If you are a current investor in Worlds, the investment got a lot taller and better looking on Friday. That may seem like a strong statement given that the stock has doubled since I first alerted investors to it in early January but Worlds Inc. (WDDD), on the brink of finally unlocking the true value of its patents involving 3-D World creation and participation in the Massively Multiple Online Role Playing Game (MMORPG) space, raised $2.3M in what we believe was a highly favorable financing for the company and its investors. The purchasers, namely Hudson, Iroquois and GRQ (affiliated with Barry Honig), bought notes and warrants from WDDD. The notes were issued at a discount of 4 & 1/6% to face value (which is why the purchase amount is less than the aggregate face amount of the notes). The notes bear interest at 14% and are due March 13, 2016. The notes are secured by a pledge of all of the company’s assets other than the company’s patents, which is an important point for current investors. The notes are convertible at various fixed prices and these prices are subject to certain adjustments. Prior to any adjustment and prior to July 1, 2013, the principal and interest on the notes is convertible as follows:
The Series A Notes convert at $.50, the Series B Notes convert at $.75 and the Series C Notes convert at $.35.
After July 1, 2013, the notes convert at the lower of the conversion rates in the preceding paragraph or 85% of the weighted average trading price of the WDDD common stock during the 20-day period prior to the date of conversion. Up to 75% of the Series A and B notes can be redeemed by the company for a 20% premium, subject to the right of the holder to convert the notes instead. The Series C notes (i.e., those convertible at $.35), are not redeemable. For those suggesting that the series C could be or already have been converted this is unlikely as registration is required to sell and once converted the interest is canceled.
The investors were also granted 4,535,714 warrants. The warrants may be exercised at a strike price of $.50 at any time prior to the fifth anniversary of issuance. The warrants are subject to cashless exercise and a number of other typical features. They are subject to so-called “full-ratchet” anti-dilution protection, which means if the company issues new shares (with certain standard exceptions for stock options and the like) at less than $.50 per share the warrants become exercisable at that lower price. Absent an emergency, this means that the company is unlikely to issue any shares at a price below $.50 per share. The investors were also given standard registration rights and a right to participate in up to 50% of future fundraisings for three years.
I realize that the foregoing short, high-level summary may beg a few questions. For this reason, I have created a “Q and A.” to anticipate some of the likely queries about the financing. (Note: I get questions sent to my personal blog and to my SA inbox and some of the questions below are those questions. I apologize in advance but I will likely not have a lot of time in coming days to answer too many more questions about the financing.)
Q: Who are the investors?
A: The investors are Hudson Bay IP Opportunities Master Fund (“Hudson”), Iroquois Master Fund (“Iroquois”) and GRQ Consultants inc, 401K. (“GRQ”). The first two funds appear to be affiliates of the well known-hedge funds which bear those names. They are both active players in the PIPE market. Hudson in particular is listed by Bloomberg as a top 100 performing hedge fund. GRQ appears to be an affiliate of Barry Honig, a well-known businessman based in Florida with experience and appetite for investing in small cap stocks with outstanding potential.
Q: Why did Hudson, Iroquois and GRQ invest?
A: First, let’s look at downside protections: If WDDD were to lay an egg at the Markman (6/27/13) and/or at trial, absent a miracle, the investors will own notes which they cannot collect on March 13, 2016, as well as the right to sell a bunch of collateral that is not worth much and which does not include the company’s patents. It is safe to assume that their $2.3 million cash investment is way under water in this scenario and therefore, this is NOT why they invested. A second, more plausible scenario is that similar to a bunch of other WDDD investors, they think (a) the price will increase prior to the Markman (being themselves the proverbial “smart investors,” they know the price should lift somewhat just because they jumped in), (b) the price may well double (or better) from its pre-Markman high on news of a successful Markman hearing, and (c) the price will go further north upon a buyout of the company, a settlement with ATVI or a victory against ATVI at trial.
But let’s consider today’s status and also what the upside scenario might look like from the perspective of the investors:
3/18/13 $2.3 cash investment in notes and warrants; investors hold paper with theoretical upside; about 19% of their notes can be converted at $.35, the rest of the note conversion rights and warrants are out of the money until the price moves north of $.50 per share. The shares under the notes and warrants are “restricted’ until a registration statement gets filed and becomes effective with the SEC permitting the resale of the shares. (The notes and warrants themselves have no registration rights.) So the investors did not invest for a quick flip – they do not have any shares to sell unless, like the rest of us, they bought them in the open market.
