By Edward Sylvan | CEO, Sycamore Entertainment Group (OTC: SEGI)

I have personally seen over $300 million in trading dollar volume change hands in SEGI stock, and the company received not one penny of it.

I have also diluted shareholders.

So I know firsthand how this all works.

The problem with OTC penny stocks is not that shareholders don’t have money to invest. The money is available. Millions of dollars are changing hands between traders every day.

The problem is that none of that money makes its way into the company’s treasury, where management could use it as operating capital to build the business and increase its value.

Shareholders trade that money among themselves, looking for short-term profits. Very few investors are in for the long haul.

There’s nothing wrong with wanting to make money trading stocks. That’s why people invest in the first place.

But I believe that the current setup is broken and works against the vast majority of penny stock traders. Only a tiny percentage of traders actually make money; the rest take massive losses. Both sides lose: the investors and the public company.

Why Trading Activity Creates an Incentive for Management to Dilute You

When penny stock traders buy and sell shares in the open market, they create trading volume and price spikes.

Those higher prices and increased volume attract the attention of public company management because management needs money to operate, grow the business, and survive.

The company sees millions of dollars changing hands in its stock, but none of that money is getting to the treasury.

Management then looks for ways to attract some of that market activity and dollar volume into the company.

Two of the most popular ways on the OTC Markets are by issuing new restricted shares at discounted prices or by selling convertible notes. On the major markets, it’s by way of S-3 shelf registrations or at-the-market (ATM) offering arrangements.

This is where share dilution comes in.

In the stock market, what should cause stock prices to rise or fall is supply and demand based on reported earnings numbers. Not press releases or chat room hype.

But when a penny stock sees a price spike for whatever reason, traders rush in to trade it. This increased volume and higher prices attract the attention of management, who might not even know why the stock is up but jump at the chance to get some money into the company.

The phone starts ringing with calls from lenders who provide money to public companies today in exchange for a convertible note that can be converted into shares at a cheaper price in six months to a year.

The company receives operating capital immediately, while the lender agrees to hold the note under the terms of the financing arrangement. The money offered is most likely not enough to accomplish a stated corporate milestone, but under the circumstances, some money is better than nothing.

The lender is making the decision to invest now based on today’s trading activity.

They see higher share prices and increased volume as evidence of liquidity, even though that same liquidity might not exist a year from now when the note converts.

This doesn’t only apply to note buyers. It can also involve direct equity sales by management at discounts, with restrictions that prevent investors from trading those shares for a year. S-3 and ATM offerings release freely trading shares directly into the market.

In all situations, the company receives money directly into its treasury.

Higher prices and trading volume create the financial incentive for management to dilute because they see a rare opportunity to raise capital.

That’s the disconnect between open-market trading and corporate financing that drives so much of the dilution in OTC penny stocks.

The note buyers and discounted stock buyers rely on traders being unorganized as a group and unwilling to hold a note for up to one year or to hold restricted stock.

The Money Is There

When I saw over $300 million in trading dollar volume in SEGI stock, that money was available to invest directly into Sycamore Entertainment Group.

Instead, shareholders traded it among themselves, trying to get a piece of the action.

They had the money. They were willing to invest in SEGI. They were already deploying their capital into the stock.

What they didn’t have was the education, a mechanism, or a pathway to invest directly into the company. Some may have declined if offered, but the option was never given to them.

That’s the missing piece.

Public company CEOs are constantly looking for new investors and new sources of money, while millions of dollars are already being traded between people who own shares in their companies.

Those same shareholders could be participating directly in financing the businesses they already own. Your best customer is your current customer.

Instead, management looks elsewhere for capital, often turning to discounted financing arrangements that dilute existing shareholders, leaving them out in the cold.

This brings me to my next observation.

Venture Capital Is an Organized Group. Individual Penny Stock Traders Are Not.

Let’s look at how venture capital works in Silicon Valley.

Startup companies raise money while they’re private. Investors provide capital directly to the company and receive private shares.

Because those shares are private, shareholders can’t easily trade them back and forth on the open market every time they see an opportunity to make a quick profit.

They hold their investment while management deploys that capital into building the business.

As the company grows, its valuation increases. When the company eventually goes public, those investors have an opportunity to realize the value built over those years.

But here’s the bigger difference.

