Turning to Hedge Funds for Financing? Beware the Death Spiral

During the best of times, raising capital is no walk in the park. Today, however, the task can be daunting. After the Bear Stearns debacle and the problems of Fannie Mae and Freddie Mac, it is more difficult to raise capital than at any other time in recent history.

Given today’s environment, a company seeking to raise capital has to be as focused as ever. Additionally, capital sources that might otherwise not be considered, have to be aggressively approached. The simple fact is that today lenders and investment banks are deluged with offers and have no problem obtaining viable investments without much promotional effort on their part.

Still, there is a source of financing that should be considered if your company needs expansion capital or capital for an acquisition.

Hedge Funds

Hedge funds have gotten a bad rap of late and in some cases deservedly so. They are very lightly regulated, and investors in these funds are taking a greater risk than they would otherwise take if they were investing in standard mutual funds.

With this in mind, you should still consider a hedge fund as an investment source so long as you are prepared to pay for the risk that the fund might be taking by investing capital in your organization. Obviously, the greater the fund’s perceived risk, the greater the cost to your company.

Hedge funds are generally repaid in either in stock of your company and/or through principal and interest fees charged for the lent capital. The question that you have to address is how much stock you want to give up and how much interest you are prepared to pay for a loan. Usually, hedge funds would prefer as a prerequisite that your company’s stock is either publicly traded or is about to go public.

Keep in mind that hedge fund agreements with borrowers can be quite convoluted and difficult to decipher. Therefore, the need for competent legal and financial advice is critical.

What’s the Death Spiral?

The death spiral is “a process where 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 and can lead to the company’s ultimate downfall,” according to Wikipedia.

Let’s examine how a death spiral works. You want to borrow money for your company and your only alternative is a hedge fund. The loan officer at the hedge fund offers to lend you the money at a certain interest rate, and then adds that his company wants warrants. A warrant is a right to buy or sell something at an agreed price and without obligation on the part of the company receiving the warrant. In other words, the warrant could be allowed to expire if the holder/lender so chooses.

The hedge fund’s goal, in a death spiral situation, is to exercise its warrants in such a fashion so as to push the price of your stock down. Such decrease in value of your stock gives, under these circumstances, the hedge fund the opportunity to be granted additional warrants for your stock. The fund takes these additional warrants, buys stock of your company with them, then sells your company’s stock and further drives its price down. The hedge fund will also likely “short” your company’s stock, thus picking up revenue as the death spiral plays out.

The upshot of this is that either the hedge fund ends up owning your company or it has diluted the value of your shares so that you as the owner possess substantially fewer shares than you had when you first went to the hedge fund. For example, before you went to the fund, you could have owned 90 percent of your company’s stock. After the hedge fund loan, you might end up with 10 percent control with the value per share being greatly diminished.

Approaching a Legitimate Hedge Fund

There are funds, however, that are honorable and that have a good track record with companies that they have financed. The first thing that you have to do is ask for some references from the hedge fund.

When you contact these references, ask them specifically how the price of their company’s stock was affected by the hedge fund debt that they took on and how much dilution of the original stockholders’ interest occurred.

Also, I would then look up the company symbol on a site like Yahoo Finance. Such a site should give you a decent history of the company and should provide you with the tools to determine just how the hedge fund financing changed the company’s fortunes.

Additionally, always ask for a term sheet that will spell out exactly how the hedge fund’s financing works and how much equity your company will lose (the degree of dilution to your company’s stock). There are some very reputable hedge funds out there, you just have to be extra careful when choosing one. Good luck!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at [email protected].

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