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Tern: Is this going to be the worst ever example of the death spiral?

By Cynical Bear | Saturday 2 December 2017

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from ShareProphets). I have no business relationship with any company whose stock is mentioned in this article.

I must admit to having a slightly morbid fascination with the various death spiral variants. They all look so similar on the face of it but the devil is in the detail and although the one announced by Tern (TERN) on Thursday looks harmless enough, it could easily crucify the share price, much more so than has been seen already.

Nigel covered the story on Thursday (HERE). In short, Tern is desperate for money as its main investee company, Device Authority, has struggled to-date to raise external funds and I presume Tern now needs funds to help it stay alive while it continues to search elsewhere.

As Nigel mentioned, the terms of the death spiral looked relatively harmless in that it was lending funds in £550,000 tranches and it converted at the lowest bid of the last three days. There isn’t even a 10% discount on the conversion.

This “lowest bid of the last three days” conversion mechanic is not a normal Yorkville / Darwin / Riverfort mechanic. The last time I saw this was with L1 Capital at CloudTag and Belastock at Kin Group (KIN). Neither of those companies are still around in the form that they were at the time for the funding although it’s hard to know whether that is the fault of the funding or just that they were shockingly bad companies.

Tern’s deal was announced on Thursday morning and the share price, having closed at 5.125p on Wednesday, closed yesterday at 2.875p, a drop of 43% in two days; but it could get a lot worse yet.

The issue with this particular funding arrangement is the size of the amount lent relative to the size of the company and, connected with that, the volume that needs to be traded by this unnamed death spiral funder, in relation to the normal volume traded at Tern.

When the deal was announced and the funder lent £550,000 (less unknown expenses of course), its aim would have been to get this money back as quickly as possible by selling shares in advance of a conversion. At a closing bid on Wednesday of 5p, that means that it would have at least 11 million shares to sell, so it would have started making inroads immediately. In fact, from looking at the volumes, it could even have started on Wednesday.

Unfortunately, if one looks at the normal volumes here, there are many days when the volume at Tern is less than a million shares traded, both buys and sells, and then along comes along L1 / Belastock / whoever and starts selling a million or more each day. This will have only one effect on the share price. I understand that a more sensible funder would look to trade about 15% of normal traded volumes to keep the effect on the share price to a minimum. Here, it is trying to trade amounts in excess of average daily volumes. It is crazy.

One needs to look at how the spiral plays out though to really understand the evil at play. The closing bid on Thursday was 3.75p, so the funder can now sell 14.7 million shares (up from 11 million) in this first tranche. Then it sells a couple more million say on Friday which has dropped the closing bid to 2.75p. This now means that it can sell 20 million shares in this first phase.

With the volumes normally traded at Tern, if this pattern continued, the funder would never catch up with itself, each day it tries to sell more than the previous day but if the share price keeps dropping, mathematically, it then has more remaining to sell than it did the previous day! By way of example, if the bid dropped to 1p next week (not totally inconceivable at this rate), the funder can convert into 55 million shares, and it’s going to struggle to get those away any time soon. This can all be done in conjunction with a friendly broker that allows it to trade at T-20 so there is no rush to covert to complete the trades.

One can now see why the funder was less worried about the 10% discount as it would have been well aware of the effect of its selling.

This supercharged spiral can only be stopped by three things.

First, the business can put out a positive announcement that increases share volumes significantly and helps boost the share price. If the share price goes above Friday’s closing bid of 2.75p on Monday and Tuesday, then the funder would convert on Wednesday. The issue here is that Al Sisto shot his bolt a bit by putting out the portfolio update on Thursday but am sure he will be working away over the weekend desperately trying to come up with something.

The other two blockers are more technical. Normally at some point, the amount of authorised share issuance capacity comes into play and it isn’t allowed to issue any more shares. However, the Board here managed to get authorisation at the last AGM for a small-looking additional £50,000 of nominal share capital to be issued. However, as Tern has a tiny nominal price of 0.02p, this actually amounts to 250 million shares.

There is a learning point here for shareholders to take a closer look at the share capital amount in that authorisation resolution to understand what it means in terms of number of shares.

This links to the second point as often the death spiral causes the share price to drop below the  nominal price of the shares meaning that no more shares can be issued., Again, that it not an issue here…..for now!

Accordingly, if there is no further news in the short-term, there is a theoretical argument that the share price could spiral its way downwards to allow the funder to cash in about 230 million shares which is around the 0.2p level!

There is obviously a fourth way to stop this which is very common when CEO’s finally come to their senses and realise that this funding arrangement will decimate the share price and that is to do whatever it takes to try to rip up the original deal and find funding elsewhere.

I’m sure Al and his lawyers are poring over the paperwork as we speak.

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