Stock Market

Shares of Massachusetts-based T2 Biosystems (NASDAQ:TTOO) surged another 30% this week on meme stock interest. According to financial data provider Fintel.io, retail ownership has now risen over six-fold since last month.

In a sense, T2’s rapid ascent comes as no surprise. Shares of the highly shorted healthcare firm have risen 110% since the start of August — a siren’s call for meme investors. The firm also has four promising medical devices in its pipeline, several of which have FDA Breakthrough Device Designations. To many non-healthcare investors, this sounds like a billion-dollar biotech waiting to happen.

T2 Biosystems, however, has a funding problem that’s quickly turning it into the next Mullen Automotive (NASDAQ:MULN), an electric vehicle startup that burned through millions of retail investor cash. Significant operational hurdles further hinders its prospects.

Investors can still make money speculating on T2’s volatile stock and options. (History tells us to expect significant short-term gains over the next several days). But the long-run outcome of these highly dilutive, cash-hungry companies is often the same: A failing stock that eventually loses it all.

Mullen, T2, and the Art of Disappointing Investors

T2 Biosystems shares some surprising similarities with Mullen Automotive, an electric vehicle startup that went public in 2021 in a reverse merger.

Both firms had promising starts. Within a month of its listing, Mullen would unveil a “good looking and sporty” electric crossover at the 2021 Los Angeles Auto Show and promised a high-end model would supposedly accelerate as quickly as a Tesla Model S Plaid. T2’s management announced similarly exciting news about its T2Dx and T2Candida Panel soon after going public.

But both firms proved to be disasters for investors. Mullen’s stock has now lost 99.97% of its original value, and the Mullen FIVE launch date has been pushed back to at least mid-2026. TTOO has lost 99.94% of its value.

On Mullen’s part, many will blame the EV startup’s operational ineffectiveness. Its board of directors consists of real estate investors, a former security guard, and a host of corporate insiders. The lack of technical knowledge is evident. In April, the company signed a roughly $5 million deal with Lawrence Hardge to access a device “previously known as a Battery Life Enhancing Technology,” only to find the product was likely a fraud. The EV startup has also failed to produce much in-house; its Mullen-GO EV appears to be a rebranded Chinese car.

T2 Biosystems is also plagued by operational issues. Its T2 Magnetic Resonance platform has been authorized by the FDA since 2014, and its T2Lyme detection system has been in development since that same year. Both have been disappointments; the former generates only $10 million in annual revenues, and the latter is still undergoing development. Analysts believe T2 Biosystems will remain unprofitable until at least fiscal 2026.

How Fundraising Usually Works…

Fundraising issues further compound T2 Biosystems and Mullen’s problems.

Most public startups raise cash in two stages.

  1. IPO. In the first stage, companies go public in an IPO, direct listing or reverse merger. This ordinarily comes with an enormous capital inflow and generates enough cash to keep the company afloat for several years.
  2. Secondary offering. In the second stage, startups will issue new shares. The new stock will dilute existing public shareholders, but these offerings are generally needed to help fund expansion. Few young companies can avoid this second round.

The two phases are usually enough for most well-run firms. Facebook parent Meta Platforms (NASDAQ:META) raised $6.7 billion in its 2012 IPO year, and then another $1.5 billion the following year. Others, like Google parent Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL), can require a third round if growth is financially taxing.

But struggling companies will quickly face problems.

Consider a simplified example of Company X, a $100 million company with 100 million shares outstanding. Ignoring transaction costs, if Company X wants to raise $25 million in a secondary offering, it will sell 25 million shares for $1 each. The value per share remains the same since the firm’s new $125 million valuation is divided by the larger 125 million share count.

Now, assume Company X has spent $25 million, reducing its overall enterprise value back to $100 million and its share price to 80 cents.

To raise another $25 million, management must offer 31.25 million new shares for 80 cents each, roughly 20% greater dilution than the first fundraising round.

The next offering becomes worse than the last since the $100 million company is now worth only 64 cents per share ($100 million divided by 156.25 million shares outstanding). 39.06 million shares are needed in the third financing round, then 48.82 million shares in the fourth round, and so on.

The company’s $100 million valuation would have also probably deteriorated since successful companies usually don’t need five additional funding rounds once they go public. That means bottom-of-the-barrel companies will often turn to convertible debt offerings instead. And that’s what T2 and Mullen Automotive have done.

…And How T2 Does It

To understand T2’s plight, consider the hypothetical Company Y, a struggling $25 million firm one-quarter the value of Company X with 100 million shares outstanding.

To raise the same $25 million, Company Y must issue 100 million shares in a secondary offering, assuming no change in stock price. That’s a highly unattractive option that dilutes existing shareholders by 50%.

But what if a company like Mullen or T2 raised convertible debt instead? These instruments allow accredited investors to put money into companies without immediate dilution.

In the best-case scenario, share prices increase, and conversions happen at higher valuations. If Company Y rises to $100 million, the debtholders’ $25 million investment will convert into a one-quarter Company Y stake. That’s what makes convertible debt such an attractive alternative to struggling firms.

But in an ordinary case, convertible debtholders have more incentives to convert at lower prices. If Company Y’s share price declined to 7 cents, convertible debtholders could have exchanged their $25 million stake for an astonishing 357 million shares. (Some even speculate that convertible debtholders themselves often short the underlying stock to boost their risk-free returns). To these debtholders, owning more shares is better than owning less.

T2’s Massive Dilution

These incentives were on full display in T2 Biosystem’s latest financial filings. According to its latest quarter report, the number of TTOO shares outstanding jumped from 24,887,722 in May to 333,580,010 on Aug. 4. In exchange, the healthcare company received only $30.2 million cash from share issuances. In other words, T2 was raising money at a 10-cent valuation, less than a fifth of its average 57-cent stock price this year.

Much of the lopsided dilution stemmed from a July 3 agreement with CRG Partners that exchanged 48.3 million shares of common stock and 93.3 million equivalent of convertible stock for canceling $10 million of debt. This came at a desperate moment when T2 risked losing its Nasdaq compliance.

But T2’s financial issues are only beginning. In the past six months, the company has burned through $25.3 million in cash from operations — a rate that would require another capital raise by October. T2 also has $40.6 million of debt payable by Dec. 30, 2024, and significant funding requirements generated by its four devices in development. The average medical device costs $54 million to develop.

That makes T2 Biosystems extremely unattractive to future investors. Term loans give CRG Partners an outsized say over T2 Bioscience’s finances, which automatically subordinates preferred shares. The company’s enormous 14X dilution will also disincentivize any new convertible bondholders from buying in.

Mullen’s stock has undergone a similar “death spiral” already. Since 2021, outstanding shares have risen by over 4,500% from increasingly dilutive issuances. Given T2’s dire financial health, don’t be surprised if it soon finds itself in that same spiral.

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Read More: Penny Stocks — How to Profit Without Getting Scammed 

As of this writing, Tom Yeung held LONG positions in GOOG and GOOGL. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Tom Yeung is a market analyst and portfolio manager of the Omnia Portfolio, the highest-tier subscription at InvestorPlace. He is the former editor of Tom Yeung’s Profit & Protection, a free e-letter about investing to profit in good times and protecting gains during the bad.

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