10. Does that capitalization take into consideration the effects of dilution if you are going to need additional funding?

Dilution occurs when a company issues additional shares. Shares can be issued for a number of reasons: raising capital, services rendered, or stock options for management and employees. But dilution can have a devastating effect on a public company’s stock.

Sometimes CEO’s who are desperate for funding enter into an agreement to fund their companies that will, in essence, sink their ship. These are the “toxic” underwritings that occur when a company unknowingly enters into a funding agreement that does not have a “floor”. Most CEO’s assume that a fund is investing in their company because they believe in the company and its management. They also assume that the funding source will make money from the stock going up. In reality, the opposite is true. Most PIPE funding sources are hedge funds—and hedge funds, my friend, are allowed to make money either betting with or against a stock. Hedge funds make more money if they short your stock than if it actually goes up in value.

Here is how this type of PIPE funding works. The funding source will be happy to fund your company based upon a self liquidating convertible debenture. This ploy is actually a cleverly disguised ruse that allows the funding source to establish a floorless conversion price for the stock. This floorless (or bottomless) pricing allows the funding source to keep hitting the bid of your stock because they can constantly adjust the bid price of your stock downward. In most cases, the funding source is buying the stock from the company at a 20% discount to the market. So no matter how low the stock goes it doesn’t matter to the funding source because they still buy it back from you at 20% less than the lowest price at which it trades. If your company stock trades at $1.00 per share and the funding source is providing you with a $4 million convertible debenture at a 20% discount to market ($.80 a share) you are probably thinking the funding source will end up with 5 million shares. WRONG! The funding source will pound your stock into the dirt until it trades at $.01 a share. Now you owe the funding source 500 million shares. You have now lost control of your company and will never be able to raise additional capital.

The good news is that the SEC is now rejecting PIPE filings that feature a floorless convertible debenture. The bad news is that the hedge funds are trying to introduce new versions of these types of funding instruments. The bottom line is “proceed with caution”. If the funding proposal sounds too good to be true, it probably is.

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