Ever wish you could “turn back time” and buy a publicly traded stock when shares were cheaper?
Even better, instead of paying full price buying shares through your broker…
What if you could negotiate a deal directly with the company to buy discounted shares today… and lock in a “sweetheart” deal that would let you buy more shares at a discount, whenever you wanted?
If that sounds like some sort of sneaky “backdoor” deal only Wall Street insiders could make, you’re right, it is.
I call it the Wall Street Double Dip.
In today’s email, I’m going to reveal the secret behind one of the most lucrative deal structures in the capital markets…
And how retail investors can take advantage of an investment strategy normally reserved for institutional investors and insiders.
-Jake Hoffberg
P.S. Equifund just launched its latest Regulation A+ offering for an already-publicly-traded gold royalty and streaming company.
As a reminder, securities sold under Reg CF, Reg A, Reg A+, and Reg D are often considered high risk, and speculative in nature. Please do not invest funds you cannot afford to lose, or otherwise need immediate access to the invested capital.
How Public Companies Raise Money
Here at Private Capital Insider, we focus a lot of our investor education on the ins and outs of investing in private equity, private credit, and real estate.
But here’s the thing you must understand about investing…
As an investor, you are not “investing in a company” per se; instead, what you are doing is purchasing a financial product – called a Security – that comes with certain features.
For example, when a company is looking to raise capital, it can sell:
- Equity Securities (or “Stock”) gives shareholders the potential for capital gains and dividends. Owning equity may also give shareholders the right to vote on corporate actions and elections for the board of directors
- Debt Securities (or “Bonds”) require the borrower to repay the principal, plus interest, over a certain period of time
- Hybrid Securities – like convertible notes – give investors a combination of debt and equity features
As investors, this means we are – quite literally – in the money business. And just like any commodities-based business, our business model is to buy low, sell high, and collect a profit.
However, instead of buying and selling physical products, we buy and sell “paper” called securities – which at one point, were literal pieces of paper, but today are almost entirely digital.
As buyers and sellers of paper, this means we need to have an understanding of how this paper is priced.
Generally speaking, there are two ways to determine the value of any asset…
- Appraisal – An “expert” examines the asset in question and assigns a price to it, based on some combination of factors deemed relevant (a model-driven pricing mechanism)
- Auction – The price of the asset is decided purely by supply and demand (a market-driven pricing mechanism)
In private markets, companies can raise money under any of several exemptions (like Reg D, Reg A, and Reg CF).
In these situations, the price of the securities being sold is determined by the company raising money (called an “Issuer”).
If the company decides to become a public company, it can raise funds through an Initial Public Offering (or “IPO”).
In this situation, oftentimes what happens is the Issuer works with an Underwriter – typically an investment bank – who will determine the initial offering price of the securities, buy the securities from the Issuer, and sell the securities to investors via the underwriter’s distribution network.
But once the company is public – and shares are being traded on a real-time basis – now it is the market that decides what the company is worth.
And depending on a lot of factors, this can have a positive or negative impact on the Issuer’s ability to raise more money.
Here’s why…
Unlike in the private markets where investors are willing to buy shares that can’t easily be traded…
Once a company goes public, its fundraising efforts are almost entirely dependent on both the current stock price… and how many shares trade per day (known as “trading volume”).
Why? Because, in order to exit your position, someone has to buy your shares at the price you’re selling, in the quantity you wish to sell, and in the timeframe in which you wish to sell them.
This is called the Bid-Ask Spread.
Stocks that have low trading volume (aka “Thinly Traded Stocks”) tend to have wider bid-ask spreads than stocks with higher trading volume.
The wider the spread, the more expensive the transaction costs become when trying to enter – and later exit – a trade… especially for larger investments.
Researchers have found that this illiquidity of small company public stocks – sometimes called penny stocks – has driven large investment funds away from them since the late 1990s.
So where do these small- and mid-sized companies turn for financing?
In 1985, Stroock & Stroock & Lavan LLP created a financing strategy called Private Investment in Public Equity (PIPE).
This form of a privately negotiated capital raise is often undertaken at a time when an Issuer’s shares are undervalued…
Or when it encounters short-term liquidity issues, including when conventional financing sources may not be readily available.
Originally invented to address the particular set of circumstances all too common for biotech companies – namely, they are often thinly traded and highly volatile…
In PlPE financings, a fixed number of securities are sold at a fixed price, not subject to market price or fluctuating ratios, to accredited institutional investors.
- Issuers like PIPEs because they can obtain financing quickly, as the company isn’t subject to the administrative burden and regulatory requirements of a public offering
- Investors like PIPEs because they provide an opportunity to obtain what could be a sizeable stake in a public company, at a negotiated and discounted price – PLUS, because the company is already public, they have a clear path to liquidity
But as usual, the devil is always in the details when it comes to the money business.
Most notably, PIPE financings often come with a little something extra to sweeten the deal for investors…
Warrant coverage – a way for one or more shareholders of a company to possibly increase their holdings if the value of the company increases.
And this is the basis of the Wall Street Double Dip.
