Part 2 - The startup - “What does it take to get a company off the ground”
This got a bit long so I appologize :)
So at the time of the Tiger interview this company had no product on the market, was little known and would be operating as a startup for the foreseeable future. How were they getting cash to finance the startup? Warrants or PIPE(Private Investment in Public Equity) financing as some refer to it, a lot of people see this as a bad thing when they don’t understand the startup phase, if you’ve ever started a company from the ground up it’s not. It’s one of the few options you have for raising necessary capital during this critical stage in your business if you don’t have substantial collateral and revenue to secure credit.
So what’s a warrant?
A stock warrant is just like a stock option because it gives you the right to purchase a company's stock at a specific price and at a specific date. However, a stock warrant differs from an option in two key ways:
1. A stock warrant is issued by the company itself and generates operational cash flow
2. New shares are issued by the company for the transaction. Unlike a stock option, a stock warrant is issued directly by the company. When a stock option is exercised, the shares usually are received or given by one investor to another; when a stock warrant is exercised, the shares that fulfill the obligation are not received from another investor, but directly from the company and the company receives cash for operations in return.
Companies issue stock warrants to raise money. When stock options are bought and sold, the company that owns the stocks does not receive any money from the transactions. However, a stock warrant is a way for a company to raise money through equity (stocks). A stock warrant is a smart way to own shares of a company because a warrant usually is offered at a price lower than that of a stock option. The longest term for an option is two to three years, while a stock warrant can last for up to 15 years. So, in many cases, a stock warrant can prove to be a better investment than a stock option if mid- to long-term investments are what you seek. Not every warrant holder will exercise their warrant they weight the risk for themselves and decide if they want skin in the game or not
what affect does a warrant have in the current phase?
1. Provides the company with critical cash to continue operations.
2. It will dilute the OS lowering the stock price initially, but really 145 million OS and some further dilution is nothing in the long term if the company turns profitable. As a long term holder you will recoup any loss you currently have on paper many times over if the company is successful in exiting the startup phase. You’re just looking for a good entry point that meets your tolerance for risk. Getting through this phase can be tough and stressful and there is always the risk they won’t be successful. But you have to be willing to accept that going in with a new business.
What is PIPE?
A private investment firms, mutual fund's or other qualified investors' purchase of stock in a company at a discount to the current market value per share for the purpose of raising capital. There are two main types of PIPEs - traditional and structured. A traditional PIPE is one in which stock, either common or preferred, is issued at a set price to raise capital for the issuer. A structured PIPE, on the other hand, issues convertible debt (common or preferred shares). Fuse is using PIPE/Warrants to raise capital and that is a normal thing for startups to do.
So where is the smart money?
If you are expecting large institutional or brokerage firms to be snapping up Drop shares forget about it. Most of these entities have specific clauses in their charters preventing them from investing in these listings, and even if they can most investment managers stay clear because of the high risks to their clients, while a few may tinker with Pinks in their personal portfolio. The other driver is the fact that there are good deals on stocks on the big boards, why invest in a highly risk stock when you can get a deal on a proven company.
The latest searches show that there are 5 firms currently holding Drop for a total of about 237,500 shares or .16% that’s less than 1% of all holdings. You have to focus on the “other qualified investors” in the startup phase. These are your Angel investors, your warrant holders. These individuals or groups are well financed and willing to put their cash on the line to own a piece of the company for the potential of a significant return in the future. That return could be right away if the stock price is trading above the warrant price at a good margin or if the margin is narrow they may have to wait. So the warrant holder determines the level of risk they want to take, buy in on a tight margin and wait for the price to rise, buy in now and sell if the margin is acceptable, buy and hold for the long term, or wait and see. It’s their money that keeps the company going in the startup phase. Obviously it’s in our best interest if they buy in now to get that money to the company, but they have to have incentive and feel that the risk is worth it.
The current breakdown on DROP from what I can find is
Brokerage firms 0.1%
Investment Managers 0.1%
Strategic Entities 13.9%
Non-Institutional 85.9%
What’s with the Warrant price changes?
Cash is the lifeline for a startup end of story. If you look at the February 2012 Series A and B they were issued at $.26 per share. At that time the stock was trading at roughly $.44 that’s 69% if the stock has the support to maintain that level after the warrant is executed and the initial dilution occurs (Value Dilution). In the case of DROP I feel that when the warrants are executed all the individual investors are panicking and selling due to the initial price hit which is what has driven the price down to the current levels. In theory the price should have recovered to the support level of the value diluted price. But when dealing with investors in pinks, the majority of investors are looking for the quick return and the stock price is driven by irrational tendencies in both directions regardless of the underlying fundamentals of the company. Other than the missed target on the drops there was really no underlying reason for this stock to fall to these levels other than individuals not understanding what was happening and abandoning ship.
Value Dilution
Value dilution describes the reduction in the current price of a stock due to the increase in the number of shares.
