I recently received an email asking me to explain the importance of share structure when investing in a penny stock. It’s an important topic that is overlooked by new traders and I think it would make a great educational post.
Penny stocks constantly need to raise capital to pursue their strategic business goals. Mainly this is to sustain growth, launch new products or acquire a competitor. That being said, there’s nothing inherently wrong with raising capital, however the structure of the raise matters immensely. In the case of equity raises, if they aren’t done properly, it can be extremely dilutive to current shareholders. It happens all the time where companies raise capital and use the money wisely to create shareholder value. However because the structure of the raise wasn’t ideal (raised capital at too low of a valuation so many more shares had to be issued), shareholders still end up losing money.
A large number of shares outstanding, usually 100 million plus, indicates management was not successful in reaching profitability in the early stages – obviously a bad thing. It also suggests they did not use the money they raised effectively. Or perhaps they were profitable, but they decided to make a bonehead acquisition which overall was more destructive to shareholder value than it was enhancing.
Another possible scenario is that they had an abusive insider equity compensation plan which significantly diluted shareholders. Most stock options plans, at the least in the microcap space, only allow management to issue a maximum number of options equal to 10% of the current shares outstanding. Conversely, a low number of outstanding shares, sub-40M, is an indicator of a well-run company and a management team with excellent capital allocation skills. It’s no coincidence that 10% of profitable microcaps have over 100 million shares out whereas 60% of them have less than 20 million shares.
Furthermore, share structure needs to be analyzed in tandem with insider ownership. If insiders own a significant percentage of the equity then they will treat their shares like gold. In other words, they won’t dilute themselves unless it’s absolutely necessary and they will be very cautious should they need to do it. For example, if they need an equity raise to fund growth, they will try to raise the lowest amount possible instead of opting for more money than they need. Additionally, they would aim to do it when the stock price is at its highest as they would need to issue less shares. In short, when management owns a considerable amount of stock it increases your odds of not getting diluted and having your shares appreciate in price.
There is also a technical reason why a tight share structure is very attractive which has to do with demand and supply. The fewer shares available, the less supply is out there so when an investor, or better yet an institution, is looking to acquire a sizeable position in the stock, they will inevitably have to pay up. The opposite is also true when you have a large seller, but that can create good opportunities to get in the stock.
In conclusion, the share structure can tell you a lot about how a company has been run in the past and how they create shareholder value. As we know, past performance is generally a good indicator of future performance in many cases.
Feel free to use the comments section below to ask any questions relating to share structure.
James Kelly is my name and penny stocks are my game! Former day trader turned long-term investor with a decade of experience in the market. Over the years, I’ve joined dozens of trading services and I aim to provide honest reviews to help traders make better decisions!
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