The Curse of the Poor Capital Structure
- by David Sable
Some of the more eye-rolling moments in meetings with company management teams occur when CEOs argue that the stock market grossly undervalues their company. Sometimes they’re right. But more often, the market has rationally chosen to ignore the value of the underlying assets of the company, instead focusing (correctly) on the stock price as an entity in and of itself.
A share of common stock should represent ownership of a percentage of the assets of the issuing company, or a percentage of the discounted future cash flows of the company. But sometimes a share of stock is a just a share of stock: a free-floating financial widget whose value floats merrily along, ignorant of any value added to the company’s assets. In these cases, the company’s management, board of directors and the investment bankers advising the company have inadvertently conspired to weaken the connection between company progress and movements in the share price.
Call it the curse of the poor capital structure.
The cap structure of a company is the combination of debt and equity used to build and grow it. A clean, logical cap structure tells a story of prudent financial management; transparent ownership; and proper alignment of the incentives of management, equity owners and debt holders.
A poorly constructed cap structure attests to haphazard and careless company financing, a condition that can make an otherwise interesting company completely uninvestable.
A common component of these black-hole capital structures are large pools of warrants from secondary stock sales. Warrants are call options issued by the company—usually with strike prices 10 to 15 percent higher than the price of the stock when issued—with five-year expiration dates. In theory, the warrants provide the basis for subsequent financing; if the stock rises, making the warrants “in the money,” the holders exercise the warrants and purchase stock from the company at a discount.
In reality, only a small percentage of these are exercised before their expiration date. The rest are kept in a portfolio and often used as the basis for a hedged short sale.
In very volatile sectors, like the life sciences sector in which I invest, the ability to strictly define the exposure of a stock sold short is unusual and the opportunity to hedge a portfolio with defined risk is very valuable. If portfolio managers own warrants and sell the stock short, they risk nothing more than the strike price of the warrants for each share sold short. If the stock runs, managers can easily cover. Even better, if managers sell the stock short and the stock price drops, they can cover the short sale in the open market, reap the profits from the trade and still own the warrant. When the shares rise again the process can be repeated, each time with a well-quantified risk.
When a large number of warrant holders hedge their portfolios in a similar way, the underlying stock has difficulty rising too far above the strike price of the warrant.
This should be preventable. The five-year duration is an industry standard for no obvious reason. Limiting the duration of warrants to six or 12 months would remove this unintended derivatization of the company’s stock.