Penny stock traders complain about dilution all the time. But why does it keep happening, and is there a better way to finance small public companies?
By Edward Sylvan | CEO, Sycamore Entertainment Group (SEGI)
Traders are always complaining about penny stock dilution. But nobody seems to want to talk about why it keeps happening.
I’ve been running a publicly traded company for 16 years. I’ve raised millions of dollars in financing, and yes, I’ve also diluted shareholders.
I’ve experienced the problem from the management side, and I believe there is a better way.
Why Does Penny Stock Dilution Keep Happening?
Here’s something most penny stock investors don’t think about.
Millions of dollars can trade back and forth in a company’s stock without a single dollar of that money ever reaching the company itself.
Think about that.
A penny stock can trade millions of dollars in volume. Traders can make money, lose money, and exchange shares all day long.
But the company whose shares they’re trading doesn’t receive any of that money.
It stays between the buyers and sellers.
Meanwhile, management still needs money to operate the business, pay expenses, develop products, and grow the company.
So where does that money come from?
The Penny Stock Financing Cycle
When trading volume picks up and share prices spike, management sees an opportunity to raise capital.
The company may issue discounted shares or convertible notes to investors willing to provide financing.
New shares enter the market.
Existing shareholders get diluted.
Selling pressure can drive the share price down.
Traders lose money.
And management eventually goes right back to looking for another financing.
Rinse and repeat.
The company may have raised enough money to survive another few months, but that doesn’t necessarily mean it has built any lasting value.
And the shareholders who believed in the company are left wondering why their investment keeps losing value.
This is one of the fundamental problems with how many penny stock companies finance themselves.
Is All Penny Stock Dilution Bad?
No.
Companies need capital to grow. Issuing new shares can be a legitimate way to finance that growth.
The real question is what happens to the money.
If a company issues shares and uses the proceeds to build a profitable business, the additional capital can create value for shareholders.
But when financing simply pays for ongoing expenses without building the business, shareholders can end up owning a smaller percentage of a company that hasn’t become more valuable.
That’s the difference investors need to understand.
Dilution itself isn’t necessarily the problem.
Dilution without meaningful value creation is the problem.
Why Aren’t Penny Stock Shareholders Part of the Financing Process?
Here’s the question I’ve been asking.
Why can’t small public companies build relationships with their existing shareholders the same way private startups build relationships with venture capital investors?
Venture capital investors don’t just buy shares and hope somebody else pays more for them tomorrow.
They study the company. They understand the business. They participate in financing its growth.
Why can’t public company shareholders have opportunities to do something similar?
Imagine a company with thousands of shareholders who understand what management is trying to accomplish.
Instead of management constantly chasing outside financiers, eligible shareholders could have opportunities to participate directly in company financings.
The company receives the investment capital.
Shareholders have an opportunity to understand how their money is being used.
And management can spend more time building the business instead of constantly looking for its next financing.
Direct investment still carries risk, and not every shareholder will want or qualify to participate. But it creates another way for companies to approach capital formation.
Capital Formation Trading: A Different Approach
I call this approach Capital Formation Trading (CFT).
The idea is to build cooperation between management and shareholders around financing the growth of the company.
Instead of relying entirely on secondary market trading activity and outside financiers, small public companies can work toward developing an educated shareholder base interested in participating in direct capital formation.
It doesn’t eliminate investment risk or guarantee success.
But it changes the conversation.
Because the purpose of a public market shouldn’t simply be to move shares back and forth between traders.
It should also help companies access capital to build businesses that create lasting value.
And that’s a conversation I believe penny stock investors and public company management need to start having.
Edward Sylvan is the CEO of Sycamore Entertainment Group Inc. (OTC: SEGI) and the developer of Capital Formation Trading, an approach focused on connecting public company financing with shareholder participation.