One interesting thing I see younger growth companies dealing with is trying to raise capital for their business but being constrained by their small market cap. When I say small, I’m thinking about it relative to the amount of capital they are looking to raise.
For example, this would apply to companies that have a $5 million market cap and are looking to raise $10 million as opposed to a company with a $100 million market cap looking to raise $15 million. There a few reasons why trying to raise a substantial amount of capital with a low market cap is considered difficult:
- Investor’s Ownership Limitation: One key roadblock is that most investors in the micro and small cap arena aren’t willing to purchase over 9.99% of a company as they wouldn’t want to be deemed as an affiliate (an individual or entity that owns over 10% of a public company). As an affiliate you are restricted by the amount of shares you are able to sell, which is constrained at 1% of the total outstanding shares during any three-month period or, if you’re exchange listed, the greater of 1% or the average weekly trading volume during the four weeks preceding a notice of sale on Form 144. Obviously an investor wouldn’t want to be in this position as they are restrained on their ability to liquidate in both a bull and bear market. So, for example, a company with a $2 million market cap will only be able to sell $200K worth of equity to a single investor. Most of the time, $200K is a great sum of capital but it is generally not enough to fund the growth smaller companies are trying to pursue. Therefore, companies with a smaller market cap are much more limited in the number of investors they can sell equity to before losing majority ownership of their own company.
- Highly Dilutive Equity: Raising equity for a substantial sum that is over 20% of the market value of your company is always a highly dilutive form of raising money. I’ve seen situations where a company with a $2.5 million market cap raised $4 million of equity at a ~$2 million valuation. Yes, you read that correctly. In that instance, not only did they raise almost double the amount they are publicly worth, but they also raised it at a fairly substantial discount to where they were trading at the time. Ask yourself this question, if you were a shareholder in that company how would you feel regarding that raise? Nine out of ten times, all support from true shareholders are lost due to the amount of dilution they’ve experienced with their holdings. While this is an extreme example, it shows how raising substantial equity capital with a small public valuation can wipe away a majority of a shareholder's ownership, which even includes management’s ownership as well.
After seeing what makes raising capital with a small market cap so difficult, let’s explore some solutions to this problem that plagues micro cap companies.
- Convertible Securities: In my opinion, utilizing a form of convertible debt or preferred is the best solution for situations like these. A convertible security allows a company to raise capital in the form of debt or preferred, which is not dilutive until later on, therefore forgoing the ownership limitation and concerns regarding dilution I previously mentioned. You can also set the conversion price at a fixed price, place selling restrictions, and issue it under Rule 144 for further protection on the dilution as this will give you a certain runway for making company improvements and letting the market cap recover before investors fully convert out. A convertible security is also beneficial for an investor as it provides them with lower volatility, fixed interest payments, and the ability to partake in the company’s equity upside once the market cap begins to recover.
- Traditional Loan: If you are a company that has revenue and some cash flow, or a path to cash flow, it could be a good idea to explore your options in terms of a traditional term loan or revolver. This is completely non-dilutive capital, which can act as a great bridge in the meantime as you work your way to a higher valuation and can go out to do a large equity raise. These types of loans will not work for pre-revenue, high R&D companies or companies with minimal revenue in the pipeline.
While there are more alternatives out there and various ways to get creative with your capital raise, I believe convertible securities and traditional loans are the best tools to raise the money you are looking for even with a small public valuation.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.