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OT: Death spiral financing definitions.... 3 Versions

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peewee   Sunday, 11/15/09 12:29:26 PM
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OT: Death spiral financing definitions.... 3 Versions


Death spiral financing

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Death spiral financing is a process where convertible financing used to fund primarily small cap companies can be used against it in the marketplace to cause the company’s stock to fall dramatically and can lead to the company’s ultimate downfall.

Many small companies rely on selling convertible debt to large private investors (see Private investment in public equity) to fund their operations and growth. This convertible debt, often convertible preferred stock or convertible debentures, can be converted to the common stock of the issuing company often at steep discounts to the market value of the common stock. Under the typical “death spiral” scenario the holder of the convertible debt initially shorts the issuer’s common stock which often causes the stock price to decline at which time the debt holder converts some of the convertible debt to common shares with which he then covers his short position. The debt holder continues to sell short and cover with converted stock which along with selling by other shareholders alarmed by the falling price continually weakens the share price making the shares unattractive to new investors and can severely limit the company’s ability to obtain new financing if the need arises.

An important characteristic of this kind of convertible debt is that it often carries conditions like a quarterly or semi-annual reset of the conversion price to keep the conversion price more or less close to the actual stock price. But a lower conversion price also increases the number of shares that a bond holder gets in exchange for one bond, increasing the dilution of existing shareholders. A lower price reset can also force investors that have set up a long CB/short stock position to sell more stock ("adjust the delta"), creating a vicious circle, hence the nickname death spiral.



The Convertible Debenture "Death Spiral”

In many ways, the issuance of toxic convertibles are a legal method to transfer assets from the existing common shareholders into the pockets of the toxic convertibles and, to a smaller degree, the management. The toxic convertible holders get the bulk of the benefit, but don't be fooled - the issuing company's management is also a beneficiary. Let's face it, most of the companies that stoop low enough to issue these death ride convertibles do it because without the quick cash they bring in the Company would be forced to go out of business. In almost every case, the small amount of cash they receive is not enough to rescue the business which is almost always a casualty of bad business decisions our faulty business plan capped off by the terminal decision to issue the death ride convertibles. The small amount of cash and brief window of time afforded by the convertible's issuance is almost never enough to rescue a company which by all rights is already on life support. In the meantime, management gets to draw what is usually generous salary and benefits for awhile longer and may even bail out of their own share positions before the ship sinks entirely.

While the only winners in the issuance of death rides is the convertible holders and the management, there are lots of losers on the deals. The biggest losers are usually the company's original creditors. If we assume that most of the issuing companies are destined for business oblivion anyway, then certainly the company should end its life while there are still assets left to pay off existing debts. After the death ride is over, there is usually nothing left and the creditors are left with nothing. That money is almost always siphoned off into the pockets of the toxic convertible holders who almost always short the issuing company right into the ground. The common shareholders are also losers. Like the creditor scenario, any possible assets that might be available to the common shareholders end up in the pockets...

While NASD Rule 3350, The Short Rule”, protects stock issues by prohibiting short sales on a down bid and the practices of "Bear Raiding" and "Piling On", NASD Rule 3370 (b)(2)(B) creates a loophole allowing primary market makers in OTCBB traded securities to make naked short sales without having to make a positive determination that securities are available to borrow for delivery by settlement date. Also, holders of convertible debentures can technically short sell securities that are technically covered” via the convertibles.

http://www.pcms-team.com/whitepapers/focus.php?id=13ece98c422e33 (unavailable)



death spiral convertible

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A convertible bond issued by a distressed company with a conversion ratio that moves in the opposite direction of the share price. A death spiral convertible offers more shares to the security-holder as the price of shares decreases (an increasing conversion ratio), which decreases the control that common shareholders can exert by dilution. This type of convertible is used by companies who would not be able to find financing through other means because of poor financial health. also called toxic convertible, floorless convertible.



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