What Is Death Spiral Convertible?

May 3, 2023
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A death spiral convertible is a type of financing agreement that is often utilized by small and mid-sized companies that are in need of capital but may not be able to obtain it through traditional means. In this arrangement, the investor provides funding to the company in exchange for convertible debt that can be converted into equity at a later date. However, there is a catch: if the company's stock price drops below a certain level, the investor can force the conversion of the debt into shares of stock, leading to a "death spiral" of dilution and further price declines.

This article will explore the mechanics of death spiral convertibles, their advantages and disadvantages, and some of the risks associated with this type of financing.

What is the origin of "death spiral?"

The term "death spiral" has been used in a variety of contexts, but its origin in the financial industry can be traced back to the 1980s when it was first used to describe a particular type of convertible bond.

At that time, some companies were looking for ways to raise capital quickly, and they turned to convertible bonds as a financing option. Convertible bonds are a type of debt instrument that can be converted into shares of the company's common stock at a predetermined price. This allows investors to benefit from any potential increase in the company's stock price while also providing a degree of downside protection in the form of the bond's fixed income stream.

However, some investors began to structure these convertible bonds in a way that was heavily tilted in their favor, leading to a phenomenon that became known as the "death spiral." The basic idea behind a death spiral convertible was that the conversion price would be set at a significant discount to the current market price, giving the investor a large potential profit if the company's stock price increased.

However, if the stock price failed to rise, the investor could still benefit by selling the convertible bond short in the market. This put downward pressure on the stock price, potentially triggering further conversions and diluting the existing shareholders' ownership stake in the company.

Over time, the term "death spiral" has been applied more broadly to describe any situation in which a company's stock price enters a downward spiral, potentially leading to insolvency or bankruptcy. While death spiral convertibles are still used today, they are subject to greater scrutiny and regulation than they were in the past, in part due to the risks associated with this type of financing structure

How death spiral convertibles work

A death spiral convertible is typically structured as follows: the investor provides a loan to the company in exchange for a convertible note. This note has a fixed interest rate and a maturity date, at which point the company must repay the principal and any outstanding interest. However, the note also gives the investor the right to convert the debt into shares of the company's stock at a predetermined conversion price.

The conversion price is usually set at a premium to the current market price of the company's stock at the time the note is issued. This gives the investor a potential upside if the stock price rises, since they can convert their debt into equity at a lower price than what the stock is trading at. However, if the stock price falls below the conversion price, the investor may choose to exercise their right to convert the debt into shares of stock, which can lead to a dilution of the company's shares and further downward pressure on the stock price.

For example, suppose that a company issues a $1 million convertible note with a conversion price of $10 per share. At the time of issuance, the company's stock is trading at $15 per share. If the stock price remains above $10, the investor will likely hold onto the note and collect interest until the maturity date. However, if the stock price falls below $10, the investor may choose to convert the debt into shares of stock, which would require the issuance of 100,000 new shares (assuming a conversion rate of 1:1). This would dilute the company's existing shares and put downward pressure on the stock price.

Why create death spiral convertible

There are several reasons why a company may choose to create a death spiral convertible. One of the primary reasons is that it provides a relatively quick and easy way to raise capital, especially for companies that may not be able to obtain financing through traditional channels like bank loans or public offerings.

In addition, death spiral convertibles can be an attractive option for investors who are willing to take on higher levels of risk in exchange for potentially higher returns. By offering a convertible note with a low conversion price, investors can potentially benefit from significant gains if the company's stock price increases.

Another reason why a company may choose to create a death spiral convertible is that it can provide a degree of flexibility in terms of the timing and structure of the financing. Because the conversion price is typically set at a discount to the current market price, the investor has an incentive to convert the debt into equity sooner rather than later. This can provide the company with a steady stream of capital over time, rather than receiving a lump sum payment upfront.

Finally, death spiral convertibles can be an effective way for companies to manage their balance sheet and financial obligations. By converting debt into equity, companies can reduce their overall debt load and improve their financial ratios, which can make them more attractive to potential investors or lenders in the future.

Overall, while death spiral convertibles carry significant risks, they can also provide benefits for both companies and investors. By carefully considering the potential risks and rewards, companies can make informed decisions about whether this type of financing is right for their needs.

Advantages and disadvantages of death spiral convertibles

One of the main advantages of death spiral convertibles is that they can provide a quick source of capital for companies that may not be able to obtain funding through traditional means, such as bank loans or equity financing. Because the investor is essentially betting on the company's future success, they may be willing to take on more risk than a traditional lender or investor.

Another advantage is that death spiral convertibles can provide an investor with a potential upside if the company's stock price rises. By converting the debt into equity at a lower price, the investor can realize a profit if the stock price continues to climb.

However, there are also several disadvantages to this type of financing. One of the main concerns is the potential for dilution of the company's shares if the investor chooses to convert the debt into equity. This can put downward pressure on the stock price and make it more difficult for the company to raise additional capital in the future.

Another concern is the potential for a "death spiral" of dilution and further stock price declines. If the investor continues to convert their debt into equity at lower prices, it can lead to a vicious cycle of dilution and declining stock prices that can be difficult for the company to recover from.

Risks associated with death spiral convertibles

There are several risks associated with death spiral convertibles that companies should be aware of before entering into this type of financing arrangement. One of the main risks is the potential for significant dilution of the company's shares if the investor chooses to convert the debt into equity. This dilution can be especially concerning for existing shareholders who may see their ownership percentage decrease as more shares are issued to the investor.

In addition to dilution, death spiral convertibles also carry the risk of triggering a downward spiral in the company's stock price. If the investor chooses to convert their debt into equity at a lower price, it can lead to a flood of new shares hitting the market, putting downward pressure on the stock price. This can make it more difficult for the company to raise additional capital in the future, as investors may be wary of investing in a company with a declining stock price.

Another risk associated with death spiral convertibles is the potential for "toxic financing." This occurs when an investor takes advantage of the company's need for capital and structures the financing in a way that is heavily tilted in their favor. For example, an investor may set the conversion price at an artificially high level, making it difficult for the company to avoid triggering a conversion event. This can result in significant dilution and potentially even bankruptcy for the company.

Companies should also be aware of the potential for conflicts of interest when entering into a death spiral convertible agreement. Because the investor has the right to convert the debt into equity, they may have an incentive to engage in activities that can harm the company's stock price, such as short selling or spreading negative rumors about the company. This can put the company at a disadvantage and make it more difficult to succeed in the long term.

Finally, companies should carefully consider the cost of capital associated with death spiral convertibles. Because these agreements are often structured as high-risk, high-reward investments, the interest rates and fees associated with the financing can be significantly higher than those associated with more traditional forms of financing. This can result in a higher overall cost of capital for the company, which can impact profitability and growth potential.

Conclusion

In conclusion, death spiral convertibles can be a useful source of financing for companies in need of capital, but they also carry significant risks. Companies should carefully consider the potential for dilution, downward spirals in the stock price, toxic financing, conflicts of interest, and high cost of capital associated with these agreements before entering into them. By carefully weighing the pros and cons of this type of financing, companies can make informed decisions that will enable them to achieve their goals and grow in a sustainable way.