Feature: Market Update. Do You Own a Toxic SmallCap?

This market really seems to want to breach the blue trend-line in our chart. If the rally is to continue, we need to see that happen soon. A pullback to 2087 wouldn’t alarm us and would likely be a decent entry point to the QQQQ’s (NASDAQ: QQQQ) or a favored Nasdaq blue chip. A break below 2087 would cause to have another look. A rally from 2087 could be very robust. There’s a chance we won’t even get back there before starting the year-end rally. Do not discount the importance of that blue trend-line. If breached with conviction, it would be a significant first sign of a positive reversal.

A Toxic Tale.

Desperation both in life and business can convince folks to embark on risky paths to keep the financial doors open. Third mortgages, ridiculous credit card rates, finance company loans and even check cashing services loom like sharks that frequently smell blood in the water.

The equivalent in the SmallCap market is the great White Shark known as toxic financing. A fledgling company, like an individual with her/his financial back against the wall, will embrace this lunacy—usually the only financing option left –as its potential savior. More often than not, it is a deal with the devil. And investors should stay away from those companies that employ this strategy. The stats for success following this type of financing are so not in the favor of the company or the shareholders. 

While not definitive, here’s one example of the form these toxic deals can take. The CEO of a small- or micro-cap company is convinced his company has the Next Big Thing. Progress as well as financing has been spotty and to get to the ‘next level’ a significant capital infusion is necessary. Unfortunately, the lack of a track record or results or both has road-blocked access to conventional financing avenues.

Then, one or more charming folk shows up at the door and schmoozes the CEO as to the potential of the company and how they can’t wait to invest. Either due to desperation, ego or stupidity, the CEO listens and in the back of his mind, rationalizes salvation for himself and shareholders. He would actually do his company and the shareholders a better service by sending these carpetbaggers packing.

The deal seems straightforward enough—although it can take many forms. The financiers will give the company money in exchange for a convertible debenture, preferred or equity line at a discount to the market price of the shares. The key here is that the conversion rate/price is not fixed, and in some cases there is a share price level, usually significantly below current market that will stop the advancement of a larger second tranche of funds. 

My stock will never get that low, concludes the CEO, confident that this deal will save his company. What he doesn’t know is that these sharks have likely found the company not based on the potential of the technology, but on the capital structure and the potential to whack the crap out of the share price and make them and their buddies a crap-load of fast money.

The result will likely be the complete destruction of the company at most, massive crippling dilution for the shareholders at least and likely land the whole thing in litigation. A handful out of hundreds of company that go down this road actually prosper, but not before a lot of financial pain for everyone other than the ‘good samaritans’ that structure these toxic deals.

Without fixed pricing, the financiers and their buddies make their money by pounding the shares through shorting—usually of the naked variety-- and, once the price has been decimated (the dreaded death spiral) convert their debenture, preferred —whatever—into ridiculously cheap shares to cover their massive short sales. Usually, the lower the price, the more shares they get courtesy of a favorable value/conversion rate. 

The company ends up having to issue massive numbers of shares to satisfy the conversions and it becomes a vicious circle as the selling begets conversion begets more dilution. Once the share price has been destroyed and the vehicle converted into all the shares necessary to cover, these buzzards move on to the next company with an equally desperate CEO. The carnage left usually means the shareholders are left with nothing the company becomes an albatross with potentially 100’s of millions of virtually worthless shares and is likely further behind than when it started.

Oh yes, if there is a threshold below which the company would not get a second, larger tranche of funding, you can be sure that’s the first level to where the short sharks will drive the company’s share price. Of course, other traders who troll around looking for this type of chum in the water will also come along for the feed. The CEO, his company and shareholders are virtually powerless to stop the decline. That’s where the litigation part usually kicks in.

In this case, the SEC website has a decent discussion of this topic:

• Good: In a conventional convertible security financing, the conversion formula is generally fixed - meaning that the convertible security converts into common stock based on a fixed price. The convertible security financing arrangements might also include caps or other provisions to limit dilution.

