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Guest Post By: Mike Starkweather

Toxic Debt: What is it and How Can Micro-Cap CEO’s Avoid it?

The term toxic debt gets tossed around regularly in the micro-cap space, and yet most people don’t understand what it means or why a CEO would accept a loan with such volatile terms. First, it is important to understand what the term toxic debt indicates before we can break down how debt becomes toxic and why a CEO would agree to receive toxic funds.

What is ‘Toxic Debt’?

Toxic debt refers to promissory notes that have defaulted and have been converted to common stock. These conversions usually occur with a heavy discount to the current market price and can even have look-back clauses. A typical convertible note is for a 6-18 month term with an interest rate between 8-12% and a 30-70% discount-to-market upon default. Convertible promissory notes can be very lengthy with creative legal language that a typical CEO or CFO may not understand.

The term toxic debt gets tossed around regularly in the micro-cap space, and yet most people don’t understand what it means or why a CEO would accept a loan with such volatile terms. First, it is important to understand what the term toxic debt indicates before we can break down how debt becomes toxic and why a CEO would agree to receive toxic funds. Toxic debt refers to promissory notes that have defaulted and have been converted to common stock. These conversions usually occur with a heavy discount to the current market price and can even have look-back clauses. A typical convertible note is for a 6-18 month term with an interest rate between 8-12% and a 30-70% discount-to-market upon default. Convertible promissory notes can be very lengthy with creative legal language that a typical CEO or CFO may not understand. Examining the terms of a convertible note and understanding how they could impact a company can be challenging, even for an experienced securities attorney. Rule 144 under the Securities Act of 1933 requires a 6 month holding period for all unregistered securities acquired directly from the issuer. Because of Rule 144, most convertible note issuers that pose a potential threat will not write terms for longer than 6 months. Interest rates on convertible notes are generally 8-12%, which does follow the typical rate for most nontraditional financing terms. With the return on investment potentially only being 8-12%, some lenders will also have a fee built into the value of the promissory note. For example: a loan for $100,000 would have a value of $110,000, giving the loan an automatic 10% upside with interest to accrue on top of that, meaning that the company owes $117,935 at the end of the 6-month term. When the company fails to repay the loan, the default terms kick in and the debt can become toxic.

Most convertible notes for micro-cap companies have a 30-70% discount to market on the lowest trade in addition to a 30-40 day look back. So, what exactly does this mean? For example: The default terms are 50% discount to market on the lowest trade with up to a 40 day look back. The stock is trading at $0.50 today, but 2 weeks ago it had a low trade of $0.20. The above note would then convert at a mere $0.10 a share. This can put the company in a tricky situation if they are unable to work out new terms on the loan.

Here is an example company and the effects that this scenario would cause:

ABC Company has 10,000,000 issued shares of common stock and 5,000,000 outstanding. The company fails to repay the $117,935 and XYZ Capital decides to convert the defaulted note of $117,935 USD into common stock. If XYZ Capital converted the whole $117,935 at $0.10, that would be 1,179,350 common shares, however XYZ will most likely want to avoid becoming an affiliate and filing a Schedule 13b. This means that XYZ will most likely convert $49,000 at $0.10 giving them 490,000 common shares and allowing them to avoid filing the Schedule 13b which could send red flags to the retail investors. XYZ then dumps as many shares as it can into the market over a week trying to recover their investment, and as a result, this would likely causes the stock price to fall. With the dilution and excess sell side, we will assume the stock takes a 40% hit and drops to $0.30; however we will also assume XYZ sold their 490,000 shares at an averaged $0.40 per share. This means that XYZ made $196,000 with an estimated $40,000 in fees from legal, conversions, and trades; XYZ would still have profited $56,000 on the original $100,000 loan. This is where it goes from ugly to toxic: XYZ still has a convertible note worth $68,935 and it’s accruing interest every day. This can quickly turn into a debt spiral if the company is unable to pay back the remaining value of the convertible note and XYZ continues to convert and dump shares. 

Now for the million-dollar question: why would a micro-cap CEO ever accept a loan with those kinds of terms knowing he/she has a fiduciary duty to shareholders?

The answer can be a variety of reasons ranging from a lack of knowledge to believing that the company will be able to pay back the loan on time. Contrary to what most believe, there are also instances when a defaulted note is converted and it becomes good for the company by increasing shareholder base and providing working capital that doesn’t need to be paid back. In my experience, the typical CEO is, or should be, focused on advancing the business and their expertise in that particular subject matter, not fundraising. Most CEOs lack knowledge on fundraising strategies, loan types, and equity distribution options, leaving the door open for “sharks” to use traditional telemarketing strategies, making it easy for a CEO to find money. The problem is that these short-term loans need to be used for bridging financial gaps. Some good examples would be:

• Large purchase order – cash shortage forces a short term loan to purchase the needed materials so that the order can be fulfilled

• Registering a secondary offering – this can be an expensive process, but would provide returns that would easily payback the loan

• Acquisition – the acquisition would need to be cash flow positive and the amount borrowed in convertible form should be less than 30% of the total acquisition price.

In each of these examples, paying back the loan before it defaulted would be a reasonable expectation and therefor justify borrowing what could be considered a risky loan. Each of these situations would also be good for the company’s bottom line increasing shareholder value and in most situations, require press releases creating market awareness. It would be justified to say that in most cases, a less risky alternative financing option would be available for the above situations if the company hired a consultant or investment bank to assist.

Toxic debt: is it really toxic?

In my experience, it is only toxic when a CEO blatantly barrows money with no intent to pay it back or makes an uneducated decision to accept money that the company can’t pay back. There are hedge funds, institutions, and individuals looking to loan micro-cap companies’ money in hopes of converting upon default, but a good CEO will have the right people advising for such topics.

About Mike Starkweather

Mike Starkweather is a business strategist specializing in mergers & acquisitions, capital markets, venture capital, and private equity. Mr. Starkweather has consulted for multiple public and private companies, served on multiple advisory boards, and is currently a Senior Partner at S5 Capital Group, VP of Business Development at Shuttle Pharmaceuticals, and Managing Director at DynamicVentures. Contact: Mike@s5capitalgroup.com

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