The term spiral debt is often tossed around often by people who don’t understand the microcap industry. Learning such a volatile term and the reasons some CEOs accept toxic financing options is important. How and when does a loan become toxic? What are the best ways to avoid it? Find out here.
Understanding Debt Spiral
As a first-time microcap CFO or CEO, you may not detect toxic financing. However, experienced professionals in this field can easily spot it from afar. Even individuals get into a debt cycle once in a while. So, what exactly is it? Basically, a debt spiral is a financial situation whereby a firm experiences never-ending levels of indebtedness. The loan burden and interest reach an unsustainable point. Eventually, the company defaults loan repayments, thus hitting rock bottom.
When promissory notes are defaulted and converted to common stock, we say that a company is in debt spiral. The conversion happens along with huge discounts for the prevailing market prices. It can even come with look-back clauses. If a microcap firm gets into this cycle, everything starts spinning out of control. Have you ever seen an aircraft going through a tailspin? That’s a perfect example of what happens to a company in debt spiral.
It is nearly impossible to pull out a company trapped in toxic debt. Surprisingly, the situation begins with common monetary mistakes such as misappropriation of funds. By the time the CEO realizes, it is already an uphill battle.
Imagine being unable to raise more funds for your company. You might end up closing the doors. The shareholders in your organization are the people who are most affected by this toxic convertible debt. Unless you know how to manage correctly, a debt spiral state may turn into death knell. It doesn’t matter how technologically advanced your microcap company is. Your products, services, and ideas could go down the drain.
How Do Microcap CEOs Get Companies Into Toxic Debt?
Poorly structured convertible financing is the culprit behind death spiral financing. The company stock falls drastically, leading to the ultimate undoing. Some firms end up selling the convertible debt to a bigger corporation.
There are a plethora of reasons why microcap firms are in death spiral financing. They range from ignorance to overrating the company’s ability to settle the debt in time. In other cases, CEOs focus too much on fundraising rather than advancing the business.
Are you aware of the different types of loans and fundraising strategies? How about equity distribution options? These are some of the concepts you should grasp as a chief executive officer. Otherwise, you might fall for loan sharks in a bid to find quick funds. Short-term loans are only good when used to bridge financial gaps. Examples of such gaps include acquisitions, large purchase orders, or registration of secondary offerings.
In those 3 scenarios, it is possible to repay a loan before it gets defaulted. So, borrowing is justified. Each case is also ideal for improving shareholder value. Hire a professional consultant to help you find the least risky financing alternatives.
Can a Debt Spiral be Broken?
In some cases, microcap companies try to use a lose-lose strategy. This entails cutting down on spending to minimize the deficit. But it leads to sluggish growth. In this case, your company loses both ways: lower output and the same level of debt. Here are some tips Microcap CEOs can try to avoid toxic debt or mitigate it.
Devaluation
Devaluation can boost sales by making them cheaper. You can use the revenue to offset the loan burden. Note that devaluation may not work in some cases. For instance, it causes capital outflow, which is a major issue with external debt.
Decline Loan Offers
A deal that seems too good to be true is usually a trap. Many CFOs take quick money, and after a few months, the company stock gets into a death spiral. You might think that some modification of loan terms can help. But this is only a temporary ineffective solution. Never accept money that your firm cannot pay back. Thousands of institutions are looking to give out loans to microcap companies. They do so hoping that you’ll default and convert the debt into common stock. To make an educated decision, always consult the right professionals.
Private Restructuring
This technique is tailored differently depending on your trade and vendor debt or toxic note debt. Private restructuring helps in adapting capitalization to the prevailing financial state. You can achieve this in several ways, such as creating new classes of equity to be used as follows:
- Remediating the loan
- Effectuating stock split to minimize the outstanding and issues shares
- Recapitalizing the management and board of governance
The above measures can reposition your company. In no time, you’ll be attracting new long term capital and new footprint for growth. Make litigation your last resort. However, it can be an effective method as you take the necessary restructuring steps.
Debt Spiral: Is it actually toxic?
A financing option becomes toxic when you blatantly borrow funds for your company with no intention to repay. Any microcap company can be saved from debt spiral. But the CFO must come to terms with reality. More importantly, you must know how to fix the situation. Remember that prevention is the key. Don’t let debt spin out of control. It will be hard to stop once it gains momentum. Stop taking loans inadvertently.
