Much like a government can print bills, diluting the value of the bills in your purse, so can owners-managers in public companies print shares and dilute your stake.
Let’s see how this takes in practice:
Joe Romanoff, the CEO of Tisco Corp, is engaged in a speculative biotech research. Although he has some meager funds coming in from various sources, they are really remote from his needs.
Romanoff took control over the company by buying large stock in it and pays himself about half a million dollars per annum, and his staff another half million. For Romanoff, his salary is the return on his investment, unlike other shareholders.
Romanoff tries to develop a cure for some really horrible disease using new approaches. But many problems arise, causing the research to be delayed and the money is running out.
Romanoff’s last resort to keep the company lights on and by that still get his fat check coming in, he has to sell shares.
Romanoff reaches out to Sharks Capital Inc., which is run by Fred. Fred is a lender of last resort for public companies, and he does so for a profit.
Fred proposes to Romanoff the following deal: Fred will pay Romanoff half a million dollars for half a million stocks, priced only $1 per share well below market prices, which is $2.3.
Romanoff has no other way to get the money and approves the deal.
The day the deal is inked and published, Fred orders his stockbroker to dump all the Tisco Corp. stocks he bought immediately. The trade fills gradually, and the stock price obviously drops like a stone into a well.
Romanoff is happy with his additional half a million dollars. Now there is funding to pay salaries and expenses for himself and his buddies, but the stock that is being abused hits penny ranges.
So, what sort of actionable lessons do we have, and how should we act?
1. Investors should always keep a keen eye on share count and dilution, which, in the startup and exploration or development stage of companies tell the story of financial management.
2. Investors should always closely inspect how much share equity the managers running the company hold. In our example, Mr. Romanoff barely holds any of the share equity, which is worth much less than what he makes in one year running the company.
3. Don’t buy stocks. Buy Great Companies led by Committed Great Managers. Don’t feed Romanoff with your hard-earned money.