Debt can be a powerful tool to raise the money needed to fund the growth and expansion of your business. However, debt, as we all know, can also be dangerous, especially when you’re unable to pay it off, for whatever reason. If you borrow too much and your business does not perform as expected, the debt can quickly become toxic.
Many people don’t understand what toxic debt is and why they should avoid borrowing money under such onerous terms.
Identifying Toxic Debt
In the micro-cap space, the term “toxic debt” refers to defaulted loans that start to convert into the company’s stock at a substantial discount to the current market price. Toxic debt is a form of legal loan-sharking that has the potential to impose harm to a businesses’ financial position. No matter how great one’s ideas, products, or technology may appear, failure to properly manage convertible debt could be the death knell of any company. Toxic debt typically contains the following features:
- Interest rates that are subject to discretionary changes
- Default rates in double digits
- Principal amounts the lender does not expect to recover via typical principal and interest payments
Typically, convertible toxic debt is between $25,000 and $100,000 and has a 6-18 month term. It comes with an interest rate of 8-12%, which can shoot up to 30-70% upon default once the loan starts to convert into the company’s common stock.
Some lenders will have an additional fee built into the value of the loan in addition to the interest rate. For instance, an upfront payment of $10,000 might be due from the borrower when agreeing to a $100,000 loan, which increases the cost of the money. As a result, the company would owe $110,000 plus the value accrued interest rate at the end of the term.
Debt becomes toxic when the company fails to repay the loan and is forced to sell a percentage of the stock so that the lender can receive it a discount. The company’s stock’s value can significantly decimate over the term of the loan, and by the time the CEO realizes it, the company may not have enough shares that the lender can covert.
In this case, the company will have to amend documents to allow for authorization of more shares and, just like that, the company has lost significant shares that will never be recovered. Moreover, since the lenders are not “investors,” they will not care about the company, its CEO, or its shareholders. They are just lenders who have figured out a legal way to reap big on monies loaned to small public companies.
Why Would CEOs of Micro Cap Companies Accept a Volatile Loan?
Micro-cap CEOs may accept “toxic debt” under the belief that they will be able to pay it back in full and on time. Unfortunately for the borrowers, this is typically not the case.
The “sharks” who offer these toxic loans make a living through loaning easy-to-find money to borrowers in precarious financial situations. Borrowing toxic debt should only be considered if there is a need to bridge financial gaps involving processes such as acquisition, large purchase orders, and registering a secondary offering. Vine Advisors can help you evaluate your strategic economic alternatives.
Is This The Only Option?
Many individuals and entities are looking to loan money to small micro-cap businesses in hopes that there will be a default and they will be able to convert it into stock. It is essential to obtain professional financial advice before agreeing to borrow toxic debt.
Our expert advisors have successfully helped clients analyze the hidden costs contained in toxic debt financing agreements. We’ve also worked with businesses to restructure their balance sheets. If you have toxic debt in your capital structure, call Vine Advisors for an expert evaluation of your financial situation.