Companies, especially small-cap companies or companies with thinly-traded stock, often seek creative ways to raise capital. Such companies are most likely not in a position to issue stock — they already had an IPO/SPAC — and their prospects for a traditional bank loan might be weak.
As an alternative, such companies consider a “death spiral,” a type of debt financing often used as a last resort.
What Is a Death Spiral?
The death spiral is a type of convertible bond or a debt instrument that yields interest but also can be converted to a number of shares of stock. It is a hybrid security with some attributes of both a bond and a stock.
The death spiral converts to a set dollar value. However, the company issuing the death spiral debt will not pay these new bondholders in cash but instead in new shares of the company’s stock.
As such, the death spiral creates an increasing number of shares of the company’s stock. With more shares being created, existing stockholders’ shares are diluted, inevitably leading to a steep drop in the price of shares.
How Death Spiral Debt Differs from Traditional Convertible Bonds
A conventional convertible bond can be converted to a fixed number of shares. However, it is important to note that the death spiral debt converts the debt into a fixed value — which is ultimately paid to the bondholders in shares of stock. This distinction is often how bankers and lawyers can spot a death spiral in their pipeline.
Simply put, the more this type of bond is converted, the more shares are created and the lower the share price will go.
Convertible bonds are attractive to investors who believe that the company is about to experience a surge in performance and that the company’s stock is about to move higher. With a substantial increase in a company’s stock price, investors in conventional convertible shares are likely to convert their bonds into shares of stock in order to capture any pricing opportunities
However, in a death spiral situation, a stock price decline will also motivate the owner of fixed-value convertible bonds, as such bondholders will receive more shares of stock when they make the conversion. By definition, the creation of more shares in the market will force prices even lower.
Death spirals happen as more and more fixed-value convertible bond owners convert their bonds into stocks as values drop lower and lower. Companies that typically issue this type of bond are likely desperate for cash in order to stay afloat.
Why Create a Death Spiral in the First Place?
As cited earlier, this type of bond is sometimes issued by a company that desperately needs cash and has few other options. There may be no other fundraising options, as a traditional bond issue or bank loan cannot be arranged: the company may have low credit quality or may have exhausted other options.
It is important to note that death spirals typically allow buyers to convert the bonds into shares at a fixed conversion ratio in which the buyer enjoys a significant premium. For example, a bond that has a face value of $1,000 may have a convertible value of $1,500. That would mean a bondholder would receive $1,500 worth of shares for giving up the $1,000 bond.
While conversion creates more shares and a lower share price, this price drop might actually be attractive to certain types of investors. Such investors might be less interested in the share price and more interested in receiving more company shares. These investors might be interested in a company takeover, or with a change in management, the company could eventually get acquired — delivering an attractive payday for such investors.
Controversy: Here Come the Short Sellers
Adding further pain to the death spiral, investors holding the convertible debt short the issuer’s common stock — causing the stock price to fall rapidly. At the same time, the death spiral bondholder converts some of the convertible debt into common shares, which then cover the holder’s short.
The debt holder will then maintain his selling of the short alongside other shareholders who are selling because of the rapidly falling price. This further weakens the share price and makes it undesirable to new investors and possible new finances, according to Capital.com.
How to Use Caplinked’s Virtual Data Room for M&A
In volatile markets or transactions, such as those involving death spirals, delays can affect asset prices, ultimately affecting the terms of the deal.
When hundreds of documents need to be shared by dozens of participants in a transaction, a virtual data room (VDR) promises the best features related to security, administration, and ease of use. In addition to rights management, permissioning, tracking and other advanced security features, a VDR also offers efficiency, as a transaction could be delayed without the ability to properly present documents to all parties involved.
Organizations should consider an enterprise document security solution like Caplinked, which has years of experience working with corporate, financial, and legal teams and providing VDRs for transactions and ventures of all sizes.
Jake Wengroff writes about technology and financial services. A former technology reporter for CBS Radio, Jake covers such topics as security, mobility, e-commerce, and IoT.
Investopedia – Death Spiral Debt
Capital.com – What is Death Spiral Financing?