The theoretical diluted price, i.e. the price after an increase in the number of shares, can be calculated as
Theoretical Diluted Price = ((O * OP) +(N * IP)) / (O + N) where
O = original number of shares
OP = Current share price
N = number of new shares to be issued
IP = issue price of new shares
So just for fun I set this up in excel to see a rough idea of what should have happened with some of the original warrants executing at $.11 over the last few months. So on the Fuse Science site there was a question concerning outstanding shares. The reply was that as of May 11th 2012 the count was 126,202,256. On May 11th the stock closed at $.24. Today we have 145.5 OS and the stock trading at or around $.11. $.11 being the execution price of the original warrants. So we’ve added roughly 19,297,744 to our share count. Not massive in the scheme of things, and if you did the math on the warrant offerings they are in line with the financing needed to meet the budget, I’d be concerned if they were going after numbers that far exceeded their required budget. Now this is ballpark but if those shares were added and price support remained at the correct level, with this amount of dilution the price should have recovered to $.22 roughly but everyone panicked and now we sit at the execution price not the value diluted price. Basically support dropped out because a lot of people don’t understand the financing behind the startup phase. I’m ok with that; it creates a good buying opportunity for long term holders to average down or get a good starting position. You can create this formula in excel very easily and play around with the numbers using the current OS and price along with the new warrant execution price and share count.
O = 126202256, OP = $0.24, N = 19297744, IP = $0.11 and TDP = ((126202256x0.11)+( 19297744x0.32))/( 126202256+19297744) = $0.222758029
However this creates a problem for Fuse in that the new warrant holders are not going to execute when the stock price is below the execution price, thus Fuse had to go back and change the price to make it attractive to keep financing coming in. Fuse can’t control the stock price so they have to adjust to what has happened in the market just like we have to adjust and move forward. They need continued cash flow and they took the steps they needed to try and bring that cash in.
Is this a dilution scam?
I don’t believe it is, sure there is always that risk, but I believe this is truly a startup that is doing what is necessary to get the business through the startup phase. A share dilution scam happens when a company, typically traded in unregulated markets such as the OTC Bulletin Board and the Pink Sheets, repeatedly issues a massive amount of shares into the market for no reason, considerably devaluing share prices until they become almost worthless, causing huge losses to shareholders. Then, after share prices are at or near the minimum price a stock can trade and the share float has increased to an unsustainable level, those fraudulent companies tend to reverse split and continue repeating the same scheme. When you look at the number of shares Fuse is issuing with warrants they are appropriate for the funding needed to meet the business plan. In the February 2012 issuance that was roughly $7m if they were all executed. The series A had 5 years to execute and the series B had 7 months.
Series A Total 15092185 @ $.26 = $3,923,968.00
Series B Total 15092186 @ $.21 = $3,169,359.00
So what’s it going to take to get this PPS headed north?
In my opinion Fuse is executing well against their business plan. They now have a base revenue stream that really is in its infancy. As distribution and awareness grows that base revenue is going to grow and reduce dependency on warrants. But don’t look for that to happen dramatically this year. It will take a few years to get there. What we really need to see is that it is moving in the right direction and financing continues to come in to support the business. Quarter over quarter growth is going to make the balance sheet look more and more attractive to investors. I’m not even looking for much at the end of this quarter what I’ll be keeping an eye on is growth over the next year or more as it gains momentum at GNC and goes into additional distribution networks. That is going to bring confidence to investors willing to finance the continued startup operations. Now we are adding a second revenue engine which will further aid in the slow march to a solid balance sheet.
People questioned the 5 year EnerJel projection that it could be $200MM plus consumer products business. Those projections are not just pulled out of the air. Whenever you bring a product to market there is a significant amount of research that goes into forecasting. It’s not “hey I’ve got this widget I want to sell, let’s just see what happens”. Target markets and distribution are planned and implemented over time given the budget you have to work with. This team is doing a great job of building incremental growth in my opinion. The sales department that I support has projections going out 5 years for each product we sell based on market conditions now and predicted conditions going forward. This is so that management can accurately budget and forecast for operations and capital improvements. For a startup this is no different. They have projected numbers for each product and distribution network they plan to go into at least for the next five years. That’s part of your presentation to potential investors.
Well that’s my current ramblings on where we are in this thing is as and where it’s heading. Continued financing is critical for at least the next year or two until FUSE products reach revenue levels that can sustain the business. The PPS will rise slowly as this thing gains momentum. The initial rise and fall in my opinion was irrational market emotions in both directions. Fuse doesn’t control the stock price, we ultimately do and when confidence starts to return that this company is for real and headed in the right direction I believe we will see it start to climb and the long term holders will be rewarded.
Take a look at SIRIUS radio it was flying high in the $50 range. Then it went steadily south to $.11 in 2008. OS count kept increasing in order to bring funding into the business and reduce debt. They now stand at 3.9B that’s billion with a B for their OS, had you bought at the low in 2008 today you would be sitting on a cushy 2200% gain. I’ll take that any day of the week. Bottom line is we can fret about OS and day to day fluctuations and drive ourselves crazy trying to make a quick buck, or we can believe in this company and support it’s long term success. They’ve delivered on bringing one product to market, now a second is coming. I’ve used EnerJel, I love it and can’t wait to try the new products. Go FUSE…
