To understand this investment environment the reader must first understand the corporate legal structure, the growth cycle of business; the different exchanges and their corresponding rules, and the overall risk scenario. The following sections explain these basic penny stock fundamentals. Read them prior to risking any hard earned money.
- 1 Corporate Legal Structure
- 2 Business Life Cycle
- 3 Stock Markets
- 4 Risk
- 5 Investment Requires Sophistication and Patience
Corporate Legal Structure
There are several different legal structures for a business. The most comprehensive legal status is the ability to exist as a corporation. The state of residence grants this privilege to an investment group (can be as little as one individual). The investors own a position (a part) in the business by purchasing shares.
Each year the company must renew its entity status with the state by filing notices of renewal and of course paying a fee. each state is different in their requirements but the essential documentation is as follows:
1) A granted legal name and address
2) Notice of filing agent (person to contact in regard to issues)
3) Board of Directors
4) List of Corporate Officers
5) A journal or resolutions
To financially start and fund growth the company is allowed to sell shares of stock. Initially shares are sold to family and friends giving the identity of a ‘Closely Held’ business.
In the early stages of development the price paid per share is primarily determined by the majority owner. This price rarely has any fundamental relationship to the financial status of the business. Since growth of any sort in business requires expansion of equity more shares are sold.
Business Life Cycle
Just like a baby grows up to be an adult, a business grows too. A child outgrows its toys, clothing and needs. A business outgrows its equipment, office space and management team. At some point a huge investment is needed to set the long-term course for the business. In life we call this college. In business this significant investment in growth can no longer be funded by the closely held owners. The business must seek funding from other sources.
Most businesses utilize the angel investor network or venture capitalists to fund this important step in maturation. Naturally the investment capitalists are merely a temporary step as they desire their money back with a reward. This is accomplished by transitioning the ownership from privately held status to a publically owned business. The company is ready to transition to the stock market.
The stock markets are governed by the Securities and Exchange Commission (SEC). In addition each market has its own set of rules and minimum requirements to join. The following is a list of the respective markets and some of their minimum standards to participate. Penny stocks exist in all of them but it doesn’t necessarily make that business a sound investment.
New York Stock Exchange
Without a doubt this exchange has the greatest amount of equity investment in the world. It is one of the oldest exchanges and the most prestigious too. Their requirements for membership are demanding and difficult for penny stock companies to comply. One of the requirements is a minimum share price of $1.00. Membership fees are expensive and compliance is costly. It is rare to find penny stock companies trading on this exchange, most that are trading were robust at one point and are having difficulties maintaining their status on this exchange.
American Stock Exchange
This exchange is where investors find better quality penny stocks. This exchange has high standards of conduct requiring minimum share trading volume, a threshold of unique investors, minimum capitalization and reporting standards. For penny stock companies this is the big league for play.
To assist the reader in understanding penny stocks, the following are the definitions of the various capitalization levels.
Market capitalization is simply the numbers of share outstanding (held by investors) times the market price. So a share trading at $70 each with 70,000,000 shares means the capitalization value is $490 million. So companies are grouped by their capitalization value and assigned a category.
Category Value Examples
Large Caps > $5 Billion Wal-Mart, Exxon-Mobile, GE
Mid Caps > $500 Million < $5 Billion Large Shipyards, Kraft Foods, Airlines
Small Caps > $50 Million < $500 Million Technology, Manufacturing
Penny Stocks < $50 Million
NASDAQ refers to the National Association of Securities Dealers Automated Quotations. This market exchange has a wide variety of all the various levels of capitalization identified above. The requirements are still strict but the costs of membership are significantly less than the two upper exchanges. The bulk of good penny stocks are found on this exchange.
This exchange actually uses tiers or levels of trading and there are minimum share prices for trading to maintain status on that tier. For those penny stocks unable to maintain these minimums, NASDAQ requires the company to participate in its over the counter exchange.
Over the Counter (Bulletin Board)
This is the most common exchange used by penny stocks. It still has minimum requirements to participate and most companies can easily meet the tests.
As stated above it is owned by NASDAQ and all participants must still comply with the federal regulations. The problem here is that often people confuse this exchange with the simple over the counter trading.
Over the Counter Trading
These types of shares are traditionally publicly offered by significant ongoing businesses but restrict their activity to within state boundaries so as not to violate federal law or regulations. Usually only those with money receive a prospectus relating to a stock offering for over the counter shares.
This is a common tool when small local banks start-up or desire to expand in neighboring districts.
The most important issue of penny stocks for an investor to understand and appreciate is the greater risk associated with this type of investment. Unlike well established operations, risk with penny stocks exist in every aspect of business.
Almost all penny stocks trading on the market trade for young inexperienced companies. Unlike the large caps at the other end of the market capitalization spectrum, penny stock companies have younger and immature management, lack of history and a product or service that may not hold favor with the consumer. The best comparison is David and Goliath. Unlike the biblical result, Goliath almost always wins in business.
Lower Reporting Standards
Mid caps and large caps have extensive legal and accounting professionals to ensure the highest level of compliance reporting as required by the two bigger exchanges and the federal government. Penny stock companies lack this professional depth due to cost and inexperience. Therefore the quality of information streaming out to investors from penny stock companies leaves a lot to be desired by potential and existing investors. This lack of information creates a heightened sense of distrust and greater extreme reactions to any set of news. These lower reporting fundamentals add to greater volatility in share price.
Low Trading Volume
One of the many drawbacks of penny stocks is the low volume of trading and number of unique shareholders. This lower volume makes the stock susceptible to price manipulation. This includes pump-and-dump schemes. The core problem is that low quality companies trade in lower standard exchanges. These exchanges don’t require extensive reporting compliance plus federal regulators are more likely to ignore illegal activity or problems because the SEC is overwhelmed with issues in the larger markets.
Stock Price Volatility
Because there is low volume and limited number of investors any news about the company creates unreasonable reactions from the investors. The price per share swings can reach 20% frequently causing heartache for investors.
One the most troublesome aspects of any new business is protecting your rights especially legal ownership such as patents and copyrights. Lawsuits abound at this level most often preventing the company from gaining a foothold with market share. Several lawsuits can cost millions of dollars wiping out young companies.
Investment Requires Sophistication and Patience
If you are looking for a quick buck, penny stocks is not the best course of action. To be honest I have yet to see a legitimate get rich quick scheme that works.
So if you desire to invest in penny stocks, read, read and read some more. Get sophisticated in a particular industry, learn how to read financial statements [link to article – How to Read Financial Statements] and have patience. It took Warren Buffet more than 30 years to become a billionaire and that was with regular stocks. This site provides the basic business principles used by business; so read, read and read some more. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.