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November 1, 1999

Web Companies Junk Equity

By Stephen Lacey

Anew group of publicly-traded Internet-based companies is looking at the debt markets for operating capital.

After this year's high-profile convertible bond offerings from, DoubleClick and Sportsline USA, several other similar companies are waiting in the wings for the same capital-raising opportunities.

The reason: Convertible bond offerings seem to offer better potential returns than the returns provided by secondary equity offerings, which have had depressed stock prices.

A convertible bond is essentially a hybrid security, incorporating elements of equity and debt. The bond is convertible into equity, usually after three years of life.

Net Convert

One recent Net-connected convertible deal involved a 144A private placement from VerticalNet valued at $115 million. VerticalNet had seen its stock price fall 50 percent since April. Clearly, the company could not afford to irritate shareholders by returning to the equity market for more capital.

"The preferred mechanism for Internet companies is to sell at a maximizing price point," said Frank J. Drazka, a managing director in the technology investment banking group at PaineWebber. "Convertible debt offerings provide an attractive way to minimize equity dilution while still raising the same amount of money."

Despite the fickleness of the convertible bond market, investment bankers suggest that convertible bonds will become increasingly popular. They say Internet companies will use them to balance their capital structure as they build their war chests.

"We're in active discussions with a lot of [Internet]companies about doing convertible debt offerings," Drazka said.

Rather than diluting existing shareholders value by selling equity at a depressed stock price, companies seek higher ownership participation via a convertible offering.

Typically that participation amounts to a 15 percent to 20 percent premium on the current stock price. For example, VerticalNet's five-year convertible note issue, which was led by Lehman Brothers, carried an initial conversion premium of 18.08 percent. Such a structure had obvious appeal to VerticalNet, a company whose stock recently slid to 35 1/6 from 74 1/2 in April. (Moreover, insiders were free to sell shares by the recent expiration of lock-up agreements.)

"It can be an attractive alternative to a secondary stock offering," said Tomas Isakowitz, an analyst at Janney Montgomery Scott. Still, Isakowitz noted that there can be some negative implications, particularly if insiders are selling stock, as is usually the case with Internet companies. Another alluring feature of a convertible offering is the ability of the deal to draw a new class of institution into a company's investor base.

Managers of convertible bond funds may provide the spark to ignite a new rash of Internet-led convertible bond deals. Until recently, these managers were consigned to watching their equity counterparts feast on hot Internet offerings.

"There are a lot of bond funds that want to play," said Dan MacKeigan, Internet analyst at Friedman, Billings, Ramsey & Co. Most of the Internet companies participating have been infrastructure and telecommunications-based outfits. But that seems to be changing as other types of Net companies join the bandwagon. was the first Internet company to expose this pent-up demand. Originally in the market for $500 million, the Internet retailer was able to sock away $1.25 billion from its 4.75 percent, 144A convertible placement in January.

Second Tier

While the convertible bond market has provided an appealing alternative for some Internet industry leaders, it may be more difficult for second-tier companies to pursue similar financing strategies. In fact, even the much-hyped fell victim to the convertible debt market's unpredictability in its August attempt to float a $250 million offering.

Although the "name-your-own-price" retailer was able to place a secondary stock offering of 5.5 million shares, the convertible market balked at the company's $33.8 million operating loss in the first half of the year.

The convertible strategy even holds risks for the likes of "The fact that Amazon's offering is convertible has no bearing on its debt rating," said Standard & Poor's analyst Jerry Hirschberg. If management fails to execute its business plan and achieve profitability, the debt never converts and the company must continue to fund coupon payments. On Amazon's $1.25 billion note, that bill comes to around $60 million annually.

Stephen Lacey is managing editor of The IPO Reporter, a sister publication of Traders Magazine.