Death spiral financing
Encyclopedia
Death spiral financing is a process where convertible financing used to fund primarily small cap companies
can be used against it in the marketplace to cause the company’s stock
to fall dramatically and can lead to the company’s ultimate downfall.
Many small companies rely on selling convertible debt to large private investors (see Private investment in public equity
) to fund their operations and growth. This convertible debt, often convertible preferred stock or convertible debentures, can be converted to the common stock
of the issuing company often at steep discounts to the market value
of the common stock. Under the typical “death spiral” scenario the holder of the convertible debt initially shorts the issuer’s common stock which often causes the stock price to decline at which time the debt holder converts some of the convertible debt to common shares with which he then covers his 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 can severely limit the company’s ability to obtain new financing if the need arises.
An important characteristic of this kind of convertible debt is that it often carries conditions like a quarterly or semi-annual reset of the conversion price to keep the conversion price more or less close to the actual stock price. But a lower conversion price also increases the number of shares that a bond holder gets in exchange for one bond, increasing the dilution of existing shareholders. A lower price reset can also force investors that have set up a long CB/short stock position to sell more stock ("adjust the delta"), creating a vicious circle, hence the nickname death spiral.
Mark Valentine, Chairman of Thompson Kernaghan, a Toronto brokerage firm, has been named in several lawsuits from companies that participated in death spiral financings.
Small cap company
A company whose market capitalization is small, under $1 billion.-Overview:A small cap company typically has under $1 billion under control and are hence considered small companies. Small companies generally are not able to secure the best borrowing rates and wield reduced power, including a...
can be used against it in the marketplace to cause the company’s stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
to fall dramatically and can lead to the company’s ultimate downfall.
Many small companies rely on selling convertible debt to large private investors (see Private investment in public equity
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. In the U.S...
) to fund their operations and growth. This convertible debt, often convertible preferred stock or convertible debentures, can be converted to the common stock
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...
of the issuing company often at steep discounts to the market value
Market value
Market value is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may differ in some...
of the common stock. Under the typical “death spiral” scenario the holder of the convertible debt initially shorts the issuer’s common stock which often causes the stock price to decline at which time the debt holder converts some of the convertible debt to common shares with which he then covers his 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 can severely limit the company’s ability to obtain new financing if the need arises.
An important characteristic of this kind of convertible debt is that it often carries conditions like a quarterly or semi-annual reset of the conversion price to keep the conversion price more or less close to the actual stock price. But a lower conversion price also increases the number of shares that a bond holder gets in exchange for one bond, increasing the dilution of existing shareholders. A lower price reset can also force investors that have set up a long CB/short stock position to sell more stock ("adjust the delta"), creating a vicious circle, hence the nickname death spiral.
Mark Valentine, Chairman of Thompson Kernaghan, a Toronto brokerage firm, has been named in several lawsuits from companies that participated in death spiral financings.
External links
- Bank of America Bails Out Countrywide forbes.com
- At death's door Stockpatrol.com
- ‘Death spiral’ financing catches on in Japan Mahalanobis