Because having a liquid trading market is a key variable in the cost-of-capital equation, many private companies use this as an important justifi cation to go public. The more liquid a company’s securities, the more likely the com- pany seeking fi nancing will be able to obtain it on favorable terms. Hence, generating interest in a newly public company’s stock is important, but should be done with a goal toward building long-term market support.
There is some truth to the notion that post–reverse merger companies face a challenge in developing a trading market for their stock. Many of the reasons for this are discussed below along with ways in which to offset these challenges and in some cases, understand why certain challenges should be of little long-term concern.
Limited Float
Very often post–reverse merger companies have very few shares available to trade. (The number of tradable shares is called the “public fl oat.”) Im- mediately after the merger, almost all the shares are held by the owners of the formerly private company—call these “owner’s shares.” At least initially, none of these shares can trade. Thus, the trading market is at fi rst limited to those shareholders who held free-trading shares in the shell prior to the merger.
In most transactions, some of the owner’s shares are registered with the SEC almost immediately after the merger so that they are available to trade. Some of those shares will be contractually locked up for various rea- sons and not available to trade immediately, but the rest will be released to help build the public fl oat. Nevertheless, the fact is that trading in shares of a shell whose stock was trading before the merger is very limited imme- diately after the merger. And even after any owner’s shares are registered, they are not released into the market that quickly.
The situation is more pronounced (though, ultimately, equally unim- portant) following a merger with a nontrading shell. As we will discuss, the immediate trading market after a merger is not really relevant long- term. But the perception is that the lack of trading following a merger with a nontrading shell is a negative to those seeking to go public.
Concentration of Control of the Float
Even if there are a fair number of shares in the shell’s trading fl oat, typi- cally one person or small group controls a large majority of that fl oat.
Source: TKTK
Usually, this is the individual or group which either purchased the shell previously, or which controlled the former public operating business that is no longer inhabited in the shell.
Even though their shares are free trading, those former control share- holders generally do not seek to sell immediately after a merger. This is because, with a limited fl oat, even a small sale could cause the stock price to drop, hurting the ability for that large holder to sell more shares.
Thus, these holders of large blocks of free-trading shares often wait until owner’s shares are registered and trading and, in turn, daily volume has increased. This dramatically reduces the number of “actual” free- trading shares available for immediate activity following a reverse merger or similar event.
Weak Analyst Coverage of Penny Stocks
Larger investors, such as hedge funds and institutions who regularly in- vest trillions of dollars in public companies, most often rely on market research delivered by major research and brokerage fi rms in order to make investment decisions. Typically, no research is available on a company completing a reverse merger because analysts who prepare the research usually are not interested in smaller companies or those trading on the OTC Bulletin Board or Pink Sheets. Some analysts will prepare a report for a fee, but that fee—and the confl ict it creates—must be disclosed.
This makes an issuer-sponsored research report of limited value to larger institutional investors.
In addition, institutional investors must often restrict their investment choices to stocks trading above a certain price, listed on a certain stock exchange, or trading in a certain volume. The point of these restrictions is to prevent the investor from taking a position in a penny stock. Many brokerage fi rms also prohibit their retail stockbrokers from actively pro- moting inexpensive stocks or stocks trading on the OTC Bulletin Board, further limiting the stock’s exposure to the investment community. Since most post–reverse merger companies’ stock trades on the OTC Bulle- tin Board, not a higher exchange such as Nasdaq or the American Stock Exchange, interest from both large Wall Street fi rms and retail investors is clearly limited.
Minimal Support from Market Makers
On the OTC Bulletin Board, a brokerage fi rm serves as market maker, creating an active market for buying and selling a particular stock. That market maker does have an interest in having its clients purchase the stock, but if a market maker is active in hundreds of stocks, it is sometimes dif- fi cult for any one to get the attention it may deserve.
Source: TKTK
In addition, there are fewer and fewer market makers involved in more and more OTC Bulletin Board stocks than in the past. This is because of regulatory changes that have made it less profi table for market makers to be involved with the activity as a stand-alone business. Again, this makes it more diffi cult to get the market maker’s attention for an individual stock, even one that deserves such attention.
Short Selling Pressure
One investment tactic that doesn’t win much favor with public companies is to bet that a stock will go down by “shorting” the stock. In a typical short sale, an investor will borrow a stock from its brokerage fi rm and resell it with the intention of buying it back after the price drops and returning it to the broker. The difference between the price at which the investor sold it and the price at which he or she bought it back is the investor’s profi t.
This technique has many valid uses, such as when an investor wants to send a message of dissatisfaction with management, or determines that a stock likely will go down in the short term.
Unfortunately, in thinly traded stocks such as those of post–reverse merger companies, it is not uncommon for the stock to suddenly take a nose dive because of the actions of one or a few short sellers. The problem with short sellers is that their very presence often sends the stock down, as the broader market may perceive these investors to be knowledgeable, thus causing other investors to fl ee.
In some cases, short sellers do not believe the stock will go down on its own; they cause it to go down so that their bet will pay off. By aggressively shorting thinly traded stocks, they can force the market to react, causing the very result they were betting on. It may have absolutely nothing to do with the merits of the company or anyone’s particular view of the future performance of the stock. It’s stock manipulation, plain and simple. When short selling is used for purposes of manipulating the market, it’s illegal, but tracking both who is shorting and what their true intentions are is very diffi cult. The history of successful legal prosecution in this area is minimal and this has encouraged continued manipulative behavior.
Just to add some perspective to this discussion, it’s important to note that the bad guys are not just manipulating thinly traded stocks. Are bad guys manipulating larger cap stocks? Yes. Are bad guys manipulating IPO stocks? Yes. Enough perspective?
Thin Trading Reduces Ability to Raise Money Versus Active Trading Since a major benefi t of being public is gaining easier access to capital, one correctly assumes that a company with a heavily traded stock has a much easier time raising money than a company whose stock trades little. But,
Source: TKTK
keeping in mind the “glass half full or half empty” analysis, one can reason that if one weren’t public, one’s access to capital would be signifi cantly less.
By being public, even thinly traded, a company’s ability to raise money is still much better than if it was not public.