Toxic Financing Explained
We have reviewed countless financing proposal and documents on behalf of our clients over the years. It seems lately that we have had a surge in calls recently asking us to review documents that were for toxic fundings. I have even gotten a few calls my office offering toxic financing to some of the companies that I am an officer and director of. To the inexperienced eye, these financing proposals may even seem legitimate. Unfortunately, they are not. Back in January of 2013, shortly after the SEC initiated action a
gainst Edward Bronson for illegal fund raising for penny stock companies, I published an article detailing are meeting with him in the summer of 2006 , and how we identified the financing he was offering as a toxic funding. Given the current fund raising environment for small cap and micro cap companies, I decided it was time to start writing again on this subject, and start getting some information out there so the companies that are receiving these fund raising offers can understand what is being presented to them.
In this article, I would like to take a look at what a toxic funding is, and what happens to a stock in a toxic funding.
What is a Toxic Funding
A toxic financing is convertible debt or preferred stock that allows the financier, the holder of the debt or preferred shares, to essentially receive an unlimited number of free trading common shares when they convert their debt or preferred shares to common stock. The debt or preferred shares carry an interest or dividend rate that the company is usually unable to pay; and as a result the financier converts the shares into common shares that they then sell into the market in order to be repaid and earn a profit on the investment. The formula for the conversion into common shares is structured so that there is no downside limit on the price received for the converted shares. This is what is known as a “floorless convertible” and this is what makes the financing or funding toxic.
These convertible preferred and convertible debts usually convert into common shares based upon a formula (“floating conversion rate“) that is effectively a discount to the market price of the shares at the time of the conversion. For example in the early days of these types of convertible instruments, the formula might call for the conversion of the debt or preferred shares into common shares at a 20% discount to the market price on the day of conversion. Therefore the language in the contract might say something “has the right to convert into common shares at a price equal to 80% of the closing price.” Now as the participants in the market have gotten more sophisticated, and the language in the contracts has gotten a lot more sophisticated as well. Now there are a whole host of clauses and provisions that take into account the price weighted volume, the average price over a several day period of time, lowest price over a period of time. The conversion clauses have become far more complicated, and far more difficult for the average person to understand. It is easy to see how these clauses can get past people who really do not understand what they are reading.
It should be noted that a conversion clause with a floor would read something like “the greater of $2.00 per share, or 80% of the market price…” With this language in a conversion clause, the lowest price at which the convertible debt or convertible preferred can be converted into common shares is $2.00 per share. This conversion clause actually has two (2) types of provisions in it. The 1st being the hard conversion price of $2.00 per share. The 2nd being the floating conversion rate of a 20% discount (80% of the market price) from the market price. The “greater of” language establishes the hard conversion price of $2.00 per share as the floor price of any conversions.
What Happens in a Toxic Funding
The vast majority of small and micro cap company Presidents and Chief Financial Officers (CFO) are not familiar with the term toxic financing, and even less understand what happens if they undertake a toxic financing. As a result it is important to understand what happens once a company engages in a toxic financing.
The form of the contract or funding agreement can vary greatly from one toxic funder to the next. However, once the agreement has been signed, usually some money is provided to the company. There is now a debt or convertible preferred that can be converted into free trading common shares one of three ways. The methods of obtaining free trading shares are either through the registration statement filed with the SEC, a court order, or Rule 144 exemption. We will take a greater look at these methods of obtaining free trading shares in a later article. However, what is important is that within a short period of time, the company now has a convertible instrument on its balance sheet that can be converted into free trading shares.
In the vast majority of instances, the companies that enter into these toxic funding agreements have a very limited amount of market liquidity for their shares. As a result, when the conversion notice arrives, and the debt or preferred is converted into common shares, the owner of the toxic debt receives free trading shares that are deposited into a brokerage account and sold into the market. This selling almost always drives the price of the stock lower.
One might be tempted to think at this point that it over and done with; that they have converted their debt or preferred and moved on. However, it does not work that they. The toxic financiers are smart. They are only going to convert a fraction of their debt or preferred into common shares. They are only going to look convert a portion of their holdings into shares. Their goal is to convert and sell as many shares as they can above the conversion price, before their selling drives the stock price below the conversion price. As a result, the conversion notices trickle in, and the stock price continues to move lower, and lower. Think of it as a death by a thousand cuts.
Each subsequent conversion, will be for a greater number of shares, even as the dollar amount being converted remains the same or declines. When this starts to happen, two other important things begin to happen. The 1st being the number of shares issued and outstanding begins to sky rocket. The 2nd being the existing shareholders are massively diluted in their existing holdings. It is not uncommon for some companies that have engaged in a toxic financing to see the number of shares they have issued and outstanding go from less than 50 million to over 5 billion.
These toxic fundings also shut off a company’s access to more legitimate fund raising sources.
In our upcoming blog articles on toxic financing a/k/a toxic funding or death spiral financing we explore the issues raised in this article in greater detail.
If you have any questions about the above blog post, please feel free to visit our web site, www.coralcapital.com and check out we have to offer. Feel free to contact us if you have any questions. We can be reached at 404-816-9220 and are always willing to speak with you.
About Coral Capital Partners
Coral Capital Partners is an independent consulting and advisory firm focused on companies and participants in the lower and middle markets. We partner with our clients to provide cost effective solutions to real world issues and situations. Our experienced team brings a diverse set of skills that allows us to service a wide variety of needs. Our area of services and expertise focuses on bringing services and solutions to our clients that are normally only available to much larger firms. Coral Capital Partners, Inc. provides services to Investment Banks, Private Equity Funds, investors, and both privately held and publicly traded companies, as well as various stakeholders in those organizations. This has included international public companies with operations on three (3) continents to smaller privately held domestic companies. Our experience in the areas of corporate advisory, due diligence reviews, and regulatory compliance allows for a cost effective and efficient solution to the issues at hand. Please feel free to contact our offices to see how we may be of assistance.