Cramer Rewrites "A Deal With the Devil," Part 2

Editor's note: This is the conclusion of a two-part rewrite column. Please be sure to read Part 1.

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Now the only hope for this company, as I see it, is the suit it just filed in Federal Court. And given the slow nature of the courts, that may not be enough to save this company from oblivion.(I don't think lawsuits save growth companies. They tend to be too slow.)

I hope not. These folks seem like honest guys. Not very smart about financing, but honest guys. (Again, some of you pointed out they were well-compensated for bringing in this financing. I said, big deal. They were definitely over their heads. Maybe even greedy. But they deserved better than this.)

I don't want them to fail. That's probably now up to a judge because these convertible preferred guys are smarter than Shylock ever was. And nowhere near as visible, or as sympathetic! (That's the takeaway I keep hearing from other guys who have dealt with these firms. They are slick and smart. They have a game and they know it. I found myself thinking, hey, I ought to invest with them? But I also found myself thinking that hey, I ought to invest with Tony Soprano when he was doing that bust out of Dave's sporting goods place in last season's "Sopranos" episodes. However, neither is really investing the way I do it.).

What I want you to do is avoid companies that make these deals so you won't have a Hayes, which ruined my 1998, or a Log On America(LOAX Quote), which, I am sure has ruined everybody's year who has bought this otherwise high-growth CLEC company. (That's the point of this piece. I don't want you to ride your position to certain oblivion. Some companies have beaten the convert monster. Not many, though.)

So I want to give you the details of what has happened to Log On, and what occurred to Efax.com, Netplex Group, Auspex Systems, MicroStrategy, General Magic, Intraware, Etoys and Entrade, according to the plaintiff's document. (I took this list from the complaint. A member emailed me and said that Auspex Systems deserved better than to be included by me. He proceeded to trip down some pretty interesting facts about Auspex and I found myself building a file on it immediately. Hopefully, I will have more tomorrow. Couldn't believe that eToys did one of these. I mean, I didn't know they were that desperate. They should have sold the company to somebody instead.)

In February, Log On entered into a deal with a couple of firms to raise money through a convertible preferred according to a "floating" conversion rate that was meant to offer some downside protection to the holders. Thus the lower the stock at the time of conversion, the greater number of common shares to be received by the holders. (Hence , the floorless nomenclature.)

(I tried to get a list of the companies that had done these from the NASD but they didn't have one. I am trying to compile one by going through filings but it is taking forever, my apologies. Remember, it is not like they title the document "Toxic" and burnish a big skull and cross bones on it. It looks like any financing for convertibles -- many of which are fine instruments that I have owned from time to time.)

What is so awful about that? For one, a floorless convertible presents, as the brief from the Log On suit says, "a tempting opportunity for market manipulation." To use the formula provided: (The document has dozens of little snippets about how bad these are, which makes me say to myself, hey jokers at Log On, if it was so easy to find out what poison these are, what they heck were you thinking? A simple search on the web would have stopped this financing in its tracks. I am hoping other cfos will see this and know better but they keep doing them. If the Journal wrote this up, they wouldn't, but there is nothing I can do about that.)

[The holder of the security] can short sell the company's stock at a price of "X" per share. A high volume of short selling pushes the share price down to X-1 or even X-2. The preferred shareholder's conversion price is then reset to a discounted percentage of X-2. The preferred shareholder then converts at that lower conversion price to cover the shares it sold at X, delivers the shares necessary to cover the short sales and has a large number of shares left over, which it can then sell at X-2. ... Further, the more the preferred shareholder can push down the market price, the more profit it makes on each conversion. If the preferred shareholder short sells at X per share, it will make much more if it can convert its shares to cover at X-4, then it will make by covering at X-2. Thus the more the preferred shareholder can drive the market price down, the more money it will make per share and the more shares it will receive.

(You have to get this picture of an instrument that gives you more and more shares the lower the stock goes.)

Hence the term "toxic," or the more colorful "death spiral convertible." The lower the stock gets driven the more in the driver's seat the convert holders are. In Log On's case they have hijacked the whole car! Log On alleges in its brief that the convert holders have driven the stock down so far through massive short sales that they would now own 8,000,000 shares as every peg down entitled them to more and more shares. How much is eight million shares? Heck, there are only 8,800,000 shares outstanding!!! Management only owns 3 million shares. (In the document the whole thing seemed ridiculous. How could this kind of Trojan Horse be legal? Who checked off on this? What lawyers would not have seen that this company could lose control of the company if the stock plummeted? How could they not have seen this coming? I know I did two years ago and I have told everybody I know about it, and I know a lot of people. Someone did NO homework here. None. )

Game over! Toxic convert holders 1, everybody else, zilch-mo!! (Remember, it is the common stock holders I care about. That would be you and me.)

Isn't that an incredible story?

Of course maybe the holders didn't short it all the way down or knock it down. For example, we know the telco market has gotten tough. And maybe the business has gotten soft because of the Verizon strike or because Verizon has lowered the price of DSL. Who knows? But the simple fact of the matter is that this company was relatively healthy before it took this suicidal financing. Now it is on intensive care with a judge trying to figure out whether the stock should be resuscitated. Don't let this happen to one of your equities. If you own a stock with a convertible preferred and it is floorless, you could soon be in this position. Sell it now if you do, because it is a cinch that it will go still lower if the ploy is still on.

(A lot of people wrote to me and said that Log On was crummy. But how crummy could a company be that got through the Business Week machine? You don't think Gene Marcial picks those names out of the Yellow Pages do you? This was pumped up after Marcial did his thorough, solid research as I am sure the editors insist on or they wouldn't keep him, would they? Do you think Annunziata doesn't know what he is doing? I wouldn't bet that way. Such a bet has wiped out a lot of people! I could see ICG doing one of these deals. That would have been typical, but now it has new management, so maybe it won't.)

What happened to Log On shouldn't be allowed to happen. But it has happened. It may be too late to save it. Until chief financial officers of the world wise up, we will keep having these toxic converts. The bankers don't seem to want to stop them. The issuers surely won't. And the government doesn't even seem to know they exist.

(I would think that the issuers of these converts must be laughing themselves silly about how dumb corporate America is. I can see them smoking some Cubans and drinking Macallan 18 years old, neat, and cackling about how they fooled Toby Lenk or the folks at Log On or dozens of other players. Here's to you! You remind me of the scene in "The Godfather, Part II" with the corrupt Cubans passing around that gold telephone from United Tel and Tel! By the way, I expect nothing from the regulators on this protecting common stock holders. I know the NASD looked at it and did nothing. Oh well! Caveat emptor, boys!!).

What a crime! Hopefully for the last time: CFOs say "no" to death spiral converts. They will kill your company more quickly than any other former of financing. Better to just give up and sell the company than to take one of these on. Don't say I didn't warn you. (Right now, at this very minute, I am sure there are a half-dozen dot-coms talking with floorless convert lenders right now, getting all sorts of comfort about how it won't happen to them. Maybe it won't. Maybe the sun won't come up tomorrow, either. But I wouldn't bet that way.)