This is from small cap digest - interesting article about toxic financing. You'd be amazed how many CEO's don't understand the consequences.
Feature: Market Update. Do You Own a Toxic SmallCap?
A Toxic Tale.
Desperation both in life and business can convince folks to embark on risky paths to keep the financial doors open. Third mortgages, ridiculous credit card rates, finance company loans and even check cashing services loom like sharks that frequently smell blood in the water.
The equivalent in the SmallCap market is the great White Shark known as toxic financing. A fledgling company, like an individual with her/his financial back against the wall, will embrace this lunacy—usually the only financing option left –as its potential savior. More often than not, it is a deal with the devil. And investors should stay away from those companies that employ this strategy. The stats for success following this type of financing are so not in the favor of the company or the shareholders.
While not definitive, here’s one example of the form these toxic deals can take. The CEO of a small- or micro-cap company is convinced his company has the Next Big Thing. Progress as well as financing has been spotty and to get to the ‘next level’ a significant capital infusion is necessary. Unfortunately, the lack of a track record or results or both has road-blocked access to conventional financing avenues.
Then, one or more charming folk shows up at the door and schmoozes the CEO as to the potential of the company and how they can’t wait to invest. Either due to desperation, ego or stupidity, the CEO listens and in the back of his mind, rationalizes salvation for himself and shareholders. He would actually do his company and the shareholders a better service by sending these carpetbaggers packing.
The deal seems straightforward enough—although it can take many forms. The financiers will give the company money in exchange for a convertible debenture, preferred or equity line at a discount to the market price of the shares. The key here is that the conversion rate/price is not fixed, and in some cases there is a share price level, usually significantly below current market that will stop the advancement of a larger second tranche of funds.
My stock will never get that low, concludes the CEO, confident that this deal will save his company. What he doesn’t know is that these sharks have likely found the company not based on the potential of the technology, but on the capital structure and the potential to whack the crap out of the share price and make them and their buddies a crap-load of fast money.
The result will likely be the complete destruction of the company at most, massive crippling dilution for the shareholders at least and likely land the whole thing in litigation. A handful out of hundreds of company that go down this road actually prosper, but not before a lot of financial pain for everyone other than the ‘good samaritans’ that structure these toxic deals.
Without fixed pricing, the financiers and their buddies make their money by pounding the shares through shorting—usually of the naked variety-- and, once the price has been decimated (the dreaded death spiral) convert their debenture, preferred —whatever—into ridiculously cheap shares to cover their massive short sales. Usually, the lower the price, the more shares they get courtesy of a favorable value/conversion rate.
The company ends up having to issue massive numbers of shares to satisfy the conversions and it becomes a vicious circle as the selling begets conversion begets more dilution. Once the share price has been destroyed and the vehicle converted into all the shares necessary to cover, these buzzards move on to the next company with an equally desperate CEO. The carnage left usually means the shareholders are left with nothing the company becomes an albatross with potentially 100’s of millions of virtually worthless shares and is likely further behind than when it started.
Oh yes, if there is a threshold below which the company would not get a second, larger tranche of funding, you can be sure that’s the first level to where the short sharks will drive the company’s share price. Of course, other traders who troll around looking for this type of chum in the water will also come along for the feed. The CEO, his company and shareholders are virtually powerless to stop the decline. That’s where the litigation part usually kicks in.
In this case, the SEC website has a decent discussion of this topic:
Good: In a conventional convertible security financing, the conversion formula is generally fixed - meaning that the convertible security converts into common stock based on a fixed price. The convertible security financing arrangements might also include caps or other provisions to limit dilution.
Bad: By contrast, in less conventional convertible security financings, the conversion ratio may be based on fluctuating market prices to determine the number of shares of common stock to be issued on conversion.
Further risks:
The company issues convertible securities that allow the holders to convert their securities to common stock at a discount to the market price at the time of conversion. That means that the lower the stock price, the more shares the company must issue on conversion.
The more shares the company issues on conversion, the greater the dilution to the company's shareholders will be. The company will have more shares outstanding after the conversion, revenues per share will be lower, and individual investors will own proportionally less of the company. While dilution can occur with either fixed or market price based conversion formulas, the risk of potential adverse effects increases with a market price based conversion formula.
The greater the dilution, the greater the potential that the stock price per share will fall. The more the stock price falls, the greater the number of shares the company may have to issue in future conversions and the harder it might be for the company to obtain other financing
The key to avoiding this type of mess is to carefully look at the terms. Is the conversion at a fixed price(s) or at market prices at the time of conversion? Is the interest rate on the vehicle stupid? Does the financier have a website and you can view other deals they’ve done? Was the company completely out of cash prior to a financing deal?
Hence, we again note the importance of carefully reading company Edgar filings. Armed with information as to how the financing process works, investors can avoid adding to the already significant risks inherent in the smallcap market by ensuring that they stay well away from toxic, shark-infested waters. |
