DryShips Stock Crashes. Here's Why

Asked by Nasdaq to provide insight into why its stock had rocketed 1,500% in a matter of days, DryShips failed to respond all of Wednesday. When it finally did reply, though, this is what it had to say:

And there you have it, folks. Asked to explain why its stock was suddenly worth 15 times more than it cost just a few days ago, DryShips essentially shrugged and answered: "Beats me!" Fundamentally speaking, there was nothing behind the rally -- other than irrational exuberance.

As for what actually is going on, though, this will take us more than a few minutes to unpack. Without further ado:

Series E-1 Convertible Preferred Shares

DryShips intends to sell Kalani20,000 of these shares, for which DryShips admits "there is no established public trading market" and which the company says "will not be listed on any national securities exchange." In exchange, the company will receive "approximately $20 million."

(That purchase price is less than 25% of what the company's market capitalization was before this news hit [$82.7 million as of market close Wednesday, per data from S&P Global Market Intelligence]. But as we'll see below, it holds the potential to give Kalani control over about 69% of the company.)

Kalani will have the right to convert these preferred shares into common stock of DryShips at $30 a share. It probably won't do this right away, however. No sooner had the news come out than DryShips stock plunged 69% in Thursday trading, and as of 3 p.m. EST is now worth less than $15 a share.

Rather, Kalani will more likely wait until its second option kicks in. Namely, if DryShips stock falls below $30 (which it already has), Kalani can convert its preferred stock into common at either 77.5% of DryShips' lowest average daily price on any day over the preceding 14 daysor, if things get really bad, at no less than $1.50 per share.

In practice, the effect of this second pricing option may be as follows: The more DryShips stock falls, the more it's likely to fall further toward "77.5%" of whatever price it's already fallen to. And DryShips stock may not stop falling until it hits $1.50.

Series E-1 Preferred Warrants

It gets worse. In tandem with its purchase of the convertible preferred stock, Kalani will acquire the right to buy an additional 30,000 Series E-1 preferred shares at the same price it paid for the initial tranche -- $1,000 apiece -- then convert them to common stock as described above, adding to the dilution.

Series E-2 Convertible Preferred Shares

Likewise, Kalani gets warrants to buy 50,000 Series E-2 preferred shares at $1,000 each. Like the Series E-1s, these are also convertible into common stock, but according to a slightly different formula. Specifically, Kalani can convert (but probably won't) Series E-2 preferredat $30, or it can convert at 85% of DryShips stock's lowest average daily price, hit on any day over the preceding 21 days.

Again, there's a floor set at the $1.50 stock price. So worst case, DryShips will get at least $1.50 a share for converting these preferred shares (should they be acquired) into common stock.

Common warrants

Finally, Kalani can exercise warrants to buy 372,874 common shares, paying "no consideration" for the privilege.

And now I have a headache.

Complexity for its own sake

If you do, too, there's probably a reason for that. When a company's management "explains" a stock issuance plan in a manner as convoluted as the one DryShips has just settled upon, historically, they may have been counting on people getting confused.But here's the upshot:

When all's said and done, DryShips says that the preferred stock and warrants it just sold for $20 million have the potential to dilute the company's current 1,137,712 common shares by nearly 69% -- if Kalani ends up converting, exercising warrants, and exercising warrants-before-converting when DryShips stock costs $30 or more.

Should DryShips stock fall further than it already has, however, then on one hand, DryShips could end up getting as much as $100 million from Kalani -- which is more than the stock is currently worth after Thursday's sell-off. In this case, however, dilution could rise to as much as 98.4%, as more than 72 million new shares of common stock pour onto the market.

What it means to investors

So what's the upshot? I could be wrong, but it looks to me like we're seeing a wholesale transfer of DryShips' equity to Kalani -- a company so mysterious that even S&P Global Market Intelligence has almost no data on it other than the fact of its existence. Who stands to lose?DryShips' current shareholders,who have now experienced a significant price dip and may have their shares further devalued by the dilution.

And that's why investors are bailing en masse.

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Rich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he currently ranks No. 314 out of more than 75,000 rated members.

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