• Bad: By contrast, in less conventional convertible security financings, the conversion ratio may be based on fluctuating market prices to determine the number of shares of common stock to be issued on conversion.

• The company issues convertible securities that allow the holders to convert their securities to common stock at a discount to the market price at the time of conversion. That means that the lower the stock price, the more shares the company must issue on conversion.

• The more shares the company issues on conversion, the greater the dilution to the company's shareholders will be. The company will have more shares outstanding after the conversion, revenues per share will be lower, and individual investors will own proportionally less of the company. While dilution can occur with either fixed or market price based conversion formulas, the risk of potential adverse effects increases with a market price based conversion formula.

• 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

Hence, we again note the importance of carefully reading company Edgar filings. Armed with information as to how the financing process works, investors can avoid adding to the already significant risks inherent in the smallcap market by ensuring that they stay well away from toxic, shark-infested waters.
 

We Value Your Feedback

Got comments, questions or suggestions? Send 'em on over: Editor@smallcapdigest.net If you wish to send a written request or inquiry, please send it to our physical address: TGR Group, LLC 4653 Carmel Mtn Rd Suite 308 #402  San Diego, CA 92130

Subscribe

Note: Your email address will be kept strictly confidential, and will not be shared with any other entity for any purpose at any time. If you no longer wish to receive the SmallCapDigest, simply follow the instructions located at the bottom of every SmallCapDigest Newsletter Edition.

Visit Here to view our compensation on every company we have ever covered, or visit the following web address:  http://www.smallcapdigest.net/compensation_disclosure.html for our full compensation disclosure and http://www.smallcapdigest.net/short_term_alerts.html for Trading Alerts compensation and disclosure. TGR Group, LLC has not been compensated for this report.

All statements and expressions are the sole  opinions of the editors and are subject to change without notice. A profile, description, or other mention of a company in the newsletter is neither an offer nor solicitation to buy or sell any securities  mentioned. While we believe all sources of information to be factual and reliable, in no way do we represent or guarantee the accuracy thereof, nor the statements made herein.

From time to time TGR Group LLC sells shares in the open market it receives as compensation for coverage of client companies. Since the shares are received as compensation for services as previously disclosed, and not for investment purposes, the editors do not view the sale of the shares as contradictory to any advice delivered in the content. This should be viewed as a conflict of interest by shareholders or prospective shareholders of the client companies.

The editor, members of the editor's family, and/or entities with  which the editor is affiliated aside from TGR Group LLC itself, are forbidden by company policy to own, buy, sell or otherwise trade stock for their own benefit in the companies who appear in the publication unless specifically disclosed in the newsletter. The profiles, critiques, and other editorial content of the SmallCap Digest and SmallCapNetwork.net may contain statements that appear forward as it relates to the expected capabilities of the companies mentioned herein.

THE READER SHOULD VERIFY ALL CLAIMS AND DO THEIR OWN DUE DILIGENCE BEFORE INVESTING IN ANY SECURITIES MENTIONED. INVESTING IN  SECURITIES IS SPECULATIVE AND CARRIES A HIGH DEGREE OF RISK. THE INFORMATION FOUND IN THIS PROFILE IS PROTECTED BY THE COPYRIGHT LAWS OF THE UNITED STATES AND MAY NOT BE COPIED, OR REPRODUCED IN ANY WAY WITHOUT THE EXPRESSED, WRITTEN  CONSENT OF THE EDITORS OF SMALLCAPNETWORK.NET.

We encourage our readers to invest carefully and read the investor information available at the web sites of  the Securities and Exchange Commission ("SEC") at http://www.sec.gov and/or the National Association of Securities Dealers ("NASD") at http://www.nasd.com. We also strongly recommend that you read the SEC advisory to investors concerning Internet Stock Fraud, which can be found at  http://www.sec.gov/consumer/cyberfr.htm . Readers can review all public filings by companies at the SEC's EDGAR page. The NASD has published information on how to invest carefully at its web site.