This article was republished from a post on the Invest Before the Street blog
For most early stage, small companies, private placements and rights offerings can be vital to fund a companies growth.
Here’s the problem: too many private placements and rights offerings can lead to an ugly share structure, which has a direct impact on the stock price. This is why it’s always important to seriously do your due diligence.
Let’s take a look at how it works.
Most private placements require an investor to be ‘accredited’, meaning you have to make a certain amount of money every year, or have a certain amount of assets, which limits who can participate. You can see the rules for the US here and in Canada the rules can vary by jurisdiction, but are much more relaxed than the US.
A company usually offers these investors the opportunity to participate in the private placement, where they are offered private placement ‘units’.
A ‘unit’ is typically comprised of the following:
- A single share at a discount to the current stock price
- A whole or half warrant to purchase an additional share at a price usually higher than the current stock price.
Rights offerings are pretty similar to private placements. With a rights offering, a company offers current shareholders the right to buy additional shares in the company at a discount to the current stock price. This allows the company to raise additional money by issuing the shares.
You see this more often with smaller us-based companies, where as you’ll see private placements more often with small Canadian companies. The primary difference between private placement and rights offerings is that in a rights offering any current shareholder can participate, whereas in a private placement you have to be an accredited investor, which limits the number of investors that can participate.
Since we are going to focus more on private placements in this article, let’s take a look at an example.
Private Placement Example: Ackroo
Here’s some text from the press release of a previous private placement Canadian-based Ackroo announced.
(For a more detailed overview of the private placement, check out the report from the guys over at Espace Microcaps here):
“OTTAWA, Sep. 30, 2016 (Canada NewsWire via COMTEX) — Ackroo Inc. a gift card, loyalty and rewards technology and services provider, announces that it will conduct a non-brokered private placement in which it will raise up to $1,000,000. The Company has secured an initial lead order of $107,500 for the private placement, and it is anticipated that closing will occur within the next few weeks.
In connection with the private placement, the Company will issue up to 5,000,000 units (each, a “Unit”) at a price of $0.20 per Unit. Each Unit will consist of one common share of the Company and one-half-of-one common share purchase warrant, each full warrant entitling the holder to purchase one additional common share of the Company (a “Warrant Share”) at a price of $0.30 per Warrant Share for a period of twenty-four (24) months from the date of the issuance. The warrants are subject to accelerated expiry in the event the Company’s shares trade at $0.40 or more for 10 consecutive trading days.”
So what does this all mean? Let’s break it down:
- Ackroo wants to raise $1 million through the private placement
- They plan on doing so by issuing 5,000,000 units at a price of $0.20 per unit
- Each ‘unit’ will consist of the following:
- One common share in the company
- One half warrant to purchase additional shares at a price of $0.30 for 24 months
So is this a good deal for an investor?
At the time of the private placement announcement, the stock was trading over $0.23, which provides investors a deal, since the private placement offered them the opportunity to by a unit for only $0.20.
How about the upside?
Pretty clear what kind of benefits you’ll get from participating in a private placement if the stock increases.
So how can a private placement hurt the stock price?
Options, Warrants, and Share Structure
If you want to understand how a private placement and other capital raises can potentially hurt a stock later down the road, you need to understand a company’s share structure.
To analyze share structure, you need to take a look at the amount of warrants and options that may be currently outstanding within a company. The less options and warrants outstanding, the better for you as a shareholder because the potential for further dilution is much more limited.
There’s three things we want to look for:
- First, we just need to find the total number of shares outstanding.
- Next, we need to take a look at the number of options outstanding which are usually a result of share-based compensation for members of the company’s management team.
- Lastly, we’ll take a look at how many warrants are outstanding and if any other private placements have occurred recently or, are going to occur in the near future.
Let’s take a look at Ackroo’s shares outstanding:
So, at 9/30/2016 Ackroo had 22,186,836 shares outstanding before the impact of any options or warrant exercises.
How about options?
As of 9/30/2016, Ackroo has 2,161,571 options outstanding. Therefore, Ackroo’s diluted share count would be 24,348,407.
That doesn’t mean ALL of the options will be exercised though.
If the exercise or strike price is above the current stock price, then it doesn’t make any sense for the option to be exercised because you can buy the stock in the open market for a cheaper price.
On the other hand, if the exercise or strike price is below the current stock price, then the option will likely be exercised because the option holder can get the shares at a lower price than what the stock is currently trading for and then sell the shares they receive back on the open market for a quick profit.
Lastly, let’s take a look at the warrants:
As of 9/30/2016, Ackroo only had 300,000 warrants outstanding at an average exercise price of $0.37.
Last, but not least, we can’t forget about the shares and warrants from the most recent private placement! Since the private placement closed in November, this won’t be reflected in these financials because they are as of 9/30/2016.
Let’s put it all together:
Now you may be wondering what ‘Lock up ends’ and ‘accelerated expiry’ mean. They are both quite important as you’ll see below.
The Two Sources of Share Price Pressure From Dilution
#1) Long-Term Share Price Pressure
The first source of share price pressure that can result from dilution is when a company just has a bad share structure in general. For example, if a company has a ton of options and warrants outstanding that can result in selling pressure on the stock as people that exercise the options and warrants try to sell their recently acquired shares in the open market.
This is why it’s a good rule of thumb to try and invest in companies that have a relatively clean share structure and don’t have a ton of options and warrants outstanding.
The brilliant ivnvestors over at Small Cap Discoveries have a great artilce where they reverse engineer the perfect stock, which you can see here.
One of their main criteria? Clean Share Structure.
#2) Short-Term Share Price Pressure
Sometimes, there are a variety of factors that result in short-term share price pressure. This can oftentimes result in some of the best buying opportunities to purchase a stock that you have identified may be under short-term share price pressure.
There are two main factors that usually result in short-term share price pressure. Take a look at this excerpt from Ackroo’s press release after announcing the closing of its private placement:
“The warrants are subject to accelerated expiry in the event the Company’s shares close at $0.40 or more for 10 consecutive trading days. In conjunction with the placement the Company has paid $14,940 and issued 67,200 common share purchase warrants as a commission to finder’s who have introduced qualified investors to the Company. The finders’ warrants are exercisable on the same terms as the private placement warrants. All securities issued on closing of the private placement are subject to a four month and a day hold period.”
What does this mean? Essentially, after a private placement closes, there is usually a four month lock up period where investors in the private placement can’t access their shares and warrants until that lock up period is over.
Why is that important? Think about this:
If investors that participated in the private placement got shares of Ackroo for $0.20 and 4 months later Ackroo’s share price is at $0.40, there is a high likelihood that investors will start to sell some of the shares they got from the private placement as soon as the lockup is over.
This essentially puts short term pricing pressure on the stock as investors from the private placement start to sell some of their shares.
This also happens in one other instance. As you can see in the quote above, there is an accelerated expiration of the warrants. Essentially, if the stock price trades over $0.40 for 10 consecutive days , the company has the right to accelerate expiration of the warrants. If they do that, investors that were in the private placement will be pressured to exercise their warrants before they expire. This could potentially lead to the same type of pricing pressure we talked about above.
While it may seem complicated at first, it’s quite important to understand a company’s share structure and how that can affect the stock price over time.
You can follow up with this post by watching the hands-on video below!