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Small and micro-cap companies often need to identify new sources of capital. Many blindly assume or are more often advised that an exchange listing IPO is the solution to all their problems. But for smaller companies, those below $300 million market cap, recent data exposes the problems with this approach: small companies are often misled by the specter of IPOs and advisors pushing them to go public before they’re ready, and can fall victim to these short-sighted intentions and a lack of long-term strategy.

OTC Markets Group conducted a study evaluating the performance of all IPOs that went to the NASDAQ CM and NYSE AMEX markets in 2022. A total of 91 deals were reviewed. The average market cap of this group of companies was $213 million the day after the offering. 28 days post the offering, the average was $102 million, and the current average sits at $56 million. This analysis included traditional IPOs as well as IPOs by issuers that uplisted from OTC Markets with the key findings as of August 2023.

Key Findings1:

92% of IPOs demonstrated a negative rate of return from their offer price, with the overall average total return of -64.8%
34% of companies appeared on an exchange non-compliance list post IPO
51% of companies completed reverse splits either prior to their IPO or post their IPO
Five bankers accounted for over half (51%) of smaller IPOs in 2022, with five law firms advising over one-quarter (26%) of transactions
Two-thirds of these deals included banker warrants
Before immediately jumping to an exchange, companies should consider whether they are a good fit for success post-raise. What is my company’s size and stage of development? As an international company, am I better off raising money in my home market? Who are the bankers and lawyers advising me and what are their incentives? What are the total advisory fees, compliance expenses and dilution costs for my existing shareholders? What investors will participate in the offering, are they long-term holders or short-term intermediaries looking to flip discounted shares? These questions must be answered before a successful exchange raise can occur.

But instead of this more thoughtful approach, a small group of conflicted investment banks, lawyers, and advisors looking for financial transactions to monetize are pitching a false narrative. Aggressively selling small companies on listing on an exchange when it is too early, not appropriate, or will harm existing shareholders. Using the glamour of an exchange listing to hide the financial engineering and destructive nature of the transactions.

This is often done with little to no regard for the long-term health and success of the company. An analysis of recent small company IPOs shows listing on an exchange too soon can be detrimental to these companies and their success in the public markets.

Smaller companies completed an IPO based on the prospect of greater opportunity for growth, access to financing, increased institutional ownership, and liquidity for their shareholders. However, over 92% of the deals were trading well below their offer price by August 2023 with an average return of -64.8%. More than one-third of these companies were already non-compliant with exchange continued listing requirements within this period and were at risk of being delisted. As the data shows, the perceived prestige of listing on an exchange gives way to a different reality once an IPO is complete.

Unfortunately, this environment is supported by the “expert advisors,” which are often concentrated amongst a few names in the small-cap space. Investment banks, lawyers, and other advisors, which take significant fees off IPO transactions, have an incentive to move quickly and capitalize on selling the ‘fear of missing out’ of a seemingly receptive IPO market. These firms have built a process around placing transactions with the same group of investors – many of whom are not long-term believers in the company – but are rather unregulated intermediaries there to quickly flip shares for a quick profit. As a result, success is often measured through the IPO alone rather than what happens to the company over time. For a company not yet ready to list, the difficulty in meeting continued listing requirements as well as the dilution and volatility in price due to the structure of the IPO means most have little control over the outcome.

Understanding the Negative Spiral

Smaller companies that do not readily meet exchange requirements and that have not yet established visibility with investors often make concessions simply to complete their offering. The terms that are necessary to advance the IPO, are also the reason that a company often struggles and fails once they go public.

Reverse splits

A company will often be advised to complete a reverse split prior to an IPO to meet initial listing standards if its share price is too low. 45% of smaller company IPOs in 2022 completed a reverse split prior to their IPO, decreasing the shares outstanding in order to increase the share price by the same factor. Fundamentally, while there is no change to the company’s market value and the company has achieved the required price requirement, this solution for qualification is viewed negatively by investors compared with organic growth in share price. It is a red flag that management does not prioritize current investors and that dilutive financings may be taking place. Furthermore, by reducing the number of shares for investment, it actually scares away long-only institutional investors and may attract short sellers.

Warrants

Included in the IPO terms to allow investors or the advising investment bank to acquire additional shares at a specified price, warrants are viewed as incentives to attract interest in smaller deals that are more difficult to complete.2 Bank warrants may also be attached, providing the advising bank additional compensation and commissions.

