What Is Death Spiral Financing?

Death spiral financing occurs when a company issues convertible securities—such as convertible loan notes — that allow the holder to convert these instruments into common stock at a discount to the market price. While this provides an immediate influx of cash, it can create a vicious cycle of stock dilution and declining share value.

Key characteristics of death spiral financing:

1. Conversion at a Discount:

   • Same as for many convertible instruments, investors can convert their debt or preferred equity into shares at a lower price than the current market value – a discount.

   • Specifically for these convertibles, the discount is not fixed –  instead it is floating in relation to the current market price (a look back period of for example VWAP of 5-10 business days prior to the conversion).

   • The investor often decides when, and if, it will convert (meaning that the company cannot control this)

   • Sometimes the conversion even has a ceiling price where the conversion will never exceed this level (which is even better for the investor and worse for the company and the other shareholders)

   • It can also have a floor, that is a lowest price at which conversion can occur – but that is basically never seen.

     
     

2. Dilution Effect:

   • As more shares are issued at a price below the current trading price given the discount, the existing shareholders’ ownership percentage and also the per-share value will decrease.

     
     

3. Downward Price Pressure:

   • The discounted conversions incentivize the investors to sell their newly acquired shares immediately, causing the stock price to drop further.

     
     

4. Short selling:

   • Given that the investor knows that it can buy shares at a discount to the market price, they often also engage in shorting the stock. I.e. they bet that the share price will drop as they know that their own conversion at a discount will most likely have such an effect. So, they “bet against” the company.

   • Since the existence of the convertibles is typically known to the market, also other players may look to short the stock in the anticipation that the price will continue to drop – exacerbating the downwards pressure on the stock price.

     
     

5. Feedback Loop:

   • The lower stock price triggers even more discounted conversions, accelerating the dilution and driving the stock price toward zero in worst cases.

   • The lower the stock price the more ownership the investor gets, however, often there is a cap as re. how much ownership the investor can own at any given time. Given that they are short term owners they however seldom see this as a problem.

     
     

Example of Death Spiral Financing

Let’s consider a fictional company, Optimistic Company LLC, that uses death spiral financing to raise $10 million to address a cash flow crisis.

• Step 1: Initial Financing Agreement

  
  

  Optimistic Company LLC issues $10 million in convertible bonds to investors. The bonds can be converted into common shares at a 20% discount to the stock’s market price, which is currently $10 per share. This gives the investor a conversion price of $8 per share.

  
  

• Step 2: First Conversion and Dilution

  
  

  The lender converts $2 million into shares at $8 per share, receiving 250,000 shares (2,000,000 ÷ 8). They immediately sell these shares on the open market, creating selling pressure that – together with the fact that there are more shares on the market - drops the stock price to $9.

  
  

• Step 3: Accelerating the Spiral

  
  

  The remaining loan is then converted more into shares, but at the new discounted conversion price of $7.20 (20% below the new market price of $9). This results in the issuance of more shares, further diluting the stock and reducing its value.

  
  

• Step 4: Stock Price Collapse

  
  

  The cycle repeats. The lender continue converting and selling shares, causing the stock price to plummet with each round of conversion.

  
  

By the time the process is complete, Optimistic Company LLC stock value approaches zero, leaving shareholders with worthless investments.

Why Does Death Spiral Financing Lead to Stock Value Collapse?

1. Excessive Dilution:

   • The issuance of more shares at increasingly lower prices reduces the value of existing shares.

     
     

2. Market Panic:

   • Investors lose confidence as they witness the stock price drop, leading to panic selling and exacerbating the price decline.

     
     

3. Short Selling:

   • Opportunistic traders may short-sell the stock, betting on its continued decline, adding more pressure to the downward spiral.

     
     

4. No Ability to Access Capital:

   • Once the stock becomes nearly worthless, the company loses the ability to raise further capital, which in a worst case scenario could leade to the company becoming insolvent.

     
     

Warning Signs of Death Spiral Financing

1. Convertible Securities at Deep Discounts with floating conversion rate:

   • Financing agreements that involve conversion terms significantly below market price that are not fixed but instead floating, and that can be converted at will by the investor/lendor.

     
     

2. Frequent Dilution Announcements:

   • Repeated issuance of shares or convertible instruments, or a big convertable that the investor converts in portions ongoingly.

     
     

3. Sharp Declines in Stock Price:

   • Rapid and unexplained drops in stock value after financing announcements where the features (some or all - the lenders are creative as to try and hide how bad the actual terms are for the company and the other shareholders) have the traits of death spiral finance.

     
     

4. High Trading Volumes:

   • Sudden spikes in trading volumes driven by heavy selling activity can be a sign of selling close to conversion having taken place at a discount to the current stock price.

     
     

Conclusion

Death spiral financing can be a short-term solution for companies in financial distress, but it often comes at the expense of long-term viability. Given that the terms are highly lender friendly and often punitive for both company nor shareholders, it is a given that there will be the more desperate or vulnerable  companies that will accept these hybrid agreements. I.e. it is a clear sign that they can not raise capital in more sound ways.

Shareholders are typically the biggest losers, as a cycle of dilution, more shares on the open market, selling pressure, and declining stock value can lead to their investments becoming worthless. Recognizing the warning signs of death spiral financing is crucial for investors to avoid being caught in this devastating scenario.

Always review a company’s financing structure and consider the risks before investing. If the company relies heavily on convertible debt or similar instruments, it may be wise to steer clear. Stockholm, 2025-01-07

Author: Kat Strandberg Email: kat@stgcommerciallaw.com