What is Death Spiral Finance?
In death spiral finance a financier or lender typically agrees to loan a publicly-traded company some amount of cash. In exchange the lender takes a convertible debenture with typically a reasonable interest rate. These folks start lining up at the door when the stock begins to hit above $1 a share.
The unfortunate aspect that is not revealed in this process is that the money doesn’t come without a catch: the lender can convert his/her debenture at any time into shares of common stock. In typical fashion, such an offer will come without a predetermined number of shares but instead with a share conversion rate that is a moving target which is always less then the prevailing market rate. That way, when the “investor” (which I use very loosely) sells the shares s/he will always profit, even on the downside.
BREAKING DOWN Death Spiral
This type of loan is sometimes undertaken by a company that desperately needs cash. It is called a death spiral because the stock of the company often plunges drastically after it issues this convertible debt. It is important to note that death spirals often allow buyers to convert the bonds into shares at a fixed conversion ratio in which the buyer has a large premium. For example, a bond with a face value of $1,000 may have a convertible value of $1,500, which means that a bondholder will receive $1,500 worth of equity for giving up the $1,000 bond. However, upon a conversion, more shares are created, which dilutes the share price. This drop in price may cause more bond holders to convert because the lower share price means that they will be receiving more shares. Any further conversions will cause more price drops as the supply of shares increases, causing the process to repeat itself as the stock’s price spirals downward.
Why Would a Company Want Death Spiral Financing?
A company that seeks death spiral financing basically has no other option to raise money to survive. Traders who want to short the stock salivate at the prospect that the stock will dive. The only hope for the company to break the death spiral is to improve its operational results. If it can effectively deploy the proceeds of the convertible debt issue in its underlying business, it may be able to avoid the hopes of short sellers and even stick losses to them.
Death spiral finance is extraordinarily interesting and both frightening for those uninitiated to this kind of manipulation. It is also likely to trigger financial reporting issues given that the convertible feature is effectively an embedded derivative. Additionally, relative to a falling share price and such high leverage, debt financing is likely to trigger gearing/debt servicing ratio warnings that could ‘spiral’ an even further decline in the share price.