Wall Street's Toxic Tool - Company Operations

Industry Standard, The, March 19, 2001 by Cory Johnson

The death-spiral convert may be the hottest tool in finance, but it's what put another nail in Stan Lee Media's coffin.

The dark side of Internet financing is here. Gone are the kinder, gentler times, when the terms of financing Net startups were simple: Young companies would take a few rounds of venture capital, each increasing the value of the company, until an P0 would bring the firm public. Bigger companies like Yahoo and Amazon.com could sell secondary stock offerings and even bonds.

But in today's complex, desperate times, Internet companies are turning to complex, desperate measures. Notorious among these is the reset security, also known as the "death-spiral convert" and sometimes as a "toxic." In the best of times, a death-spiral convert can be the elixir that brings a company back to life. More often, it can suck the last breath from a struggling business. Indeed, this seems to have ultimately doomed Stan Lee Media.

Death-spiral convertibles are privately held preferred stock or bonds that can be exchanged for shares of common stock. An investor will offer a company cash in exchange for a percentage of the company, but with a catch: The investor wants a guarantee that the investment's value won't fall (or won't fall much). If the stock does fall, the investor gets more shares -- and a bigger stake in the company.

And what about the existing investors? As the stock falls, they own less of the company as their shares are diluted. That's why the investors in death spirals are known as vulture capitalists, because they prey on firms, like Stan Lee Media, desperately burning through cash.

Here's a hypothetical example of a death-spiral convertible. Acme.com takes a $30 million investment for 30 percent of the company. If Acme's shares rise, the vulture capitalist keeps 30 percent of the business and makes money. [See chart.] But Let's say the stock price is cut in half-which means, of course, that the value of the company is cut in half. By the terms of this death-spiral convert, the vulture's stake cannot fall below $25 million. So instantly, a pile of new shares is handed over to the vulture capitalist, and his stake rises to 50 percent. And if the stock ever recovers, he'll still own half of Acme.com.

Of course, there's risk for the vulture capitalist. If the company goes bankrupt, he's left with nothing. That's a very real possibility. When the stock falls, the death-spiral converts force the company to issue more shares. That, in turn, causes the existing shares to lose value, which can trigger a further sell-off and more dilution.

Few of these stocks ever recover. According to J.P. Morgan H&Q, desperate firms like Auspex, Drkoopcom, eFax, eGain, eToys, Intraware, NetpLex, MicroStrategy and Value America have turned to death-spiral converts for financing. But the results have largely been disastrous. One business-school study of 490 death-spiral converts found companies lose an average of 72 percent of their value within three years of issuing a death-spiral convert.

"There have been some pretty egregious deals," says Zach Hulsey, a managing director at J.R Morgan H&Q, who says that CEOs, rather than more cautious CFOs, typically agree to such deals.

The use of death spirals can get even more sinister. The same vulture capitalists who take a stake in a company suddenly have a vested interest in seeing the stock price fall, so they can gain more shares of the company. Some have been known to invest in a company with one hand and hammer the stock with short-selling to drive the share price down with the other. Either way, they make money.

But when companies are really in trouble, they do whatever they can to raise funds. "Stan Lee Media had a horrible balance sheet, no cash and was burning through something like $1.5 million a month," says an investor in the company's death-spiral convertible, who asked not to be identified. "In the end, the guys at Stan Lee did a very poor job of financing the company."

                    How Death-Spiral Convertibles Work
                      With the high-risk securities,
                       vulture capitalists own more
                     of a company as its stock tanks.
               Vulture capitalists Existing shareholders
Investment             $30                  $70
Stock rises            $45                 $105
Stock falls            $25                  $25
Stock recovers         $50                  $50
Stock crashes          $25
If stock falls, original investors get squeezed out...
... while convertible holders see their stake increase.
If the stock recovers, convertible holders get a bigger piece.
If the stock crashes, convertible holders can end up with the whole company.
SOURCE: THE STANDARD