I’ve heard of startups going public with penny stocks. Is this a good way to raise money? What is the downside? Should I spend my time looking into this?
by Ethan Stone, Stone Business Law
First, a quick but important clarification: I’m not your lawyer and this answer doesn’t establish a lawyer-client relationship. I’m giving a generic answer to a generic question to educate the users of this site. The information below is general in nature and should not be understood as a substitute for personal legal advice.
The quick answer is “no.” I’ll elaborate, but it’s worth emphasizing first that the world of “penny stocks” is, generally speaking, disreputable. There are exceptions. I don’t mean to disparage any company with a low stock price. But the reputation is well known and, by and large, well deserved. So an entrepreneur going this route should bear in mind that informed people will assume the enterprise is shady. I’ll try to explain below some of the reasons that this tends to be true.
So why don’t reputable companies raise capital this way?
It’s Very Difficult, Time-Consuming and Expensive
When people say that a company is “public,” they usually mean that it has registered some class of securities with the SEC under the Securities Act of 1933 and assumed reporting obligations under the Securities Exchange Act of 1934. Registration is the only way a company can sell securities to the public at large and allow their unrestricted resale on a secondary market. To register securities, the company must prepare a “registration statement” (an elaborate set of disclosures). As a practical matter, a registration statement does not become “effective” until the SEC is satisfied that the company has addressed any concerns it raises on review. After the company registers its securities, it must generally make periodic disclosure filings with the SEC, such as quarterly and annual reports. All of this is subject to intricate written and unwritten rules. Compliance requires significant effort and expertise. So registering securities publicly means devoting a lot of time and money to compliance and disclosure, both before the offering and on an ongoing basis. For small amounts of capital, this time and expense is almost never justified . . . for people who take compliance responsibilities seriously. Shady operators and their advisers are often less troubled by the niceties of legal compliance.
It Only Helps if the Company Is Selling to Unsophisticated Investors.
There are a number of exemptions to the general requirement to register securities. The most versatile and commonly used exemption is under Rule 506 of the SEC’s Regulation D which, generally speaking, allows a company to offer and sell securities to “accredited investors” with a minimum of regulatory burden. “Accredited investors” are, summarizing again, institutional investors and individuals meeting certain income or asset thresholds. There are other exemptions for offering that do not meet the criteria or Rule 506, but they are more restrictive. None of the exemptions allows a broad-based offering to the public.
So the advantage of registering is that it allows the company to offer and sell its securities to a broad swathe of unsophisticated investors. Honest entrepreneurs looking for capital to build a company aren’t normally interested in this prospect. They do not want a constantly shifting shareholder base of people who presumptively had no idea what they were doing and very little understanding of the business when they invested. If things don’t go perfectly, these investors will not support the company; they will sue for fraud or, worse yet, try to get the SEC to do so. Even if things go well, dealing with them will take time and money an entrepreneur can’t spare. Again, shady promoters are much less concerned about this problem.
Bear in mind that good angel and VC investors are not only much less trouble than unsophisticated investors (bad ones can be a serious burden), they also add value by giving the company the benefit of their reputation, experience and contacts.
What About Liquidity?
In theory, registered securities are much more “liquid” than unregistered securities, since they can be legally bought and sold on the secondary market with almost no restrictions. Securities purchased under an exemption from registration are generally subject to significant resale restrictions. The practical reality is more complicated.
Registering securities does not, in itself, create a liquid market for them. For that, the company must list the securities on an exchange or other securities trading platform, get securities analyst coverage, and get the securities distributed fairly broadly. Without those additional steps, there won’t be the constant dealer quotations and buyer and seller interest that allow securities to be traded quickly and easily at a price that reflects the collective judgment of an efficient market (for whatever that’s worth). By contrast, there are now fairly good mechanisms, such as Sharespost (http://www.sharespost.com/), to buy and sell unregistered securities in which there is significant interest.
Sophisticated investors know this, so they won’t attach much value to the fact that a company is offering registered securities if there’s no prospect of a liquid market. That leaves unsophisticated people who will be disappointed and angry when they discover what they’ve purchased. Once again, the prospect of duping unsophisticated investors isn’t troubling to shady operators.
What About Public “Shells”?
All of the above applies to both new companies issuing securities for the first time and companies that merge with so-called “shell” companies that are public but dormant. If a company is going public anyway, merging with a shell can sometimes save some time and money, but it doesn’t change the overall regulatory burden.
So I’m sorry to say it, but selling penny stocks isn’t a secret source of quick and easy funding for startups. That said, there are often good alternatives to angel and VC funding. I have discussed some of them here: http://www.foundersspace.com/open/?mingleforumaction=viewtopic&t=43.0.