What Are Variable Rate Convertible Notes? The Complete Guide to Death Spiral Financing

Imagine watching your stock position lose 50% of its value in a matter of weeks. No bad earnings report, no FDA rejection, no scandal — just a relentless, grinding selloff that seems to come out of nowhere. For thousands of retail investors in micro-cap and OTC stocks, this nightmare scenario plays out regularly. The culprit? A financial instrument known as a variable rate convertible note.

These instruments — often called "toxic notes" or "death spiral financing" — are one of the most dangerous and misunderstood risks in small-cap investing. In this guide, we'll break down exactly how they work, why companies issue them, and most importantly, how you can spot them before they destroy your investment.

What Is a Variable Rate Convertible Note?

A variable rate convertible note is a type of debt instrument where a company borrows money from an investor (typically a specialized fund or lender), and the lender has the right to convert that debt into the company's common stock at a price that floats based on recent stock performance.

Unlike a traditional convertible note with a fixed conversion price, the conversion rate on a variable rate note adjusts dynamically — almost always to the lender's advantage. The typical structure works like this:

• The company borrows a set amount (e.g., $500,000)
• The lender can convert the debt into shares at a discount to the recent market price (e.g., 70–95% of the lowest VWAP over the prior 10–20 trading days)
• As the stock price falls, the lender receives more shares per dollar of debt converted

This floating conversion rate is what makes these notes so toxic. The lender is structurally incentivized to convert and sell, which pushes the stock price lower, which allows even more favorable conversions on the next round.

Key Terms You Need to Know

Before diving deeper, here are the critical terms you'll encounter when analyzing these notes:

• Conversion Discount: The percentage below market price at which the lender can convert. A 25% discount means the lender converts at 75% of the market price. Typical discounts range from 5% to 30%.
• Lookback Period: The number of trading days used to calculate the conversion price. A 10-day lookback uses the lowest VWAP (Volume Weighted Average Price) of the last 10 trading days. Longer lookback periods generally favor the lender.
• Floor Price: A minimum conversion price written into the note. While this sounds protective, floor prices are often set far below the current stock price and provide limited real protection.
• Beneficial Ownership Blocker: A cap (typically 4.99% or 9.99%) on the percentage of outstanding shares the lender can hold at any one time. This doesn't limit total conversions — only the pace at which they occur.

The Math: How Dilution Explodes

The numbers tell the story better than anything else. Consider a $100,000 convertible note with a 25% discount to market price:

The same $100,000 in debt produces 20x more shares when the stock falls from $2.00 to $0.10. This is the mathematical engine behind the death spiral.

Why Do Companies Issue These Notes?

If variable rate convertible notes are so destructive, why would any company agree to them? The answer is simple: desperation.

Companies that issue these notes typically share several characteristics:

• No access to traditional capital markets. Banks won't lend to them. Institutional investors won't participate in a standard equity offering.
• Facing imminent cash shortfalls. They need money now to keep the lights on, make payroll, or avoid defaulting on existing obligations.
• Risk of delisting. Many are OTC or NASDAQ-listed companies that need to maintain minimum bid price requirements and see toxic financing as a short-term lifeline.
• Limited revenue or pre-revenue. Common among micro-cap biotechs, speculative resource companies, and early-stage technology firms.

For these companies, a variable rate note offers something no one else will: fast cash with minimal upfront requirements. The lender takes on the risk of holding debt in a struggling company, and in exchange, they get conversion terms that virtually guarantee a profit — at existing shareholders' expense.

The Death Spiral: How It Works Step by Step

The term "death spiral" isn't hyperbole. Here's exactly how the cycle unfolds:

1. The Note Is Issued: The company announces (via an 8-K filing) that it has entered into a convertible note agreement. The stock may dip on the news, but many investors overlook the filing.
2. Conversions Begin: The lender starts converting portions of the debt into shares, typically in small batches to stay under beneficial ownership limits.
3. Shares Hit the Market: The newly converted shares are immediately sold on the open market. For illiquid micro-cap stocks, even modest selling volume creates significant downward pressure.
4. The Stock Price Drops: Increased supply and persistent selling push the stock price lower.
5. The Conversion Price Adjusts Down: Because the conversion price is tied to recent market prices, the lender now gets even more shares per dollar on the next conversion.
6. The Cycle Repeats: More shares, more selling, lower prices, even more shares. This continues until the note is fully converted or the company's stock approaches zero.

Floor prices, when they exist, can slow this cycle but rarely stop it. A floor at $0.50 on a stock trading at $3.00 may seem like adequate protection — until the stock falls to $0.50 and the lender is still converting and dumping millions of shares at that level.

Case Study: Castor Maritime (CTRM)

One of the most well-documented examples of death spiral dilution involves Castor Maritime (CTRM), a shipping company that became a cautionary tale for retail investors.

