Search Google for stock dilution Reddit and you’ll find retail investors asking the same questions.
Why does management keep issuing more shares? Why do convertible note holders get such favorable terms? How can shareholders stop their investments from being diluted?
I run a publicly traded company. I’ve negotiated financing agreements, issued shares and dealt with the pressure of finding capital to keep a business moving forward.
I think we’re asking the wrong question.
The problem isn’t dilution. The problem is who gets the new shares.
One of the main reasons a company goes public is to access the capital markets and raise money by issuing stock.
Retail investors have been conditioned to believe dilution is always bad.
It’s not. The question is what the company receives in exchange, how the money is used and whether shareholders have an opportunity to participate.
Here’s my argument.
Why not have retail investors dilute themselves?
What Reddit Investors Are Missing About Stock Dilution
Look at this Reddit discussion about protecting shareholders through a rights offering. An investor proposes giving existing shareholders the first opportunity to finance their company instead of immediately relying on outside capital.
Or this discussion about the dangers of stock dilution, where investors debate the impact of issuing new shares.
There’s also a discussion about how rights offerings affect shareholders.
These are the conversations retail investors should be having.
But I want to take the discussion further.
When an early stage public company needs capital, management often turns to outside investors.
They use Convertible notes. Equity lines of credit. Registered direct offerings or At-the-market offerings.
The terms vary. Some are reasonable. Others can be expensive for existing shareholders.
The investors negotiating these deals are organized and they have pools of money to invest. They also understand how public company financing works.
Retail investors are not organized, it’s every person for them self. They also have short term mentality and are at times trading with money that they cant afford to lose.
And that’s a major disadvantage.
Why Aren’t Existing Shareholders Financing Their Own Companies?
Think about this.
A small public company might have thousands of shareholders buying and selling millions of shares in the open market.
But when management needs $500,000 to fund operations, it’s forced to go looking for an outside investor. More often than not it’s a single person.
Why?
When shareholders buy stock from one another, that money doesn’t go to the company.
It goes to the person selling the shares to the buyer.
But when shareholders purchase newly issued stock directly from the company, that money goes into the business.
That’s capital formation.
Now imagine management organizing its existing shareholders into a long-term financing base of investors.
Not a trading group. Not a stock promotion.
A reliable relationship between management and shareholders.
The company builds a multiyear financing strategy. Shareholders understand that additional capital may be required in multiple rounds.
They have opportunities to participate through rights offerings or other structured financings.
Management reports its progress. Investors decide whether to commit additional money.
The company gets capital. Existing shareholders get the opportunity to receive the new shares.
Yes, the company is issuing additional stock. That’s agreed dilution.
But shareholders who participate can maintain their ownership percentage rather than automatically giving up a larger portion of the business to outside financiers.
Why isn’t this the starting point?
Management Should Organize Capital Before It Needs Money
I believe one of the biggest mistakes early stage public companies make is waiting until they desperately need financing before looking for investors.
By then, management has lost negotiating leverage.
The company needs money immediately. Outside financiers know it.
And sometimes management’s hand is forced.
I’ve experienced the pressures of operating a public company. It’s difficult to focus on developing products, making acquisitions, attracting customers and competing for market share when you’re constantly hunting for the next financing.
What if management could plan its capital needs over several years with a shareholder base that understands those requirements?
Not guaranteed financing. Not unconditional loyalty.
A transparent capital plan with milestones, responsible spending and investors who can decide whether management has earned their continued support.
Management also needs reasonable, disclosed compensation, subject to proper oversight. A CEO struggling with personal financial survival is not necessarily in the best position to make long term financing decisions.
A public company needs leadership focused on operating the business.
Retail Investors Need to Understand Where Their Shares Are Held
There’s another part of shareholder education that almost no one thinks about. How to defend against short sellers.
Most retail investors don’t fully understand what happens to their shares after they’ve bought them.
What’s the difference between a cash account and a margin account?
When can a brokerage lend an investor’s shares?
What is a fully paid securities lending program?
What happens when shares are held directly through the company’s transfer agent instead of in street name?
These are basic ownership questions.
Where available, newly issued shares can be registered directly in the shareholder’s name through the company’s transfer agent.
This can keep those shares outside brokerage lending inventories. Physical certificates aren’t always necessary because eligible shares can be held through electronic direct registration.
That doesn’t eliminate short selling, and individual investors should remain free to make their own decisions about lending and selling their shares.
But management should make sure shareholders understand their options.
An educated shareholder base is an asset to a public company.
The Retail to Institutional Handoff
Now here’s where the strategy becomes interesting.
Most institutional investors aren’t interested in very small public companies.
They’re too early. Too risky. Too illiquid. Their financial reporting or corporate governance may not meet institutional requirements.
So who finances many of these businesses in their earliest stages?
Retail investors and other high risk tolerant capital providers.
What happens if the company succeeds?
What happens if management builds revenue, develops valuable assets, improves its financial position and becomes attractive to institutional investors?
That’s where I believe the long term plan should lead.
Early retail investors finance the company. Management builds the business. Institutional investors eventually have an opportunity to purchase positions from willing early shareholders.
The handoff would happen through market transactions or structured secondary sales, at prices determined by actual demand and business value.
The early investors take the risk. If the company succeeds and institutions become interested, those investors have a potential route to realizing returns.
None of this guarantees a higher stock price or even institutional interest.
But why shouldn’t management work toward that outcome from the beginning?
Why should institutional ownership be something a CEO only thinks about after the company becomes successful?
Retail Investors Have More Power Than They Realize
Hollywood is being transformed by filmmakers who arrive with built-in audiences.
GameStop demonstrated how powerful an engaged retail investor community could become.
Politicians understand the importance of organizing their supporters long before they need their votes.
Why aren’t more public-company CEOs organizing their shareholders before they need their capital?
Many early stage CEOs come from science, engineering, medicine, agriculture or technology.
They may understand their businesses extremely well while having very little experience navigating public capital markets.
Raising capital shouldn’t be an emergency exercise.
It should be part of the company’s long term strategy.
If management expects shareholders to provide patient capital, management must earn that patience through performance, transparency and accountability.
Stop Fighting Dilution. Start Understanding Capital Formation.
I don’t believe retail investors should spend their entire investing lives trying to avoid dilution.
They should understand why dilution happens, who benefits, what the company receives and whether they can participate on reasonable terms.
I’ve written previously about How to Find Penny Stocks Before They Explode and the concept I call Capital Formation Trading.
That argument starts with following the money financing a public company instead of looking only at stock charts.
This argument takes it a step further.
What if management organized the retail capital that already supports the company?
What if investors understood from the beginning that they’re financing a business through multiple stages of growth?
What if the company’s leadership could spend more time competing in its industry instead of constantly searching for the next lender?
And what if management planned for an eventual transition from retail ownership toward institutional investment from day one?
The company might still fail. Investors might still lose everything.
That’s the reality of early stage investing.
But I believe there’s a better way to organize the relationship between public company management and the shareholders who finance it.
Retail investors shouldn’t always be the last people in the financing chain. They should have the opportunity to be the first.
About the Author
Edward Sylvan is CEO of Sycamore Entertainment Group, Inc., a publicly traded company. He writes about OTC stocks, capital formation, corporate financing and shareholder ownership from his firsthand experience running a public company.
This article is educational commentary and does not constitute investment advice or an offer to purchase securities. Early-stage public-company investing involves substantial risk, including loss of principal.
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