A Financing Technique Rife With Risk

“Poison preferred” and “death-spiral convertible” sound more like the latest blockbuster movie titles than nicknames for financing tools used by small companies.

But these financings, a type of derivative with a value pegged to--and potentially ruinous for--a company’s common stock, are being blamed for the share price woes of an increasing number of businesses, including Southern California-based Koo Koo Roo Inc. and Techniclone Corp.

For small-stock investors, such financings ought to at least sound a warning bell.

“Whatever you call these deals, they’re bad news. These are being pitched to unfortunate and stupid companies,” said Stanford Fingerhood, an analyst with Dirks & Co. in New York. “They [investment bankers] promise, ‘We’ll get you the money and you’ll be able to do great things,’ but often, when they are through, the stock is at 1 cent a share.”

The deals are defended by Alex Capello, founder of Capello Group, which includes Capello Capital Corp., a 4-year-old Santa Monica-based investment banking boutique that has structured more than 25 such transactions, including nearly $60 million in convertible preferreds for restaurant chain Koo Koo Roo and a $12-million deal for Techniclone, a biotech firm.

“We don’t take blame or credit if a company does well or if it fails. We give the company exactly what they ask for,” said Capello from his office overlooking the ocean.

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Variable convertible preferred stock offerings, as they are called, work this way: A cash-strapped small company that believes its stock is undervalued wants to raise capital but doesn’t want to issue more stock at current prices.

Instead, the company sells convertible preferred shares via private placements to institutional investors, such as mutual funds. The securities allow the buyers to convert to common stock in the future, at progressively lower prices relative to the stock’s market price. For example, a preferred issue might be exchangeable for common shares at a 20% discount to the market in 10 months and a 25% discount in 14 months.

The company is betting that its stock price will rise, encouraging the preferred investors to hold on for as long as possible. If the stock price slides, however, the preferred investors may begin converting quickly, thinking that today’s price may be the best price they’ll get.

That’s when the “death spiral” begins: Some preferred holders begin converting, then selling their common shares in the market, driving the price lower--which can encourage other preferred holders to convert as well.

With a rush of conversions, a firm’s outstanding share base can mushroom. For example, Koo Koo Roo’s outstanding shares have more than tripled to 50 million since 1996. That hurts the stock’s appeal by severely diluting per-share earnings.

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Koo Koo Roo’s nearly $60 million in convertible preferred financing was supposed to help fund its aggressive-growth strategy. But the company failed to open the expected number of new restaurants or show a profit. As its common shares outstanding have ballooned with the conversion of preferred stock, the stock price has plunged--to $3 as of Monday on Nasdaq, from a high of $7.69 last year.

“We borrowed the money to make it a big company, and we borrowed it in the form of a convertible. That’s turning out to be not such a good thing,” former Koo Koo Roo Chairman Kenneth Berg said earlier this year. He resigned March 30, citing recent heart surgery.

For Tustin-based biotech company Techniclone, the need to raise research funds for its experimental cancer treatments made a $12-million convertible preferred financing seem appealing last year. The deal, structured by Capello’s firm in April 1997, encouraged the investors to put off converting to common stock by setting up a scale of rising conversion discounts over time.

But Techniclone’s stock began declining last spring, falling from $5 then to $3 by September. And the owners of the convertible preferred began converting. On Monday, Techniclone was priced at 78 cents a share on Nasdaq. The company has until June 18 to get its stock above $1 a share for 10 consecutive days or it will be delisted from Nasdaq.

Former Chief Executive Lon H. Stone, who resigned March 5, blamed the company’s financial ills on the convertible preferred. “I wish we had never heard of these people,” he said of Capello.

Stone said the company agreed to the financing because it was strapped for capital and had few options.

This week, Techniclone will ask shareholders to OK a doubling of its authorized shares, to 120 million, to handle all of the conversions. The company has 46 million shares currently outstanding.

“We were surprised by the downward spiral, but I think most people are surprised how significant the impact can be,” said Elizabeth Corbett-Frost, who became Techniclone’s chief financial officer this year, well after the offering had been completed. “It’s such a frustrating experience. All you can do is sit and watch.”

Now Techniclone is trying to raise more money through a stock rights offering or private placement and has hired another investment banking firm, Pacific Growth Equities in San Francisco.

Capello argues that his firm’s financings aren’t to blame. He says the convertible preferred investors face certain restrictions on trading that are aimed at protecting the issuing companies and common shareholders. But problems can arise, he said, if companies fail to use money raised in such deals to improve financial performance. He noted that both Koo Koo Roo and Techniclone have changed managements since the deals were done.

“If a company does what it says it’s going to do, it will be very happy with these deals,” Capello contended.

Current Koo Koo Roo Chairman Bill Allen said of the financing: “The truth is the company understood the terms of the instrument we used to raise money. We took the capital, and clearly we didn’t use the capital as effectively as we should have. We’re all grown-ups. We understood what we were getting into.”

Capello, who had famous supply-side economist and Reagan administration advisor Arthur Laffer as a partner until the two parted ways last summer, says the derogatory nicknames for convertible preferred deals are just potshots by rivals.

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Capello compares the financing technique to corporate junk bonds, which were viewed suspiciously in the mid-1980s but are common and respectable today.

“There are people who think anyone who deals with derivatives at all must be more evil than Mike Milken,” Capello said, referring to the man who pioneered the use of junk bonds.

Still, analyst Fingerhood cautioned that struggling entrepreneurs at growing companies need to be careful when picking such financing tools.

“If they think the investment banker is their best friend, they ought to have their head examined,” Fingerhood said. “You can’t stop a scorpion from being a scorpion--but a board should get decent advice.”

Times staff writer Barbara Marsh contributed to this report.

Times staff writer Debora Vrana can be reached by e-mail at debora.vrana@latimes.com

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Hammered

Performance of Koo Koo Roo and Techniclone shares since April, 1997; Koo Koo Roo Monday close: $3.00, Techniclone: $0.78.

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Debora Vrana can be reached at debora.vrana@latimes.com

Times staff writer Barbara Marsh contributed to this story.