Summary
Small public companies, particularly those quoted on the OTC Markets, often have limited access to conventional capital. Into that gap steps a category of financing that looks like a lifeline and frequently operates like an anchor.
Key points
- A floating conversion price means a lower stock price produces more shares, more selling, and a still lower price.
- Disclose the material terms and the potential dilution in plain language.
- Before signing, the board should model the capitalization at several prices, including prices far below market, and understand every default trigger.
- Hard terms can be a legitimate choice. They must be an informed and disclosed one.
Small public companies, particularly those quoted on the OTC Markets, often have limited access to conventional capital. Into that gap steps a category of financing that looks like a lifeline and frequently operates like an anchor.
The Structure
The typical instrument is a convertible note or preferred stock that converts into common stock at a discount to the market price at the time of conversion, often the lowest trading price over a period of days before conversion. There may be an original issue discount, meaning the company receives less than the face amount. There may be high default interest, penalties, and provisions that increase the principal if the company falls behind in its reporting or its share price declines.
The Spiral
The problem is arithmetic. Because the conversion price floats with the market, the lower the stock goes, the more shares the holder receives on conversion. The holder converts and sells. The selling pressure pushes the price down. The next conversion yields even more shares. Dilution compounds. The company may exhaust its authorized shares, need to increase them, effect a reverse split, and begin again.
For the holder, the structure can be profitable regardless of how the company performs, because the discount is locked in and the shares are sold quickly. For the company and its existing shareholders, the result is often catastrophic.
The Legal Questions
Toxic financing raises several issues beyond business judgment.
Disclosure. A company that enters into these instruments must disclose their material terms, the potential for dilution, and the risks they create. Disclosure that describes a "financing" without explaining that the conversion price floats, and what that could mean, may be misleading.
Resale and Rule 144. The holder's ability to sell the conversion shares often depends on Rule 144 and on legal opinions supporting removal of restrictive legends. Chapter 13 discusses those opinions and the risk they carry for the lawyers who give them.
Dealer registration. The SEC has brought actions asserting that certain toxic lenders were acting as unregistered securities dealers by buying convertible notes, converting, and selling in volume as a regular business. Courts have reached differing conclusions on aspects of that theory, but the issue remains live.
Manipulation. Trading around conversion windows, short selling ahead of conversion, and coordinated promotion can give rise to manipulation claims.
Before You Sign
If a company is considering financing of this kind, the board should see a model of what happens to the capitalization at several different stock prices, including prices well below the current market. It should understand every default trigger. It should know how many authorized shares it has and how quickly they could be consumed. And it should ask whether there is any alternative, including a smaller raise on better terms, a registered direct offering, or a strategic investor.
Sometimes there is no alternative, and a company chooses to survive on hard terms. That can be a legitimate decision. It should be an informed one, and it should be disclosed honestly.
Frequently asked questions
What is a death spiral convertible?
A floating conversion price means a lower stock price produces more shares, more selling, and a still lower price.
What must a company disclose about toxic financing?
Disclose the material terms and the potential dilution in plain language.
What should a board do before signing a floating-price convertible note?
Before signing, the board should model the capitalization at several prices, including prices far below market, and understand every default trigger.
Is accepting hard financing terms ever legitimate?
Hard terms can be a legitimate choice. They must be an informed and disclosed one.
This is general information, not legal advice.
Continue with the book
From the appendices
Download the working tools
Three printable checklists drawn directly from Fred’s manuscript, with definitions from the book’s glossary.