What Toxic Financing Is And How Public Companies Can Avoid It

Interest rates have skyrocketed over the last year, and as a result, companies with variable-rate debt on their balance sheets are paying more in debt service than at any other time in the last 15 years. Currently, the bond market is pricing in a terminal federal funds rate between 5.3% and 5.5%. 

In comparison, a year ago, the federal funds rate was less than 1%. Companies that are paying more in debt service obviously are finding their net profit margins declining, which could trigger a domino effect. Lower net profit margins could lead to a decrease in their credit rating, which, in turn, could then increase the interest rates they are forced to service as well.

Right now is the worst time in 15 years to take on new debt. As a result, this is a good time to discuss toxic financing — and what public companies can do to avoid it.

Toxic financing is an especially big concern for small- and micro-cap companies because their stocks tend to be less liquid. Additionally, they lack the scale to support any major investments in growth or capital expenditures.

How does toxic financing work?

Most convertible debt has a floor, or a price at which the lender cannot convert it once the share price falls below that level. However, what makes debt toxic is that its terms allow the lender to convert both the principal and the interest on it into common shares at a massive discount to the market, usually with no bottom price. Essentially, the lender continues to make money as he converts the debt into common shares — even if the stock is plunging and eventually falls to zero. 

Toxic financing can come in the form of convertible debt or convertible preferred stock. One of the most common scenarios is that the terms of the debt may grant the debtholder an unlimited number of common shares when they convert their debt or preferred shares to common stock.

Since the company can't afford to service the debt, the debt or convertible preferred shares get converted into common shares at hugely discounted stock prices. The debtholder then sells those common shares to the open market, creating downward pressure on the stock.

The formula used to convert the convertible debt or convertible preferred shares into common shares is generally structured in such a way that there's no floor on the price received for the converted shares. 

This scenario is referred to as "floorless convertible" debt, and it's easy to see why it's toxic for a company. This floorless convertible debt generally utilizes a floating conversion rate that's often at a deep discount to the market price of the company's shares at the time of conversion.

Beware the "death spiral" scenario

Toxic debt is also sometimes referred to as "death spiral financing" because it usually triggers a sharp selloff in a company's shares, especially those of a small-cap or micro-cap company with low liquidity in their common stock. When a low-liquidity company's stock is in freefall, the result can be devastating.

There is more than one way toxic financing can go wrong. In a "death spiral" scenario, the holder of the convertible debt might sell shares of the company short while converting some of the convertible debt into common shares. The debtholder can then cover that short position using the common shares they just acquired in the conversion.

As a result, the company's stock price plunges sharply, and other investors might start to dump shares out of alarm, triggering a vicious cycle of selling. If the debtholder continues to sell shares short and cover the position with converted shares, the company's stock price will continue to plummet.

At some point, new investors won't even consider buying the shares. As a result, the company's ability to secure new financing may become exceedingly difficult, if not impossible in some cases.

A gradual conversion

One final point that should be made about the toxic financing process is that when a debtholder converts debt into common shares, it doesn't usually convert the entire amount all at once. The goal is to convert and sell as many shares as possible for more than the conversion price, but they can't sell all their shares at once without driving the stock price down dramatically.

Thus, they may convert a small percentage of the debt or preferred stock at any one time. The percentages gradually grow until all the debt has been converted to common shares and sold.

Additionally, as more and more of the debt is converted into common shares, the company's outstanding share count explodes. This process dilutes the positions held by the previous shareholders — further incentivizing them to sell and increasing the risk of a death spiral for the company's stock price.

Red flags for toxic debt

With all the problems caused by toxic financing, it's worth considering why management would enter into such agreements. The reality is that many executives aren't aware of this problem or lack the legal background needed to spot problematic language in a financing agreement.

In some cases, executives might be convinced the company can pay the debt back. Others might be desperate for funding, feeling or even discovering that toxic debt is the only way they can secure financing for their company. Some factors that could restrict a company's debt options to toxic financing include being in an early stage of development or having a particularly unattractive credit risk profile.

A double-digit default rate on that particular type of debt is also a major red flag. Another red flag is a situation in which more debt is accumulated than what the debtor can comfortably pay back. 

Additionally, convertible note issuers with a track record of driving toxic financing deals generally limit the holding period on their notes to six months for SEC-reporting companies. The Securities Act of 1933 requires all unregistered securities acquired directly from the issuer to be held for at least six months, which is why a six-month timeframe is often given as the holding period on toxic debt.

Avoiding toxic financing

Executives of a company potentially facing toxic financing offers will have to pay careful attention to the language used in the terms of the debt. The best-case scenario when dealing with convertible debt is to secure terms that restrict what the debtholder can do.

The hallmark of toxic debt is the lack of a floor on the price at which debt converts to common shares. Thus, the management of public companies considering entering into a convertible debt deal should try to secure language that sets a floor on the conversion price.

For example, including conversion language something along the lines of this: "The debtholder has the right to convert the debt into common shares at the greater of $1 per share or 80% of the market price." In this scenario, the floor is $1 per share, which limits the potential for a death spiral in the company's stock.

This scenario also includes another protection for the company. It restricts the discount at which the debtholder can convert the debt into shares. The largest discount this phrase allows is 20%.

Final thought: consider delegation

Toxic financing is a serious issue, especially for small- and micro-cap companies, which can go bankrupt quickly and easily under such debt terms. The Securities and Exchange Commission has begun cracking down on some of the worst offenders, but the fines it has been doling out amount to little more than a slap on the wrist.

Thus, company founders may want to consider delegating their fundraising needs to those with the experience needed to be able to spot toxic terms on a financing offer.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.