The financing cycle behind OTC stock dilution, and why shareholders and management need a different approach.
By Edward Sylvan | Public Company CEO
Penny stock investors constantly complain about dilution. They watch the outstanding share count increase, see convertible notes being issued, and wonder why management can’t find another way to finance the company.
But there’s another side to this conversation that rarely gets discussed.
Why do so many publicly traded companies keep going back to the same financing sources, on terms that frustrate their existing shareholders?
I’ve spent years running a public company, negotiating financing transactions, and dealing with the consequences of raising capital in the OTC market.
What I’ve learned is that the problem goes much deeper than issuing additional shares.
The Money Trading Penny Stocks Doesn’t Go to the Company
This is where I believe the conversation needs to start.
When an investor buys $5,000 worth of penny stock through a brokerage account. Another investor sells $5,000 worth to them.
The company receives nothing from that transaction.
Now imagine thousands of investors trading millions of dollars in a company’s stock. The activity may generate excitement, higher trading volume, and price movement.
But the company still needs money to operate.
The company needs operating capital , money to develop products, pay employees, and to execute its business plan.
When that capital isn’t available, management has to raise it from somewhere.
That’s when shareholders start hearing about private placements, convertible notes, and new share issuances.
The same investors who were celebrating trading volume yesterday may be complaining about dilution tomorrow.
Why the Financing Cycle Keeps Repeating
Consider what happens when an OTC company needs $500,000.
Management approaches a new investor and negotiates a transaction. The investor provides capital, in exchange for restricted stock or a convertible note.
A convertible note is debt that can be converted into shares under specified terms.
Some agreements use a fixed conversion price. Others use a conversion price tied to the market price of the stock, at a discount.
The details matter.
With certain market price based conversion agreements, a falling share price can result in more shares being issued when the debt converts. That can create selling pressure and further dilution. This known as a death spiral.
The SEC explains this financing mechanism in its investor education materials.
But here’s the part where everything goes off the rails.
After the financing closes, the company still has to execute its business plan. The money eventually gets spent, and unless the business can generate revenue, management will need another financing round.
Meanwhile, shareholders are watching the stock price and questioning management.
The CEO is now spending time chasing money, negotiating terms, responding to shareholders, and attempting to keep market confidence.
And the cycle repeats.
The Hidden Cost of Dilution Is Management’s Time
When people talk about stock dilution, they usually concentrate on the percentage of ownership percentage existing shareholders lose.
I think there’s another hidden cost that no one talks about.
Its the amount of time management spends trying to find new money.
Compare this to a private startup backed by Venture Capital investors.
The company raises its first round of financing, hits milestones, and returns to its existing financial backers to discuss another funding round.
Those first investors understand the company will need multiple rounds of financing before it reaches revenue and profitability.
Now compare that with a small publicly traded company whose shareholders change constantly and whose management must continually chase new sources of funding.
One management team can devote all its attention to growing a business.
The other spends all of its time keeping the company alive
For a public company CEO, that can be the difference between success and failure.
The company still needs leadership even when the stock price is falling.
Why Aren’t Existing Shareholders Part of the Financing Conversation?
This is the question I believe smaller publicly traded companies should be asking.
Public companies can have thousands of existing shareholders who already know the business, follow management, and have a financial interest in its future.
Yet when companies need fresh capital, they always look outside that valuable shareholder base.
Why?
Why shouldn’t management work toward developing relationships with existing shareholders who understand the company’s financing requirements and may be willing to participate directly?
I’m not talking about shareholders simply buying more stock from other investors in the open market.
I’m talking about structured opportunities for investors to provide capital directly to the company.
Depending on the transaction and securities laws, that can involve direct equity financing, shareholder participation in a Rights Issue offering, or other forms of debt financing.
Participation would be voluntary, and financing terms would matter.
The point is to develop a more informed shareholder base that understands capital formation instead of treating every financing announcement as an unexpected betrayal.
Capital Formation Trading: Changing the Relationship
This thinking led me to introduce Capital Formation Trading (CFT).
CFT examines publicly traded companies through their financing transactions rather than concentrating exclusively on market momentum.
It asks investors to understand who provides capital, what securities are issued, what obligations the company assumes, and how management intends to use the money.
CFT could be a better alternative than management must chasing a new group of investors whenever new funding is needed.
A shareholder base that understands how a company is financed can become a valuable long term financial relationship.
That doesn’t eliminate dilution or guarantee that a financing will succeed.
It just changes the conversation from reacting to dilution to understanding and participating in capital formation.
Five Questions Penny Stock Investors Should Ask
Before reacting to a new financing announcement, shareholders should ask:
- How much money is the company actually getting? The number of shares being issued doesn’t tell the whole story.
- Who is providing the capital? Is it a new investor, an existing shareholder, or a lender converting outstanding debt?
- What are the financing terms? Understand the conversion price, discounts, interest, maturity, and potential share issuance.
- What will the company do with the money? Is it financing business development, acquiring assets, or simply covering expenses?
- Is management developing a sustainable financing relationship? Or will the company be searching for another investor immediately after this transaction?
These questions provide a much more complete picture than looking at the outstanding share count alone.
Penny Stock Dilution Is a Financing Problem Before It Becomes a Trading Problem
I don’t think the solution is for shareholders to blindly accept more dilution.
I believe management and shareholders need to rethink how smaller public companies are financed.
Public companies need access to capital. Shareholders want management to create value. Those objectives shouldn’t automatically put the two groups in conflict.
A company that can develop an informed, stable pool of potential financing partners may give management something that many OTC CEOs desperately need.
More time to actually run the business.
And that, to me, is where the real conversation about penny stock dilution should begin.
About the Author
Edward Sylvan is the CEO of Sycamore Entertainment Group, a publicly traded entertainment company. He introduced Capital Formation Trading (CFT) as a framework for examining corporate financing transactions and developing stronger relationships between management and shareholders.
Read more of at EdwardSylvan.com.