Capital-raising during times of uncertainty: Issuers beware

Apr 16, 2020
Small and micro-cap companies must tread carefully when raising capital

As the public market for thousands of early-stage and growth companies, OTC Markets Group has seen the good, the hard and the plain ugly when it comes to what happens after a capital-raising. Even in the best of economic times, issuers often fall prey to bad advisers offering ‘too good to be true’ financings with terms that dump shares, dilute shareholder value and destroy companies.

Small and micro-caps have always had to work harder to secure growth capital. These challenges have only been exacerbated by the current Covid-19 pandemic and its effects on the global economy. In navigating financing options, management teams need to develop the skills necessary to discern a good deal from a bad one, avoid questionable players and successfully raise capital in turbulent times.

Josh Lawler, partner at Zuber Lawler, points out: ‘If you are looking for a capital infusion to maintain operations, recognize that it may come at greater cost, both financially and in terms of governance, liquidation preferences and other areas.’

But what good is raising money now if it will ultimately destroy the company later?

Best practices for securing growth capital

Here are some helpful tips based on our years of experience in the small/micro-cap financing space. First and foremost, it is important to do your due diligence on the adviser/investment banker offering to help you with the raise.

‘There are many firms across the country – select the bank that is appropriate for your company size and knows your industry,’ suggests Doug Ellenoff, managing partner of law firm Ellenoff Grossman & Schole. ‘Make sure it has been active in the capital markets recently. 

‘Ideally, make sure that the firm has depth of experience in your industry. Does it mention your industry on its website? Does it have analyst coverage? Does it write research? Does it know public market investors it works with regularly that are familiar with your industry and your business? Just because you haven’t heard of the firm before, it shouldn’t mean you shouldn’t talk to it or that it isn’t very credible. It may be – but do your homework. 

‘Speak to other clients and get a sense of the firm, whether it over-promises. If it isn’t a licensed broker-dealer, it cannot get paid for helping you raise money. There are individuals that opportunistically want to prey on your desperation, so do not dispense with good judgment and your own proper due diligence.’

How not to fall prey to bad actors

As with any industry, there are several ‘bad actors’ in the private placement and convertible-note financing space. Know all the players in a financing – and their associates. We recommend that any issuer investigate the principals of any prospective lender and its history of deals. Financings through offshore entities, newly formed or anonymous vehicles with opaque ownership should raise red flags.

FINRA’s BrokerCheck, the SEC’s Sali database and the various enforcement materials made publicly available by state regulators are good resources for an issuer to start its research. The Canadian Securities Administrators, the collection of provincial regulators, also has a large, publicly available repository of individuals who have been the subject of securities-related disciplinary actions.

Once you have decided on an adviser or banker to help with your raise, the most important thing is to know the terms. Receiving the money is the end goal, but it should not be done at the expense of your company’s long-term viability.

Private placements and convertible debt

We all know private placements and convertible-debt arrangements are intentionally structured to maximize profits for lenders. From an issuer’s perspective, though, there’s no excuse for not understanding the mechanics of this type of financing. Issuers should fully comprehend all the terms of any arrangement, paying particular attention to the specifics regarding conversion and default.

Conversion features at a fixed price – especially a price that closely resembles prevailing market prices – pose fewer risks to an issuer and its shareholders. Conversely, variable priced conversion features that are based on the market price of an issuer’s securities, sometimes called ‘death spiral’ or ‘toxic’ financings, can have more drastic effects. 

In our experience, notes with these features commonly lead to dilution and can depress the trading price of an issuer’s securities – and, worse still, can dilute existing shareholders holdings to almost nothing. Industry practices differ, but these features generally allow for conversion at anywhere from 95 percent to as little as 50 percent of the market price (resulting in discounts of 5 percent-50 percent for the lender).

Additionally, many of the most egregiously structured conversion agreements peg the conversion to the lesser of the company’s lowest trading price or closing bid price over a specific time period. So not only do the notes always convert at a discount to the market price but they will also generally be at the absolute bottom of the company’s recent price range.