These warrants can pose significant challenges to newly listed companies. The exercise of these warrants ultimately dilutes the holdings of long-term shareholders, including company management and employees, and can lead to a fall in the price of the stock. Warrants offered to advising banks are particularly concerning. The opportunity to exercise the warrant at a discount and the potential short-term nature of the holding misalign the interest of the bank with that of the company. Bankers have already received compensation for the deal – they should not be provided additional compensation, which results in hidden costs and the dilution of current shareholders.

Companies should be wary of any IPO transaction that requires the attachment of warrants to a small group of advisors or financiers, particularly those with bank warrants. They often benefit advisors and new investors at the company’s and existing shareholders’ expense. This in turn, also puts the company in jeopardy of no longer meeting exchange requirements.

Short term investors

The lower profile and less developed investor base of smaller companies often leads to lower share demand. Investment banks may lean on selling the deal to investors that do not have a long horizon for their investment in the company. These investors hold the stock with the intention of selling within a short timeframe. This includes unregulated funds that provide financing at a discount to the public share price. The concentration of these short-term investors looking to flip a stream of discounted shares into the market again depresses the share price, dilutes ownership stakes, and creates volatility at the expense of long-term shareholders.

Non-Compliance and More Reverse Splits

More than one-third of 2022 smaller company IPOs are currently on an exchange non-compliance list, almost all had failed to meet bid price requirements, meaning that the price has fallen below the required threshold. A company has a specified time period to regain the set price or it will be delisted.

Companies in this situation have limited options for growing their share price. One possibility is for share price to increase organically which is subject to a number of factors outside of a company’s control, made all the more difficult by the company’s placement on a non-compliance list. Another option is effecting a reverse split, decreasing the shares outstanding and correspondingly increasing the share price. 10% of the 2022 smaller company IPOs had already completed another reverse split post IPO by August 2023. Investors, however, often see through the optics, inviting short sellers and placing continued downward pressure on the stock price. This sets the company up for a continuous and often unsustainable cycle of non-compliance notices and reverse splits. We have found that many of these executives spend more time and money focused on exchange requirements and listing than they do growing their business – which is where the real shareholder value is derived.

List smarter, not harder

While the promise of an exchange listing is appealing, companies need to take a hard look at whether they are at the right size and stage of development to meet both the initial and ongoing requirements. If you are not eligible for the Russell 3,000 a US exchange listing presents a real challenge.

After paying sizeable advisory fees, undertaking new compliance requirements, and competing with larger companies for investor interest and visibility, companies are left with few of the expected benefits of being publicly traded and struggle to maintain their listing.

There is an alternative. The OTCQX and OTCQB Markets allow companies to become publicly traded without requiring them to rearrange the cap table or effect a reverse split. These markets offer a simplified path with financial, corporate governance, and disclosure requirements tailored to smaller companies. While bankers insist that companies need to go to an exchange to raise capital, this is not the case. Companies can complete private placements, raise money in the local markets, or, if eligible, avail themselves of Regulation A. All while continuing to build their business, diversify their investor base, and create real value for long-term shareholders.

[1] Based on data from Factset and SEC Filings

[2] https://www.renaissancecapital.com/IPO-Center/News/90601/Completely-warranted-Small-IPOs-are-enhancing-their-deals-with-warrants

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Jason Paltrowitz
Jason Paltrowitz is Executive Vice President, Corporate Services at OTC Markets Group, where he is responsible for managing the firm’s international and domestic Corporate Services business. Drawing upon his expertise in cross-border trading and as a recognized proponent of Reg A+ and small company capital raising, Jason is an advocate for small cap issuers, start-ups, and entrepreneurial innovators working to alleviate the cost, time and complexity associated with being a public company. Prior to joining OTC Markets in October 2013, Jason was Managing Director and Segment Head at JP Morgan Chase responsible for the custody, clearing and collateral management business in the Corporate and Investment Bank division. Jason also held multiple senior management positions at BNY Mellon, most notably, as Head of M&A for the Financial Markets and Treasury Services Sector and 11 years as the Head of the Global Capital Markets Group in the Depositary Receipt Division. Jason currently serves on the Board of Directors of the Crowdfunding Professional Association (CfPA) and also served as a member of the Board of Directors at OTC Markets Group from 2008 – 2011. Jason holds a Bachelor's degree in International Relations from Boston University and received his MBA from the NYU Stern School of Business.