When capital markets are difficult, as the last few years have been for resource companies, alternative financings become an increasingly popular source of capital. It is largely because traditional equity finance has dried up and alternative financings are often readily available. This allows small and mid-cap companies to continue to expand and grow.
Alternative financings are generally considered to be anything other than a plain vanilla share issuance in a placing. It often seems to shareholders and company officers that there are a wide variety of ways to raise capital, however, not all of them are beneficial to the company or to existing shareholders. Occasionally, due to the structure of some alternative financings, they are labelled “financings of last resort”. But not all alternative financings are bad. As you will see, some forms of alternative financings can be used in harmony with companies and their shareholders to fund business growth when the alternative is stagnation.
Alternative financings fall into three basic categories: debt convertible into stock; an arrangement to sell shares in the future; and a placing of shares in conjunction with something else tied to the company’s share price in the future (sometimes called a “placing plus”). An assumption is commonly made that anything other than a straight equity placing is not good for a company and is only used by smaller companies. But large, sophisticated public companies will sometimes utilize selected forms of alternative financing. These large cap companies occasionally use specific alternative financings to achieve desired outcomes in their capital structure that are often very beneficial to existing shareholders. What is needed is a simple way to assess alternative financings so that management teams and shareholders can assess a proposed or completed alternative financing and act accordingly.
When considering the potential impact of an alternative financing there are five main factors to keep in mind to help evaluate a proposal:
- Dilution – is the dilution to existing shareholders fixed and known at the outset;
- Trading volume – is the access to cash limited by trading volume in the company’s stock;
- Investor profile – does the alternative investor act and function like a traditional investor or is it just a trading firm that really doesn’t care about a company’s potential or the investment thesis;
- Transparency – what can be known about any share dispositions of the provider of financing; and
- Financial incentive – how does the provider of the financing make the most money?
Through determining these five key considerations one can easily determine the outcome of an alternative financing in a variety of scenarios and also determine who benefits. Ideally an alternative financing will provide sufficient capital to a company, a fair and reasonable price and with dilution no worse than a plain share issuance.
Dilution is important because it can impact current shareholders. Shares can be issued in ways that are very harmful to existing shareholders and disproportionately transfer value from existing shareholders to the new purchasers. The best alternative financings have a fixed and known quantity of shares issued regardless of any future circumstances or scenarios. When the dilution is not known at the outset of the financing this is usually due to the quantity of shares being issued, being dependent on a yet-to-be-known future market price in a company’s stock.
When it comes time to issue shares, the then-current market price is utilized in determining how many shares are issued to the financing provider. This means that the lower the stock price the more shares the alternative financier receives for the same amount of cash. This can lead to an unfortunate cycle where a company’s price is depressed in anticipation of shares being issued in the alternative financing. This lower price means that an increased amount of shares are issued for the amount of cash the company requires. This increased issuance of shares leads to a lower price and the cycle begins again for the next round of financing. Financings that have this as a component often receive the label of “toxic” or “death spiral”.
Some alternative financings have a limit on the amount of cash a company can access at any one time that is tied to trading volume. The only real reason an alternative financier would demand such a limit is that the financier needs the ability to quickly sell the shares it is purchasing from the company. This is not the hallmark of a true investor but of a trader only concerned about making a quick spread between the issue price and what it can sell the shares for in the market.
This is more of a qualitative assessment than a check the box factor but the presence of some conditions in an alternative financing will contra-indicate investor status such as the presence of a trading volume limit on a company’s access to cash. Does the investor spend time to get to know and understand the company that it is investing in and its potential, or does it just need to know how much cash a company needs and the trading volume? Does it have people knowledgeable and experienced in the resource sector? A company may find a trading outfit as a perfectly acceptable alternative financier, all I am saying is make sure you understand the type of financier you are dealing with.
If an alternative financing is larger than 5% of the outstanding shares then the financier will have to disclose its holdings and will be required to file disclosure of any changes of 1% up or down. Sometimes the structure of the financing is such that even though the total contemplated over the life of the alternative financing is greater than 5% the financier will dispose of shares quickly enough that it never hasto file. This means shares are constantly being sold in the market to complete the financing. The best alternative financings have disclosure on large holdings and disclosure on changes in holdings so the company and other shareholders can understand what a large shareholder is doing.
An old adage states that however one will make the most money is usually how one will act. In today’s financial markets there are innumerable ways to trade, sell, short and hedge a position or investment both on and off an exchange. Restrictions in alternative financings where the financier promises not to short or sell shares or similar restrictions will never be able to contemplate all the ways to accomplish the same economic effect.
So the first question that needs to be answered is why would a company even ask for such a restriction? It usually indicates that the structure of the alternative financing is set up so the financier has a real financial incentive to push the share price as low as possible. If the way someone makes the most money is by having a share price go lower, then a method will usually be found to make that happen even while complying with contractual restrictions that a company thought would protect it.
