5 Financing Mistakes Small-Caps Make, and the Industries That Hope It Continues16 minute read
Though you would never know it from reading The Wall Street Journal or watching CNBC, the industry of providing growth capital to small-cap companies is larger in many years than the IPO market. In 2016: according to Sagient Research, small-caps raised approximately $21 billion, while the IPO market was $18.8 billion, according to Renaissance Capital. These financings take place nearly every business day – there is no such thing as the window being open or closed for “must have” capital. Unfortunately, most of these financings are wildly more dilutive than need be. Having co-managed a leading special situation hedge fund that invested in hundreds of these small-cap financings, and having also been on the other side of the table inside many small-cap boardrooms as an advisor, I’ve witnessed a debilitating disconnect when it comes to these financings that is rarely discussed by anyone other than fund managers.
- On the one hand, there are thousands of small-cap officers and directors, who collectively believe that they do a good job accessing and navigating the equity capital markets.
- Then there are the special situation hedge funds that provide the billions of dollars of growth capital. They benefit materially, in part, because small-cap officers and directors often aren’t the capital markets experts they might think they are.
- Lastly, there are retail shareholders and institutional investors who are the daily victims of the unnecessary dilution.
A few quick observations regarding these three constituencies: (i) the lion’s share of small-cap officers and directors I’ve interacted with are smart, sophisticated, and doing their best to create long-term shareholder value – many simply lack material experience shepherding public companies; (ii) in fairness to the special situation hedge funds, they don’t create most of the financing challenges brought to them every day. Many really want to see these companies succeed, but they are entitled to make a profit like anyone else; and (iii) if you don’t want to wake up and find out that your investment has been diluted by 20%, you probably shouldn’t be investing in small-cap companies that aren’t cash flow positive.
The Good, Bad & Worse News
The good news is that most serial corporate finance mistakes are avoidable – it’s predominantly a matter of education. The bad news is that every small public company I’ve interacted with makes at least one out of five critical capital raising mistakes. The worse news is that companies seem to be performing more poorly in this regard with the passage of time. The reason for this unenviable stasis? Special situation funds and investment banks make billions of dollars a year due, in part, to small-cap CEOs and boards continuing the status quo. Put differently, there is an awfully big business that’s based upon the capital markets version of Groundhog Day. I’m not speculating in this regard – I was one of them.
1. Flying blind – no data
Though every company likes to believe they are unique in the marketplace, data conclusively show that the likely terms and amount of capital a company can raise are strikingly similar to what other comparable companies have recently garnered in the small-cap financing continuum. However, companies routinely decide in a vacuum how much capital they “need,” the terms they think are “fair,” and then hire an investment bank/finder/agent (usually whoever agrees with and promises the same) to facilitate the financing. Deal data vendors such as PrivateRaise, PlacementTracker, Dealogic, and CapitalIQ are easy to use, comparatively inexpensive compared to how much waste they can help mitigate, and provide data which depict all the relevant information on historical peer company financings (i.e., name of issuer, industry, market cap, ticker symbol, exchange, closing date, the amount of capital raised, the structure, the pricing, warrant coverage, bankers, banking fees, etc.). Nearly every constituent in the capital markets utilizes historical deal data, except the party that stands to benefit the most: issuers. It’s impossible to overstate how much time, energy, and money are wasted by small-cap companies planning financings that are just not going to happen remotely as envisioned (or promised by a third party). The majority of that waste is avoidable by analyzing historical deal data.
Why wouldn’t you and your team want to know months in advance of a financing that every company similar to yours (i.e., industry, market cap, trading volume, etc.) that raised capital in the last six months was only able to raise 15% of their market caps, and all of the financings had a minimum of 75% warrant coverage? Might it not also change the way you select bankers if you knew in advance that of the four investment banks that undertook most of those transactions, one of them seemed to garner much less dilutive terms in their financings than the other three, and also had the lowest fees? Why would you and your team exclusively trust an investment banker (who only gets paid if your company transacts their deal) that the terms being presented to the company are the best available when you could verify independently by using a cost-effective, objective database? When buying a used car, do you trust the seller to tell you a fair price for their car or do you look at Kelly Blue Book? Most investment bankers don’t want you to know there are Kelly Blue Books for capital raising. There are, and issuers rarely use them. Investment banks and special situation hedge funds hope you never do.
2. Clinging to unsupported valuations
Far too many small-cap officers and directors make critical capital markets decisions based on their day-to-day stock prices. Why does this matter? It matters a lot. IBM’s stock trades billions of dollars per day; when IBM is $155, it can be bought sold at that price in material quantities. In other words, at that moment in time, the market has determined that IBM is worth $155 per share. Isn’t the stock of a $150 million market cap biotech company worth $2.50/share when that’s what Yahoo Finance says? Maybe, but not if selling $25,000 worth of stock drops it to $1.68. Very often, stock prices for small-cap companies are more advisory than indicative; due to illiquidity, some stock prices are borderline fictional. If you can’t buy or sell material amounts of stock at the quoted price (i.e., at least six-digit dollar amounts), then it’s not a price in the same way as IBM. This is an exceptionally hard concept for most small-cap CEOs and boards to grasp, particularly if they don’t have significant capital markets experience. Most small public companies have illiquid stock, and illiquid stocks aren’t “worth” what it says on Yahoo Finance. Understandably, it seems real because there is a value ascribed to that stock in everyone’s Schwab statements, but therein lies the problem: if the average small-cap CEO or board member tried to actually monetize their stock, it would be worth pennies on the dollar when they were done. As a result of that selling exercise, they would find out what their stock is truly worth. Ask any small-cap institutional investor, and they will tell you about the time they saw an illiquid small public company treat their stock valuation like IBM’s, turn down “must have” growth capital because of a recently buoyant (read: fictional) stock price, and then end up undertaking catastrophic dilution when the engine was running on fumes. Public company stewards need to be cognizant of their stock price, as it is the seminal means by which to determine shareholder value creation. But all stock prices are not created equal, so making life and death corporate decisions predicated exclusively on a small-cap stock quote rarely ends well.
