What is toxic financing?

Many small-cap and micro-cap companies are in a need of additional capital. Obtaining funding can be tricky and it is best to have someone experiences to advise you about financing proposals. Many of the offers can seem legit at first sight but if you look deeper they are just camouflaged toxic financing contracts.

The real question is what is toxic financing and how you can recognize it? Toxic financing can be defined as convertible debt or preferred stock that allows financier to receive unlimited number of common shares by converting their debt. This type of debt has low chance that it will be repaid because it carries an interest rate that company usually cannot repay. Financier uses this situation to convert debt or preferred shares to common shares and sell them on the market. Formulas that are used for conversion in toxic financing is structured so there is no downside limit on the price for converted shares. It gives discount to the market price on the day of conversion. What is problematic is the fact that agreement are not written in clear language but complicated clauses with obscure language are added which is very difficult to understand for average company's executive. When you are offered financing you need to be sure that conversion clause in the agreement has defined floor is . This means that the lowest price at which debt and preferred shares can be converted is determined.

Of course these financing agreements can vary greatly but after the agreement is signed company will receive some capital and financier gets the right to convert debt or preferred shares to common shares and sell them on the market. Company will have convertible instrument on its balance sheet.. Smaller companies that usually seek financing also commonly have low liquidity so selling converted shares almost exclusively decreases the price of stock. Toxic financiers don't convert all debt and preferred stock at once but over time which results in rapid increase of outstanding shares and dilutes stock of existing shareholders. Not only this type of financing will cause company's stock to fall dramatically but it will also limit company's access to other sources of funding.

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