Suppose a small company takes a straight loan at 10% interest.
The economics of it are that the company will plow the money into its business, and hopes to grow in such a way that it will be able to repay the loan, the 10% interest, and still have extra revenues that will benefit its shareholders.
The impact of the loan on the share price is low. In subpenny stocks, nobody seems to pay attention to debt levels anyways.
Now take a similar company borrowing at 6%, convertible into shares at a 40% discount.
There's a direct impact on share price, once the 6-months holding period is over. The arrival of new dilutive shares drive down the price, and the O/S increase by itself also lessens the value of the stock.
As the regular loan, one would hope that the money would be used wisely and that the growth in revenues would outweigh the dilution effects. But in subpenny stocks that is almost never the case.
1) when the dilution start, the beneficial effects of the loan, that was taken 6 months back, ought to already be perceptible. That rarely happens.
2) The money is often wasted, goes to pay high salaries to obviously inept officers, or goes to repay older debt. Old debt is being refinanced at worse conditions. This is rarely mentioned to shareholders.
The great advantage of convertible debt is that it "costs nothing". The shareholders foot the bill entirely, paying both for the money borrowed, for various fees and "cash discounts" and for a fat profit margin for the toxic lender. Since the conversion rate is often based on a medium-recent lowest share price,
the lender benefits from any upbeat PR, locking in a guaranteed profit on top of its usual discount.
For the toxic lender, it's hard to lose money at that game, except when the penny stock company welshes on the contract, refuses conversion, or just plain folds. Ordinary business risks.
The company and the lenders often announce a debt cancellation, which happens to be followed by more borrowing. In fact it was just a ploy to increase volume. It works.
So, yes, the outlook for shareholders of companies that borrow convertible debt is bleak. You can attempt to track how the money was used, and if it dild help to grow sales enough to make up for the dilution.
Or, you can amuse yourself by computing the effective loan rate, which is the money effectively received by the company (which is often less than the nominal amount borrowed), vs the total value of the discounted shares issued.
Its a sobering exercise. You discover that your company borrowed at an effective 100% annual rate, and still has no sales at all.
