Investing in MicroCap Private Placements

In general, you can invest in microcaps in one of two ways. First, you can buy a company’s stock in the open market, or Second, you can invest directly into the company via Private Placement. As an accredited investor I get pitched tons of private placement opportunities. Just like the IPO market, private placements and funding of microcap companies have been on the rise thanks to the bullish market we are currently in. The purpose of this article isn’t to showcase what types of companies to invest in, but rather what structural things to consider when investing in companies via private placements.

Definition of ‘Private Placement’: The sale of securities to a relatively small number of select investors as a way of raising capital. Since a private placement is offered to a few, select individuals, the placement does not have to be registered with the Securities and Exchange Commission. In many cases, detailed financial information is not disclosed and a the need for a prospectus is waived. Finally, since the placements are private rather than public, the average investor is only made aware of the placement after it has occurred.

For the basis of this article I’m using Private Placement interchangeably with any funding structure such as restricted common stock, registered common stock, convertible preferred stock, convertible notes, equity lines, etc.  A great book hitting on many of the challenges of microcaps, specifically those that need to raise money is, The Perfect Corporate Board, by Adam Epstein.

Successfully investing in microcaps is all about stacking the deck in your favor. Much of that favor goes out the window when a company needs to raise capital.

I normally stay away from private placement investing because I tend to look for companies that don’t need to raise money, A MicroCap Investors Worst Enemy is Dilution. But for this article I’m going to focus on the companies that do need to raise money.

There are currently 7,000 public companies on all US Exchanges (including OTCBB/OTC Markets) under $100 million market cap.  1,100 (15%) of these companies are profitable LTM. Said another way, 85% of companies under $100 million market cap don’t make money.

This is also why “microcap” investing has such a negative connotation by the mainstream financial media. I’m broad brushing a little bit here, but when you have 85% of a market with unprofitable businesses, many will fail, and the media loves to bring publicity to failure.  Very little attention is brought to the fact that EVEN TODAY, 41% of the 1,100 profitable microcaps are trading at less than a 12 PE. But I digress…

An interesting phenomenon is that a lot of microcap institutions can only buy into microcap companies if there is a private placement opportunity because of lack of liquidity in the open market. So, a lot of the perceived “smart money” can only look at the 85% of unprofitable companies, and also a small percentage of profitable companies that need to raise capital to grow.

All of the above said, there are times when even I participate in private placements. I have personally participated in about 23 private placements over the last eight years. I normally have a small speculative slice devoted to such investments, but I only do them under certain circumstances.

In general, I only invest in small private placements, when I know all the investors that are participating, when terms are right for the company, and when I know the story better than anyone else.

I only invest in private placement when I know the story better than anyone else. Take the same approach to buying microcaps in the open market as you do when doing a private placement. Know the story better than anyone else. I often times see investors just throwing money at private placements. This is a big mistake. I have lost more money passively investing in companies via private placements than I’d like to admit.

I only invest in private placements where I know and trust the participants. It is important you know who the villains and heroes are as it relates to private placement investors.There are certain institutions in particular that you have to watch out for. As a side story, the churn and burn microcap financing years of pre-2008 (pre-financial crisis) had several large institutions ($500 million – $5 billion in AUM) that strictly invested in microcaps and smallcaps. These institutions would do “structured deals” with microcap companies. They were normally convertible debt structures that had 100%, 200%, even 300% warrant coverage that also paid a yield of cash and or stock. They would structure them in this way because accounting rules at the time would give the funds a cost basis of close to -0- but a value on their books near market which allowed them to show great performance for their investors, but also the ability to leverage these illiquid investments to do even more of these types of structured deals. When the financial crisis hit, Goldman, Smith Barney, etc would not let these funds leverage these types of investments, so most of these institutions have gotten much smaller or have closed down.

There are still quite a few funds around that do this and you don’t want to invest alongside them. There motivations are often times not the same as yours. For example, if there is significant warrant coverage these institutions will dump the stock (even at a loss) and hold the warrant(s). These types of participants often times force the company to deploy a percentage of the money raised (sometimes up to 25%) into hiring stock promoters and even deploying hard mailers to provide liquidity around the same time their stock becomes unrestricted.  Also, if a company is simultaneously reverse merging into a shell and raising money, some institutional investors will be given free shares from the shell. So in essence, their cost basis is much lower than other participants in the private placement. There are a lot of games played by these slimy institutions, and if you don’t know how the game is played, you will get played.  

Know who the villain and heroes are

On the other side of the quality spectrum are a group of great institutions that will immediately attract other quality shareholders. These funds are not looking to flip the stock but to own it for years. I’ve invested alongside a couple of such funds, and it’s been a wonderful experience. Bottom-line, stay away from the slimy institutions, and make sure the other participant’s motivations are the same as yours.

I only invest in private placements that are good for the company. Beware of structured deals and private placements with too much warrant coverage (multiple warrants). These deals might look good for the investor but they aren’t for the company. Companies still take the money because they are weak and don’t have a choice. Don’t invest in these types of companies or deals. The terms of the private placement should be good for the company and for investors.

Everyone in a private placement invests on the same terms and everyone is unlocked and can sell at the same time. If there is significant warrant coverage, when the underlying stock becomes free trading, many will sell their shares at a loss and hold the warrant(s). Beware of this dynamic. 

The real investors and institutions that don’t just want to “rent” the stock, but own it longer term make it a priority to do simple, straight forward, private placements. They don’t want the dilution and overhang that significant warrant coverage and structured deals create.

I prefer doing straight equity at a slight discount with no warrants. Here is an example of a recent private placement I participated in. There were no warrants, no investment banking fees, no registration statements, no BS.  It was a good deal for the company and let myself and another investor build a position.

Smaller is better

I only invest in small private placements (<$2 million deals) in microcap companies. I don’t like participating in large financings in small microcap companies because these companies are normally illiquid. For example, when a $0.50 per share company that averages 10,000 – 50,000 in daily volume raises $10+ million, issuing 20 million shares plus likely millions of warrants, I pass. All of that stock will hit the market at the same time and create an impenetrable wall for the stock price. It’s not a winning situation. Smaller is better. You will not get crushed by the overhang of stock. 

In conclusion, be very careful when investing in companies via private placements, and use the same investment philosophy you use for buying companies in the open market. Be sure you know who you are investing with and be leery of structured private placements with a lot of warrant coverage. Lastly, be cautious of large private placements because you will be eating through all that stock in the months ahead. This is a hard subject matter to explain in a brief article, but I hope I’ve outlined a few points you will find useful. Even taking this all into consideration, my rule of thumb is don’t write a check unless your willing to write another one.

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