A PIPE involves the sale of a public company’s equity to accredited private investors, usually at a discount of about 10-20% from the market price. Because a PIPE is a private investment, it does not require registration with the Securities and Exchange Commission, can be completed quickly, and involves less administrative expense than would be the case for a large public offering. Since stock is sold in large blocks under this method, a company tends to gain larger, more long-term investors, especially if the issuing company sells the shares directly, and so can select which investors it wants.
However, some PIPE agreements also require a company to pay out additional shares if its stock price falls within a certain time period, which can result in a considerable level of ownership dilution for other investors. It may also be necessary to sweeten the PIPE deal with warrants or a variety of conversion options that are highly favorable to the investor. Another problem arises when an investment bank is used to find investors, since the company no longer has control over who is buying its shares, which may result in an investor pool with short-term cash-out expectations. This last problem can be handled to some extent by forcing investors to sign lock-up agreements under which they will not sell their shares for a certain period of time.
The worst-case scenario when a PIPE is used is when the PIPE agreement grants more shares to investors when the common stock price declines. When manipulated by short selling, a company may find that its share price declines precipitously, requiring more stock to be issued, followed by more short selling, and so on, until the company’s ownership shifts to the PIPE investors. This is known as a “death spiral” PIPE. To avoid this problem, the PIPE agreement should specify a floor price below which no further shares of compensatory stock will be issued to investors.