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DBL%20Hendrix%20small.png College chemistry, 1983

Derek Lowe The 2002 Model

Dbl%20new%20portrait%20B%26W.png After 10 years of blogging. . .

Derek Lowe, an Arkansan by birth, got his BA from Hendrix College and his PhD in organic chemistry from Duke before spending time in Germany on a Humboldt Fellowship on his post-doc. He's worked for several major pharmaceutical companies since 1989 on drug discovery projects against schizophrenia, Alzheimer's, diabetes, osteoporosis and other diseases. To contact Derek email him directly: derekb.lowe@gmail.com Twitter: Dereklowe

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In the Pipeline

« Your Press Release Has Already Been Written | Main | Part Eleven? Really? »

November 16, 2012

That's Where The Money Is

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Posted by Derek

Continuing with some more short links for today, those of you who are interested in what small-stock operators can get up to will enjoy this one, from Adam Feuerstein. What should have been about a $50 million dollar infusion of cash for a small nutritional-supplement company turned into an $18 million dollar infusion of cash. Where, you ask, did the rest of the money go? Read the fine print, and remember, this sort of thing goes on a lot, although it's rarely quite so blatant as this cynical rip-off. Something to keep in mind when you hear about a distressed small company being "rescued".

Comments (7) + TrackBacks (0) | Category: Business and Markets


COMMENTS

1. tryingtobeamused on November 16, 2012 11:47 AM writes...

Same behaviour as has been so evident over the last few years.


“Wall Street CEOs -- the same ones who wrecked our economy and destroyed millions of jobs -- still strut around Congress, no shame, demanding favors, and acting like we should thank them,”

-- Elizabeth Warren

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2. Molecular Geek on November 16, 2012 12:25 PM writes...

One more reason that those aspiring to industrial employment need to learn enough about finance and law to recognize how badly their management is screwing them and their research when these kind of games get played.

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3. Mark on November 16, 2012 3:17 PM writes...

Wait a second, I'm not sure why this is bad.

So a number of warrants are outstanding with an exercise price of $2.71/share. They are worthless since the share price is floating around $1.60/share.

The company is worried that they are going to run out of cash, so they need to raise money. My guess is that they looked at doing an IPO or selling bonds and realized that was a dead end.

So they thought to themselves "OK, we have these outstanding warrants out there, but they are worthless. The financing structure is already in place, so maybe if we reduced the exercise price, we could entice these people to exercise them."

Keep in mind that the company is sliding into bankruptcy. So how do you incentivize people to buy a share of a failing company? You price the warrants under the current share price. The company gets some cash and the people that handed over the cash get an instant return.

It's not that different than selling high interest rate bonds. The company sells a $10M bond with a promised interest rate of 20% (let's say $12M payable in one year). You buy the bond for $10M, then immediately turn around and sell it for $1.1M (to someone who thinks that's a fair trade) and pocket the $100K.

The company certainly isn't get fleeced, since they probably couldn't raise the money any other way.

Also, if you look at what the CEO got for his 1.5M warrants, it amounts to ~$150K. Not exactly enough to retire on.

But maybe I'm missing something here?

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4. Matt on November 16, 2012 4:24 PM writes...

I don't understand why this transaction excites such outrage. I'm not sure I understand the transaction, so maybe that's the problem.

These investors were given the chance to buy "warrants" which I guess get turned into additional shares of stock? The original price, Feuerstein writes, was $2.71. Where did that price come from? At any rate, if their stock price at the time was $1.61, then the warrants would have been a loss to the investors--who would do that? The investors presumably don't want a charitable writeoff, they want a profit. I don't see how the $50 million figure Feuerstein cites would be reachable, without utterly screwing the investors.

