An earlier article noted that the lack of liquidity is one of four major stock market-related challenges confronting nano-cap and microcap companies. (Stock trading liquidity for the typical small cap company has been crushed by Dodd-Frank as discussed here).
Stock trading volume is key to a small cap company’s ability to raise capital and survive. For nano-cap and microcap companies, more trading volume means:
- the stock can be used as a currency for acquisitions
- the stock is more valuable as an employee retention mechanism (through stock options, restricted stock grants, etc.)
- it is easier to attract investment firm capital and on more favorable terms
- it is possible to attract the attention of investment analysts
With respect to point (3), why does more trading volume make it easier to attract capital from investment firms (a.k.a. institutional investors) and on more favorable terms? There are two reasons:
One, an investment firm is typically unwilling to invest in a company where the firm’s stock purchases (or sales) through the open market affect the company’s stock price. Consider the following example:
- assume $2MM is to be invested by the investment firm
- the firm typically seeks to complete its investment within 20 trading days (1 month)
- $100,000 per day is to be invested. ($2MM/20)
- the firm typically seeks to limit its purchases to < 10 – 15% of daily trading volume since it does not want its stock purchases to drive up the company’s stock price as it makes its purchases
- to invest $100,000/day within the 10 – 15% parameter means there must be daily trading volume of between $667,000 – $1MM
Companies WITHOUT the requisite trading volume typically will NOT receive investment capital from an investment firm.
Two, the investment firm needs to be able to exit its investment position readily. If the stock price increases to an advantageous level, the firm may want to sell shares to capture the gain. Similarly, if the stock price begins to “tank,” the firm will want to sell shares to avoid or mitigate the loss. If the firm does not believe there is sufficient trading liquidity to enable it to sell its stock position readily, then the firm either will NOT make the investment or WILL require a pricing premium to reflect the risk from the lack of liquidity.
A future article will explore another of the four major stock market-related challenges confronting nano-cap and microcap companies – lack of investment analyst coverage. What role do investment analysts play in the capital markets and why it is so difficult for small cap companies to secure investment analyst coverage …?
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