Net firms get creative to keep coffers full

Faced with slumping stock prices and the need to bolster corporate coffers, some Net companies are resorting to creative financing.

E-tailers, such as Amazon.com, and financial sites such as E*Trade and Ameritrade, are increasingly relying on financial instruments called convertible bonds. Such a method of financing can offer companies serious benefits, but can also present them with other financial drawbacks.

Convertibles are part interest-paying bond, part stock. When selling such bonds, a company agrees to pay an interest rate of 5 percent for several years, for example.

The benefit to the buyers is that they not only receive the interest payments, but they also may receive paper profits when their bonds convert to shares, providing the stock has appreciated above its conversion price.

The companies issuing the bonds are able to raise cash despite weakness in their stock value. But there is a price to pay: Interest payments can add up to millions of dollars each year. And as interest rates rise, so does a company's cost of raising funds through a convertible-bond offering.

Tech companies have typically been considered immune from interest-rate hikes because they sell stock to raise money. But that can change when they use convertibles.

"As interest rates rise, it will cause some companies to increase their coupon rates on convertibles," said Eric Alt, a principal with Robertson Stephens. "But the ripple effect is more severe with straight debt offerings."

Tech companies accounted for roughly a third of the $43.4 billion U.S. convertible market last year, said Mark Dicioccio, head of Lehman Brothers' West Coast technology group. That's a significant jump from the previous three years, when tech companies represented about 14 percent of the market.

The reason for the increase can be found in the slowly sinking stock prices of many e-commerce companies. Companies like Amazon, when their stock prices were at all-time highs, could simply offer more shares to the public to help raise cash. But as shares fall, these firms need to find alternate ways to finance expansion projects.

"E-tailers have definitely fallen out of favor ... that's part of the reason why they're doing convertibles," said William Wong, an analyst with Josephthal & Co. "I don't view it as a negative. They have to finance their future growth."

Where the money is
Publicly traded companies have several options for raising funds. One is selling additional stock in a follow-on offering; this requires no interest payments but forces a company to sell the shares at the current price, which may be depressed. Other strategies include issuing corporate bonds or taking out bank loans, options that usually require higher interest rates than issuing convertible bonds.

"There is a class of (business-to-consumer companies) that aren't happy to sell their stock at a depressed price in a follow-on offering, so they prefer to sell it at a 20 to 30 percent premium when it later converts," Dicioccio said.

Creative financing Some tech companies have recently sold convertible bonds to raise money. According to Robertson Stephens, this is how such an offering works:

•  "NoProfits.com" needs to raise $500 million, but its stock is trading at just $10.

•  The company could try to sell 50 million shares at $10 but instead decides to launch a convertible debt offering.

•  Upon meeting with investment bankers, NoProfits discusses four key areas of a convertible debt offering and establishes ranges.

•  One key area is setting a range on the interest rate it will pay investors, otherwise known as the coupon rate. The company settles on a range of 4.75% to 5.25%.

•  A second key area is determining a premium range. This will be used to set the conversion price, which is a premium over the current stock price. NoProfits considers setting a range of 22% to 25%.

•  Call provisions are reviewed. These determine the circumstances that would trigger the company to force investors to redeem their bonds for stock before the maturity date.

•  Finally, a maturity date is established. That's when NoProfits has to pay back the principal to investors if the bonds are not redeemed beforehand.

•  The company makes presentations to prospective institutional investors during a "road show."

•  After measuring investor reaction, the company sets a coupon rate of 5%, a premium of 25%, a three-year non-call provision and a seven-year maturity date.

•  Assuming NoProfits stock is still trading at $10, the bonds will be convertible into stock at $12.50 a share.

•  Investors are paid semiannual interest payments for the next four years, a total of $100 million.

•  If the stock had reached the conversion price after three years, the bonds could have been converted one year earlier, saving the company $25 million.

•  On the day the bonds convert to shares, if NoProfit is trading at $100, the investors could acquire the shares for $12.50. The company would have had to allocate only 40 million shares to raise $500 million in capital--far less than if it had gone through with a follow-on offering.

Amazon.com, for example, has seen its stock price lose about 40 percent of its value from its 52-week high of $113 in early December. The stock is trading around $70.

In an effort to bolster its cash reserves, the giant e-tailer last month priced 690 million euros ($671.5 million) with a relatively rich conversion premium of 36 percent. Under its European debt offering, investors will pay about 104.95 euros ( $103.53) to convert their bonds into Amazon shares.

Amazon had to pay a pricey interest rate of nearly 6.88 percent to attract investors, however. The average coupon rate is roughly 4 percent, investment bankers say.

"Convertibles are a great way to increase shareholder value over time--if you do it the right way," said Russell Grandinetti, Amazon investor relations director. "Our share price, assuming the same market value, would be 10 to 15 percent lower if this was done through (a follow-on offering)."

Meanwhile, online brokerage E*Trade last month sweetened its convertible deal to attract investors. The company increased its interest rate to 6 percent from 5.5 percent and lowered the premium investors will have to pay to convert the shares to 18 percent from about 26 percent, Wong said.

Based on the new premium, investors will pay nearly $24 a share to convert their notes to E*Trade stock. When the company was constructing the deal in early February, its stock was trading as low as $19. The shares are now trading around $30, but that's less than half the $70 they sold for last April.

The sweetened terms also landed E*Trade greater interest among investors. The company was able to raise $650 million--a $150 million increase from its original plans, Wong said.

Some companies have turned to convertible-debt offerings after aborting plans for a follow-on offering.

Ameritrade, for example, planned to raise $235 million in a post-IPO stock sale, or follow-on deal, last July. The offering called for the sale of 8.5 million shares at $27.88. But as the markets went south, so did the company's plans.

"Ameritrade had a difficult time pulling it off," Wong said. "Demand for the offering was lukewarm, and the company didn't want to issue (the shares) at the current market price, so it decided to issue a convertible."

The online brokerage instead raised $200 million via a convertible debt offering, which carried a 5.75 percent interest rate and had a conversion price of $32.56--a premium of 22 percent.

"Historically, we didn't look to finance tech issues with debt because investors weren't interested. Investors looked for return (on investments) and cash flows," said Dyan Triffo, who co-leads investment banking at Deutsche Banc Alex Brown. "But these buyers of debt have seen tremendous gains in the tech sector, and they want access to those issues."

Companies, or issuers, usually set a time period of three years in which they cannot force investors to convert the bonds to shares. That's because investors want in on the bonds as the stock rises above its conversion price, allowing them to collect the interest and reap additional profits when the notes are converted to shares.

But companies prefer to call the bonds as soon as possible when the conversion price is reached. And with the markets soaring and numerous tech companies hitting their conversion prices before the non-call period is over, much of the available convertible notes are taken out of the market long before they hit their maturity dates.

"A lot have been called by the issuer, so these funds are drying up," Dicioccio said. "(Convertibles allow) issuers to go out and get attractive terms. The cost of capital is as good as a follow-on. That's why we've seen a mini-boomlet in convertibles."