Junk Bonds Were A Farce...... Welcome to 2001

Desperately Seeking Financing
                    Wednesday, June 13, 2001
                    Cory Johnson

                    The first thing to go was the money. After it gushed out of the stock market last year, institutional investors turned up their noses at IPOs while venture capitalists turned from ingratiating to indifferent. Now desperate times call for desperate financing. Companies are resolved to go to hell and back to get the money they need to push forward. In some cases, it turns out to be more thana figure of speech.

                    In this post-IPOcalyptic world, financing can be complex and brutal, and companies can face a beating that is more medieval than modern. Some are resorting to high-risk tricks to raise money - tactics that carry colorful names such as the cram-down, liquidation-preferenced bridge loans, bought deals and death-spiral convertibles. They are dangerous, some say foolhardy measures.

                    But these are tumultuous times: Since January 2000, 209 companies have entered  TheStandard.com's Flop Tracker, which tallies Internet and technology firms that have pulled the plug.

                    It's a far cry from a few years ago, when the terms of new-economy financing were so well understood. It was the definition of modern times:Venture deals begat IPOs begat millions of dollars. But terms have changed.

                    "Without the option of an IPO, people are forced to find more creative financing," says Greg Soukup, co-director of Ernst & Young's West Coast-based mergers and acquisitions practice. "We've seen a lot of that in the last year, where companies can't get the money they want on the terms they want."

                    The harsh truth is that companies aren't worth what investors once paid for them - something that's never more apparent than when a company is broke and desperate. And that is precisely when any salvation comes with strings attached. Complex deals, which can be dilutive if not destructive essentially fill the gaps between what companies need to survive and what the market is willing to offer. "The fact people are doing these hard-core deals means there aren't a lot of people doing deals at all," says Charles Lax, general partner of Softbank Capital Partners. "Right now, this is the only game in town."

                    Herewith are the tools of a desperate trade.

                    Take It to The Bridge The bridge loan is nothing new; it's a cushion for an unexpectedly tough time. But with new-economy companies going under at a
rate of more than five a week, bridge loans are being constructed with more conflict and implicit self-destruction than any bridge since the one built on the River Kwai.

                    "A good friend came to me recently trying to get me in on a bridge loan deal," says one hedge-fund manager in San Francisco. "And I said to him, 'A
bridge? A bridge to what?'"

                    It's become common for bridge loans to come with a catch - chief among them the liquidation preference. A liquidation preference ensures that the
bridge-loan lender is first in line to get paid when a company is sold - and often at a steep premium to the amount lent. Some bridge loans demand that companies repay the principal several times over. It's not quite loan-sharking, but it's not far off.

                    "We're seeing deals happen at extremely onerous rates, as high as 30 percent plus warrants that give the holder a significant equity stake" says Greg
Soukup, a veteran mergers and acquisition specialist with Ernst & Young. "But these companies are close to bankruptcy. The people making the bridge loan want to make sure that they're going to get their money back."

                    In the case of Livemind, a now-defunct San Francisco-based wireless startup, a bridge loan was the final blow, even though the money was never lent. Last February, Livemind CEO Karen Wilson was negotiating to sell the company, but was rapidly running out of money. She reportedly hoped a $3 million loan would buy some time.

                    Livemind got that loan from its chief backer, VC firm Technology Crossover Ventures of Palo Alto, Calif. But liquidation preferences guaranteed Technology Crossover a huge premium if Livemind was sold. The premium: a $12 million return on a $3 million loan. When employees at Livemind found out that their shares would be dramatically diluted because of the loan, many staffers threatened not to return to work. In the end, Technology Crossover Ventures didn't make the loan, and the company went out of business.

                    Technology Crossover couldn't be reached for comment.

                    The Cram-Down Cram-down rounds are about as uncomfortable and difficult as they sound. The very nature of these deals is stealthy: They're designed to repair reputations and avoid the embarrassment of public losses. As such, few companies or VCs are willing to talk about them.

                    The cram-down is a financing scheme where a needy company gets money only if it agrees to restate the value of earlier investment rounds. Say Acme Technologies raises an early round worth $10 million, with 2 million shares at $5 a share. The investors obviously expect those shares to increase in value.

                    But later, when Acme needs more money, times have changed; Acme can sell only another 2 million shares for $4 a share - an $8 million round.
What of the first round investors? They'll have to take a loss, marking down their original investment to Acme's current value of $4 a share.

                    This goes over poorly with the venture capitalists, since they are, after all, entrusted by investors to make money, not rack up losses. And imagine the
predicament of explaining why a company that wasn't worth the initial $10 million is now worth another $8 million. Following good money with bad is one of the cardinal sins of investing, and can lead wealthy investors to pull their money out of venture funds.

                    The solution? A cram-down, in which venture capitalists refuse to invest unless earlier investors retroactively lower the value of their investment. So
unless the earlier investors are able to pony up new cash for the new round, their interest in the company is essentially "crammed down." It can lead to tense and protracted transactions - some early investors might want out, others might want new stock for free. But in the end, it gives the company money to fight on and early investors a chance to save face.

