Dilution and Reverse Splits: Warning Signs in Small Cap Stocks

In short: How dilution and reverse splits hurt small cap shareholders, what death spiral converts are, and a checklist of warning signs to review.

Small companies are where many investors hope to find the next big winner, and also where a lot of them get hurt. One of the most common ways it happens is quiet. The stock keeps falling, the company keeps issuing new shares, and eventually it announces a reverse split to keep its listing. If you do not understand what is happening, you may think it is good news. Usually it is a warning.

What dilution is

A company is divided into shares. When it creates new shares and sells them, each existing share represents a smaller piece of the business. That is dilution. If you own 1 percent of a company and it doubles the number of shares without you buying any, you now own 0.5 percent. Dilution is not always bad. A company that raises money at a good price and uses it to grow can create more value than it gives up. But constant dilution, especially at falling prices, steadily erodes shareholders.

How small companies dilute

There are several routes. Public offerings sell new shares directly to investors. Private placements sell to specific buyers, often at a discount, sometimes with warrants attached that allow even more shares later. At-the-market programs let a company sell shares into the open market over time. Convertible notes are loans that can be exchanged for shares, sometimes at a discount to the market price, which can create more shares as the price drops. Stock based pay to executives and employees adds more. Check the company’s filings for the share count each quarter. If it keeps climbing, your slice keeps shrinking.

The toxic convertible spiral

The worst version is often called a death spiral. A tiny company borrows from a lender through a convertible note that converts at a discount to the recent trading price. As the lender converts and sells shares, the price falls. A lower price means the next conversion creates even more shares, which pushes the price down again. The share count can grow by hundreds or thousands of percent. Existing shareholders watch their stakes collapse. If a company’s balance sheet shows convertible notes with variable conversion prices, take it as a serious red flag.

What a reverse split is

A reverse split reduces the number of shares and raises the price per share by the same ratio. In a 1 for 10 reverse split, you swap 10 shares for 1, and the price goes from, say, $0.50 to $5. Your total value does not change on the day. Nothing about the business improved. The company often does this to meet minimum price rules for an exchange listing, or to look more respectable.

Why reverse splits are risky

Studies of small companies have found that many stocks keep falling after a reverse split. The reason is that the underlying problem, losing money and needing cash, is still there. Once the share price is higher, the company can issue more shares, and the cycle can start again. It is common to see a company do multiple reverse splits in a few years, each time wiping out most of the earlier price history. When you look at a chart, check whether it has been adjusted for splits. A chart that looks calm may hide a stock that has lost 99 percent of its value.

Warning signs checklist

Look for these: share count rising every quarter, going concern language in the auditor’s notes, cash that covers less than a year of spending, convertible notes with discounts to market price, frequent press releases that sound exciting without revenue to back them, and a history of previous reverse splits. One may be explainable. Several together point to a business that survives by selling pieces of itself.

What healthy small companies do differently

Good small caps raise money rarely and for clear reasons. They tell you what the money will be used for, and they show progress after. Insiders often buy shares themselves, which you can check through Form 4 filings. Revenue grows, losses shrink, and the share count stays stable or grows slowly. Management speaks in specific numbers, not slogans.

How to protect yourself

Read the latest quarterly filing, not just the news release. Compare the share count to a year ago. Keep position sizes small in speculative names, using the position size calculator to cap your loss. Never average down on a company that keeps issuing shares just because the price looks low. And remember that cheap can be cheap for a reason. The goal is not to avoid all small companies. It is to find the ones that respect their owners, and to let the rest go.

Further reading: Investor.gov from the U.S. SEC and the Canadian Securities Administrators investor education site offer free, independent guides for new investors.

Keep reading

• Get Noticed by Investors: 9 Ways for Small Companies
• Investor Update: How to Write One People Read
• Penny Stocks: The Complete Guide to Risks and Rewards

This article is for education only and is not investment advice. Do your own research and speak with a licensed professional before you invest.