Wikipedia defines death spiral financing as a process in which convertible financing used to fund primarily small cap companies can be used against it in the marketplace to cause the company’s stock to fall dramatically, which can lead to the company’s ultimate downfall.
While generalization is fraught with risk, typically companies require multiple financings to fund rapid growth or to offset cash losses during periods of underperformance. The key issue is, are the multiple financings on increasingly favorable or unfavorable terms.
Companies demonstrating rapid growth have generally been able to raise new capital based on increasing valuations. While capital raises tend to be dilutive to current shareholders, increasing valuations represent a material offset.
On the other hand, death spiral financing is usually associated with an unsustainable cash burn as a company fails to meet revenue and cash generation goals. In those cases, each new financing comes at ever harsher terms and forces existing shareholders to accept increasingly onerous dilution.
Investors may want to reflect on Tesla and its struggle to reach target volumes for its new model 3. While it is far too early to predict an outcome, Tesla is currently burning through cash at an unsustainable rate and will have to raise additional capital in the relatively near future. Regardless of Tesla’s long term future, it is very likely that the company, and its efforts to become an important vehicle manufacturer, will become a case study for business schools for many years.
All comments and suggestions are welcome.
Walter J. Kirchberger, CFA