7/1/13 (The day the second conversion price option under the Notes becomes effective): Let’s assume a scenario that permits an exercise of all the in-the-money conversion rights and warrants on this date. The principal and interest (at 14%) on the notes is about $2,500,000 in the aggregate on this date. The three series of Notes break down into roughly 40/40/20% of the total investment amount. Let’s assume again, conservatively, that on 7/1/13, after the Markman hearing but before the actual ruling from the Court on the Markman hearing, the price of WDDD shares is $1.00. (I say “conservatively” because I think that the price of WDDD shares will exceed $1 before the hearing and that based on reports (including mine which will be issued at breaks during and after the hearing), if things go well for WDDD the price could well be $2-3, or more.) Thus, I assume that the alternative conversion pricing of 85% times the 20-day weighted average price is not going to be relevant because it will be higher than the fixed prices of $.35, $.50 and $.75 and more favorable to the investors. At an assumed $1 PPS, upon exercise of all of the Notes the investors would receive about 4,726,190 shares of WDDD common worth $4,726,190. So the gain on the investment in the Notes as of this date would be $2,426,190, a tad over 100%. But wait, there’s more: the warrants are now in the money and there are 4,535,714 shares available under those warrants at a price of just $.50! So this is worth another $2,267,857 upon exercise. So now the profits on that $2.3 million investment come to $4,694,047 – so we now have a 200% return in under 5 months. To the extent the share price on 7/1/13 (in my hypothetical conversion) or on the date of actual conversion is greater than $1, as I believe it will be, the profits for the investors will be even greater. We feel strongly that Hudson and Iroquois did not invest with a view to flipping on a successful Markman, so our 7/1/13 hypothetical is just that. (For what it is worth, according to its SEC filings, Iroquois still owns most of its VRNG position so at this point it would be hard to characterize them as a “flipper.”) Their returns and other WDDD longs’ returns could go up and down after that date depending on the usual factors involved in patent litigation.
Q: What does Worlds get in this investment?
A: For one thing, the amount of cash Worlds gets (which will be placed in an account over which the investors will have control-and our guess is that this was done to prevent unsecured creditors of the company from having any incentive or means to get their hands on these funds) will allow the company to largely or entirely clean up its balance sheet, which was one of the perceived risks of the WDDD profile. It could also allow the company to do other things such as: (1) hire additional team members, expand its board of directors, upgrade its SEC reporting or IR efforts, complete more road shows, etc.; (2) file more lawsuits (and there are plenty of potential additional infringers out there) and possibly “buy down” the legal fee contingency rate on current or future lawsuits by agreeing to pay a portion of the costs (nothing against Max Tribble and SG but I would rather WDDD pay them, say, 35% than 40%, with the resulting discount potentially worth millions), and (3) engage in strategic discussions with would be acquirers without having a balance sheet that signals weakness, (4) engage in further R&D and innovation, and so on.
Q: What has happened to the company’s capital structure? Does this increase the float? Does this dilute existing WDDD shareholders?
A: At present, no shares of common stock have been issued to the investors because they have not exercised their conversion options or warrants. Thus, these underlying shares have not been added to the “float” and cannot be traded until they are registered with the SEC. These shares are indeed dilutive to existing owners. Keep in mind however, that dilution, like cholesterol comes in two forms: the (relatively) “good kind” which in this case is merely “ownership dilution”, which simply means more shares got issued and the company raised money, and “price dilution”, the “bad kind” which is when a company sells shares below the current trading price. The conversion price of the C Notes at $.35 was probably struck to take into account a 20- day average price leading up to the announcement of the deal so there was effectively zero price dilution – in fact more than 80% of the Notes and 100% of the warrants convert out of the money as of the date the deal was announced.
Q: What does this mean for John Q Public who owns shares that he bought in the market?
A: I think John is far better off now than he was before this deal got announced. For one thing, keep in mind that in my scenario above, the market cap of the company would be about about $70 million on 7/1/13, including the shares under the assumed conversion of notes and assuming the investors simply hold onto their warrants. So the existing shareholders will see the price of their shares double. Likewise, at higher prices we all own shares that we can eventually sell at much greater profit.
Q: What will this deal do for liquidity of our holdings?
A: In the short term, I think this transaction will result in a modest improvement in liquidity. Here’s why: the reputation of these investors will likely draw significant additional investors to the stock, increasing the volume and liquidity. In the very recent past, a 100k-share order had a bit of an impact on price and it would be hard to sell that block “at the market.” I think that in the near future there will be larger trades in the quotation system and the volume will pick up. If you like to think of your WDDD stock as a liquid asset, this is a good thing.
With the addition of these institutional shareholders to WDDD’s base the overall volume in the stock should intensify making this stock more liquid for all of us (though it could also become more volatile). However, the fact of the matter is that the increased share count (assuming conversion of the notes and exercise of the warrants) should actually alleviate possible volatility. The shares issue-able upon conversion would add about 4.8 million to the total outstanding (using the hypothetical price and conversion date I used above; the number will grow to cover the amount of interest accruing after that date (interest is also convertible) unless and until the company calls the Notes for redemption (which will force their conversion if the notes are in the money). Prior to the issuance of these new securities, per the company’s rep in section 3(r) of the purchase agreement, the company had outstanding commitments to issue 10,562,500 shares under options and other common equivalents and it now has the notes and warrants that are also convertible/exchangeable into common stock.
