Memo to Small-Cap CEOs: The “Investor” You Just Met With… Might Not Be an Investor
By Small-Cap Institute
Small-caps raise between $30 billion to $50 billion annually in the equity capital markets to facilitate expansion and innovation. Nearly every business day, CEOs and CFOs meet with institutional money managers that supply growth capital. Most executives assume that the interests of these “investors” are aligned with their company; that is, capital injections induce growth, and growth drives long-term share price appreciation. But, many of those CEOs and CFOs are wrong. The fund managers they thought were “investors” were actually… “financiers.” And the ramifications for that error can be dilutive and time-wasting.
What’s The Difference?
An investor is in the business of using their industry and business expertise to surmise whether a stock is going to rise or fall. Long-biased investors buy stock at one price with the goal of selling the stock at a higher price at some point in the future. Short-biased investors sell borrowed shares with the goal of purchasing them back in the market at a lower price. Most small-cap executives assume that the institutions that provide growth capital to their companies are long-biased investors. Some of them certainly are. Many are not.
A financier, on the other hand, has a business more akin to a commercial lender; they aim to make a comparatively small, reliable return on their invested capital, whether the company they provide growth capital with executes well or not. Financiers expertly assess risk and create a financing structure that is as close to “heads I win, tails I win a bit less” structure as possible. Financiers utilize warrants[i] in order to augment their otherwise modest risk-adjusted returns without adding any additional risk. They also seek to minimize risk through amortization, options, short sales, securitization, and operating/financial covenants. Financiers will typically make more money if your company’s stock rises above their purchase price[ii], but the business model is more about engineering and capturing “singles” with their risk capital than it is utilizing industry expertise to accurately predict long-term growth a dozen quarters out for a “home run.”
How Do You Know Who You’re Meeting With?
Management teams that are paying attention during investor meetings in advance of a financing will possibly notice that some meetings are characterized by material domain expertise and insightful questions about the company’s science, technology, products, services, competitors, etc., while other meetings are nearly devoid of these conversations.
Have you ever wondered why you just met with an institutional money manager about providing growth capital to your biotech company – who didn’t seem to understand anything about rudimentary science whatsoever – and less than 24 hours later they are willing to “invest” $1 million?
- Neither institutional investors nor investment bankers are going to outwardly state that they or their clients are financiers versus investors, so it’s best to disregard what you’re told, and focus on what you see/hear
- Be smart: listen carefully to the questions you’re being asked during your meeting… and not asked
- With some exceptions[iii], “investors” don’t typically propose complex, structured financings
Things to Keep in Mind Regarding Financiers
Not only do many small-cap officers and directors fail to distinguish between investors and financiers, but when it comes to financiers there are many half-truths and misconceptions.
They play a critical role. It’s important to be clear that financiers are critically important to the small-cap funding environment. Many nascent public companies are not only risky, but they also have stocks that trade infrequently. If it weren’t for financiers, thousands of small public companies that aren’t yet of interest to fundamentally driven, long-biased investors would have nowhere to turn for growth capital. This calculus isn’t about bad (financiers) versus good (investors), and those that reflexively depict financiers in a pejorative light are displaying their corporate finance ignorance more than their acumen. Rather it’s about how important it is for officers and directors to understand who they are dealing with, and how those parties make a living. To be sure, there are abusive, dishonorable financiers. But there are also abusive, dishonorable investors.
One financier SCI spoke to said: “Financiers are a bit like lawyers. Everyone speaks poorly of them, until they need one.”
Wasting time[iv]. Officers and directors often wrongfully assume that any party that invests capital directly into their company is a “partner.” Financiers, though, are not really in the “partnering” business; they are, instead, more often in the “make a small-ish, replicable return on their capital and move on” business. This disconnect plays out regularly when small-cap companies expend precious time and energy asking their “partners” for more capital or contractual concessions (e.g., waiving covenants, waiving antidilution provisions, waiving penalties, requesting early warrant exercises, etc.), only to be mystified by the repeated refusals to cooperate, as an example.
Understand what you’re signing. The deal documentation for a convertible financing can be inches thick. Financiers marvel at how regularly officers and directors have no idea what they just signed. Financiers also frequently remark how easy it is for their attorneys to out-negotiate issuer’s counsel, since the buy-side’s lawyers have done 100s of deals. Here’s why these things matter:
- If you don’t really understand what you just signed, your company is likely going to breach at least one – or several – provision(s). It’s almost a certainty, and financiers know it
- The penalties for these breaches can be very severe, and, with few exceptions, financiers are not going to waive receipt of the penalties (i.e., the penalties are profit centers for them)
- In fact, every breached provision is an opportunity for financiers to exact a richer deal
So, CEOs and CFOs have to be astute: if you’re going to transact a convertible instrument with financiers, hire lawyers with a lot of recent experience in that regard to help your regular outside lawyers, and then spend some time after the deal closes to understand what you signed and carefully calendar all deliverables.
Yes, they will sell your stock. Financiers have learned the hard way that time is not their friend. That is, the best way to de-risk their portfolio is to get back their risk capital sooner versus later. In practice, this means that most financiers would rather earn a 7 percent return on their risk capital, for example, in the space of a week, than make 12 percent over the course of a month or two. The resulting “race for the exit” can cause material downward pressure on stocks, and a lot of aggravation in C-suites and boardrooms. Some issues to keep in mind:
- Someone is buying those shares, and the liquidity might be enabling larger, more fundamental buyers to acquire your stock in the open market
- In the simplest of terms, your company got its growth capital, and the financiers got their return – it’s a microcosm of how capital markets function
- The best path to a less dilutive financing with more fundamentally oriented investors in the future is to use the new growth capital to execute your way out of the challenges that brought you to the financiers to begin with
Let’s all be frank: A big part of the consternation about “fast money” is that financiers and bankers often mislead companies about how long positions will be held for, and sometimes downright lie about it. Accordingly, the best path for officers and directors is to simply assume that there will be a “race for the exit” when dealing with financiers, and instead be pleasantly surprised if it doesn’t transpire. It’s one of the many reasons why understanding who you’re dealing with – and what they do for a living – is so important.
