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What is “death spiral financing?”

Simply put, death spiral financing is a last resort method of raising money, used by desperate companies. Most of these stocks never recover.

Here’s how it works. Death spiral convertibles are privately held preferred stock or bonds that can be converted to common stock. An investor offers a struggling company cash in exchange for a percentage of the company, but in the event the stock loses value, the investor receives more shares, and a larger percentage of ownership in the company. It’s bad news for the existing investors, because it means that their shares are diluted as the stock value falls. There is a large risk for the new investor (also known as a “vulture capitalist”), since if the value of the company falls to zero, his investment is lost. Here’s an example: ABC Company accepts a $10 million investment in exchange for 25 per cent of the company. If the value of ABC’s shares rise, the investor keeps 25 per cent of the business and earns a return on his money. But if the stock falls to half its value, that means the value of the company is also halved. In order to keep to the terms of this kind of financing, new shares are handed over to the investor, and the percentage of his ownership rises. If the stock ever recovers, he'll still own a significant percentage of ABC Company. Another risk for the company is that the investor may short sell the company's stock and try to push its price down. The lower the stock price drops, the more shares the investor will receive upon conversion. This process is called a spiral because when the stock falls, the company is forced to issue more shares. That causes the existing shares to lose value, which can trigger further selling and more dilution.