Death spiral financing is the result of a badly structured
convertible financing used to fund primarily
small cap companies in the marketplace, causing the company's
stock to fall dramatically, which can lead to the company's ultimate downfall.
Some small companies rely on selling
convertible debt
In finance, a convertible bond or convertible note or convertible debt (or a convertible debenture if it has a maturity of greater than 10 years) is a type of bond that the holder can convert into a specified number of shares of common stock in ...
to large private investors (see
private investment in public equity
A private investment in public equity, often called a PIPE deal, involves the selling of publicly traded common shares or some form of preferred stock or convertible security to private investors. It is an allocation of shares in a public company ...
) to fund their operations and growth. This convertible debt, often
convertible preferred stock or
convertible debenture
In finance, a convertible bond or convertible note or convertible debt (or a convertible debenture if it has a maturity of greater than 10 years) is a type of bond that the holder can convert into a specified number of shares of common stock in ...
s, can be converted to the
common stock
Common stock is a form of corporate equity ownership, a type of security. The terms voting share and ordinary share are also used frequently outside of the United States. They are known as equity shares or ordinary shares in the UK and other Comm ...
of the issuing company at a discount to the
market value of the common stock at the time of each conversion.
Under a “death spiral” scenario, the holder of the convertible debt might
short the issuer's common stock at which time the debt holder converts some of the convertible debt to common shares with which he then
covers the debt holder's short position. The debt holder continues to sell short and cover with converted stock, which, along with selling by other shareholders alarmed by the falling price, continually weakens the share price, making the shares unattractive to new investors and possibly severely limiting the company's ability to obtain new financing if necessary.
The lender would have a potentially greater gain if the shares were to increase in value, but if they decrease in value, there is some protection. Otherwise, they would probably not be willing to lend the money because of the poor risk profiles of the companies interested in this type of financing.
There are some ways to limit the "spiral" situation, e.g. by prohibiting short selling so as to have a stronger incentive for the debt holder to see the stock price increase. It is also worth noting that in a spiral scenario, it becomes more and more difficult for the debt holder to recover its investment because of the increasing volume of common stock it receives upon each conversion of its debt. Another mean to limit the "spiral" risk is to ensure that the amount of funding is in line with the trading activity of the common stock so as to reduce the potential decrease resulting from the sale of common stock by the debt holder.
Companies willing to agree to financing on these terms often could not obtain funding through any other means due to their early development stage or credit risk profile. The terms, though viewed by some as onerous, give the lender a potential way to recover their debt regardless of what happens to the shares of the company, and the company an easy access to dilutive but relatively cheap funding in terms of cash cost.
See also
*
Convertible security A convertible security is a financial instrument whose holder has the right to convert it into another security of the same issuer. Most convertible securities are convertible bonds or preferred stocks that pay regular interest and can be converted ...
*
Convertible bond
External links
Bank of America Bails Out Countrywide''forbes.com''
At death's door''Stockpatrol.com''
‘Death spiral’ financing catches on in Japan''Mahalanobis''
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Commercial bonds