The Road to Successful Financings Is Paved with Brutal Frankness
Small-cap companies raise $25-$40 billion every year in the equity capital markets, and every special situation fund manager that provides this growth capital would confide in private that most of the financings are needlessly dilutive.
The systemic problem is that there are no publicly disseminated report cards for capital raising. Who is going to tell companies that the financing they just completed was 25 percent more dilutive than it could have been; the bankers who just got paid a fee equal to 7-10% of the proceeds? The special situation fund managers who are still high-fiving each other?
Company X seeks to raise $20 million. Company X closes a financing for $20 million. Company X thinks it was a terrific financing, largely because their investment bankers assured them it was. Rinse, repeat.
So, how does your company break the insidious cycle of needless dilution? The key to smart equity financings is for officers and directors to start months before a financing with a corporate self-assessment – a state of the union, if you will. The purpose of this five-step process is to provide planning parameters that are realistic, not optimistic.
1. The fine print matters. Small-caps need to work together with lawyers to determine well in advance of any capital raise whether there are any corporate bylaws, stock exchange rules, pre-existing contractual rights, or state/federal regulations that can cause delay or even scuttle their plans. The devil is definitely in these details.
Are you thinking this step isn’t that important for your company? Think again. Dozens of small-cap financings every year are delayed, hastily effectuated, or cancelled, because companies realize at the last second that: (a) the company is forbidden from selling shares in a particular state due to Blue Sky issues; (b) an otherwise effective shelf registration doesn’t include the kinds of securities investors are likely going to demand; (c) the company has insufficient authorized shares, or the share class contemplated for the capital raise isn’t even authorized by the company; or (d) the exchange’s rules forbid the size of the financing because of the company’s market capitalization. And, make no mistake, the buy-side will take maximum advantage of your poor preparation, and they will also remember the shoddy attention to detail the next time you need capital.
2. Macro temperature check. Small-cap stocks often ebb and flow in ways that aren’t correlated with broader financial markets. But that doesn’t mean that capital raises are unaffected by overall market vibrancy, industry cyclicality, and legislative uncertainty. Well in advance of a contemplated capital raise, officers and directors need to assess these headwinds and tailwinds, because small-caps have a narrow margin of error when it comes to transacting a solid financing. It could be a waste of everyone’s time to plan on raising 25 percent of your market cap by selling common stock “at market,” if: (1) the market is volatile or plummeting; (2) your company’s industry is collectively trading at a 52-week low; or (3) potentially transformative legislation affecting your industry is expected 6 months from now. Investment bankers are constantly bemused by small-cap companies that seem oblivious to these pressures. No matter what anyone tells you, ticker symbols definitely do not confer access to capital, particularly for companies that are unaware of their surroundings.
3. Become a student of your competitors. More often than not in small-cap finance, companies garner similar amounts of capital and similar financing terms to similarly situated companies (i.e., industry, market capitalization, exchange, trading volume, etc.) that recently raised capital. In other words, in the last six months if the last three companies that look quite a bit like your company weren’t able to raise more than 15% of their market caps, and each one issued one warrant for each share of common stock they sold, there is a pretty good chance your financing terms could look similar. There is no excuse for not being apprised of these peer financings, and planning accordingly.
4. The mighty cap table. Investors that supply growth capital to small-cap companies are fixated more on not losing money, than they are on making money. In the small-cap ecosystem, a sure-fire way for investors to lose money is by not completely understanding the minutiae of a company’s capitalization. They’ve learned the hard way, that a company can be executing in spades, but the principal benefactors of that success are going to be, for example, the owners of the self-amortizing convertible note that still has two years left on its term rather than common shareholders. Since this is where investors will focus, companies need to be astute about it as well. For example, if 20 percent of your issued and outstanding stock conceivably resides in warrants that will all reset to the price of an impending financing, investors are going to focus on that fact a lot more than your outsized operating performance of late.
5. History really matters. Most small-cap companies are serial capital raisers; hence the $25 – $40 billion in annualized financings. And institutional investors are market historians; they listen very carefully, they take great notes, and they save all of your prior investor presentations. That combination means that small-cap companies repetitively visit the same cadre of special situation hedge funds, who all have a great sense of whether you’ve done what you said you were going to with all the capital you’ve raised. If you haven’t, that signals to them that there will likely be more financings after the one you’re presently envisioning no matter what the company says, and their financing terms will reflect that. Accordingly, CEOs need to objectively evaluate whether they’ve done what they’ve promised. If you haven’t, then the amount of capital you can expect to raise, and the terms of the financing will reflect your track record.
An enormous number of small-cap companies spend time planning financings that are simply never going to happen as envisioned. The antidote for this systemic waste is focusing more on what flavor of financing is likely… not what’s possible. And, what’s “likely” isn’t a function of what bankers tell you, and it’s not a function of what a top down analysis depicts. What’s likely – at a high level – is what kinds of financings have been transacted by similar companies in the last six months, augmented – positively or negatively – by what this assessment brings to light.