What is a Death Spiral
Death spiral is a term applied to a type of convertible debt that stimulates an ever-increasing number of shares, leading to steep stock price drops. The convertible bond, unlike a conventional convertible one, converts into a fixed value instead of a fixed number of shares. If this bond is converted into stock, the price of the stock tends to drop due to the increased supply of shares. This, in turn, encourages more conversion because the convertible debt owners can obtain — and then sell — even more shares of the stock with the fixed value feature. Theoretically, the death spiral can end with the stock at or near a zero dollar value.
BREAKING DOWN Death Spiral
This type of loan is sometimes undertaken by a company that desperately needs cash. It is called a death spiral because the stock of the company often plunges drastically after it issues this convertible debt. It is important to note that death spirals often allow buyers to convert the bonds into shares at a fixed conversion ratio in which the buyer has a large premium. For example, a bond with a face value of $1,000 may have a convertible value of $1,500, which means that a bondholder will receive $1,500 worth of equity for giving up the $1,000 bond. However, upon a conversion, more shares are created, which dilutes the share price. This drop in price may cause more bond holders to convert because the lower share price means that they will be receiving more shares. Any further conversions will cause more price drops as the supply of shares increases, causing the process to repeat itself as the stock's price spirals downward.
Why Would a Company Want Death Spiral Financing?
A company that seeks death spiral financing basically has no other option to raise money to survive. Traders who want to short the stock salivate at the prospect that the stock will dive. The only hope for the company to break the death spiral is to improve its operational results. If it can effectively deploy the proceeds of the convertible debt issue in its underlying business, it may be able to avoid the hopes of short sellers and even stick losses to them.