The Importance of Share Structure

Neil Cataldi Blog, Educational 12 Comments

Understanding share structure is an extremely important component of the due diligence process and in determining the value of an equity. This article will provide an introduction to the key principles one should look at when trying to identify whether a share structure is healthy for investors.

The first and more important component is shares outstanding, which is defined as the shares of a corporation that have been authorized, issued, and purchased by investors and are held by them. Though basic mathematics by nature, beginning investors sometime fail to recognize the relevance of shares outstanding when calculating the value of a company. This important component is directly correlated to market capitalization and also inversely correlated to the most important earnings metric, EPS (earnings per share). A higher number of shares outstanding makes it more difficult for a company to increase its profitability on a per share level. Thus, when you look at companies who are relatively young and investing in their growth, it’s important to watch the shares outstanding, whether they’ve been increasing or remaining relatively stagnant. A stagnant shares outstanding in this case is a positive. Companies often fund their growth by selling new shares to raise capital. Though a common practice and in many cases warranted, as an investor, you never want to see your shares suffer further dilution. A share count between 20 mln – 30 mln is healthy for many micro cap companies. I typically do not view shares outstanding as a negative characteristic unless it is approaching 75 mln – 100 mln.

The second component which ties directly into shares outstanding is the available float, and is defined as the total number of shares publicly owned which are available for trading. The difference between shares outstanding and available float lies with those shares held by insiders that are not publicly available for trading. For example, a company may have 20 mln shares outstanding but only 15 mln may be available for trading. The other 5 mln shares may be held by management or an institutional investor. Float is an important factor to consider when you are looking at a stock, its trading liquidity, and when attempting to determine whether recent trading volumes have been normal or abnormal. A stock with a low float may have liquidity issues and as you build a position of significant size, liquidity is always an important risk factor to consider. I typically view both lower float stocks, as well as companies who have a large portion of their shares held by insiders or institutions as a positive characteristic.

The third component that is important is insider ownership. An investor who owns more than 5% is required to disclose publicly with the SEC. Insider ownership is the percentage of common stock held by all officers and directors as a group. This statistic is important to watch for many reasons. First and foremost, incentivized management teams should have an alignment of interest and thus when they do so, it is viewed favorably. I always question why management teams are not incentivized with equity in their company. Being so close to the story, if they believe in it, why would they not want to own shares and even further, if they don’t want to, why should you? As a rule of thumb, avoid companies where management is not invested themselves. Taking it a step further, insider activity is also very interesting and relevant to watch. Most insider trading activity is either defined as an open market purchase/sale, a purchase or sale as a part of a 10b5-1 plan (predetermined activity and thus not as noteworthy), or activity driven by the execution or conversion of options/warrants. Open market purchases and sales are by far the most notable. When I look at companies, I like to see management with a large stake in the company – 10% or more especially when you look at micro cap companies. Open market purchases are viewed very favorably as they speak to confidence in the story. Companies with little or no insider ownership should be looked at with an eye of caution.

Finally, the fully diluted shares outstanding number is also very important to make note of. Often times, small and micro cap companies fund their growth through the issuance of options and warrants. A company with a relatively low shares outstanding, may have a very large number of options and/or warrants issued which can lead to significant dilution in the years to come. It is very important that investors who are performing initial due diligence look at the fully diluted shares number as it can materially change their forecasting model of future EPS growth. Not only can the fully diluted amount be materially higher, but significant issuance of warrants and options can sometimes lead to an overhang on shares at certain exercise price levels.

In summary, share structure is an important characteristic to research during the due diligence process. Companies that issue shares, options, and warrants are diluting their share count and that is never viewed favorably by investors. Companies who have abnormally large shares outstanding may struggle to reduce them. Small cap investors typically desire growth and would rather see companies utilize free cash flow to fuel further growth, rather than using resources to reduce the share count. In addition, a lower share count can provide flexibility for small companies to strategically use capital markets in the future. Understanding this structure can provide insight into management and their alignment of interest which is very important when assessing management teams. There are many great story stocks but differentiating between the great story without a proper share structure and the great story with a healthy share structure can be the difference between investment success and investment failure.

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Comments 12

  1. Very nice article especially when considering investing in microcap companies. Question?

    Let’s say there is a microcap company xyz, it has 20 million shares outstanding with 10 million floating. Let’s say it’s share price is 1:00 usd giving it a market cap of 20 million usd. Now when the company does well and institutional investors want a piece of the action doesn’t the company issue more shares to increase liquidity??? Currently xyz trades 10,000 shares/ day but if it going to jump to say 500,000 shares a day or more and if more funds/institutions want to buy how does it affect the little guy who has been holding the shares for 5-7 yrs

    Answers from members appreciated

    1. Good companies don’t issue shares just to increase liquidity. Some issue shares to raise capital. Increased liquidity normally happens simply by more and more investors participating in the stock. Normally for example as a stock increases the liquidity increases. ZAGG is a perfect example of this when it traded 5k a day in summer of 2008 and 6 months later it was trading 200k per day after the stock doubled in price.