How Warrants Work
A Warrant is a contract between the issuer (i.e., the company) and the investor (i.e., you) that grants the option to buy more shares – at a pre-negotiated price (the “exercise price” or “strike price”) – for a specific period of time (the “expiration date”).
If that sounds a lot like an Options contract, that’s because it’s almost the same thing, but with one crucial difference.
- Options are typically sold in “lots” that give the owner the right to buy 100 shares of a specific stock
- Warrants can be customized to give the owner the right to buy any number of shares specified.
Also, unlike options, warrants are issued by the company itself. Stock options, on the other hand, can be freely created by individual market participants who may be trying to speculate, hedge their position, or earn extra income.
“A warrant is different from an option because the company doesn’t receive the proceeds from an option”
For the typical individual investor, warrants have virtually all the same characteristics and may serve most of the same objectives as call options or long-term equity anticipation securities (called “LEAPS”).
So why buy a warrant? The most important practical difference between warrants and options is that warrants typically have a longer lifespan than options.
Most options trading happens on contracts that expire in days, weeks, or months; those with the longest durations, the LEAPS, only go out about two years.
Warrants, however, can sometimes confer the right to buy or sell for many years down the road: On occasion, those dates can be five or 10 years down the line, giving the buyer a lot of time for the “wager” to play out.
Because it’s hard to predict where a company’s stock will be five years from now – especially when it’s a smaller company with unpredictable revenues – Warrants create an opportunity to “buy in” cheap today, for the chance to “buy more” for cheap in the future.
Why do investors like these?
Answer: An opportunity to “double dip” should the company successfully reach its growth targets.
For example: Company A sells a Unit – consisting of one common share and one warrant with a $1.20 strike price valid for 24 months – for $0.80 cents.
Let’s also assume that in the public market, the stock is trading at $1 per share.
Right off the bat, you are “in the money” on the shares you’ve purchased and have – on paper – a locked-in profit (subject, of course, to there being a market for those shares in which you can sell into).
However, the warrant is currently “out of the money,” but if the stock traded above $1.20 in the next 24 months (by the “expiration date”), this means you can again lock in profits – on paper – by exercising the warrant and purchasing more shares.
One of the most common examples of this is when Warren Buffett famously made a deal to invest in the publicly traded Bank of America, which also came with warrant coverage at a strike price of $7.14 each.
Eventually, the stock reached $24.32 per share, and the Oracle of Omaha netted a 240% gain… turning a $5 billion investment into $17 billion.
That’s why we call this the Wall Street Double Dip.
It gives investors two opportunities to potentially profit from the same deal.
Normally, this investment format is only available to institutional investors…
But thanks to Regulation A+, certain public companies can raise PIPE financing directly from retail investors.
Why would public companies prefer to raise capital from retail instead of a cashed-up institution?
Because as we’ve learned previously, in the Game of Money, Bankers are masters of shifting risk onto the borrower.
When Issuers sell shares to a Banker in a PIPE transaction, while they may get the money in the short term… the Banker wants to dump those shares as fast as they possibly can to recoup their investment.
But if we look back at the reason why the Issuer accepted a PIPE financing – the stock is likely thinly traded and volatile…
What happens when the Banker starts dumping shares into the market?
Unless there is enough demand to absorb the selling pressure which doesn’t usually occur in thinly traded stocks, it means the stock price will likely drop, which only serves to further exacerbate the fundraising problems…
And in some instances, PIPE financing is designed with some predatory terms that – should the stock price fall below a certain level – entitle the Banker to more shares, which they continue to dump into the market, which continues to put downward pressure on the stock and continues the conversion mechanism (called “death spiral” financing).
This is the classic “Heads I Win, Tails You Lose” deal for the Banker.
In these situations, the Issuer usually winds up losing, because they are unable to continue raising capital…
The investors who are purchasing the stock from the Banker lose because they not only get diluted, but the stock price keeps dropping…
But the Banker wins.
This is unfortunately common in the land of junior mining companies.
A typical junior mining company will find an asset that has promise… raise capital to explore the property… and then raise more money to develop it.
To secure financing, they have to go to a very small number of brokers [investment bankers] who will consider funding these types of deals.
However, these brokers are not long-term investors, and in our opinion their business model is to dump their shares as soon as they can, which inevitably causes the share price to crater from the selling activity.
These financiers can be the biggest problem in these deals and may be the primary reason why mine operators – and retail investors – tend to have far greater risks, in both the short term and long term.
There’s no reliable way to remove the most obvious risk in mining operations: whether the mining company can successfully find and develop a mineral asset into a fully producing mine, and sustain production over the long term, or not.
But what if there was a way to decrease one of the most controllable forms of risk…
The company is unable to execute its business plan because they run out of capital – and are potentially unable to secure additional capital – due to predatory financing arrangements.
This, in essence, is the appeal of a “Retail PIPE” for small public companies.
Therefore, Instead of having financiers in the deal who might profit more by actively shorting and bankrupting the company…
The goal is to build a shareholder base that is properly incentivized to be long-term holders of the stock.
