Death Spiral and Ghost Busters

[Dragon Lady]

How does one recognize a "toxic" finance deal when reading a company's 10-K or 10-Q report? Many investors don't know how to spot the "toxic" or typical "death spiral" finance deal when reading the SEC filing for any particular company.

There's some very common wording (in addition to learning to recognize the most common names of "toxic" firms- Asher, Magna, Daniel James, KBM, Vis Vires, Fourth Man, etc but new names pop up all the time, so it's best to recognize the specific terms that lets one know it's a "toxic" deal)- so what does one look for when reading the 10-K or 10-Q SEC quarterly or annual filing for a company?

It's actually pretty easy to spot in most cases- as there is some common wording that will almost always appear when a financing deal is "toxic". One can read the 10-K or 10-Q cover to cover or just use a "word search" function in their browser (I use Chrome, and just use the search function when I open the 10-K or 10-Q and I can spot the toxic finance wording in a few seconds or less, every time). The wording is based on the fact that every "toxic" deal is deemed "toxic" via the fact that it is a "floorless" conversion deal. Meaning, the lending firm gets to convert the debt deal to common, free trading shares with NO BOTTOM PRICE set in the terms of the deal. Instead, the conversion price- is always done via a "conversion formula" and that's the easiest way to spot and know that a financing deal is indeed "toxic".

I'll give a few examples using the 10-K or 10-Q SEC filing for Bioheart, BHRT, just because I'm familiar with their filings as I've followed that particular stock and just read their latest 10-K, cover to cover. I'll highlight the "toxic wording" aka the "conversion formula" and show how one can spot it. It will almost always read just like what I'm going to highlight in red, some variation on the wording.

Here is 3 examples from Bioheart's most recent 10-K, showing qty-3 new "toxic" aka "floorless" financing deals they just did- one will see the fact they are 1) Loans or a debt for shares deal 2) They have a fairly high interest rate, typically 8% to 12% 3) That they provide for a STEEP share discount upon conversion- in this case 45% to 47% and most importantly, 4) the TOXIC CONVERSION FORMULA, the wording like, "The note is convertible to common shares of stock BASED ON THE AVERAGE OF THE LOWEST PRICE (note LOWEST PRICE) of the LATEST 3 or LATEST 10 DAYS AVG SHARE PRICE" prior to conversion.

It's that last line that makes it "toxic" the "conversion formula" being based on the avg of the LOWEST PRICE of the prior 3 or prior 10 days trading, blah, blah, blah. That's what makes it "floorless". Meaning NO MATTER HOW LOW THE SHARE PRICE GOES, the debt holder converts on the average LOWEST share price based right when they're going to convert, and THEN gets the 45% or 47% discount too boot. Meaning the lower the price goes- it's actually even better for these toxic note holders as they get that many more shares when they convert.

Here is examples of how to spot a "toxic" financing deal in a SEC filing:

http://www.sec.gov/Archives/edgar/data/1388319/000114544315000378/bioheart_10k.htm

From the latest filed BHRT 10-K, PAGE F-43:

Subsequent financing

On January 7, 2015, the Company entered into a Securities Purchase Agreement with KBM Worldwide, Inc. (“KBM”), for the sale of an 8% convertible note in the principal amount of $38,000 (the “Note”).

The Note bears interest at the rate of 8% per annum. All interest and principal must be repaid on October 9, 2015. The Note is convertible into common stock, at KBM’s option, at a 45% discount to the average of the three lowest closing bid prices of the common stock during the 10 trading day period prior to conversion. In the event the Company prepays the Note in full, the Company is required to pay off all principal, interest and any other amounts owing multiplied by (i) 140% if prepaid during the period commencing on the closing date through 179 days thereafter. After the expiration of 180 days following the date of the Note, the Company has no right of prepayment.

On January 28, 2015, the Company entered into a Securities Purchase Agreement with Fourth Man, LLC., for the sale of an 9.5% convertible note in the principal amount of $25,000 (the “Note”).