If a financing structure is set up so the financier is selling shares as quickly as possible and it has a builtin spread between the issue price by the company and the market price, the financier has no incentive to discourage it causing the share price to go lower. All it is concerned with is selling the shares within a certain amount of time. Interestingly, the smaller the spread the greater the incentive to make sure the shares are sold within the allotted time regardless of price because there is less margin for error before the profit is wiped out if the shares are not sold in the allotted time. Some select alternative financings have the financial incentives aligned with the company and the existing shareholders.
You want to make sure that the financier can’t make more money the lower the price goes, that it loses money/value if the share price goes down and it makes the most money if the share price goes up, thus aligning the financor’s interests with the interests of the company.
Now that we have some tools to evaluate alternative financings we will take a look at specific types and structures and determine how they fare using the five factors outlined above.
Debt Convertible into Stock
Convertible bonds are used by even the largest companies. The idea of a traditional convertible bond is that the conversion is set at a premium to the market and the interest rate is usually slightly lower than straight debt. The conversion price is fixed and the impact on the conversion of the bonds is known and can be factored into financial models.
The advantage for the issuing company is that it is raising money at an interest rate below that of straight debt combined with an expectation of a rising share price, which will trigger conversion of the bonds into stock and thus retiring the debt. The investor in the convertible bond is usually earning a higher rate than the dividend yield on the stock and if the stock price declines the bond value will underpin the market price of the bond and the bond can be held to maturity if the stock is below the conversion price.
A version of the convertible bond that can cause problems for a company is when the conversion price is not fixed. One example would be a conversion at the lower of preset conversion price or the market price of the stock at the time of conversion. This potentially could lead to unlimited dilution.
Another version is a plain bond with warrants. If the warrants have a variable conversion price or resetting conversion price then this can also lead to potentially unlimited dilution. A third version is straight debt that can be paid off at the company’s option with shares. While appearing more benign than a convertible, the reality is that for a company that is pre-cashflow or that cash flow will not generate sufficient cash in time to pay off the debt, the net effect can be potentially unlimited dilution.
Arrangement for Future Sale of Shares
This type of alternative financing has gone by a number of names such as equity line, standby equity facility and SEDA (standby equity distribution agreement). Usually announced as an arrangement for a very large dollar amount, the cash actually received by the company is a function of the stock trading volume in the future. The price the shares are issued at is usually at a discount to the current market price of the stock. The company notifies the facility provider and, subject to the trading volume constraints, the facility provider will then purchase shares, typically at a discount to the market price over several days. The facility provider usually sells all the shares within the specified period and often will make more money the lower the market price. If the trading volume is not sufficient then the company may not be able to access any cash at all.
I am not aware of any large cap companies entering into anything even remotely similar to this type of alternative finance. Given that the facility provider sells shares as quickly as possible, no disclosure is made other than the company announcing the share issuance each time the facility is used to access cash.
One version of this that has dropped in popularity is issuance of shares coupled with a large amount of warrants. As markets have matured, the value of warrants has come to be generally recognized as the issuance of massive amounts of warrants in conjunction with a placing as a wealth transfer from existing shareholders to new shareholders. Large cap companies will often use
a variety of instruments in the capital formation process. The use of options, puts, equity swaps and interest rate swaps is well documented by some of the largest.
Our firm, Lanstead, combines an investment in equity with a sharing agreement with the issuer. The sharing agreement makes it possible for a company to receive additional cash as the stock price appreciates above a pre-agreed benchmark in return for giving the investor some limited downside protection – all without issuing any additional shares beyond the initial closing. The quantity of shares we receive is fixed and disclosed within the placing announcement.
There is not a scenario where we can receive additional shares because of a reduction in share price or for any other reason. As we are investors, not a facility provider, we are not concerned about share trading volume now or in the future. There is no reference to share trading volume in any of our documentation. Our key people all come from traditional institutional investor backgrounds such as private equity, fund management, family offices and investment banking. We have invested extensively in resource stocks and some of our people even have significant ownership in privately held explorers.
Our typical holding period is several years and our investments are usually large enough that we disclose not only the initial investment but any changes up or down 1% so share activity is transparent. There is also not a way for us to make more money with a decline in share price. Like other shareholders we make the most money by having the shares appreciate as much as possible.
While there are a variety of alternative financings available to companies, not all financings are created equally. As discussed above, there are five factors that are helpful in assessing an alternative financing. By looking carefully at an alternative financing company, management and shareholders can make an informed evaluation of the likely outcome, the pros and cons as well as the impact on existing shareholders.
This article was original published by RESOURCESTOCKS, March 2014.