The Upside and Risks of MicroStrategy

TLDR: MicroStrategy is a software company-turned Bitcoin bank. With over 400.000 BTC in their treasury, they have migrated to a second business model: they offer institutions who invest in bonds a way to be exposed to the upside of BTC. As they are now a levered play on the Bitcoin price, the question arises how large the risk has become. Long story short: if BTC will trade above 150k in four/five years time, they appear to be good. Still, there are always risks with leveraged positions such as this one. 

Starting in August 2020, MicroStrategy (MSTR) transformed its business by using its balance sheet—they had a lot of cash on hand—to buy Bitcoin. The first buy was 500 million dollars. As a result, the stock stopped being valued based on its software business, which had been languishing, and instead became valued as a holder of Bitcoin.

Since MicroStrategy went on the Bitcoin standard (meaning they started relying on BTC instead of dollars as their treasury reserve asset), it has used four ways to acquire more Bitcoin:

• Exchange their former treasury reserve asset – US dollars – for BTC
• Raise capital (bonds)
• Issue shares
• Issue convertible bonds: bonds that can be exchanged for MSTR stocks at a fixed date.

You might wonder why bondholders are buying these bonds. Well, some types of institutions have a mandate to invest in bonds. So they can’t buy the Bitcoin ETF, for example. For the first time, MicroStrategy is offering the opportunity to buy bonds with exposure to Bitcoin. These bonds have performed incredibly well, becoming some of the best-performing bonds available. 

MicroStrategy has used these ways to raise capital for over four years now (the dots indicate purchasing points).

Another way to say this is that MicroStrategy is leveraging debt (via bonds) to acquire Bitcoin. As a publicly traded company, they can use their equity as collateral for this debt.

This strategy allows them to borrow at low interest rates. Since adopting this approach in 2020, Bitcoin has delivered an average annual return of 55%. This means MicroStrategy pays between 0.875% and 1.76% to invest in an asset that appreciates by 55% annually.

The Flywheel

The returns are extraordinary, but the strategy doesn’t stop there. There’s a flywheel effect in play, resulting in what Saylor has dubbed: Bitcoin yield. Let’s explain.

1. Bitcoin buys increase market value of MSTR

• Initial purchase: When MSTR buys Bitcoin, it positions itself as a company with significant BTC holdings, tying its valuation closely to Bitcoin’s price.
• Market cap growth: Increased demand for MSTR shares pushes its stock price higher, increasing its market cap.

2. Increased market cap improves ability to raise capital

• Stock issuance via ATM (At-the-Market Offerings): A higher market cap allows MSTR to issue shares at a premium relative to its book value. This process raises cash without significant dilution to existing shareholders.
• Convertible debt: With a higher market cap and stock volatility, MSTR can issue convertible bonds, attracting investors who want upside exposure to Bitcoin through equity conversion options.

3. Use of raised capital to buy more Bitcoin

• Strategic purchases: The funds raised from stock offerings and convertible debt are reinvested to acquire more Bitcoin.
• Treasury growth: As the Bitcoin treasury grows, it further strengthens the balance sheet, increasing MSTR’s leverage to Bitcoin price movements.

4. Bitcoin price gains amplify the cycle

• Treasury valuation Increase: If Bitcoin’s price appreciates, the value of MSTR’s Bitcoin holdings grows significantly, boosting the perceived value of MSTR.
• Market perception: This price appreciation attracts more investors who see MSTR as an effective vehicle for Bitcoin exposure, further increasing its market cap.

Etcetera, ad infinitum. So this is a matter of self-reinforcing growth: The cycle of (1) Bitcoin purchases, (2) higher stock valuation, (3) capital raising, and (4) reinvestment into Bitcoin perpetuates itself.

What is the Infamous Bitcoin Yield?

So what does Saylor mean when he refers to ‘Bitcoin yield’? 

When MSTR raises capital and uses it to buy more Bitcoin, the company’s total Bitcoin holdings increase. As long as the number of outstanding shares grows at a slower rate than the Bitcoin treasury, the amount of BTC per share increases.

A key aspect of Michael Saylor’s strategy is to make the amount of Bitcoin per share (BTC/share) grow over time. Let’s say it grows with 20% in a year, that’s a 20% ‘yield’.

Shareholders usually oppose the issuance of new shares as it reduces their ownership percentage in the company. In this case, $MSTR investors support it because their Bitcoin per share increases.

In the chart, you see MSTR versus BTC. In the bear market, MSTR traded lower, but in the current bull market, it has run much harder than BTC. Since it adopted the Bitcoin strategy, MSTR has seen a 2600% gains, compared to BTC an 800%. 

The ‘Infinite Money Glitch’

Saylor sometimes compares Bitcoin to a credit default swap (CDS, in essence a type of insurance) on the traditional financial system. This comparison implies that traditional 20th-century assets are over-leveraged and at risk of systemic failure. Bitcoin functions as a CDS-like hedge because if the legacy systems fail, Bitcoin’s value could skyrocket as capital flees from these failing assets to a resilient, non-sovereign store of value.

What Saylor is offering to traditional institutions is a pipeline from the traditional financial system to Bitcoin. With a traditional instrument like bonds, they get exposure to the new financial system of Bitcoin. He has compared it to ‘refining’ traditional money in the way that crude oil is refined into a pure form, namely gasoline.

There are about $450 trillion in investable assets worldwide. Bitcoin’s market cap is $1.8 trillion, around 0.4% of the total. MicroStrategy believes Bitcoin’s share could grow to 7% over the next 20 years, which would be a 17.5x increase. By offering stock and bonds tied to Bitcoin, MicroStrategy helps capital migrate from traditional systems to the Bitcoin network.