The Note bears interest at the rate of 9.5% per annum. All interest and principal must be repaid on January 27, 2016. The Note is convertible into common stock, at Asher’s option, at a 47% discount to the lowest daily closing trading price of the common stock during the 10 trading day period prior to conversion. In the event the Company prepays the Note in full, the Company is required to pay off all principal at 150%, interest and any other amounts.

On February 19, 2015, the Company entered into a Securities Purchase Agreement with Vis Vires Group, Inc. (“VIS”), for the sale of an 8% convertible note in the principal amount of $38,000 (the “Note”).

The Note bears interest at the rate of 8% per annum. All interest and principal must be repaid on November 23, 2015. The Note is convertible into common stock, at VIS’s option, at a 45% discount to the average of the three lowest closing bid prices of the common stock during the 10 trading day period prior to conversion. In the event the Company prepays the Note in full, the Company is required to pay off all principal, interest and any other amounts owing multiplied by (i) 140% if prepaid during the period commencing on the closing date through 179 days thereafter. After the expiration of 180 days following the date of the Note, the Company has no right of prepayment."

See, every deal is worded nearly identical- some are based on the avg of the prior 3 days, some on the prior 10 days, but always that wording- the "conversion formula" of the avg of the LOWEST "x" number of days prior to conversion. And then the steep share discount. That's a toxic finance deal - too the tee. Almost every one you'll ever see will be worded almost exactly like those highlighted in red above.

Also, notice that the deals typically carry stiff pre-pay penalties too boot- such as 150% of face value, blah, blah, blah. That's how one spots a "toxic" deal. Look for that "conversion formula" wording and you know a company just took on a toxic note deal. Also, notice the amounts- they're typically pittances of cash like $25K or $38K (almost never more than about $100K which is how the toxic firms also protect their downside risk)- so these cash desperate companies usually end up doing what I just listed/highlighted above. They end up doing many of these deals one after another- as in $25K with firm "X" and then $38K with toxic firm "Y" and then another $30K with firm "Z" to get a lousy $100K more survival cash or whatever- usually a month's or less worth of survival cash.

How bad can these deals be on conversion? Just do the math- it's staggering how a toxic firm can loan a company say $25K, but with a dropping share price and then a 47% discount, the toxic lender might get 10 or 20 MILLION shares of stock for a lousy $25K loan (if you get into where the stock drops to double zeroes .00X and then triple zeroes, .000Y then it can be 50 MILLION or 100 MILLION shares or whatever, staggering dilution). They, the toxic note holder, they then dump those shares in "stair steps", driving the price lower as they sell, getting more shares on each leg down (and shorting, which they say they don't do, but everyone knows or suspects they do) - and then finally covering at the bottom with their last pile of shares on their last leg of converting.

That's it in a nut shell. If you see, "convertible to common shares based on the LOWEST avg price of the prior 3 or prior 10 days trading"- any wording to that effect, you're probably looking at a "toxic", floorless financing deal- and that means IMO, be watching for potential massive dilution to be hitting the stock, usually within about 6 months max from the time the deal is inked.

Brutal, price crushing dilution- often so powerful, so overwhelming, that no amount of retail buying eventually can off-set it or ever overtake it- and then it's the "death spiral" down. Some act like "death spiral" is some made up, "negative" sounding word or term- but the SEC itself actually uses exactly that term to describe these kind of "floorless" and "convertible" debt deals- also "ratchet" financing and some other terms. See the link below- the words "death spiral" are right on the SEC site itself:

http://www.sec.gov/answers/convertibles.htm

From the SEC itself:

"By contrast, in less conventional convertible security financings, the conversion ratio may be based on fluctuating market prices to determine the number of shares of common stock to be issued on conversion. A market price based conversion formula protects the holders of the convertibles against price declines, while subjecting both the company and the holders of its common stock to certain risks. Because a market price based conversion formula can lead to dramatic stock price reductions and corresponding negative effects on both the company and its shareholders, convertible security financings with market price based conversion ratios have colloquially been called "floorless", "toxic," "death spiral," and "ratchet" convertibles."