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The Importance of Share Structure

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

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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MicroCapClub is an exclusive forum for experienced microcap investors focused on microcap companies (sub $500m market cap) trading on United States, Canadian, European, and Australian markets. MicroCapClub was created to be a platform for experienced microcap investors to share and discuss stock ideas. Since 2011, our members have profiled 1000+ microcap companies. Investors can join our community by applying to become a member or subscribing to gain instant view only access. MicroCapClub’s mission is to foster the highest quality microcap investor Community, produce Educational content for investors, and promote better Leadership in the microcap arena. For more information, visit http://microcapclub.com and https://microcapclub.com/summit/

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