It seems to me Star needed cash, so they sold these warrants to investors who were still willing to give them a shot. They were a good deal, but it's like venture capital, right? You'd expect to have to offer a good return, in exchange for the risk you represent (in this case, a company staring insolvency in the face within a quarter or two). I don't know when they could exercise these warrants, but either way it seems reasonable. If they've exercised them already, they made a nice profit, but Star's stock price didn't tank, so win-win. If they will exercise them in the future, they've still got a lot of risk and a sizable pricing advantage would seem necessary.

Star got $18.5 million in extra cash to operate, the investors got perhaps $11 million in profit, the rest of the market got a crisis averted and a stock price that didn't drop...what's the complaint? That the management didn't drive a harder bargain, and claw in some of that $11 million? I'd imagine such a bargain would be hard to make, when you are staring bankruptcy in the face.

Now, the CEO getting a million-dollar salary in the past is clearly a bad, bad sign in a tiny struggling company; and giving him a neat > $1 million windfall also smells a bit rank. On the other hand, it looks as if he may not be getting paid for a while--in salary, true, but stock in a dying company might not be a great payment either.

I do find it a little odd the stock price went up a bit after the announcement, but perhaps the stock was priced for grim circumstances. As we've seen in this forum, and can be seen from the comments Feuerstein generates, not all small cap investors appear to be playing with a full deck. (I'm sure this is true of the larger market as well, but there the crazy tends to get a little softened by large numbers.)

What have I missed? Under what scenario could Star have actually gotten $50 million, other than as a charitable gift?

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5. Matt on November 16, 2012 5:03 PM writes...

Oops, sorry to repeat Mark's question. Took too long to type, I suppose.

While we are talking about stinky behavior, what's the deal with TheStreet.com posting that link "see if we own this stock" (that is, the one listed in the article, and thus might represent a conflict of interest) which points to signing up for their product. That's a really poor setup.

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6. David on November 16, 2012 9:37 PM writes...

@Mark this is wrong. The market knows the company's situation and has placed a value on the company of ~235.5 million. These people gave the company $20 million , so at a minimum, the company's value should now be considered $255.5 million. With the new 19.5 milliion shares and the rise in the stock price, the market cap of the company is now at a market cap $291.78 million. This shows that it is pretty evident that the wider market believes there will be return on investment from the new cash. If the market believes there will be a return on investment, then management should be able to demand a higher price for exercising warrants than 62% of share value. In fact, they should have been able to demand at least the share price, and really they should have been able to demand a couple percent over the share price. There is no mention of any standoff agreement with the warrants, but as it stands, those who exercised the warrant made 76% profit in a single day. If you believe you can't issue junk bonds with such a rate, you are delusional. This was a pure insider play for massive profits.

@Matt there is a huge difference to venture capital in that a venture capitalist isn't buying in at below market value, VCs buy in at above market value in the belief that they have done some diligence that gives them the knowledge that this company is undervalued by the market. Basically, a VC is estimating the "goodwill" within the company, frequently due to the investor's belief in management. Good management finds the investor that maximizes goodwill and thus places the highest value on the company before adding in his cash.

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7. Mark on November 18, 2012 11:45 PM writes...

@David,

I don't know the details of this deal, so you may very well be right, but a few comments:

- This type of deal is not unknown. Look up Zion Oil & Gas, Inc. They reduced the price of outstanding warrants from $7, down to $1.75 when their stock was at $2.23 the day before.

- It's highly unlikely the people that exercised the warrants actually offloaded them immediately. Look at the volume traded in the last week, it's barely broken 500K shares. At that rate it'll take a month or more to offload those share.

- I disagree with the idea that they could have raised this with junk bonds. For a company that has less than a year's worth of cash in the bank, would you agree to buy their commercial paper or bonds? The likelihood of ever seeing the principal again is basically nil, while at least you could offload the shares you just purchased ( or at least some of them).

- The stock price was around $1.61, but again, look at the volumes. Do you think they could have really sold 19.5 million shares and maintained that stock price? I would argue there wouldn't be a market for that type of volume.

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