Venture capital is organized capital.

Investors understand the company’s business plan, the amount of money required, and the time it will take to build value.

They participate in financing rounds A, B, and C and return with even more capital if the company needs it, working with management toward increasing the company’s value.

Individual OTC penny stock traders, on the other hand, are an unorganized group of individuals. It’s every person for themselves. Take the money and run. A lot of times, traders don’t know and don’t care what the company does or what industry it’s in. It’s just a ticker to trade.

They’re buying and selling shares independently, reacting to price movements, announcements, and trading volume.

They may all want the same outcome, which is to make money from a successful company, but they’re approaching it as individual traders rather than an organized group of investors.

And this is where I believe the difference between winning and losing lies.

A small number may walk away with profits, while the majority are left holding the bag, as they say.

I’m not criticizing traders for doing what they’ve been taught to do.

I’m saying there is another way to look at investing in penny stocks, and retail shareholders need to understand it.

Public Company CEOs Spend Too Much Time Chasing Money

Management and shareholders of OTC penny stock companies often have two very different time horizons.

Management is focused on long-term goals and building the company.

Traders are focused on short-term profits based on random price spikes.

These two objectives are constantly working against each other.

This is where the distrust between management and shareholders begins.

Shareholders become upset about dilution, while management is trying to find the money required to keep the business operating.

Think about what happens when management spends 95% of its time and energy chasing money and dealing with disgruntled shareholders.

That leaves only 5% of its attention for actually running the company.

It becomes a challenge for management to compete in its industry under those circumstances.

Meanwhile, a venture-backed startup with reliable financing can concentrate its attention on developing products, finding customers, making acquisitions, expanding operations, and increasing the company’s value.

The public company CEO is chasing money while the venture-backed startup CEO is growing a business.

Private startups can return to the same group of venture capital investors for multiple rounds of financing.

Why can’t OTC public companies develop that same relationship with their existing shareholders?

Penny Stock Shareholders Need to Start Thinking Like Private Investors

Management needs to focus on educating its shareholder base, which is its biggest asset.

In order for penny stock traders to make money from the long-term value being built within a company, they need to start treating their shares as if they were private.

That means changing the way they look at ownership.

Instead of constantly trading shares back and forth every time the stock price spikes, shareholders need to understand that the money they’re trading could be deployed directly into the corporation to build value.

Most traders may not even be aware that they can contact any company they own shares in to inquire if there are any opportunities to invest directly at a discount from the current share price.

That might mean taking direct delivery of their shares which also helps to remove the temptation to sell every time prices increase.

The idea is to recreate the long-term investment discipline that exists in private startups.

And management needs to understand that its existing shareholders represent a pool of potential investors who could participate in multiple rounds of financing.

This is where a method called a RIGHTS ISSUE can come into play. A rights issue allows existing shareholders the RIGHT (if they choose) to buy additional shares directly from the company at a discount, instead of buying shares the from the open market. 

There is no reason the relationship between an OTC public company and its shareholders has to be limited to buying and selling shares on the open market.

I’m not suggesting that traders should stop trading.

I’m suggesting they educate themselves about other ways of participating in the public markets.

One where they’re not simply buying shares from another investor, but actually providing money to the company whose shares they want to increase in value.

Management and Shareholders Need to Work Together

The only way to fix this disconnect is for management and shareholders to come together and understand the ultimate goal.

That goal is to build value within the public company and then transfer that value into higher share prices.

Instead of management constantly searching for new investors, it should be able to return to an educated pool of existing shareholders for multiple rounds of financing, just as private startups return to their venture capital investors.

Shareholders would be investing directly in the company, where management could deploy that money into growing the business.

Management would spend less time chasing capital and dealing with upset shareholders.

And shareholders would be participating in building the value they ultimately want reflected in the stock price.

As the company’s valuation increases, that value can eventually attract institutional investors at much higher share prices.

That’s how management and shareholders begin working toward the same objective instead of competing against each other.

That’s the thinking behind what I call Capital Formation Trading.

Momentum traders follow the price.

Capital Formation Traders follow the money.

Edward Sylvan is the CEO of publicly traded Sycamore Entertainment Group (OTC: SEGI). He writes about OTC penny stocks, stock dilution, corporate financing, and capital formation from his experience managing a public company.