                    "It's a way to avoid a bad thing," says Richard Ling, CEO of AlterEgo, a Redwood City, Calif.-based wireless middleware startup considering a type of cram-down for its next financing round. "A down round without some restructuring of earlier rounds can
be a bad deal for both the company and the investors."

                    At first blush, companies that are hurting might not look like the kind of companies worth investing in. But it's not the worst fate a startup can suffer. "Hey, the companies doing cram-downs are the good ones," says Michael Fitzsimmons, who runs the San Francisco-based Lodestone Investment fund and has invested in a handful of cram-downs. "At least they can get the money."

                    The Bought Companies that are already public also find themselves in need of money. Even if the company is profitable, big projects can cost big bucks. The traditional method for raising capital might be a secondary stock offering. But secondary offerings require a stable or, ideally, a rising stock price. They also take time. The road shows required to sell new shares to the world's investing community can take several weeks at best. It's time spent away from the very deals that might sustain a business.

                    Unlike an IPO, the price of a secondary is directly tied to the price of the existing shares. In today's extremely volatile markets, a company might start its secondary offering with its stock in the $40s and finish with its stock in the teens.

                    Lately, a few firms have been relying on gutsy investment banks to finance what's known as a "bought." It's a one-day, one-stop-shopping stock offering. There's no diversified group of shareholders here. All shares in the offering have only one buyer: the bank underwriting the deal. For the bank, it's a chance to make a quick underwriting fee - sometimes upwards of $10 million - as well as commissions when it unloads all those shares to investors.

                    But the bank faces a huge risk. It's betting millions of dollars that the stock won't fall as long as it holds the offering's shares. While the clock ticks, factors completely out of a firm's control can tank the stock: an earnings surprise from a big customer or a key company in the same sector; natural calamities; Dick Cheney's fragile heart. With a bought, there's no insuring against acts of God.

                    Last June, Thomas Weisel Partners did a $526 million bought for Jabil Circuit, taking on 13 million newly minted Jabil shares overnight. Long before the sun came up over Weisel's trading floor, sales traders were working the phones, shouting out every big sale as the firm unwound its massive position. By day's end, the stock was down just a quarter of a point; Weisel had earned about $17 million; and Jabil Circuit had a huge chunk of changeto weather what proved to be a tough year.

                    Yet say Jabil's stock had plunged for reasons beyond its control. After Sun Microsystems, a tech company with little relationship with Jabil, warned of
weak earnings May 29, Jabil shares fell 11 percent overnight. Tech investors well know a single stock can drive down most of the sector. An 11 percent slide would have left Weisel with a $59 million loss.

                    Few investment banks have the capital or the cojones to do these deals. Goldman Sachs, Merrill Lynch, Morgan Stanley and Weisel are among them. The beneficiaries have been companies like Cable & Wireless, Exodus, Greka Energy and Tektronics,but most of these stocks saw declines during their overnight boughts.

                    "For a firm to do this," says Mark Shafir, Weisel's director of investment banking, "you have to know exactly how strong demand is for this stock and
you have to know it better than anybody on the Street."

                    Gauging that demand incorrectly can be damning to a firm. Credit Suisse First Boston and UBS Warburg have reportedly been jammed with big chunks in boughts they were unable to pawn off on investors fast enough. Both firms say they've sold their positions in the deals. Any bank that fails to do so can expect little sympathy for its inability to understand its own market.

                    The Death-Spiral Convertible A convertible bond is part bond, part stock option. It pays interest like a bond, but it can be exchanged for stock. A
death-spiral is a privately held convertible with a catch: Investors are guaranteed against losses.

                    Written into the fine print is a trigger that will issue new shares to bondholders if the underlying stock falls far enough. In effect, it boosts the equity of the bondholder while destroying the equity of the stockholder.

                    Where's the spiral part? When a falling stock triggers the issuance of new shares, it dilutes the existing shares, causing the stock to fall further,
which issues new shares and so on. The toxic nature of these deals has hastened the fall of Drkoop.com, eFax, eGain, eToys, Stan Lee Media and Value America, among others.

                    Companies that do these deals are very desperate, very stupid or very both. "If the stock goes up, these deals work out for everyone," says Rana Mookherjee, a convertible specialist with J.P. Morgan H&Q. Sometimes an investor will buy a convertible bond while secretly shorting the stock, betting heavily on the company's decline. When the stock falls, the investor profits not just from the short sale, but has his equity in the company increase as provided by the death spiral.

                    "The way these deals are structured, they lend themselves to abuse," says Mookherjee.

                    What Now? These are a sampling of the complicated deals being done - and they're painted in broad strokes. Devils are indeed in the details.

                    An odd aspect of the public markets this year has been the refusal of money managers to invest big, even as their funds are growing. Until the markets
start to loosen, most investors expect the complexity of investment rounds to increase. But this too will end.

                    And when that day comes, investing will probably return to its simpler ways. For many, it can't happen too soon.

                    "All this talk of funky deals has obscured the most important part of being a venture capitalist," says Gregory Waldorf, general partner of Charles River
Ventures. "What I care about - all I care about - is investing in great entrepreneurs building great companies."

                    If only finance today could be so simple.