What is a Death Spiral?
A death spiral is a kind of loan investors provide to a company in exchange for debt that can convert into stock, typically at below-market share prices.
How Does a Death Spiral Work?
Let's say Company XYZ is running low on cash and needs $1 million in capital. Its shares are trading at $10 per share. The company finds a group of investors who are willing to lend the company the money it needs, but only if the investors can get the option to be repaid in shares at any time rather than in cash. The parties agree that if the lenders elect to be repaid in shares, then the company will do so at a price of just $5 per share.
Now let's assume a year goes by and Company XYZ and the lenders agree that they will be repaid in shares. How many shares do the lenders get? The answer is $1 million divided by $5 per share, or 200,000 shares. If Company XYZ's shares are currently trading at $8 in the open market, then the lenders might turn around and sell those shares for a quick $3-per-share profit.
In the marketing world, a death spiral refers to a continuous process of eliminating products without a corresponding decrease in overhead. The result often prompts companies to increase prices to cover the overhead, which often results in fewer sales, putting the company in a worse position.
Why Does a Death Spiral Matter?
Death spirals are called death spirals because they often start a chain-reaction of value loss. Companies often lose value after they disclose these types of lending agreements. That in turn can cause more bondholders to convert their loans into shares of stock, which they subsequently sell, dropping the value of the company again. A death spiral can dilute existing shareholders considerably if the loans are repaid in shares of stock.