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A Warning To Penny Stock Investors: Do You Know About Death Spiral Financing

Josh Sason was just 27 when Bloomberg reported in 2015 that he had made US$200 million by financing US penny stocks that were about to go broke.

A different financing method

Sason structured the loans he made slightly differently from traditional loans. His loans usually involve offering debt which can be converted into equity.

The deals are commonly known as “death spiral financing” as most of the companies that are involved with this sort of dealing (the companies are mostly penny stocks) usually end up with stock prices that plummet. The interesting thing is that the lender would still be able to make a healthy profit.

What to know about death spiral financing

So what exactly is “death spiral financing” and should investors in penny stocks be worried?

Death spiral financing involves a lender offering a loan to a company that is traded on a stock exchange. The company is typically in very bad financial shape and desperately in need of cash to stay afloat.

The lender would demand payback-plus-interest over a short period of time (usually around six months). If the company involved is unable to pay back the loan – which is often the case – it will instead offer shares to the lender at a huge discount to the market rate. In this way, the lender is able to get the company’s stock and immediately sell it for a profit, even though the company is unable to pay back the loan.

An example of a death spiral deal

Take this scenario for example. Lender B decides that company X is a good candidate for a $1 million loan with a six-month maturity. Company X agrees to take the loan at a 10% interest to keep itself afloat.

If it is unable to pay back the loan, Company X would offer Lender B shares of itself at say, a 70% discount, to the then-current market price. Since the shares were bought at a 70% discount to the market price, Lender B would be able to get around $3.3 million worth of shares which he can immediately sell in the open market for a healthy profit.

There are two positives that come out of such a deal. Firstly, Company X would be able to stay afloat. Secondly, Lender B ends up with a nice return on his investment – regardless of whether Company X can pay back the loan.

However, at the same time, there are also two parties that will suffer from this sort of financing.

The first group is the existing shareholders of Company X who may not have realised that the company has potentially diluted their shareholdings by offering Lender B cheap equity. The financing deal dilutes current shareholders’ equity and would very likely cause Company X’s stock price to decline steeply.

The second party to suffer would be unwitting new shareholders who buy Company X’s shares while Lender B is dumping his shares. Because getting information on penny stocks may often be difficult, investors or speculators may decide to buy, without realising what is happening.

The Foolish bottom line

There are other financiers besides Sason who have structured similar deals in the past to desperate companies. As investors and long-term shareholders, we need to be aware that such dealings are occurring, even if they don’t seem to be common in Singapore. In any case, the best way to avoid companies that could potentially be embroiled in death spiral financing is to stay away from companies that are in desperate need of cash.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.