In January 2020, Castor Maritime issued a $5 million convertible note with the following terms:

• Conversion price: The lower of a fixed price of $2.25 per share OR 90% of the lowest volume weighted average price during a defined lookback period
• Floor price: $0.60 per share

The implications were dramatic:

At the floor price, the lender received nearly 4x more shares than at the fixed price.

By March 2020, approximately 3.5 million new shares had been converted at an average price of roughly $0.66 — nearly at the floor. This was approximately equal to the company's entire prior shares outstanding. The conversion volume represented roughly 20% of daily trading volume, creating relentless selling pressure. Existing shareholders saw their ownership effectively cut in half.

CTRM is far from an isolated case. According to securities attorneys who specialize in this area, it's not uncommon for companies that engage in toxic financing to see their outstanding share count balloon from under 50 million to over 5 billion shares. The pattern repeats across the OTC and micro-cap space: a cash-strapped company issues a variable rate note, the lender systematically converts and sells, and by the time retail investors realize what's happening, the damage is done.

How to Spot Variable Rate Convertible Notes

The good news is that these notes must be disclosed in SEC filings. Here's where and what to look for:

Where to Find Them

• 8-K Filings: Companies must report material agreements, including convertible note issuances, on Form 8-K — you can search EDGAR filings directly for these. This is usually your earliest warning.
• 10-Q and 10-K Footnotes: The notes to financial statements will detail outstanding convertible debt, including conversion terms.
• S-1 and S-3 Registration Statements: When the lender registers the shares they intend to sell after conversion, the full terms of the note are typically disclosed.

Red Flag Phrases

Search filings for these terms:

• "Variable rate" or "adjustable conversion price"
• "Lowest VWAP" or "lowest closing bid price"
• "Beneficial ownership limitation" or "4.99% blocker"
• "Equity line of credit"
• "Market price discount"

Red Flags in the Stock Chart

• Persistent, steady decline on no news
• Consistent small-block selling throughout the trading day
• Increasing share count visible in quarterly filings
• Unusual volume spikes coinciding with new low prices

Use DiluTracker

Manually monitoring SEC filings for every stock in your portfolio is time-consuming and easy to miss. DiluTracker automatically identifies and flags dilution events — including variable rate convertible note issuances — so you can stay ahead of the selling pressure before it hits your portfolio.

The Regulatory Landscape: SEC Enforcement Is Fading

For years, the SEC recognized the harm that variable rate convertible notes cause to retail investors. In 2023 and 2024, the agency pursued an aggressive strategy, bringing enforcement actions against toxic lenders under the theory that their systematic buying and selling of convertible notes made them unregistered securities dealers in violation of Section 15(a) of the Securities Exchange Act.

That strategy has since stalled. In May 2025, the SEC announced that it was dismissing three enforcement actions with prejudice against convertible note financiers — effectively abandoning its primary legal tool for combating death spiral financing.

What does this mean for investors? Less regulatory protection, not more. With the SEC stepping back from active enforcement, toxic lenders face fewer deterrents. The burden of protecting yourself from dilution has shifted even further onto individual investors.

This makes tools like DiluTracker more important than ever. When regulators step back, informed investors need to step up.

Variable Rate Notes vs. Other Convertible Instruments

Not all convertible instruments are created equal. Here's how variable rate notes compare to other common structures:

The critical difference is the feedback loop. Fixed-rate instruments create a known, one-time dilution event. Variable rate notes create an accelerating dilution event where the damage compounds as the stock price falls. This is what makes them uniquely dangerous.

Strategies for Investors

If You're Long a Stock With a Variable Rate Note

• Assess the severity: How large is the note relative to the company's market cap? A $500K note on a $100M company is manageable. A $500K note on a $2M company is catastrophic.
• Check the conversion schedule: How much has already been converted? How much remains?
• Consider your exit: If significant conversion remains, the selling pressure is likely to continue. Cutting losses early is often the right move.

If You're a Short Seller

• Variable rate notes create predictable, sustained selling pressure that can last weeks or months.
• Monitor 8-K filings for new note issuances and track conversion activity through subsequent filings.
• Be aware that beneficial ownership blockers mean conversions happen in waves, not all at once.

For All Investors

• Check the capital structure before you buy. The balance sheet matters more than the stock chart when it comes to dilution risk.
• Set up alerts for new SEC filings on any stock you hold or are considering.
• Use DiluTracker to monitor dilution events across your watchlist automatically.

Key Takeaways

• Variable rate convertible notes are debt instruments where the conversion price floats at a discount to market price — the lower the stock goes, the more shares the lender gets.
• They create a "death spiral" feedback loop: conversions lead to selling, selling leads to lower prices, lower prices lead to more shares on the next conversion.
• Companies issue them out of desperation when no other financing is available.
• SEC enforcement against toxic lenders has weakened significantly since mid-2025, removing a key regulatory deterrent.
• You can spot them in 8-K filings, 10-Q footnotes, and registration statements by searching for key phrases like "lowest VWAP" and "variable rate."
• DiluTracker helps you identify and monitor these events automatically, so you're never caught off guard.