This is part 1 of a series:
Penny stocks, or micro cap stocks, are loosely defined as stocks which sell below $5 and have market capitalization of below $50 million. They are largely traded on the OTC Bulletin Board and on the Pink Sheets Electronic Quotation Service, which exist primarily for the listing of stocks which cannot be listed on stock exchanges, such as the NYSE.
It is the nature of penny stocks that make them targets of scam. They are often manipulated and distorted. However, this by far does not mean you cannot make money on microcap stock investments. It does mean that you must be aware of the scams and able to identify a manipulated stock (or the nature of stocks that are most heavily manipulated). In this particular review I will examine the commonest penny stock scams briefly.
The most popular would have to be the pump and dump scam, which I will tell more about later. Today we will be looking at stock dilution scams. This is something that is difficult to explain without writing volumes, so read carefully.
Firstly, Dilution is basically when a company spreads out ownership of its stock by increasing its volume of shares and thus decreasing share value. Fundamentally, the less ownership you have over a company, the less money value of your ownership. So, creation of more new shares generally decreases the degree of ownership which generally decreases the ownership value per share. Less shares = higher value. Adding new shares is a legitimate process, when dealing with stocks with regulated dilution-prevention rules ^_^. The problem with many penny stocks, however, is that they are not regulated.
Thus, you have this problem. Lets say Penny Stock Company X has 20 million shares and $10 million in equity (ownership value), which is $.50 a share. Company X takes a loan from Loaner Y, one of $1.5 million. Company X then asks Loaner Y to exchange this debt for equity (ownership by shares), changing the nature of the loan. The agreement is struck. Company X creates/issues massive amounts of new shares and does not sell them to anyone, only gives them to Loaner Y as compensation. The issuance of new shares to Loaner Y is essential to transfer the agreed equity percentage-wise. Loaner Y happy to accept because he now owns 60 million/80 million or 3/4 or 75% of Company X’s stock. This transaction results in dilution, or the rapid loss in share value. The common shareholders (holding the original untouched 20 million shares) have lost ownership and thus have lost money. Their original equity in Company X of $10 million is now worth 1/4 of that value, or $2.5 million. They have lost (or essentially paid) $7.5 million to Loaner Y for one little loan =).
Now, the question is: how does this benefit Penny Stock Company X? Well, next quarter, Company X can take another loan, quadruple the share volume again, transfer another 3/4 of the stock to Loaner Y as payment, and repeat the process until Loaner Y owns all of the stock in question. Company X can now walk away.
Meanwhile, Loaner Y can sell the highly diluted, messed up, low price shares to unsuspecting, unaware new investors.