      1. So Ian when the company moves from a microcap to a mid cap would it have the same number of outstanding shares? I guess the company will split shares to reduce value of each share and thereby increase floating shares. Isn’t this the reason brk-a (Berkshire Hathaway class a) trades thinly but brk-b trades more number/day

        1. Suryan, Microcaps that grow in market valuation have a strong management team that executes upon their business model. Typically these companies have a recurring revenue component built into their products/service offering that is scalable and higher margin. The companies that have been very successful within my experience have had anywhere between 15-30 million shares outstanding and keep them managed around that level until their market valuation is much higher. These companies typically engage investors with the mentality of under promising while over delivering on a consistent basis. Investors like to see improvement along with real people running the company.

          Other Microcap companies these days are executing upon reverse splits if their company is performing giving them the access to the NASDAQ Capital Markets. I believe NASDAQ lowered their uplisting requirement from $4/share to $2.50-3/share depending on the revenue and earnings generation.

          Just my 2 cents.

        2. Yes, the point I was making was that liquidity increases when the stock price increases even while keeping the float the same.

          In many cases companies do capital raises which does increase the the shares outstanding or do forward splits, which in turn can also help to increase liquidity.

  2. Suryan,

    Thanks for the comment. I think Ian and Sean covered most of it. The points I would further emphasize are: companies don’t increase their shares outstanding unless they need capital; liquidity increases as more investors are involved and you’ll find a very high correlation between more investors and a rising share price; and finally, as microcap companies grow into small cap companies, they move to more prominent exchanges which usually leads to market makers and an overall more active marketplace. In its most simple form, liquidity typically increases as the company grows. The growth and profitability drives valuation and subsequently a higher share price. Ian’s example with ZAGG is an interesting case study. If you look at the progression of the company, you’ll see a fairly illiquid stock in 2008- the first half of 2010. However, in late 2010, company specific events led to the price moving higher by 2-3x during a short period and as a result, average volume increased to multiple millions of shares per day.

  3. Just now reading this for the first time, Neil; great article. One comment: not all warrants are created equal. An increasing number of micro-cap financings now contain not only full-ratchet anti-dilution protection, but also have an “exploding” feature as well. Simply put, full-ratchet anti-dilution in warrants historically amounted to price protection; if a subsequent financing is undertaken at a price below an existing warrant strike price then the strike price is reset to the subsequent (and lower) offering price. Now, exploding warrant features not only reset the strike price, but also provide for the issuance of more warrants in order to maintain former ownership percentages (i.e., more akin to V.C.-type anti-dilution than capital markets price protection). What this means is that share counts could rise “dramatically” for those companies with exploding warrant features that are triggered. Moreover, these provisions are worded in such a way that it often obfuscates the “exploding” feature. Buyer beware….

  4. I just want to have a simple query, something that Suryan also points out..if a company split its stock and also issues bonus, it increase the shares outstanding but the paid-up and issued capital remains unchanged and so does market capital..it obviously increases the liquidity, but effect would it have on future growth? Is constant stock split good or bad for investors?

    1. It depends if you are talking about a forward split (increasing shares outstanding) versus a reverse split (decreasing shares outstanding).

      Forward splits are rare and very frowned upon in the micro cap space. Mainly because most micro caps are on the OTC, and they should want a higher stock price (not a lower one) so that they can graduate to the NYSE and/or Nasdaq.

      In my mind the smaller the share count the better. Here in the US reverse stock splits have had a historically negative reaction because they were normally done by weak companies and weak businesses to keep a Nasdaq or NYSE listing (stocks get kicked off if they go below a certain stock price). I call this doing a reverse stock split out of weakness..this is always a bad thing.

      But lately more and more strong companies are doing reverse splits so they can increase the share price to uplist onto a major stock exchange. These reverse splits have been received very well by the investor community here in the US.

      1. Thanks Ian..In India, we have been observing more and forward split..Very rarely a company announce a reverse split..In fact quite a few companies announce a split as long as a stock touches the psychological level of INR 500 OR INR 1000, mostly 1:5 ratio..In the current bull run it is having no impact on their share performance..

  5. I think stock split and bonuses and Rights do increase shares outstanding, whereas the the issued and paid-up capital remains unchanged.. so, how do we view constant splits done by the management?

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