Capital Raising During Times of Uncertainty — Issuers Beware!

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 advisors 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 like non-financial terms.” 

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

Best Practices for Securing Growth Capital

Below 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 advisor/investment banker offering to help you with the raise.

Doug Ellenoff, Managing Partner of law firm Ellenoff, Grossman & Schole suggests: There are many firms across the country, select the bank that is appropriate for your size company and knows your industry. Make sure that they have been active in the capital markets recently. Ideally, make sure that the firm has depth of experience in your industry. Do they mention your industry on their website? Do they have analyst coverage? Do they write research? Do they know public market investors that they work with regularly and are familiar with your industry and your business? Just because you haven’t heard of them before, shouldn’t mean that you shouldn’t talk to them or that they aren’t very credible. They may be but do your homework. Speak to other clients and get a sense of them, whether they over promise, avoid finders. If they aren’t licensed broker dealers, they 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[1] 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 their history of deals.  Financings through offshore entities, newly formed or anonymous vehicles with opaque ownership should raise red flags.

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

Once you have decided on an advisor 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 that private placements and convertible debt[2] 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 one 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, the worst, can dilute existing shareholders holdings[3] to almost nothing.  Industry practices differ, but these features generally allow for conversion at anywhere from 95% to as low as 50% of the market price (resulting in discounts of 5%-50% 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 will 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 they’re 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 they’re able, avoid defaulting on notes.

Beneficial Ownership

Convertible notes are also intentionally structured to impose limits on the amount of shares a lender can obtain. The most common terms specifically prevent situations where the lender could be deemed to be a five or ten 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 the 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 the dilution for existing shareholders and the effect that 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 that there must be naked shorting in their stock given price activity.  Yet, often, this price activity can be directly tied to a recent financing.   In certain cases, lenders may coordinate their selling of an issuer’s securities with stock promotion campaigns. To optimize their returns, a lender might initiate an anonymous promotional campaign touting an issuer while they attempt to sell of a tranche of shares at inflated prices. These promotional campaigns by third parties often make unsubstantiated or fraudulent representations.  Promotional campaigns can be a short as one or two day– -long enough for a lender to sell of most of its position.

The process can be chronic as anonymous bad actors seek to stay under 5% ownership. 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 issuers stock and destroying shareholder value.

Josh Lawler adds: “…. you must keep in mind that any transaction that heavily dilutes or subordinates your existing investors will be scrutinized.  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 meets 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 that 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.

As Yoel Goldfeder from VStock Transfer notes, “We realize that things may be difficult now, but always remember that as an officer or director you have a duty to your shareholders. Make sure that 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: “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, Corporate Services at OTC Markets Group, where he is responsible for managing the firm’s international and domestic Corporate Services business. Drawing upon his expertise in cross-border trading and as a recognized proponent of Reg A+ and small company capital raising, Jason is an advocate for small cap issuers, start-ups, and entrepreneurial innovators working to alleviate the cost, time and complexity associated with being a public company. Prior to joining OTC Markets in October 2013, Jason was Managing Director and Segment Head at JP Morgan Chase responsible for the custody, clearing and collateral management business in the Corporate and Investment Bank division. Jason also held multiple senior management positions at BNY Mellon, most notably, as Head of M&A for the Financial Markets and Treasury Services Sector and 11 years as the Head of the Global Capital Markets Group in the Depositary Receipt Division. Jason currently serves on the Board of Directors of the Crowdfunding Professional Association (CfPA) and also served as a member of the Board of Directors at OTC Markets Group from 2008 – 2011. Jason holds a Bachelor's degree in International Relations from Boston University and received his MBA from the NYU Stern School of Business.

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