Risks

This is all nice and dandy, but terms like infinite money glitch should ring some alarm bells. There’s no such thing as a free lunch. What are the risks of this strategy?

Let’s look at some broad types of risks: regulation risks, premium contraction and BTC price.

Regulation risks

Regulators could decide MicroStrategy is an investment company instead of an operating company, which could hurt its business. New Bitcoin laws could also create challenges. This risk appears to be low until Trump leaves office and/or the Republicans lose the next election.

Premium contraction

MicroStrategy currently sells stock and bonds at a 3x premium over the value of its Bitcoin holdings. This premium lets MicroStrategy deliver a positive Bitcoin Yield. If demand for $MSTR stock and bonds drops, this premium could shrink and reduce Bitcoin Yield. Is this  a problem? 

Well, yes and no. If MicroStrategy’s premium disappears or even inverts during a bear market, this means that the strategy of issuing convertible bonds won’t make sense then – it has to be put on hold. This is not a catastrophe though.

Another question often asked is if $MSTR will be able to sustain this premium above its net tangible assets. The answer is yes. Companies like the tech giants can trade at a 50x premium to their assets. MicroStrategy’s premium is quite low.

Bitcoin Volatility

The entire flywheel depends on Bitcoin’s price, which is of course highly volatile. It’s to be expected that demand for $MSTR will go down during a Bitcoin downturn. MSTR’s convertible bonds will start costing the company a lot of money if the stock trades lower at the time of maturity than the conversion price, which is about 40% higher than the stock price when the convertible bonds were issued.

Here’s a table by Willy Woo, listing the issuance dates, size of the bond tranches, the maturity date and the BTC pump needed.

As you can see, BTC needs to rise between 35% and 55% within 5 to 7 years, depending on the maturity date of the convertible bond. While this doesn’t seem like a tall order, remember that BTC bear markets can be brutal. 

The Bear Case

Ben Werkman on X laid out some thoughts on the bear case.

According to him, the main risks are tied to the convertible debt. The first major point in time risk will be in 2028. When the maturity of a big chunk of bonds kicks in. As mentioned, MicroStrategy deploys a ‘ladder strategy’ for their convertible bond offerings. They mature at different times, which will hopefully allow MSTR to ride out fluctuations in Bitcoins price.

Imagine that the timing is bad and in 2028 BTC is in the throes of a huge bearmarket. Or worse, some kind of black swan has made the price plummet. It’s likely the the price of the MSTR stock at that time will trade below its conversion price. MicroStrategy will need cash to pay up the difference.

So, will their BTC get liquidated? No. There is NO Bitcoin price at which MSTR gets “force liquidated”.  

Should they then just voluntarily sell all their BTC? (FYI, a price of $2.611 per BTC would cover the 2028 maturity.)

Not so fast. After all, the US government also doesn’t start selling land and real estate when the budget hits the debt ceiling. It just issues new debt!

Werkman:

“The goal here is to “roll the debt” further out in the future. It’s possible they can still offer unsecured bonds with either a fixed or floating rate. This basically buys time for conditions to change in the Bitcoin market.  The proceeds would be used to cash redeem the 2028 notes and the new bonds would likely go out another 4-5 years before maturity.  So this doesn’t come with additional Bitcoin (unless upsized), but it makes sure that no Bitcoin is sold and also doesn’t come with any equity attached like the converts.”

Key here is if MicroStrategy will still be a healthy company at the time. They need a healthy cash flow to support the offering of new bonds. Other options that MSTR has before the last resort of selling 

Another option would be traditional debt: get a bank loan to redeem the notes. Offering shares is also an option.

Werkman:

“Only if several years go by and the debt all has to be cash redeemed then we start having to consider the potential for Bitcoin to be sold.”

The unknowns

Above is a list of known risks. The problem with these things is that there are also unknowns.

The classic example in finance is the bankruptcy of star hedge fund of the 1990s Long-Term Capital Management (LTCM). It collapsed in 1998 and serves as a cautionary tale about the dangers of excessive leverage, reliance on mathematical models, and underestimation of systemic risk in financial markets. The primary risk LTCM ignored was liquidity risk, which became catastrophic when market conditions deviated from their models’ assumptions. During the 1998 Russian financial crisis, market liquidity evaporated. As a result, LTCM couldn’t unwind its positions without incurring massive losses. 

Now tie this to Saylor and MSTR. He assumes Bitcoin will continue to grow in adoption and value over the long term, driven by its scarcity, decentralization, and position as a store of value. While Saylor’s thesis aligns with many crypto advocates, unforeseen regulatory changes, technological disruptions, or market dynamics could challenge these assumptions.

Takeaway: Overreliance on historical patterns or ideological beliefs about an asset (Bitcoin, in this case) without considering worst-case scenarios can lead to overexposure and potential losses.

Conclusion

MicroStrategy is onto something. As long as the BTC price keeps climbing, the strategy should work. The main risks are the freak accidents, the ‘unkowns’ or black swans. There are risks that we haven’t discussed such as Michael Saylor dying. Or what if he has a stroke and suddenly changes his view on Bitcoin? The whole trade could unwind as his successor dumps 400k BTC on the market. Leverage should always lead to caution. In the meantime, MSTR’s stock and convertible bond offerings will remain attractive to investors as long as demand for Bitcoin remains strong, legal and practical obstacles prevent many investors from buying Bitcoin directly, and regulators don’t disrupt MSTR’s business.