Death Spiral Financing

A couple of readers emailed to ask what a "death spiral" was, which was referenced in a recent post on Financing Fees . A death spiral is a financing where massive equity dilution is attached as a condition if a certain event does not take place. For example, you issue convertible bonds which convert into one million shares of common stock, but if the company does not go public by 2009 the conversion ratio changes to 50 million shares. In most death spirals, the existing controlling shareholders lose control if the death spiral triggers.

In my experience two types of investors offer death spiral financings--very large sophisticated investors (like the Walton family) and hedge funds. Sophisticated investors offer death spirals because they see sufficient value to be happy if they end up as the controlling shareholder. Hedge funds use them because they are another alternative to balance risk and return. The bravado and unceasing optimism of entrepreneurs make them very susceptible to death spiral financing offers. They call them death spirals for a reason. They should be the last alternative that one considers and you should be facing imminent liquidation before you accept such a financing.