In a fast-growing sector like cannabis, new investors need to learn the trading and investing language, and ultimately dive into SEC filings to really learn about the financial structure of a company, especially in the OTC markets. The language and numbers may take a while to learn so it is advisable to prioritize them, especially those that indicate malfeasance or the use of investors’ money to pay off debt. These practices can erode your investment. Although technically legal in most cases, these practices can saddle the shareholder with the debt instead of it being absorbed into the business. While toxic financing may be an ominous term, what exactly does it mean?
Raising money is difficult even for good companies, but it is aggravated for cannabis companies in the OTC markets because of their small size and legal uncertainty. This has made the usual sources of venture capital and loans reluctant to provide funding. Companies may search out individual accredited investors or loan companies willing to offer funds. Financing is available, but it may come with large interest rates or unreasonable terms to protect their investment. Toxic financing can take a number of forms and can include different aspects of financing.
You can’t predict that a company will grow, but protecting your investment means that certain terms should raise red flags, and propel you to investigate further. It would require more than a single article to adequately explain all the forms of toxic financing, but there is one form that you will see more frequently than others, especially in the penny-stock market—convertible notes. Although convertible notes can be complicated, it works more or less like the following example.
If a company needs to borrow money, it may have to agree to its debt being converted to free-trading shares instead of cash, but at a huge discount, perhaps based on the lowest closing prices within a period of time, say two weeks. This discount could be as high as 50-60% and could include a large percentage of the total shares. Since penny stocks are volatile, that price could be considerably below the actual market value.
Once the shares have been converted, the debt holder would then pay someone to promote the company publicly in order to raise the price again. This could attract new investors or cause the existing ones to buy more, who may not know about the debt. The lender would then sell the shares at the higher price. Referred to as dumping, this would drive down the price of the shares. In turn, this would make it difficult to raise more money and the company would likely resort to even more toxic financing. The lower the share price, the more discounted shares have to be issued to settle the new toxic debts. This is known as dilution; and this vicious cycle can often result in the collapse of the business. Because penny stocks are not fully reporting companies, you may not be able to find any information about these arrangements.
In one sense it is no different from old-fashioned usury, where the interest terms of a loan can end up exceeding the actual principal of the loan. It can hurt the company, of course, but more importantly, it is often at the expense of individual shareholders. The worst case scenario is when the insiders of the company set up these toxic convertible notes between each other for personal enrichment, in other words, nothing more than a business scam, creating a business out of the money that shareholders have contributed. Proceed with caution any time you see convertible notes appear in a company’s filings.
Starting a business without serious capital is difficult. High interest rates might not be attractive, but a well-run business might pay that debt back, even with convertible notes. The real issue is the relaxed reporting environment of the penny stock sector which attracts opportunists who take advantage of lax reporting requirements and the need for financing. It’s essential that an individual investor is aware of the legal issues and unique obstacles that companies face here.
In the end, the real conversion of convertible notes might result in money from the shareholders’ pockets being converted into money in the pockets of insiders and lenders.