The Importance of Share Structure

I was recently asked by a member to explain the importance of share structure and I thought it would make a great educational post. Microcaps as a whole consistently need to perform equity raises in order to pursue their business goals -- whether it be growth, new product launch, acquisitions, etc. -- because they are small companies with a paucity of cash on their balance sheets. That being said, there's nothing inherently wrong with raising capital, however the structure of the raise matters immensely. In the case of equity raises, if they aren't done properly, it can be extremely dilutive to present shareholders. It happens all the time where companies raise capital and use the money wisely to create shareholder value (e.g. they make an acquisition), however because the structure of the raise wasn't ideal (e.g. raised capital at too low of a valuation so many more shares had to be issued), shareholders still end up losing money.

When looking at a new investment idea, the share structure tells you a lot about how well management has used the money they've raised (i.e. how good capital allocators they are) and how they've treated shareholders. A large number of shares outstanding, usually 80M+, indicates that management was not successful in reaching profitability early on in the company's life -- obviously a bad thing. It also suggests they did not use the money they raised effectively. Or perhaps they were profitable, but they decided to make a bonehead acquisition which overall was more destructive to shareholder value than it was enhancing. Another possible scenario is that they had an abusive insider equity compensation plan which significantly diluted shareholders. Most stock options plans, at the least in the microcap space, only allow management to issue a maximum number of options equal to 10% of the current shares outstanding in order to prevent abuse. Conversely, a low number of outstanding shares, sub-40M, is an indicator of a company that runs lean and a management team with excellent capital allocation skills. It's no coincidence that 10% of profitable microcaps have over 100M shares out whereas 60% of them have less than 20M shares.

Furthermore, share structure needs to be analyzed in tandem with insider ownership. If insiders own a significant percentage of the equity -- this varies case by case depending on management's age and financial situation -- then they will treat their shares like gold. In other words, they won't dilute themselves unless it's absolutely necessary and they will be very cautious should they need to do it. For example, if they need an equity raise to fund growth, they will try to raise the lowest amount possible instead of opting for more money than they would need. Additionally, they would aim to do it when the stock price is at its highest as they would need to issue less shares. In short, when management owns a considerable amount of stock it increases your odds of not getting diluted and having your shares appreciate in price.

There is also a technical reason why a tight share structure is very attractive which has to do with demand and supply. The fewer shares there are, the less supply is out there so when an investor, or better yet an institution, is looking to acquire sizeable position in the stock, they will inevitably have to pay up. The opposite is also true when you have a large seller, but that can create good opportunities to get in the stock. 

In conclusion, the share structure can tell you a lot about how the company has been run in the past and how conscientious of shareholders management really is despite suggesting otherwise. As we know, past performance is generally a good indicator of future performance in many cases.

Feel free to use the comments section below to ask any questions relating to share structure.