Ending Toxic Financing: Paving the Way for a Leaner, More Entrepreneurial Public Market

This article was originally published on Creatd: https://www.creatd.com/whitepaper/ending-toxic-financing-paving-the-way-for-a-leaner-more-entrepreneurial-public-market

As we approach the end of the summer, which has been one of the most challenging periods of my career, there is no time to rest. The public markets have been an extremely difficult environment, particularly for entrepreneurs in companies with valuations under $100 million. Despite this, my team and I are committed to staying the course and working diligently to uplist back to a national exchange within the next six months. Completing our audited financials is a critical step in this process.

Public markets in this space have always been characterized by high risk, but also by the potential for substantial rewards. This high-reward potential is particularly evident when the management team has a significant personal financial stake in the business, betting on themselves and their vision. The alignment of the management team’s incentives with the company’s success often drives innovation and resilience, further enhancing the potential for outsized returns. 

I can authentically attest to this, having invested my entire life—both personally and financially—into the success of my companies. I’m all in.

However, recent developments, particularly in 2024, have led to an unprecedented crisis in this segment of the market. I find parallels to past market downturns. They can be found in the regulatory responses aimed at curbing the contributing destructive forces, while also outlining the potential solutions for companies caught in this cycle.

My team is committed to being a part of that solution. Part of our proactive strategy for Creatd starts with completing the first of five planned cross-holding exchanges with other publicly traded companies. To date we have completed two of them. We expect to complete the rest by quarter end. These transactions are a small part of a much broader solution. Mergers and acquisitions are the tools needed to navigate a rapidly consolidating market place and create an organization where seasoned executives can work together in the interest of the collective.

Historical Context: The Dot-Com Bust and Its Aftermath

In the late 1990s, speculative investing during the internet boom drove the NASDAQ to a peak of 5,048 in March 2000, only for it to crash by 78% by October 2002. The microcap sector, inherently speculative, fared even worse, with many stocks losing over 90% of their value. This collapse bears striking similarities to today’s downturn in small, micro, and nano-cap markets. Both periods are marked by speculative exuberance followed by dramatic declines. During the dot-com crash, the OTC market became a haven for delisted companies, but they often traded at much lower valuations, prompting the market to mature rapidly. A key development was the creation of the OTCQB in 2010, providing a more structured platform with higher standards.

Parallels to 2024: A New Microcap Crisis

The microcap market in 2024 is experiencing a crisis reminiscent of the dot-com bust, driven by plummeting valuations, economic tightening, and speculative financing. Like the late 1990s, the post-COVID era saw a surge in liquidity, which has now led to a market downturn as conditions tighten. However, the optimism of the dot-com era has been replaced by caution toward new technologies like AI and blockchain, with added concerns about privacy and job displacement. Politically, increased regulation and polarization have created a more challenging environment for microcap companies. Government policies, once focused on unchecked innovation, now emphasize caution, reflecting a shift in public sentiment from enthusiasm for tech to wariness of speculative markets.

The Evolution of Convertible Bonds into Toxic Financing

The convertible bond, once a straightforward tool for raising capital in the 1990s, has undergone a significant transformation, evolving into what is now often termed “toxic financing.” This shift illustrates how these instruments have been repurposed in ways that can be detrimental to issuing companies, particularly smaller, high-growth firms in need of capital. The impact of this trend has also rippled into the private sector, notably affecting the use of SAFE notes.

Traditionally, a convertible bond allowed investors to convert their bonds into equity at a fixed price, offering potential upside if the company’s stock performed well. However, the modern version often includes highly favorable terms for the lender, such as adjustable conversion rates, deep discounts, and other mechanisms that can lead to significant dilution of existing shareholders’ equity. This can create a vicious cycle where the company must issue more shares at progressively lower prices, driving down the stock price, diluting retail investors, and potentially leading to financial ruin. What was once a helpful tool for capital raising has, in many cases, become a weapon that can sap the life out of a company if not managed carefully. This phenomenon has become synonymous with what’s now often called “death spiral financing.”

As the microcap market evolved, these instruments mutated into tools for predatory lending, particularly with the rise of “floorless” convertible notes and excessive warrant coverage. This marked the beginning of a new era of structured products, where borrowers, often lacking the necessary sophistication, found themselves overwhelmed by complex terms that gradually dominated the entire space.