3. Market timing and piecemealing
Most small-cap companies don’t raise capital from positions of strength as they don’t generate sufficient cash flow to finance their growth objectives. Therefore, most small-cap financings are “must have” situations, not “nice to have.” You needn’t be a sophisticated investor to examine a company’s SEC filings, subtract the recent average quarterly cash burn from cash on hand, and know approximately when that company will likely run out of money. There is nowhere to hide. As companies get closer to running out of capital, their stock price will drop to reflect the impending dilution and the possibility that capital won’t be raised. Financing alternatives will commensurately dwindle with the passage of time. A couple of cautions based on observing many of these fact patterns:
- If Warren Buffett can’t accurately time the market, then neither can you. Always raise “must have” capital sooner rather than later – later is almost always bad.
- Virtually no small-cap shareholder has ever been rewarded when a company that needed $10 million decided to raise $5 million and wait for a better time to raise the other $5 million. Piecemealing is flawed, because the “better time” rarely arrives, and investors have seen this play out time and again.
How it all goes bad in real life.
Life science company WeHealYou, Inc. (WHY) has three quarters of cash left, and needs to raise $10m to advance its oncology drug through the clinic. WHY is 85% owned by retail investors, and nearly 100% retail traded (daily dollar trading volume is ~ $50K). WHY was offered a $10m convertible preferred term sheet, but felt that the dividend and warrants made the convertible instrument too expensive (despite historic deal data reflecting that the terms were average for peer companies). The real reason WHY rejected the term sheet is because they are readying an announcement that they have garnered the intellectual property to an additional molecule that they believe transforms the efficacy of their oncology drug. Fast forward a few months: WHY announces the news and the stock rises 60% in two days on 3x/daily volume. A week later, the stock price reverts to where it was before the news, and the volume reverts to the prior trading levels (i.e., WHY’s predominantly retail investors didn’t really understand the significance of the new intellectual property, WHY has no equity research coverage, and investors know that substantive dilution is coming). With approximately 1.5 quarters of cash remaining, WHY raises $6m in a senior, secured, amortizing, 10% original issue discount, convertible note with a 13% coupon (the instrument contains a possible second tranche of $4m subject to certain equity conditions/milestones being met). For “must have” capital… later is almost always bad. It’s just a matter of how bad.
4. Wrong lawyers
A small-cap company’s outside counsel could be a great choice to represent shareholders’ interests in a financing. They could also be a terrible choice. How could you possibly go wrong hiring your existing, large, well-known, international law firm to assist with a financing? Special situation hedge funds have lawyers that have done hundreds (sometimes thousands) of small-cap financings – it’s all they do. If your company’s outside counsel doesn’t have recent, highly relevant experience (i.e., representing companies like yours, in substantially similar financings in the last six to 12 months) then you have the wrong lawyers to represent the company in the financing. Your company need not fire existing outside counsel. Rather, your company needs to retain special counsel for the financing. In plain vanilla common stock financings (registered or unregistered), having the wrong attorney is unlikely to be impactful on shareholders. But if the company is doing any type of convertible or structured financing, existing shareholders are going to suffer mightily with the wrong lawyers. Every time. Still not sold that it is an important issue? Rest assured that special situation hedge funds benefit dramatically from consistently out-lawyering small-cap companies. And… they desperately hope you continue using the wrong lawyers. To make matters worse, if your company doesn’t have in-house counsel, then you are also likely overpaying dramatically for the inapt advice.
5. No idea what the company just agreed to
Structured or convertible financings are a fact of life in the small-cap world. The documentation for these financings can literally be 6 inches thick and the definitive deal terms can be extremely complex. Many of the affirmative and negative covenants in these financings are enforced by monetary penalties that can collectively be severe enough to lay waste to frail balance sheets. Ask any small-cap special situation fund manager and they will candidly admit that companies constantly breach these covenants; it couldn’t be clearer from the ensuing “work-out” conversations that the officers, directors, auditors, lawyers, and transfer agents didn’t thoroughly understand what was just signed. A few observations: (a) don’t ever depend on institutional investors to look the other way or waive the penalties (i.e., it’s actually a profit center for them); (b) make sure that before your company agrees to any financing, that you understand the terms in plain English (if the investor won’t explain all of the provisions clearly, with examples, find other investors); and (c) when the financing is closed, convene a meeting with all relevant parties to make sure the company and its service providers are clear about how conversions, pricing periods, legend removal, etc. work, and choreograph what each party will do when necessary to satisfy the conditions in the financing documents. Special situation hedge funds benefit dramatically from the fact that most small-cap companies enter into complex structured financings without understanding them.
While you can certainly fake some things in life, you either truly understand capital markets and corporate finance, or you don’t. Small-cap CEOs need to be honest with themselves and their colleagues about their Street experience. Though they might be able to fool their colleagues, board, and service providers, they’re never going to remotely fool the professional financiers on the other side of the table. There are many small-cap officers and directors who are seasoned capital markets experts. To the many more who aren’t, take note: many investment bankers and special situation hedge funds would love for you to stay that way – they profit from the delta between your perception and their reality. The status quo comes at a much steeper price than needless dilution: America is losing the high quality jobs and boundless innovation supplied by the small-cap ecosystem. The great news, though, is that… a little education goes a long way