Death by Death Spiral

What is a Death Spiral loan?

A death spiral convertible note is simply one that converts into common stock at a percent discount to the stock's market price. The conversion price varies according to the dollar market price of the stock, without a floor on the conversion price. These securities are also called “future priced securities” as their dollar conversion price is set in the future when the conversion occurs.

It is called a death spiral because when the holder converts and sells, it typically depresses the price of the common stock. The more the holder converts, the lower the price of the stock.

The lower the price of the stock, the more stock the holder gets to sell.

For example, the lender buys a note convertible into common stock at 50% of the then market price.

When the holding period for purposes of Rule 144 is up, the holder can convert. The holding period for companies registered with the SEC is six months, and for non-registered companies it is one year.

Assume the price is $10 per share. The holder converts into the stock a portion of the note and sells it. The selling drives the price down to $9.

The holder then converts more stock and sells, driving the price to $8.

After several iterations of this, the price can fall to the cellar – zero bid.

With the stock depressed, the company has trouble raising money because it has to sell more stock to get the same amount of money. At $10, it has to sell one million shares to get $10 million. At ten cents, it has to sell one hundred million shares. This further dilutes the equity of the common stock and drives the price down. This is how the massive dilution is possible.

I recently studied the loans made by one particular Death Spiral lender, loans to 31 companies in all. It is important to note that these companies got Death Spiral loans from many lenders, not just one. These loans had also aged enough to allow the lender to use Rule 144 to convert and sell the loan.

In a two-year period or less, virtually all of these companies lost 99% or more of their stock price and a large percentage of them went to zero bid.

From the point of view of a short seller, two points are important to note here:

Shorting companies that have accepted Death Spiral loans is like shooting fish in a barrel. Almost all of them will have total or near total destruction of their stock price.

Alas, these companies tend to be small companies with limited capitalization giving the short seller a small market to sell into.

Nifty New Tool to Fight Short Sellers

Shareholder Intelligence Services, LLC – (ShareIntel) is a service for public companies to obtain, aggregate, track and analyze shareholder trading information. Find it at ShareIntel.com.

They have a proprietary patent pending web-based application they call the “Data Repository Information Link” system DRIL-Down^TM.

This allows public companies to track broker-dealer, clearing firm and shareholder position movements. With ShareIntel you can track equity flows and identify suspicious, aberrant and/or unusual trading activity in your stock.

You can also historically aggregate repository data from reporting entities, broker-dealers, and shareholders.

You can effectively identify, interpret and communicate shareholder and broker-dealer movement to the market.

Companies can see stock price manipulation, insider trading, "naked" short-selling, market timing, violations of Rule 144, and corporate governance and compliance violations. 

Truly successful stock trading and investor relations depends on getting all the data you can. The system is affordable and a must for public companies seeking to see below the surface of their stock price movement.

Email Bradley Kline <bkline@globalselectadvisors.com> to get a demo. Tell him John Lux sent you. No, I am not being paid anything for this.

Reg A+ Portal Opportunity for Short Sellers?

As a former IPO market maker for a Wall Street investment bank and as one who found short sales for short sellers, I would like to comment on Reg A+ IPO portals. 

As I understand the model, the portal gets companies to list on the portal. The portal then helps the company beat the drum to attract investors. So far so good.

Presumably, the Reg A+ offerings will be smaller and more speculative. Institutional investor interest may be limited and the deal will be placed in some part with small, speculative individual investors. 

Next, when the deal is ready, the investors buy the stock. 

The issues raised are (1) when all the demand is filled, who buys the stock in the aftermarket, and (2) small holders are not necessarily the most stable. 

Historically , there are two IPOs that show the result of these factors.

First, Facebook filled all the demand for stock that it saw. Normally, for a hot issue, you make an indication of interest beyond what you actually want so you can wind up getting what you want. So if you want 100,000 shares, you may request 200,000. Now Facebook was a hot issue so people were making indications for many times what they actually wanted, believing that they would be greatly cut back.

Facebook increased the offering at the last minute to fill all this demand, with the result that not only was there no buying power left, people had more than they actually wanted. The stock price dropped like a stone to nearly half price in a few months. There was no one left to buy in the aftermarket. No demand = price drop. 

Second, Vonage sold to many customers who were small, perhaps even new, investors. The shorts, who love to look for vulnerable IPOs anyway, loved this and drove the price down in the aftermarket to panic these small investors into selling. 

Thus, a process that fills all the demand by selling to small investors, is likely to be bait for short sellers.

By the way, both these deals attracted plaintiffs' attorneys when the price fell. This is automatic. If the stock goes way down, the attorneys show up. Fortunately, they were both successful companies and went on to do well. 

IPO underwriters generally have something called a Green Shoe – https://en.wikipedia.org/wiki/Greenshoe -- which allows the underwriter to buy more stock in a deal. They can go short as much stock is covered by the Green Shoe with no risk because they can always cover the short with the Green Shoe. Thus, the underwriters can afford to support the stock in the immediate aftermarket.

I do not believe any portals will have Green Shoes. 

Time will tell if Reg A+ deals attract short sellers. The offerings may not be large enough. 

The smart company will pay attention to its aftermarket.  

Reg A+ Trumps Reverse Merger

Death Spiral Loan Securities Fraud