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.
