Naked Brand Group (NASDAQ:NAKD) raised another $100 million in a private Securities Purchase Agreement (SPA) on February 25.

However, the hedge funds that bought these shares also received warrants with some strange, highly dilutive provisions. These warrants could force Naked Brand Group to issue a “substantial” number of NAKD stock in a cashless exercise.

The problem here is the company doesn’t seem to know what that potential dilution will look like. The company sold 107.526 million shares at 93 cents, raising about $100 million. But it also issued an equal number of warrants with an exercise price of $1.13 per share. And the cashless exercise provision on those warrants could easily result in substantial dilution to shareholders.

The Cashless Exercise Provisions

Here is what management said about these cashless exercise warrants in its Feb. 25 Form 6-K filing:

“At any time, the Warrants may be exercised on a cashless basis for a number of Warrant Shares equal to the Black-Scholes value per Warrant Share, multiplied by the number of Ordinary Shares as to which the Warrant is being exercised, divided by the Closing Bid Price (defined below)…”

Later on in the paragraph, it stated that the Closing Price would be equal to the bid price as of Feb. 23. The stock closed at $1.02 on Feb. 23, and I suspect that the bid price was at least $1.01 per share.

Therefore, management said this:

“As a result, the number of Ordinary Shares issued upon exercise of the February 2021 Warrants may substantially exceed 107,526,882 shares.“

At first, I couldn’t understand this. Whoever heard of a cashless exercise provision resulting in a larger number of shares than the amount issued? I thought they had made a mistake. After all, it is mathematically impossible for the number of shares issued in a cashless exercise to be more than the shares to be issued in the warrants.

At least under normal provisions. But then I carefully looked at the provisions above and worked out some examples. I finally realized that apparently management agreed, either out of desperation or their willingness to get $100 million, to be heavily diluted.

They agreed to a math trick, a change in the normal way cashless exercise provisions are calculated. The hedge fund buyers imposed this on them in order to guarantee themselves a profit. Let me explain the details.

Cashless Exercise NAKD Stock Warrants

Normally a cashless exercise of warrants implies that the company will take any cash it receives and buyback public shares at the current price. Therefore the remaining number of shares, after the buybacks, is how many “cashless exercise” common stock shares the warrant holders receive.

As a result, the greater the price difference between the market price and the exercise price, the greater the number of common stock the cashless exercise warrant holders receive.

For example, here is a typical math provision in a public company filing that incorporates this model. Note that the denominator in this model is the “fair market value” of the underlying stock. This is by definition always higher than the exercise price. Otherwise, the warrants would not be profitable to the holder.

This is where Naked Brand agreed to a discrepancy from normal cashless exercise models. Their provision above says that the closing bid price on February 23, or $1.01 per share, will be the denominator. But the exercise price is $1.13. Therefore, by mathematical definition, the number of shares issued will always be greater than the number of underlying warrants.

Moreover, by using a modified Black-Scholes formula instead of the exercise price, the numerator is much higher than it would otherwise be. The company agreed to a 6-month period where this would be in effect. This is in the actual warrant document. They agreed to a permanent 5 year period in the Black-Scholes model as well.

A Math Example

If you use a Black-Scholes calculator and assume NAKD stock hits its previous high of $1.65 per share, the resulting price, assuming 135% volatility and a 1.5% interest rate, is $1.48 for the warrants. Sp we plug that value into the following formula:

( $1.48 x 107.526882 million warrants ) / $1.01 = 159.139785 / 1.01 = 157.564143 million shares

In other words, the hedge funds get 157.564 million shares, for free. This is 46.5% more than the 107.526883 million warrants they held. They would normally have been required to pay $1.13 by exercising these warrants (and the company would have received $121.5 million). This would have been on top of the $100 million for the 107.526 million shares they bought.

But now the hedge funds, through the cashless exercise, receive 107.526 million shares plus an additional “free” 157.564 million shares. Their investment of $100 million resulted in 265.09 million shares. That implies they get to buy in at a below-market cost of 37.72 cents per share (i.e. $100 million divided by 265.09 million shares). They make a profit of $1.2727 (at $1.65 market price) or $337.4 million on an investment of $100 million.

And that’s not all either. The SPA also states that the hedge funds have a put right. The investors are allowed to buy up more shares at an amount equal to one-third of their profits. In this case, they have to pay the market price.

In other words, they probably plan on flipping their shares and warrants within the 6 month period. That would bring in another $112 million to Naked Brand Group.

What This Means For NAKD Stock

If you have been wondering why any investor would put money in NAKD stock, I just explained it to you. As long as the stock rises, the hedge funds have an almost guaranteed huge profit opportunity. I estimate that the additional dilution from this provision is close to 33%.

Management is willing to put up with this massive amount of dilution in order to get their hands on the $100 million. As long as the stock rises, this might work out for a while. But they will have to show that the $100 million is going to be put to good use.

This also raises the question of which company will get to have the $100 million. As I explained in my last article, Naked Brand Group is going to have a management buyout. I will look at this further in a future article.

On the date of publication, Mark R. Hake did not hold a long or short position in any of the securities in this article.

Mark Hake writes about personal finance on mrhake.medium.com and runs the Total Yield Value Guide which you can review here.