By Charles Roques
Creation myths, fables and parables are part of most if not all cultures. Many grew from real events, becoming embellished through the ages. Some are unique to their culture but many are also shared because of their universality. A common one is about a curse or debt being passed through generations because of past wrongdoing. The “sins of the fathers” still resonates with inequity and outrage. It has become one of our cautionary tales about the repercussions of retribution, affecting innocent people who are only distantly connected with the actual circumstances.
When new companies are forming, funding can be very difficult, especially in the penny-stock sector. Angel financing from an affluent individual or small group is one way money can be raised to help them get started. In a sense they are the financial founding fathers of a company; however, in this unsettled sector, some of these angel financiers could be the devil in disguise.
Notwithstanding pump-and-dump scams where only the insiders profit, even legitimate companies may have to resort to some toxic financing arrangements to get started. Startups may have to agree to unreasonable terms, including high interest rates or convertible notes. If these startups are cannabis companies, it can be even more difficult. This might be an unfortunate choice, but it might also be an unavoidable one.
As the company grows it may need more cash and one way to do this is by increasing the share count. This is not unusual nor bad financing if the company is truly growing. But it is not good if the share count is increased only to pay off previously incurred debt. In the best of worlds, the new company would generate enough revenue to pay down these formative debts. But more often the opposite is true if the share price falls. Then the companies have to resort to increasing the share count to attract more investors to repay them. This potential increase in funds may not actually benefit the company. Even worse, it may only benefit insiders. Without revenues, this can sometimes trigger an irreversible downward spiral, with the repercussions too often passing on to the unaware individual shareholder.
This information may not be available to the average investor but there are some red flags that can indicate possible toxic financing. One is extreme changes in the stock ticker within a very short period. If a past debt holder sees a place to sell and decides to unload a disproportionate number of shares, it would be seen on the chart as an extreme drop; likewise, when the share count is suddenly increased, there could be an equal spike in the price. These stocks are already volatile so it can be difficult to discern this activity as abnormal. Don’t simply be suspicious of negative changes while welcoming the positive ones. It is always good to see the share price rise but that can be a smokescreen as well. Be wary of increases in the authorized share count without signs of revenue or growth.
As an investor in a new company via the purchase of shares on the OTC market, you have little to do with the original financing of the company; however, this doesn’t mean that the toxic financial arrangements won’t eventually affect you. Even if they remain hidden, their effects can reverberate out to the individual shareholders.
Shareholders may buy into a company based on many factors, but paying off an old debt to one of the founding fathers is probably not one of them. Hopefully, shareholders know what they are buying, but this sector’s lack of transparency does not allow easy access to company family history. In this sector any stock could have skeletons in the closet, but some have more than others. You may not be able to avoid a few, but you don’t want them reappearing to haunt you.
Raising more shares to pay maturing debt is like the “sins of the fathers” being passed on to the shareholders; it shouldn’t be the responsibility of shareholders, but they could end up paying for it. The consequences may not be biblical in proportion, but that depends on how much you have invested. If you inherit the sins of these company ancestors, you could still lose a lot; and to make matters worse, you often don’t even know who these ancestors are.