Death spiral finance

Publicly traded companies under pressure that have a hard time raising funds with an ordinary new share issue can be tempted to accept something known as death spiral financing. This is a highly controversial method of raising capital that can lead to the collapse of a company’s stock value, often leaving shareholders with worthless shares. This type of financing typically involves convertible debt or equity instruments that create downward pressure on the company’s stock price. So for any other, general investor it is key to recognise such structures and sell fast, or stay away from companies that have such a structure.

What Is Death Spiral Financing?

Death spiral financing occurs when a company issues convertible securities, such as convertible loan notes, that allow the holder to convert these instruments into common stock at a discount to the market price. While this provides an immediate influx of cash, it can create a vicious cycle of stock dilution and declining share value.

It can be a short-term solution for companies in financial distress, but it often comes at the expense of long-term viability. Given that the terms are highly lender friendly and often punitive for both company nor shareholders, it is a given that there will be the more desperate or vulnerable  companies that will accept these hybrid agreements. I.e. it is a clear sign that they can not raise capital in more sound ways.

Shareholders are typically the biggest losers, as a cycle of dilution, more shares on the open market, selling pressure, and declining stock value can lead to their investments becoming worthless. Recognizing the warning signs of death spiral financing is crucial for investors to avoid being caught in this devastating scenario.

Always review a company’s financing structure and consider the risks before investing. If the company relies heavily on convertible debt or similar instruments, it may be wise to steer clear. Check out our in-depth explanation of death spiral financing along with some examples and warning signs here.