02 Jun "Death Spiral" Finance: Avoiding the Temptation for Easy Money
Once your offering becomes effective and your share price begins to climb, a number of things can and will happen. First, you’ll likely begin to receive more exposure. More people will know about you, what you do and who you are. Since good, solid analyst coverage on smaller stocks is scant at best, you’ll likely not make the cover of Forbes–at least immediately–but you will still get some cursory interest from some investors who like to dabble across the market, including in stocks that may trade a bit more thinly than say Microsoft or GE. But stock seller beware. There remains a temptation from those seeking capital to get it at just about any cost to the company, even if it means handing the keys over to the undertaker and screwing shareholders–including the founders. It’s what the finance world has rightly deemed Death Spiral Finance.
What is Death Spiral Finance?
In death spiral finance a financier or lender typically agrees to loan a publicly-traded company some amount of cash. In exchange the lender takes a convertible debenture with typically a reasonable interest rate. These folks start lining up at the door when the stock begins to hit above $1 a share.
The unfortunate aspect that is not revealed in this process is that the money doesn’t come without a catch: the lender can convert his/her debenture at any time into shares of common stock. In typical fashion, such an offer will come without a predetermined number of shares but instead with a share conversion rate that is a moving target which is always less then the prevailing market rate. That way, when the “investor” (which I use very loosely) sells the shares s/he will always profit, even on the downside.
“Death Spiral” Finance in Practice
Let me paint a picture with a potential example. Let’s say Fred (our fictitious, yet unscrupulous shark investor) notices your getting some traction on your stock in the market. He likely thinks your share price is too high for what your business does and sees a chance to manipulate. He offers you $1,000,000 debenture (loan). At any time, Fred can convert to stock at any moving price below the prevailing market to recoup his “investment” in your company. That means that whether the stock is trading at $1.50 a share or $0.50 a share Fred can sell $1,000,000 worth of common stock when his debt note converts into common shares. And, it stands to reason that the lower the price goes the more common shares “investor” Fred needs to recoup his initial $1,000,000 investment. That means that at $2/share, Fred would demand 500,000 shares and at $1/share he would demand 1,000,000 shares.
Do you see the catch? Do you see the incentive that’s included with Fred’s investment stipulation?
If Fred were only entitled to a fixed number of shares, he would have NO incentive or desire to see the stock price decline. In our previous example, Fred and his group has a moving target on the number of total shares, incentivizing the “investors” into manipulating the stock downward. Even if the price of the stock dips, the investors still make their money back. Here’s the real catch: the investors now short the stock, covering their short positions with their convertible debenture at any time, regardless of the price of the stock. This is especially egregious and easy to do with microcap stocks where the stock is thinly-traded with little to no public float. The “investors” can more easily significantly drive the price downward by selling short.
In a famous case in 2003, Thomas Newkirk, then the Associate Director of the SEC’s Division of Enforcement, stated the following in relation to toxicity of “death spiral” finance:
Certain convertible securities, particularly those referred to as ‘toxic’ or ‘death spiral’ convertibles, present the temptation for persons holding the convertible securities to engage in manipulative short selling of the issuer's stock in order to receive more shares at the time of conversion.
Manipulators of this type rarely get away with such a scheme without collusive, stupid or desperate company owners. Legitimate, institutional investors don’t typically come calling until the share price reaches at least the $4 level. Even then, one must be cautious and perform relevant due diligence on the terms of an convertible debenture. Even desperate company managers who knowingly allow such shorts to happen run the risk of later unwanted action by regulators. In all, it’s best not to even contemplate playing in the mud, otherwise you’re liable to get very dirty. In other words, work on building a great company, instead of using fanciful financial engineering to attempt to make a quick buck.