6/30/2023 0 Comments Death spiral financingIn some cases, executives might be convinced the company can pay the debt back. The reality is that many executives aren't aware of this problem or lack the legal background needed to spot problematic language in a financing agreement. With all the problems caused by toxic financing, it's worth considering why management would enter into such agreements. This process dilutes the positions held by the previous shareholders - further incentivizing them to sell and increasing the risk of a death spiral for the company's stock price. The percentages gradually grow until all the debt has been converted to common shares and sold.Īdditionally, as more and more of the debt is converted into common shares, the company's outstanding share count explodes. Thus, they may convert a small percentage of the debt or preferred stock at any one time. The goal is to convert and sell as many shares as possible for more than the conversion price, but they can't sell all their shares at once without driving the stock price down dramatically. One final point that should be made about the toxic financing process is that when a debtholder converts debt into common shares, it doesn't usually convert the entire amount all at once. As a result, the company's ability to secure new financing may become exceedingly difficult, if not impossible in some cases. If the debtholder continues to sell shares short and cover the position with converted shares, the company's stock price will continue to plummet.Īt some point, new investors won't even consider buying the shares. The debtholder can then cover that short position using the common shares they just acquired in the conversion.Īs a result, the company's stock price plunges sharply, and other investors might start to dump shares out of alarm, triggering a vicious cycle of selling. In a "death spiral" scenario, the holder of the convertible debt might sell shares of the company short while converting some of the convertible debt into common shares. There is more than one way toxic financing can go wrong. When a low-liquidity company's stock is in freefall, the result can be devastating. Toxic debt is also sometimes referred to as "death spiral financing" because it usually triggers a sharp selloff in a company's shares, especially those of a small-cap or micro-cap company with low liquidity in their common stock. This floorless convertible debt generally utilizes a floating conversion rate that's often at a deep discount to the market price of the company's shares at the time of conversion. This scenario is referred to as "floorless convertible" debt, and it's easy to see why it's toxic for a company. The formula used to convert the convertible debt or convertible preferred shares into common shares is generally structured in such a way that there's no floor on the price received for the converted shares. The debtholder then sells those common shares to the open market, creating downward pressure on the stock. Since the company can't afford to service the debt, the debt or convertible preferred shares get converted into common shares at hugely discounted stock prices. One of the most common scenarios is that the terms of the debt may grant the debtholder an unlimited number of common shares when they convert their debt or preferred shares to common stock. Toxic financing can come in the form of convertible debt or convertible preferred stock. Essentially, the lender continues to make money as he converts the debt into common shares - even if the stock is plunging and eventually falls to zero. However, what makes debt toxic is that its terms allow the lender to convert both the principal and the interest on it into common shares at a massive discount to the market, usually with no bottom price. Most convertible debt has a floor, or a price at which the lender cannot convert it once the share price falls below that level. Additionally, they lack the scale to support any major investments in growth or capital expenditures. Toxic financing is an especially big concern for small- and micro-cap companies because their stocks tend to be less liquid. As a result, this is a good time to discuss toxic financing - and what public companies can do to avoid it. Right now is the worst time in 15 years to take on new debt.
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