If you’ve owned penny stocks for any length of time, you’ve probably experienced stock dilution. You don’t need another explanation about how issuing additional shares reduces your percentage of ownership. Most shareholders already understand that.

The more important question is whether the money raised through dilution actually creates value for the people who already own shares and if the dilution gets the company closer to its goals.

My name is Edward Sylvan, CEO of publicly traded Sycamore Entertainment Group (OTC: SEGI). I’ve faced this question from the other side of the transaction.

I’ve financed SEGI through transactions that diluted shareholders. Looking back, those financings didn’t move us far enough ahead. They placed pressure on our share price and eroded shareholder confidence.

That’s a problem public company management must take seriously.

Stock Dilution Isn’t the Enemy. Financing Without Creating Additional Value Is.

Small public companies need a constant supply of new money. They have employees, operating expenses, acquisitions to make, technology to build, and product development costs, among other things.

For a small public company that may be pre-revenue or not yet profitable, this takes money, and issuing shares to raise that money is one of the only ways available to the company.

Raising capital is only half the battle. Management now needs to deploy that capital so it generates enough value to justify the dilution.

A company issues millions of shares to raise operating capital. They burn through it, the business hasn’t grown or earned new market share, and management needs to raise more money.

Existing shareholders take on dilution, but the company has nothing meaningful to show for it.

Repeat that process enough times and shareholders start losing faith.

I’ve seen firsthand how difficult it becomes to rebuild that confidence.

The hidden cost of stock dilution isn’t only the additional increase in outstanding shares and share price pressure. It’s what happens when shareholders stop believing management can create value with the money.

Can Existing Shareholders Participate in the Solution?

One approach I believe deserves more attention is giving existing shareholders the first right to participate in any new dilution that will need to occur.

A rights offering can give qualifying existing shareholders the opportunity to purchase additional shares, often in proportion to their current holdings at a discount to the current market price.

It isn’t a perfect solution. Shareholders who cannot or choose not to participate will still experience dilution if they elect to hold the shares.

But it raises a question worth discussing:

Why shouldn’t companies explore ways for their existing shareholders to participate in financing first before repeatedly turning to outside investors?

Shareholder Education Needs a Bigger Role in Capital Formation

I developed the concept of Capital Formation Trading (CFT) to explore opportunities for investors to participate more directly in public company financing, including negotiated investments, direct lending and debt restructuring, rather than having new investors always buying shares in the open market.

That approach involves risks of its own. But I believe understanding where corporate capital comes from is key.

Shareholders need to understand convertible notes, financing discounts, share issuance, debt restructuring and how these transactions affect their holdings.

They should also understand management’s business strategy.

An educated shareholder community can ask better questions, participate in legitimate financing opportunities where available, and hold management accountable for results.

Building shareholder trust isn’t about telling investors to hold shares. It’s about giving them credible reasons to believe the company can create long-term value.

Why Are Penny Stock Shareholders Always Selling to Each Other?

What I believe more retail investors need to understand:

Most buying and selling in the stock market happens between investors. When you purchase shares from another shareholder, that transaction generally doesn’t put new operating capital into the company.

One investor sells. Another buys.

In penny stocks, this often becomes a game of hot potato. Traders buy hoping another investor will pay more tomorrow.

None of that trading activity goes to the company bank account, so management more often than not has no other option but to dilute into the trading activity. We see this in the form of Self Offerings, Registered Direct Offerings and Convertible Note Offerings.

I don’t believe retail shareholders should have to depend entirely on the next retail buyer to realize value from their investment.

What needs to be understood is that the ultimate penny stock or retail shareholder end buyer of their shares is not another retail buyer coming in after them to take the shares off their hands at a higher price.

A public company’s management should be working together side by side with its current shareholder base toward building a business capable of attracting additional sources of capital, including institutional investors with different investment objectives and time horizons.

Three Pools of Capital That Shareholders Should Understand

Throughout my career, I’ve studied three enormous sources of capital.

Government Capital. Advertising Budgets. Wall Street Institutional Capital.

These three pools hold TRILLIONS of dollars combined. What interests me is that all three pools have the same thing in common: ordinary everyday people are where a large portion of the money moving through those systems comes from.

Government capital is in large part funded by income tax and other various forms of personal tax. Advertising budgets are largely funded by businesses selling products and services to their retail consumers, and Institutional Wall Street investment pools are funded in part by worker pension contributions, individual retirement savings contributions and other personal savings.

These are different pools of money, with different rules and purposes. But understanding how they operate changes how I think about building a public company.

As CEO of Sycamore Entertainment Group, I see potential access to two of these markets through our business structure.

SEGI TV operates in the advertising-supported streaming market, where brands and their agencies allocate advertising budgets.

Sycamore Entertainment Group is publicly traded, creating the potential to pursue capital market financing and, if the company meets the necessary requirements, institutional investment.

My objective isn’t simply to find more retail investors willing to buy shares. It’s to develop the business, relationships and financial structure necessary to compete for access to these larger sources of capital.

That’s a very different objective from encouraging shareholders to trade the stock among themselves.

What I’ve Learned About Stock Dilution

My experience running SEGI has changed how I think about financing a public company.

I don’t believe the answer is to promise shareholders there will never be more dilution. That would be unrealistic.

The answer is to seek better financing structures, improve shareholder communication, build businesses capable of attracting outside capital and demonstrate measurable progress.

Sometimes companies must dilute to survive. But survival alone cannot remain the long-term business strategy.

As a public company CEO, I believe my responsibility is to work toward making capital formation benefit both the company and the shareholders who take on high risk to finance its future.

That’s the discussion I want more OTC shareholders and company executives to have.

Edward Sylvan is CEO of Sycamore Entertainment Group (OTC: SEGI). He writes about penny stocks, stock dilution, shareholder-friendly financing and Capital Formation Trading at EdwardSylvan.com.

This article presents personal business experience and general commentary, not an announcement of a securities offering or investment recommendation.