Excerpt from an academic research on "toxic financing":
"II Characteristics of Toxic Convertibles
Toxic convertibles are a particular class of instruments called private investment in public equities (PIPEs). A PIPE is the sale of equity by a public issuer, either in the form of common stock or a fixed-price convertible. PIPEs in the form of common stock are typically sold at a discount to the market price. Usually these shares are registered for resale after the closing. According to PlacementTracker,3 since 1995, there have been 6,904 PIPE transactions of which 1,846 (27%) were "structured deals" or death spirals. In terms of amount of capital raised over the same period, all PIPE transactions cumulatively raised about $98.2 billion, of which about $12.5 billion (13%) were of the "toxic" or "structured" variety. In general, smaller, cash-intensive, high-growth companies in the high-tech or biotech sectors have been the most common users of PIPEs.
Elias (2001) delineates the chronology of events surrounding a toxic PIPE deal as follows:
1. An embryonic venture goes public.
2. The new venture burns through all of its IPO capital and desperately needs more cash.
3. With profitability prospects receding, mainstream capital markets rebuff the company's plea for cash.
4. Private equity firms offer to infuse cash, receive death spiral convertibles, obtain steep discounts-as high as 30%-on common stock purchases, and reserve the right to sell the stock short.
5. In exchange for their cash infusion, these private equity investors receive preferred stock that can be converted to the discounted common stock, usually within 90 days. Notably, there is no "floor" on this provision, so that the more the price of the stock drops, the more common stock the company must issue to satisfy its obligation to the original investors in the "toxic."
6. The private investors begin to sell the company's stock short. As the stock price falls, their ownership stake increases.
7. Others, such as professional short sellers and individual investors, alerted by a volume increase in the thinly traded stock, jump on the selling bandwagon, thereby driving down the price even further.
8. The stock hits a low of $5, triggering sales by institutional investors and causing brokerages to stop research coverage.
9. The stock continues to plummet, and delisting appears inevitable.
10. The company converts the private investors' preferred stock into common stock at the current market rate, less an agreed upon discount of between 20% and 30%.
11. The private investors use newly converted common stock to cover their short positions, earning considerable profits.
12. The same investors sell off any remaining common stock they hold, or hold the shares for the inevitable liquidation or takeover.
13. In some cases, the private investors end up with enough stock to have a majority position in the company.
An example depicts the magnitude of gain that accrues to the toxic investor.4 An institutional investor owns and is entitled to convert a debenture into $1.5 million worth of common stock. If the holder were entitled to convert the debenture into a fixed number of shares - say 500,000 - he or she would have no incentive to see the stock price decline. If anything, the value of those 500,000 shares would increase if the stock price increased. The holder's motivations, however, might change if he or she receives more shares as the stock price decreases.
If the company's shares were trading at $5 at the time of issuance, the debenture holder might start by selling short 500,000 shares and realizing proceeds of $2.5 million. If, as with many micro-cap firms, the stock is not heavily traded, those sales could help drive the price of the stock downward. As prices fall to $3, the debenture holder can short another 500,000 shares and realize $1.5 million more. It need not stop there. When the stock decreases to $2 per share the debenture holder can short 500,000 more shares for another $1 million. At that point, this investor will have generated cumulative proceeds of $5 million from the short sale.
In this hypothetical situation, when the stock reaches $1, the debenture can be converted into 1.5 million shares. The debenture holder may then deliver those shares to cover the outstanding short position. For a $1.5 million investment, the investor winds up with proceeds of $5 million, for a $3.5 million, or 233%, profit.5 "Companies would be very ill-advised to take this type of loan," according to David Beim at Columbia University's Graduate School of Business. "A death spiral precipitates a crisis." (Wengroff, 2001)."
Toxic Convertibles: Catalysts of Doom or Financing of Last Resort?
Sudhir Singh. S.A.M. Advanced Management Journal. Cincinnati: Winter 2005. Vol. 70, Iss. 1; pg. 36, 7 pgs
