Winning Against the Broken Capital Markets Machine

James West
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If you’re an investor in small cap startups or early stage resource stocks or cannabis tech or AI or crypto currency or medical devices or robotics or athletic products or anything really except the FAANG (Facebook, Amazon, Apple, Netflix or Google) stocks, you are probably continuously licking your wounds as these stocks get pummelled by short sellers, High Frequency Trading scalpers, and promoters’ cheap shares.

There was a time when the market for capital was a vastly simpler place where everyone could understand the concept of investment and return. But the market structure has  become like a hive or wasps, with many present whose sole role in the entire enterprise is to suck the lifeblood out of its peers, only to at some point become the next victim.

Here are the main defects of capital markets that have ruined investors’ chances of a positive (profitable)  experience:

1. The Dirty Layer
There are successive layers of intermediaries who purport to offer some valuable function to issuers or investors, but whose value is non-existent, or negligible, relative to their “take” from the market. Case in point: Numerous publishers offer issuers access to investors through “check swaps” whereby the publisher writes a cheque to the issuer as an “investor” and the issuer writes a cheque in the same amount back to the publisher as a “customer”. This creates a zero-cost share for the publisher, which incentivizes them to exit the position into the investor interest they create through publishing activities. This puts this class of investor in a discounted advantage position ahead of the normal cash investor.

2. The Investment Banking Layer
Investment bankers receive broker warrants and agency fees for raising capital from their inventory of accounts. They are thus incentivized to provide the service of raising capital for issuers. The problem is the obligation is to only hold the stock for 4 months plus one day in most cases. Pros have the ability to short their position up to 10 days before the hold expires. Most investment bankers blow out the share as soon as possible to recycle the capital for new deals and new fees.

3. The Short Seller Layer
Short sellers know that, post financing, there is going to be a flood of shares hitting the market with the expiry of the hold period, so they aggressively short these companies (driving the price lower by selling shares they don’t own), knowing they will buy back the shares when the selling begins at the end of the hold period.

4. The Insider Layer
Then there is the large shareholders who wrote the initial cheques for the company’s startup. Usually, they have acquired millions of shares for pennies per share, and are a constant downward pressure on the stock price because they have a wayyyyyy lower cost per share than every other investors.

5. The Options Racket
Options often create continuous downward pressure on share prices when company employees and management can sell shares for no advanced cost. They pay the strike price from proceeds of the sale of the option.

6. The Poor Mope Retail Bag-holder Layer
Finally, way down here in 6th position, is where the retail shareholder waits for extraordinary company achievements that might cause the public market for the company shares to absorb all of the above mentioned selling, and still deliver a higher exit price than the poor retail joe paid. That happens about 2 percent of the time, if at all.

The noble concepts of enterprise being funded by investors who would patiently wait for their invested capital to become more valuable through its application to business are laughable in today’s day and age. Or is it?

The JOBS Act of 2012 (Jumpstart Our Business Startups Act) ushered in a series of new rules for startup companies (those with less than a $billion in revenue) that incrementally eased the ability of entrepreneurs to access capital from non-accredited investors. Since October 2015, those rules include the ability for small companies to raise up to $50 million each year through advertising to non-accredited investors who can invest up to $2,500 if they earn less than $100,000 per year, or $10,000 if they earn above $100k per year.

The issuer must still register with the SEC and provide audited financial statements and communications with the shareholders. But there is no obligation to become publicly traded.

In other words, items 1 – 6 above are not part of the mix, because there is no public market to sell shares into. This obviously doesn’t guarantee the success of the investment. The shareholder will be able to exit the investment on a secondary private company exchange, of which there are 22 in the United States in various stages of development. (None in Canada yet, but one is in the formation process.)

This relatively new private company funding methodology is the silver bullet for the corroded burnt out hulk of the capital markets ecosystem. As ever, quality of management and their ability to execute will be the key to success. But at least there won’t be layer upon layer of predatory intermediaries waiting to cream off their cut in front of the investors who put in real money.

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James West

James West

Editor and Publisher

James West founded Midas Letter in 2008 and has since been covering the best of Canadian and US small cap companies. He covers global economics, monetary policy, geopolitical evolution, political corruption, commodities, cannabis and cryptocurrencies. As an active market participant, James is not a journalist and is invariably discussing markets...
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