Q: Does this financing set us up for a listing on Nasdaq or Amex (NYSE Mkt)?
A: Not in and of itself, no. But it is an important step in that direction. The alternative listing criteria of the exchanges permit issuers to qualify in various ways but Worlds does not currently meet any of them. However, if its share price approaches $1 they could begin thinking about the mechanics of this. (There are other non-quantitative requirements for listing but these are usually fairly easy to meet.) My $.02 is that even if the price of the stock gets to $1.00 (we actually just need a $75 million market cap, to be precise) the company is better off waiting until after the Markman (assuming it is positive) and then potentially doing a reverse split (unless the price is robust enough which it could be) in connection with (a) a Nasdaq or Amex listing, and (b) a secondary offering or private placement that will allow it to call the redeemable portion of the March 2013 Convertible Notes (they will get converted instead because they will be in the money if the Markman hearing goes well, and thus this debt will become equity on the balance sheet). Assuming that any funds raised will not actually get used to redeem Notes, these funds can then be used to clean up WDDD’s balance sheet by paying off any of its remaining payables. Calling the Notes will allow the Company to stop the accrual of the 14% interest rate on 75% of the series A and B Notes, which constitute over 80% of the total loan amount. I can envision circumstances that would make a listing with no secondary offering preferable, but again I think the Company should wait until after the Markman to do a listing (and I strongly believe they will), which could then come six to nine months down the road.
Q: Does WDDD really need this money and if so did they raise too much?
A: One could argue that WDDD does not have an immediate need for $2.3 million (although it fixes a hole in its balance sheet caused by unpaid payables and loans) but the price to pay for bringing in these kinds of investors is that you have to give them an opportunity to put some money to work. I think the right balance was struck. (BTW, I saw this sort of PIPE deal happening at a point when the price was at $.50. Given the out-of-the money conversion and warrant pricing that the company negotiated, I think this deal is NOT premature from the company’s standpoint.)
Q: Are Hudson, Iroquois and GRQ now insiders of the company? Are they subject to any restrictions on trading?
A: Unless these investors own more shares than they bought in the financing, they are not likely to be insiders who are subject to any reporting obligations or any duty to refrain from trading in WDDD shares. (Note that they did not obtain any control rights with respect to WDDD, such as the right to sit on the board. In all likelihood, the only non-public information they had about WDDD was that they were about to announce the financing. Now that the financing has been announced, these investors are free to buy and sell shares like the rest of us, and to speak to people they know about Worlds. To the extent that actions speak louder than words, once again the mere fact that these folks invested is likely to attract interest in the stock. Hudson and Iroquois are known commodities and Honig has a history of investing in public companies and is often accompanied in such investments by billionaire investor and businessman Philip Frost. These investors have other cohorts as well, billionaires among them. Accumulation by these folks or their friends can be expected and it will take place anonymously unless and until one of them (or a group) reaches a 5% ownership threshold. This is perfectly legal and is nothing but good news for current shareholders.
My strong sense is that these investors have done their homework on the patents and the ATVI case. (Full disclosure: my group has been studying the patents for several months. We continue to study the prior art references cited by the defendant and are matching them up to the PA listed in the most recent WDDD patents. We have not completed that work or I might have more to say on that topic).
Q: How does this deal rate from the standpoint of WDDD and the standpoint of current investors?
A: We rate it an 8.5/10 for both sides. I had initially thought $1 pre-Markman, which I said when I first started a public dialogue on Worlds. My own damages analysis broadened that range slightly. In my earlier analysis while I was hoping to see a major investor enter the scene I did not add that to my estimate. With this new investment a case may be made for exponential movement. I am not saying that will happen but many factors may be brought to bear here. They include: elevated marketing exposure, increased press coverage, additional lawsuits and additional and potentially much bigger investors coming aboard. That list is hardly exhaustive but it forms the rationale for the elements that would provide greater movement.
A note to those on the sidelines wondering when is the right time to get in. Each minute, each hour, each day that passes by you run the risk of a significant price surge the likes of which we have not seen thus far. My sense is that even those with an instinct to flip for small gains hoping to get back in for a few pennies less have realized that is a fool’s errand. In my opinion this stock remains significantly if not dramatically undervalued. Whether that changes today or this week I can’t say for sure but it will change and soon.
Disclosure: I wrote this analysis with a member of my group who is an attorney with a long-standing background in securities law. Please do your own due diligence before investing in this or any other investment. We are long VRNG and long WDDD. After the financing on 3/15/13 was announced we added 20% to our current WDDD position and depending upon other developments we may add more.