No, they didn’t just sell your stock for a loss. Your company just transacted a fully marketed, public offering, where investors bought registered common stock at $2.00, and received one warrant for every share they purchased. Your stock closed yesterday afternoon at $2.40. A few hours into the subsequent trading day, your stock is trading millions of shares at $1.75. If you’re like most CEOs, CFOs, and board members, you’re thinking the same thing: why are these investors selling our stock hand over fist for a loss? The short answer is they’re not; you are applying a “purchase price” that’s different from the financiers’. Financiers often ascribe a value[v] to warrants on their balance sheets, and that value is blended with the purchase price of the common stock – $2.00 in our example – to create a given fund’s actual purchase price for accounting purposes. For example, if a fund values that warrant at $0.35, then their blended purchase price is really $1.65 (i.e., $2.00 purchase price less the $0.35/warrant with 100 percent warrant coverage). Accordingly, at $1.75, they are still capturing $0.10/share gross gain.
“But they’re going to short our stock!” Yes, they very well might. But short sales are legal, public companies can’t prevent anyone from shorting their stocks, and some of the smartest fundamental investors you meet with are short your stock, you just didn’t know it. A few things to keep in mind regarding financiers and shorting:
- Naked short sales definitely happen, but it’s not a material problem for Nasdaq- and NYSE-listed companies
- Very often when small, exchange-listed companies are experiencing a drop in their share price, it’s simply a function of there being more sellers than buyers
- If your stock isn’t liquid enough to support institutional buying (e.g., it trades more than $250K+/day), then it’s also not liquid enough to support institutional shorting
- If your stock is predominantly owned by retail investors, it’s much less attractive to short (i.e., the cost to borrow shares will be higher, and the duration of the borrow is much less predictable)
Financiers most typically short stocks to lock-in gains on convertible instruments and warrants. For example, if a convertible note has a conversion price of $5.00 and the underlying common stock trades up to $7.00, a note holder can secure the $2.00 spread by shorting the stock at $7.00. By doing so, the note holder can guarantee a minimum of $2.00 gain per converted share (less the cost of borrowing the stock), and continue to accrue interest, etc. for the remainder of the note term. The same rationale applies to warrants as well.
Some Final Thoughts
Whether it’s due to overpromising and underdelivering, a diminutive market cap, an encumbered balance sheet, a messy cap table, illiquid stock, an imperiled exchange listing, or all of the above, small-cap companies that are under some sort of duress are likely going to secure their growth capital from financiers, not investors.
Ask a savvy small-cap CEO about the financier – investor divide, and they will likely give you three pieces of advice: (1) keep your eyes wide open when dealing with financiers, and be brutally aware about how they earn a living; (2) the best way to heal from the resulting decrease in your stock price and the dilution is to put the financier’s growth capital to exceptionally good use; and (3) ticker symbols don’t provide access to long-term oriented capital, but great execution coupled with honest and compelling storytelling do.
[i] Some long-biased investors are also fine with having warrants appended to common stock financings, inasmuch as it also augments their risk-adjusted returns. That said, many fundamentally oriented, long-biased investors don’t want warrants, because they don’t want to deal with derivative accounting issues, and they also know that warrants can encumber cap tables to a degree that discourages other long-biased investors from buying stock in those companies in the open market.
[ii] If a financier’s portfolio company happens to “cure cancer,” that upside is often captured with warrants (provided the stock appreciation takes place prior to warrant expiration), typically after the risk capital has been returned.
[iii] It’s important to be mindful that the employment of structure can be nuanced. That is, there are family offices and small, fundamentally oriented, long-biased investors that will employ a convertible structure in order to provide some downside mitigation, yet they are absolutely “invested” in the long-term success of the company. It’s also instructive to note that there are financiers that have a long-biased portion of their portfolio; in other words, they employ a hybrid financier – investor modality. The investor – financier divide most definitely has some grey area; it would be disingenuous and inaccurate to imply otherwise.
[iv] Even officers and directors that understand the difference between financiers and investors waste time by failing to objectively analyze which type of institutional money manager will have interest in providing growth capital to them. Every small-cap investment banker will regale you with stories about nascent, illiquid, companies with poor execution track records that have instructed bankers that they “only want to meet with fundamental investors. No PIPE funds, under any circumstances.” The only constant in these stories is: wasted time. And, for nascent small-caps, wasted time typically equals raising less money and on worse terms.
[v] Generally speaking, funds that ascribe a value to warrants use the Black-Scholes pricing methodology. For simplicity, Black-Scholes has three key inputs: intrinsic value, time, and volatility. Intrinsic value is the relationship between the warrant’s exercise price and the current market value of the underlying common stock. Time value is simply how much time remains until the warrant expires. And volatility is a number taken directly from Bloomberg for any given stock. Some funds will value warrants at 100 percent of Black-Scholes, and some funds apply a percentage discount. Other funds will also discount Black-Scholes based upon whether the underlying shares are registered for resale, and whether the underlying stock is sufficiently liquid to exercise/sell for the quoted price.