Private placements — good, bad or neutral?

Private Placements can either be good or bad for a stock.

Companies often need a rush of new money for many purposes. Maybe they aren’t earning enough to meet expenses, or maybe they need a big chunk of money quickly to buy new assets or repair or enlarge existing assets to continue growing and increasing their profits.

Also, there may be various reasons that prevent a company from going to a lending institution to borrow money. For example, if the business is not a steady earner or if there are variations in the business cycle, it may be impossible to meet the fixed repayment terms imposed by banks or other lending institutions.

These conditions make many companies turn to private placements as a fast source of immediate cash.

Is this harmful to ordinary shareholders? In many ways it is, especially if it’s only to increase the company’s cash in the bank for the purpose of paying ongoing expenses, regardless of whether business is good or bad. In other words, it’s harmful if the company is being used as a source of revenue in order to sustain the inflated salaries of officers.

How do private placements work? If those running the company need a chunk of money quickly, they will contact others interested in making a fast “protected” profit. How? They will sell them blocks of shares at a much lower price than the going market price of the company’s shares, and also throw in a warrant or a half-warrant to buy future shares, again at a discounted price.

As an example, suppose the market price of the stock is 30 a share. The company will offer 5 million shares in 100,000-share blocks at 20 each, or 10 below the current market price, and 50,000 warrants to buy further shares at around 20 or more, depending on the future outlook.

The buyers, interested principally in making money, will sell “short” as many shares as they can. Since their original block of shares is usually not negotiable (tradable) for a year, they will find a firm (usually their own brokerage company) that will let them short the shares for at least a year, or until such time as they can trade, in the market, their original block of private-placement shares.

The stockbroker firm is fully covered since it hangs on to the original “block” share certificate, gets the block of shares from the company, covers the client’s “short” sales, and leaves whatever shares are left in the client’s account for him to dispose of as he pleases.

In the meantime, all the money from the “short” sales is deposited in the client’s account, and since the stockbroker firm is already covered by the original private-placement block stock certificate, the client is allowed to do as he pleases with that money. Remember that the client originally paid 20 a share for his block, so any short sale above 20 counts as profit.

This accumulated profit allows him to sell short as many shares as he wants, even below 20 a share if he only wants to get his original investment back. He can work out his average selling price to come out at 20. This could drive the stock price below 20 a share, and make the price look like a bargain to ordinary investors who believe in the company, even with the increased number of total shares resulting from the private placement.

The original private-placement investor gets all his money back, and even sometimes makes a fast profit, and is also left with a block of warrants to buy further stock in a year or so hence. These warrants were part of the original private-placement deal, and he owns them at absolutely no cost.

When the purpose of a private placement is to inflate the company’s cash position to enable its officers and directors to continue milking the company for their own benefit, many, if not all, of its officers and directors will subscribe for private-placement shares since there is little, if any, risk involved.

Remember also that losses are deductible from profits for income-tax purposes, so any loss incurred from selling shares below an average purchase price can be deducted from any profit made from selling other shares, to arrive at a net profit for income tax purposes.

If the purpose of a private placement is to raise cash to buy other assets and thereby increase the company’s profits, it may be worthwhile. It becomes a question of how big the number of outstanding shares will be, and how much this will reduce the “profit-per-share” number usually referred to in the company’s year-end statement.

It may take a lot more total profit to match or increase the previous year-end profit per share or asset value per share — the two measures generally used to value a company.

Usually this doesn’t happen right away. A year or more of production, including the production from the newly purchased assets, is required before the profit per share value is matched or increased over previous years.

All of which is to say that private placements need to be looked at carefully by anyone thinking of investing in a company. You have to ask yourself a lot of questions before putting your money down, such as:

— Have one or more private placements been made lately, and if so, when?

— How many shares are now outstanding and were outstanding when the last year-end statement was made?

— Have the company’s previous profits increased or decreased according to the number of shares that are or will be out there?

— Is the company still increasing in value?

— How long will it take to show profit increases?

— Am I willing to wait for the share values to increase, or should I think of something better and faster to increase in price?

— Is this a good long-term investment, even if it does not look very good at present?

Potential investors should also look at the existing stock options of management and directors. How are they priced? How many are outstanding, and for how long? What is required to grant new options? Do ordinary shareholders have a say in how these options are doled out?

Many management teams and directors are just running companies for their personal gain and lifestyle, and ordinary shareholders usually don’t enter the picture. Enron was an example. But there are many others, both in the U.S. and Canada, and investors need to take a close look before jumping in.

— The author is a retired stockbroker residing in Ottawa, Ont.