A Deal For All Seasons

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Although by its nature a debt obligation with restrictive covenants places something of a cushion under the equity play, in bankruptcy court it could turn into a Whoopee Cushion. A zero convertible debenture's standing in a Chapter 7 or Chapter 11 is still untested. If it comes to that, the judge will have to rule whether an unsecured convertible zero debenture is true debt or thinly disguised equity. The bondholder, of course, would plead the case for debt, and thus rank it senior to common stock.But real-interest-bearing unsecured debt-holders would argue that the start-up company, what with its liberal conversion factors and the assortment of options and warrants that also reek of equity, ever intended to pay back the loan. Yet Equitable and other long-term zero holders will have been paying taxes on interest accrual. Thanks to the IRS, that's undeniable proof -- however layered with options, warrants, and convertibility -- that the instrument constitutes a loan. Moreover, by the same argument, a secured zero convertible would have equal license with any other secured note to go after available assets.

So far, Air Atlanta has been able to borrow nearly at will. To do so, it must secure waivers from its creditors, but, says Kolber, "that has never been a problem, because we are adding value to the company." But unforeseen snares could yet develop, not only for the investor, but for the beneficiary. What if, when in five years the note matures and it comes time either to convert or to be paid back in cash, the deal is a wash -- that is, the value of the stock is exactly equal to the face value of the note? An uneasy lender might opt to get its money back while the opportunity was there, instead of taking the common and chancing a still-clouded future. In that case, even though Air Atlanta had enough cash to meet its debt obligations, it still could be grounded.

But Equitable and other lenders are not asking for a parachute. "If we needed a secured position," Edmunds admits, "we would not consider a zero. There has to be upside potential. If we went for current return, the upside participation would normally be reduced."

Surely one wouldn't want anything so passe as current return to blemish an idyll in which management owns less than 1 million shares of common -- far less than Equitable and others control through conversion. On top of lending over $10 million in zeros -- convertible into nearly 5 million shares -- Equitable holds such other modes of convertible debt as secured demand notes, plus warrants and options to load up on yet more common. Equitable already is about a 15% owner, based on outstanding shares. If everything is exercised before convertibility expires (even if the other lenders make all their conversions) it will come close to owning half the company (on a diluted basis). This is a far larger chunk of the corporation than they would have had through early-stage equity alone.

That happy event will occur only if the new airline soars into the wild black yonder. If it continues to cruise in and out of the red, however, yet another complication could arise should Air Atlanta again attempt an initial public offering, either to raise more capital or to establish a market price for its stock. Convertible holders would want to cash out as well, but the days of capitalizing profitless companies merely by tapping the public market have passed, and no underwriter could be expected to sell stock from debt-laden balance sheets. Equitable and other lenders would have to cooperate, cleaning up the liabilities by converting to common. They would then hope to "piggyback" on the offering and dispose of at least some of their holdings. Unfortunately, Wall Street has come to frown on IPOs that seem designed to favor individual holders. The idea of an IPO is to let the public in on a good thing, the Securities and Exchange Commission agrees, not to bail an institution out of a flat investment.

In the end, the beauty of a zero convertible is in the eye of the holder: it looks like it's a performing asset, such as revolving debt, but it's really not.It reflects the tacit intent of both parties to structure debt that accrues interest, but which the borrower has no intention of redeeming. Still, even the borrower's highly explicit willingness to bathe its creditors in equity surely is not the sole reason big money came to Air Atlanta, whose management in any event is worth betting on. However, Kolber reckons, "they invested more because of it. We were able to go to the well again, where we wouldn't have gotten a penny if they could say they were maxxed out on the equity side, and you're not going to get anymore. Now we can answer, well, this isn't really equity."

If it's so magical a device, why don't more start-ups use it? There's no apparent reason, Kolber concludes. "The only argument against a zero coupon is its lack of an income stream. It's not an instrument for traditional venture capitalists. They have to have dollars coming in. Yet it's such a flexible creature -- you can keep layering and layering it, and fine-tune the covenants and the restrictions, and play with the cross-collateralization. At first it seemed like there had to be something wrong. Were we being naive? Were we missing some tax thing or accounting standard? Is it really this simple?"

The jury may still be out, but so far, so good. After the concept and its various sweeteners were scrutinized by the company's accounting firm, Peat, Marwick, Mitchell & Co., and given official blessing, "that's when the phones started ringing," Kolber says. On the other end of the line were cash-hungry start-ups, wanting to know how to do it themselves.

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