Toxic lenders exploit these terms to their advantage, using excessive warrant coverage to short and dump stock, profiting from the resulting dilution. The floorless convert shields them from downside risk, ensuring their protection even if the stock price declines. If the stock rises, they still benefit, as the warrant hedge secures their upside. This one-sided strategy allows toxic lenders to profit regardless of the company’s performance.

Moreover, the SEC and PCAOB have taken a more critical approach to these structures, making it increasingly difficult to complete audits in a timely and cost-effective manner. The requirement to pay external experts for derivative valuations and probabilistic analysis of these notes is not only costly but also dangerously subjective, especially when the auditors themselves often struggle to understand the specialists’ conclusions. This added layer of complexity and uncertainty further burdens companies, making it even more challenging to navigate the already treacherous waters of toxic financing.

Why not just ban floorless notes?

Banning floorless convertible notes might seem like a straightforward solution, but the reality is more complex. Financial markets are highly intricate, and an outright ban could lead to unintended consequences, such as pushing toxic lenders to create other harmful instruments or structures. Moreover, such a ban could limit financing options for legitimate microcap companies, forcing them to turn to more expensive or restrictive alternatives.

A total ban could also stifle financial innovation and close off one of the few financing avenues available to high-risk ventures. Policymakers must balance the need to protect companies and investors from predatory practices with the importance of maintaining an open market that encourages innovation.

Instead of relying solely on regulatory bans, promoting alternative financing methods, such as Regulation A offerings of preferred stock, could provide a more sustainable solution. These options allow companies to raise capital without triggering the destructive dilution associated with floorless convertibles.

The Role of Algorithmic Trading and Market Dynamics

Algorithmic trading and market maker strategies have brought new challenges to the microcap market, often worsening volatility and draining liquidity. Toxic lenders, who flood the market with shares after causing massive dilution, have no intention of being long-term investors. Their actions create a downward spiral in stock prices, which is further amplified by algorithms designed to maximize profit. These algorithms, picking up on the downward pressure, intensify the sell-off, making it even harder for stocks to recover. As a retail investor, this means you could see the value of your investments drop even when the company releases positive news, all because of this vicious cycle.

The concentration of capital in large-cap stocks only makes matters worse by draining liquidity from the microcap space, leaving these smaller companies vulnerable. This lack of liquidity means that when you, as a retail investor, buy into a microcap stock, you’re stepping into an environment where your investment is at greater risk of being eroded by forces beyond your control.

In the end, it’s the retail investors who bear the brunt of these practices. The toxic lenders profit by offloading shares at your expense, while the algorithms lock in and exacerbate the downward trend. This perfect storm of dilution and algorithmic reinforcement creates a feedback loop where your losses are compounded, making it nearly impossible for you to see a return on your investment, even when the company itself is doing well. It’s a rigged game, and retail investors like you are getting caught in the crossfire.

Fighting Back Against Predatory Practices

In the current microcap landscape, the need for CEOs to unite against predatory practices has never been more critical. Exposing unethical lenders is essential to protect companies and their investors, though it comes with risks such as stock pressure, legal challenges, and retaliation. Managing toxic equity holders—those who convert debt into shares only to liquidate quickly—requires a firm approach, including enforcing restrictions to prevent further downward spirals.

To survive and thrive, microcap companies must adopt a strategic approach to managing equity and financing transactions. At Creatd, we are actively implementing solutions, including cross-holding exchanges and mergers, to combat toxic financing. Our commitment is exemplified by Project 100, an initiative aimed at building partnerships with 100 companies through cross-holdings, mergers, and acquisitions. This project is central to our strategy of creating a stronger, more resilient market presence that can withstand the pressures of toxic financing. By restricting immediate conversions in future financing and focusing on attracting long-term investors, companies can better control dilution and stabilize their stock.

The microcap market is at a pivotal moment, facing unprecedented challenges from toxic financing, short-selling, and algorithmic trading. While increased SEC enforcement offers hope, the future health of the microcap space depends on developing fairer, more sustainable financing models. At Creatd, through Project 100 and other initiatives, we are committed to building a new foundation for the entrepreneurial community—one free from the grip of toxic lending. By learning from the current crisis, we can navigate the path forward together, creating a more stable and equitable market environment.

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