Today marks the one year anniversary of my “Investment Red Flags” column. During the past 12 months, through a series of articles, I have been highlighting a number of early warning signs indicating a business may be experiencing turbulent times and even, in some instances, be tinkering on the brink of failure.
Some of the more easily recognizable signals I emphasized included: the frequent turnover of partners, advisors and employees; products that only exist in a press release;stale and irrelevant news feeds and the one that investors hate the most: a radio silent CEO.
But, I cannot believe that I have forgotten the most obvious red flag of all – when company insiders start abandoning their shares.
I began my career on Wall Street right before the Internet revolution. Back when I was a broker trainee at Dean Witter, we didn’t even have computers on our desks. Instead, we had communal quotron machines, microfiche and books. Wow, just typing that sentence makes me feel old!
In any event, back then, my favorite book to read at work was William O’Neil’s, Daily Graphs – a printed collection of stock charts that was delivered weekly to its subscribers. I waited on bated breath each week for the latest edition of Daily Graphs to arrive. As soon as I received it, I would scan the book for just two glaring items: charts trending upwards containing many plus signs and charts trending downward consisting of many minus signs. The plus signs denoted “insider buys”. The minus signs revealed “insider sells”. To me, this was the best insight into what management really thought of their company.
I would buy calls on the stocks trending upward with lots of pluses, and puts on the ones trending downward with lots of minuses. This was how I traded my own account. It didn’t always pan out when I was trading options, but it did work pretty well for a longer term investment strategy.
Today, investors don’t have to sit around waiting for the mailman. When dealing with publicly traded companies, this “insider” information is readily available online.
But what about private companies? How do startup investors know what company management really thinks of its stock? I will seek to answer this question in my best Jeff Foxworthy. If a CEO is readily willing to part with company shares, she might think the stock is overvalued.
When a business is first formed, most starry-eyed founders think of their company stock as gold. It pains them to even give up one half of one percent. Many cash-starved CEOs would rather borrow money at exorbitant interest rates to compensate consultants and employees than to relinquish equity. I call this the “my idea is going to change the world” stage. If, after a few years of continual revenue growth, a CEO is still cheap or even cheaper with her stock, consider yourself fortunate.
But, as time goes on, if the company is not gaining any traction with its products or prospective investors, it may reach the “cash is king” stage. At this point, the CEO needs to do anything he can to preserve his cash. He is much more amenable to using company stock in order to attract and retain advisors, consultants and employees – hoping that a strong team might lure investment.
There could even come a time when the CEO is so desperate for cash that she seeks buyers for her personal shares at a discount to the most recent financing round. I call this the “shit may be hitting the fan” stage.
You need to request company records such as all previous cap tables and employee/consultant/advisor compensation packages. These documents will help you gain a better understanding of how cheap or generous a CEO is with company stock, and more significantly, if this “generosity” has increased with time. Capitalization tables will also help you verify whether or not key employees, advisors or even early investors have liquidated personal shares.
Remember, although the company may be private, as an investor, you are entitled to receive information concerning YOUR investment. Your legal rights vary depending upon what state the company is domiciled in and what is written in your shareholder agreement. It is important for you to know your information rights and use them.
This article was originally published on LinkedIn Pulse
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