6) RR(0,+12) RR(0,+24) CAR(0,+6) CAR(0,+12) CAR(0,+24)

Warrant only (PDWT) Mean 0.18 -0.00 -0.03 0.11 -0.12 -0.23 (0.02) (0.95) (0.76) (0.11) (0.13) (0.03) Median -0.12 -0.33 -0.52 -0.14 -0.37 -0.68 (0.06) (0.01) (0.01) (0.01) (0.01) (0.01) SDRET 1.09 1.14 1.51 0.99 1.10 1.49 25th Pct -0.44 -0.67 -0.83 -0.46 -0.74 -0.99 75th Pct 0.41 0.23 -0.01 0.33 0.12 -0.16 N 206 205 201 206 205 201 RESET

Mean -0.14*** -0.19** -0.26* -0.16*** -0.27* -0.50** (0.01) (0.01) (0.01) (0.01) (0.01) (0.01) Median -0.34*** -0.50*** -0.67*** -0.34*** -0.48*** -0.78*** (0.01) (0.01) (0.01) (0.01) (0.01) (0.01) SDRET 0.92*** 1.04 1.19*** 0.85** 1.00* 1.18*** 25th Pct -0.61 -0.76 -0.90 -0.61 -0.81 -1.12 75th Pct -0.02 -0.10 -0.18 -0.05 -0.15 -0.36 N 500 498 489 500 498 489

53

Table 8

Rate of Delisting following PIPE offerings

The table shows the fraction of the issuers delisted through 6, 12, and 24 months following the announcement of a PIPE offering. ***, **, * indicates differences between groups are significant at the 1%, 5%, and 10% level, respectively.

(0,+6) (0,+12) (0,+24)

Use of Contingent claims Purchase Discount-only (PD) 0.00 0.04 0.15

Contingent Claims (CC) 0.04*** 0.11*** 0.26***

Choice of Contingent Claim Warrants only (PDWT) 0.02 0.04 0.19

RESET 0.05** 0.14*** 0.29***

54

Table 9

Post-Issue Abnormal Returns to PIPE Investors

Returns to PIPE Investors incorporate purchase discounts, warrants, repricing rights, or interest on the security. For the procedure used to estimate investor returns, see the Appendix. Buy-and-hold abnormal stock returns are equally weighted and calculated as the difference in investor returns and a portfolio matched on size and book–to-market (ICAR). p-values indicating whether a value is different from zero are shown in parentheses under the mean and median. Values are winsorized at the 1% and 99% levels. ***, **, * in the last two columns indicates that differences between groups are significantly different from zero at the 1%, 5%, and 10% level, respectively.

Panel A: Use of Contingent Claims PD CC Tests of Differences N Mean Median N Mean Median Mean Median ICAR(0,+6) 353

0.40

(0.01) 0.04

(0.59)706

0.43 (0.01)

0.13 (0.01)

*

ICAR(0,+12) 351

0.22 (0.01)

-0.20 (0.01)

703 0.26 (0.01)

0.00 (0.82)

**

ICAR(0,+24) 346

-0.08 (0.34)

-0.57 (0.01)

690 -0.06 (0.34)

-0.42 (0.01)

Panel B: Choice of Contingent Claims PDWT RESET Tests of Differences N Mean Median N Mean Median Mean Median ICAR(0,+6) 206

0.81

(0.01) 0.04

(0.37)500 0.27

(0.01)0.14

(0.01)***

ICAR(0,+12) 205

0.42 (0.01)

-0.23 (0.01)

498 0.19(0.01)

0.08(0.01)

***

ICAR(0,+24) 201

0.21 (0.18)

-0.59 (0.01)

489 -0.17(0.01)

-0.34(0.01)

**

55

0

2

4

6

8

10

12

14

-1

-0.9

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1 0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9 1

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

1.9 2

2.1

2.2

2.3

2.4

2.5

2.6

2.7

2.8

2.9 3

Returns (%)

Frac

tion

of s

ampl

e (%

)

PD CC

<0%

Figure 1. Distribution of Post-Issue Abnormal Stock Returns to non-PIPE Shareholders Shareholder abnormal returns (CAR) are cumulated from the date of the closing of the PIPE to the end of month +12. The sample includes PIPEs issued between 1995 and 2000 by companies that are in the CRSP database. The figure separates the returns for purchase discount-only PIPEs (PD) and PIPEs with contingent claims (CC).

56

0

1

2

3

4

5

6

7

8

9

-1

-0.9

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1 0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9 1

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

1.9 2

2.1

2.2

2.3

2.4

2.5

2.6

2.7

2.8

2.9 3

Returns (%)

Frac

tion

of s

ampl

e (%

)

PD CC

<0%

Figure 2. Distribution of Post-Issue Abnormal Stock Returns to PIPE Investors Investor abnormal returns (ICAR) are cumulated from the date of the closing of the PIPE to the end of month +12. The sample includes PIPEs issued between 1995 and 2000 by companies that are in the CRSP database. Estimated returns to PIPE investors are calculated using an approach described in the Appendix. The figure separates the returns for purchase discount-only PIPEs (PD) and PIPEs with contingent claims (CC).