refers to publicly traded stock that trades for $5 or less per share. Often, the phrase penny stock is used to indicate shares that actually trade for pennies. Penny stock also refers to an alternative form of venture financing, in which money is raised through a public offering of company stock at prices as low as ten shares for a dollar (or less). Usually, the penny stock offering is underwritten by a professional underwriter who, for a fee, structures the financing and uses his best efforts to sell the shares to the public.
In most cases, the underwriter charges a fee up front for undertaking the offering. The underwriter receives additional compensation if he successfully completes the offering. Often, the charges are steep. They reflect the level of risk the underwriter accepts in agreeing to put together the offering. As with all initial public offerings, the other costs associated with completing an offering are high as well. These include the cost of management’s involvement in the public offering, the cost of preparing an offering circular and complying with federal and state securities laws, and the costs of engaging independent accountants and lawyers to complete the project.
Entrepreneurs who attempt penny stock offerings often do so in lieu of trying to raise money from private investors. Many do so because they are unable to attract funds from private investors. Others believe they can raise money more cheaply in the public market even after paying the high transaction costs associated with a public offering. Still others enter the penny stock market to increase the liquidity of their shareholdings by creating a public market for shares they may hold personally.
Whatever the reason, management should consider carefully the potential ramifications of a penny stock deal before rushing into one. Many professional venture investors view a penny stock offering as an indication of weakness and hesitate to participate in a later round of funding. The large number of shareholders a penny stock offering can create can discourage later investments by venture investors. This is because a large class of unsophisticated and unrepresented (by virtue of their inability to elect a representative to the company’s board of directors) shareholders exposes directors to greater potential liability for shareholder suits claiming the directors have not fulfilled their fiduciary responsibilities. A sophisticated investor willing to provide significant funding may want a voice in management but not the potential liability that such participation may expose him to with a large class of investors who each hold a very small percentage of the outstanding stock.
Some observers believe that selling penny stock depresses the trading value of the company’s stock over the long term. These observers contend that investors always will think of the company as a bargain-basement company whose stock price reflects its low value (as compared to companies with higher-priced stocks). Others contend that penny stock attracts speculative investors whose frequent trading on small price gains makes it difficult for a company to sustain a long-term increase in share price. Overcoming these market disadvantages can be difficult and make it harder for the price of the company’s stock to increase significantly.
On the other hand it may be true for a given company that a penny stock offering to the public can command a better price per share than a corresponding offering to private investors because the liquidity of publicly tradable shares adds to their value. If the liquidity adds enough value to offset the high costs of conducting the offering, a penny stock offering may be the least expensive way to raise money.
When a venture investor cannot be found, a penny stock offering may be a company’s only alternative for raising money. When this is the case, comparing the relative advantages of conducting a public offering to private funding may be irrelevant. However, in every other case, management should compare the two alternatives carefully before engaging an underwriter and initiating a penny stock offering. In their analysis, management should consider whether the liquidity created by a public offering will create enough extra value to offset the high transaction costs associated with such offering and whether this extra value is worth the extra hassle associated with being a public company. In making the decision, management should also evaluate how likely it is that going public with a penny stock will depress the growth of market value for the stock and, thereby, make future financings more costly to the company than they might otherwise be. See: Going Public, IPOs (Initial Public Offerings), Mezzanine Financing, Private Placements, Public Offerings, Reg D, Underwriters, Unit Offerings.