The default provisions of convertible-note financings typically exacerbate an issuer’s situation when it’s deemed to be in default. When an issuer is deemed to be in default for whatever reason (of which there can be many hidden in the worst financing agreements) these clauses often increase the total amount owed by an issuer by adding multipliers to the outstanding principal and interest. In some cases, a default also allows lenders to convert debt at an even steeper discount. It’s important for an issuer to understand what constitutes a default event and, to the extent it is able, avoid defaulting on notes.

Beneficial ownership

Convertible notes are also intentionally structured to impose limits on the number of shares a lender can obtain. The most common terms specifically prevent situations where the lender could be deemed to be a 5 percent or 10 percent beneficial owner of a class of the issuer’s securities. This is done purposely to avoid disclosure and various other requirements employed under federal securities laws. While not necessarily indicative of any wrongdoing, issuers should be aware that these limits are present in convertible notes for a reason, including perhaps to avoid scrutiny or detection by existing investors or regulators.

Dilution and effect on trading price

Issuers raising capital with convertible-note financings should know the risks as they relate to dilution for existing shareholders and the effect convertibles can have on the trading price of their securities. These arrangements (especially those with variable price conversion mechanics) subject the issuer’s securities to dilution and downward pressure as a result of lenders converting debt to shares and selling those shares. 

Generally, lenders will convert notes in tranches with a view to quickly liquidating their positions. As lenders sell their newly issued shares, the price can decline quickly, allowing them to convert portions of the note into larger and larger share amounts. The overall effect reduces the proportional ownership of other existing shareholders and can drastically reduce the trading price for an issuer’s securities.

Monitor news and promotional activity in your stock

After you have done the financing, it is very important that management teams monitor the news and promotional activity in their stock. We often get calls from management teams claiming there must be naked shorting in their stock given price activity. Often, however, this price activity can be directly tied to a recent financing. 

In certain cases, lenders may co-ordinate their selling of an issuer’s securities with stock promotion campaigns. To optimize its returns, a lender might initiate an anonymous promotional campaign touting an issuer while it attempts to sell off a tranche of shares at inflated prices. These promotional campaigns by third parties often make unsubstantiated or fraudulent representations. Promotional campaigns can be as short as one or two days – enough for a lender to sell off most of its position.

The process can be chronic as anonymous bad actors seek to stay under the 5 percent ownership threshold. A lender might convert another portion of a note when the share price has receded after a promotional campaign has ended and then begin a new campaign to sell that portion later. Issuers should be aware that lenders have a vested interest in maximizing their return from these financings. All these sales have the net effect of putting downward pressure on an issuer’s stock and destroying shareholder value.

‘You must keep in mind that any transaction that heavily dilutes or subordinates your existing investors will be scrutinized,’ says Josh Lawler. ‘Especially if insiders are part of the purchasing syndicate.’

Where issuers may run into trouble

Accepting financing in the form of convertible notes can be a decent short-term option for meeting an issuer’s cash flow needs. That said, some issuers run into trouble when they resort to this type of financing habitually. Issuing convertible debt to repay debt obligations from other notes is a poor outcome for issuers and their shareholders, so institutional and long-term investors will avoid companies with these bad habits.

It’s possible for an issuer to improve its standing by negotiating with its existing noteholders rather than continuing to seek further financings to meet its obligations. There have been cases where outstanding debt is forgiven as a result of negotiations and issuances of other classes of securities. In other cases, issuers have renegotiated the terms of their outstanding debt to restrict the amount the lender can sell during specified periods. Issuers overwhelmed by their debt situation should consult with their securities attorney to construct a plan that’s right for them.

‘We realize things may be difficult now, but always remember that as an officer or director you have a duty to your shareholders,’ notes Yoel Goldfeder from Vstock Transfer. ‘Make sure you understand all the benefits and risks associated with your decision and consult with experts in the space who have had many years working with companies like yours.’

Lawler adds: ‘It’s true that the challenge is often the opportunity, but both success and failure will be magnified. Follow good practices and you will survive, and possibly thrive.’

Jason Paltrowitz is executive vice president for corporate services at OTC Markets Group

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