One of our services is assistance with funding, when needed. However, for those companies who prefer to search for their own funding source we are providing this informational page. You need to avoid the disasterous funding arrangements which have sprung up since the late 1900s.
Whatever you do, do not get funding via a debenture with a market price based conversion formula. Per the SEC: "Because a market price based conversion formula can lead to dramatic stock price reductions and corresponding negative effects on both the company and its shareholders, convertible security financings with market price based conversion ratios have colloquially been called 'floorless', 'toxic' ,'death spiral', and 'ratchet' convertibles.".
Read all about Convertible Securities at the SEC.
Read Pros and Cons of Private Equity at Bowne.com.
Do not accept a funding arrangement that has any toxic component. Toxic arrangements can masquerade as PIPEs, preferred stocks, convertible bonds or other financial instruments. This does not mean that all PIPEs, etc. are bad. However, you must look very carefully at the details.
A corporate bond, is usually a junior debenture that can be exchanged, at the option of the holder, for a specific number of shares of the company's preferred stock or common stock. However a floorless convertible is convertible at a discount to the share price at issuance and for a fixed dollar amount rather than a specific number of shares. This means the investors can convert their securities at a discount to the current market price, usually with no limit as to how low the conversion can go. With a toxic convertible the further the stock falls, the more shares the investor gets. Therefore, the lender could profit from shorting the borrower's stock in the open market since it would be able to convert its bonds (or other type of debenture) and use these shares to cover its short position easily when settlement is due.
Why is this called a "death spiral"? As the SEC explains, "The more shares the company issues on conversion, the greater the dilution to the company's shareholders will be.... The greater the dilution, the greater the potential that the stock price per share will fall.... The more the stock price falls, the greater the number of shares the company may have to issue in future conversions and the harder it might be for the company to obtain other financing. "
You might find yourself having to re-finance through the same, friendly people that sold you on the toxic convertible in the first place!
You really do not want to be in debt to someone who could earn a little from your company's success but even more from its failure!
So many people have learned to keep away from these disasterous funding arrangements, that investment firms have started to disguise them. Read about a wolf in sheep's clothing in the article PIPEs: Traditional or Structured at Taglich Brothers.
As Rieves and Lefebvre point out in their book Investor Relations for the Emerging Company: "Short-term bank financing may not provide enough money to finance longer-term projects, and an emerging company may need to raise money with special securities. Experienced investors in emerging companies have developed a tolerance for this; however, there are just a few instruments that they will accept." The book suggests warrants and convertible bonds, pointing out that managers of microcap mutual funds won't touch 144A shares of stock because of their illiquid nature.
Per Jennifer Van Brunnt, Editor of "Signals: The Online Magazine of Biotechnology Industry Analysis", "...public companies generate most of their cash in down markets by turning to private sources.". She gives examples of companies who used traditional (non-toxic) PIPEs.
Small companies sometimes use several small ways to raise cash rather than finding one big one. Following is a summary of the types of funding available with their advantages and disadvantages.
| Name | Type | Description | Advantages | Disadvantages |
|---|---|---|---|---|
| PIPE (Private Investment in Public Equity) | Equity - Private | A transaction in which accredited investors (often a private investment or mutual fund) are allowed to purchase stock in a public company, usually below the market price. The stock is registered with the SEC so that it may later be resold to the public. | Builds up a pool of sophisticated investors. Increases float. | Seen by existing investors as diluting their shares. |
| Secondary Offerings | Equity - Public | Issue of more common shares. | Creates more float. | Dilutes shares. Costs more than a PIPE. |
| Shelf Registrations | Equity - Public or Private | Issue of more common shares. | Creates more float. | Dilutes shares. Costs more than a PIPE. |
| Options | Equity - Private | Gives its owner the right to purchase shares of a company's price at a fixed price for a given period of time. | Can be used to pay employees in lieu of cash. Seen by existing investors as giving employees an incentive to make the company do well. | Does not raise cash. Stock option strike prices can cause difficulties with a public company's accounting and reporting, most often when a company's stock price is trending upward. |
| Warrants | Equity - Public or Private | Gives its owner the right to purchase shares of a company's price at a fixed price for a given period of time. | Cash goes to company. | Seen by existing investors as eventually diluting their shares. |
| Convertible Bonds and Notes (Traditional Type) | Debt - Usually Private | Can be exchanged for a fixed number of common stock shares, or at a stipulated conversion price, during and up to the date the bond matures. | Cash can be raised quickly, especially when offering is private. Less expensive than secondary public offering. | No near-term dilution. But seen by existing investors as eventually diluting their shares. If stock price falls company may have a hard time eventually paying off. |
| Bank Loan or Investment Bank Loan | Debt - Private | Many types. In addition to traditional loans, many banks and investment banks now have private equity divisions. Some specific types of loans are covered below. | Cash can be raised quickly. | Difficult to get. Has to be paid off! |
| Equity Line of Credit | Debt - Private | Typically, a bank accepts equity in your home, your company's building, or both, to meet the financing needs of your growing business. | Cash can be raised quickly. | Difficult to get. May risk too much. Has to be paid off! |
| Equipment Loan | Debt - Private | Some companies, for example Oxford Venture Finance, specialize in this kind of loan. | Lower cost than the dilutive effect of using equity dollars. Company shows more cash on its books. | Won't work in all fields. Has to be paid off. |
| Accounts Receivable Loan or Factoring Service | Debt - Private | Depending on the business you are in, you may find a financial institution specializing in this type of loan. | Offsets cash flow problems. | Not available in all cases. |
| Loan from a venture fund | Debt - Private | Many types of arrangements. Avoid toxic ones! | Cash can be raised quickly. | The lenders may want a large share of your company and a lot of control. |
| Royalty Interest Transaction | Alternative to Debt and Equity | Firms exchange uncertain future product royalties for immediate cash. | Immediate cash. Flexible, inventive and can be attractive to investors. | Works only in certain fields. Has been successful in entertainment, gold mining and biotech. |
| Leasing Equipment Rather Than Buying | Alternative to Debt and Equity | Many types of arrangements. | Less cash needed. May be advantageous tax-wise. | Practical only in certain situations. |
| R & D Tax Credits | Alternative to Debt and Equity | Government gives tax credits. | Less cash needs to go to taxes. | Available only to companies in certain fields. |
| Corporate Alliances | Alternative to Debt and Equity | Many types of deals, some exclusive, some non-exclusive. | The big company has cash. The small company has a technology that is a source of competitive advantage. | Available only to certain companies in certain situations. And you may end up with a Faustian deal. |
| Mergers and Acquisitions | Alternative to Debt and Equity | Many types of M&A arrangements. | When a partnership is a great fit, it can enhance productivity and reduce expenses. Some microcaps grow not only through new business, but by acquisition. | Companies should not necessarily try to finance their growth by acquisition but rather be prepared with other, most often equity, monies to handle the transactions. M&A can sometimes be expensive and perilous, with compliance and disclosure headaches. |