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Toxic Financing

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Toxic Financing explained

Additional Information:

Company: Death Spiral financing
Date Published: Feb 5, 2023
Transcript: Available

Video Transcript:

You open your email and find the following.

Predator Corp specializes in funding OTC listed public companies.

We fund companies at any price and there's no cap on the stock price we can fund.

We infuse capital into these companies on a large scale, depending on the company.

We also like to clean up the company's “bad” parts, such as debt on the books, unwanted shareholders, outstanding payables, or notes to creditors.

If you're a small company struggling to raise funds, you may think your problems are behind you.

Welcome to the world of death spiral financing or toxic financing, as is it is sometimes called.

Let's look at an example of how this can destroy your company.

For this example, we’ll call your company Victim Corp.

You may not consider your company to be a victim, but it will be shortly.

Victim Corp has 10 million shares outstanding and is trading at a dollar, giving it a capitalization of 10 million dollars.

The lender says he likes your business model, thinks it will do well and wants to lend you a hundred thousand dollars.

The lender is willing to accept a convertible debenture, which he will only convert at a premium of 10% to your average closing market price, based on the 10 days prior to the date he chooses to exercise his conversion privilege.

It looks like the financer shares your vision for the future, or he wouldn't agree to convert his debt to shares at a premium to your trading price.

If your share price stays at a dollar and he converts his shares at a $1.10, he would only get about 90,900 shares.

You can certainly live with that, so you sign the papers and get back to growing your business.

A week later, you see a lot of selling coming into your market.

You have a pretty thin float and think you know all of your shareholders, so you assume it is someone shorting your stock.

After 40,000 shares are sold at an average price of 90 cents, your shares are now bid at 80 cents.

You curse the stock market gods and you optimistically go about your company's business believing these shorts will turn into future buying after you release your next sales figures, which you are pretty exited about.

The following week, your market is hit with 200,000 shares, driving your price down to 40 cents.

The average trading price was 55 cents, which put another $110,000 into the seller's pockets.

You are now really concerned, but you're too busy taking calls from angry shareholders and trying to find buyers for your stock to even deal with your day to day business.

The next week, your stock gets driven down to 20 cents, as some of your long-term shareholders start panicking and start selling alongside the mysterious seller who has now sold another 300,000 shares at an average price of 30 cents.

But your horror story is just beginning.
As you scramble to try to arrange some buying, which is pretty much impossible as your stock just dropped from a dollar to 20 cents, your mystery seller keeps coming, selling another million shares at an average of 5 cents.
This is followed by more selling the next week with the unknown seller liquidating another million shares at an average price of 1 cent.
You are now panicking and trading at one tenth of a cent.
A courier comes to your office with an envelope from a lawyer, which states that your lender wishes to exchange his $100,000 debenture for 50 million shares.
By the lender’s calculations, two-tenths of a cent per share is 10% above the average trading price for the last five days.
You have no recourse and are obligated to issue 50 million shares to the lender.
Over the last two months, your lender has sold 2,540,000 shares for $296,000.
He has tripled his original investment of $100,000 and still holds about 47.5 million shares.
You originally had 10 million shares outstanding, and you now have 60 million with 47.5 million in very unfriendly hands, which will be overhanging your market for a very long time.
Your $10 million capitalization is now $120,000, and you have no choice but to significantly roll back your shares.
Although this example is fictitious, we'd like to show you a couple of real cases.
We've removed the symbols to save anyone embarrassment.
The key take away is to always have your conversion set for a fixed number of shares and not based on the market price.