In today’s post, I’m going to talk about share issuances and dilution in the penny stock realm, and then tie it into AITX. This is one of those topics that makes me want to put my head through a plate glass window when flipping through Twitter. The concept of dilution in the pennies might be the most misunderstood concept there is, and especially is for AITX.
Open basically any tweet from Steve Reinharz, the AITX CEO, and you’ll see a small army of two-week-old accounts equating him to the devil incarnate for AITX’s dilution. Aliens landing on earth for the first time will likely think he invented single use plastic, this classic song, and the NFL’s taunting rules based on the anger that gets directed at him on Twitter, Stocktwits, etc.
Well, today we’re going to cut through the nonsense and get into the gritty details of dilution in general and with AITX. When is it good? When is it bad? What does it mean for me, the investor? Let’s get into it!
At the core of it, share dilution is when a company issues (sells) news shares of its common stock in exchange for cash, services, or assets (an acquisition). Say I want to start a hotdog stand; I make a great hotdog, know all the tricks to make it taste just right, but there’s one problem… I have no money. I personally know my idea is great, I am 80% sure it will be a big success in five years if I stick with it. So what do I do?
First, you can’t have a company until you incorporate, so I use the last of my money to hire an attorney and I am now the 100% owner of Sam’s Hot Dogs. I own 100 common shares, appointed my cat as CFO and Wall Street analysts can direct their questions to my goldfish, the head of investor relations.
Now that I have my company, now I need some money to build the business. The first thing I do is try to find someone to loan me the money. I have no assets, no income, nothing as collateral. And I’m not even making money yet. My local banker proceeds to laugh me out of the bank.
What’s my next option? The most common option (and let’s skip convertible debt, I’m sick of talking about it) is to bring someone in as a partner in exchange for some seed capital. My grandma always believed in me, but she treats nickels like manhole covers (Sopranos fans anyone?). I need the money, and she knows that she could make a lot of money on this investment. So I negotiate a price with her for her to buy an additional 50 shares from me, leaving me with 66% ownership (100/150).
Now, let’s set this up into good versus bad dilution.
This will seem a bit self-explanatory, but good dilution would be Sam selling off a portion of a company at a value he thinks the future company is worth. Say he thinks the company is worth 100 dollars today considering his big ideas, business plans, future profits, etc. all discounted back to today. He then thinks, okay, 33% of my investment grandma wants to buy is 33% of 100 dollars, so 33 dollars.
So I put on my best “Art of the Deal” pose and hardline negotiate with grandma. Much to my surprise, she agrees to my price per share! She gives me 33 dollars for a 33% stake, and in doing so I dilute my share ownership by issuing 50 new shares in exchange for 33 dollars. The price was fair in my opinion, so technically I am right back where I was before, but now with seed capital.
Sure, I could pick up loose change for 20 years until I scrape together enough money to build my first Hot Dog Stand, but realistically this company doesn’t exist without grandma. Would I rather have a 66% stake in a company that makes lots of money, or a 100% stake in a company that is an utter failure?
This is good dilution in a nutshell. Everyone wins. If the company bombs, it bombs, it’s part of doing business. grandma and I knew what the risks were. If that’s good dilution, then what’s bad dilution?
Using my same example above, I’m going to go through some many examples of bad dilution and how it many times becomes a death spiral.
Let’s say grandma spent most of her last social security check at bingo night and will only give me ten dollars for a 33% stake. But man am I desperate to put this idea into action and I can’t wait much longer to get started because I already owe attorney fees, I have to pay my accountant, and pay myself of course. Also, I’m having trouble convincing other investors that my idea is a winner. At least with the ten dollars I can buy the absolute bare minimum to get the worst hot dog stand in the history of mankind. It’s going to be ugly, but by God I’m going to make it work.
So I cave and sell her a 33% stake for ten dollars and issue 50 new common shares. This is the most basic case of bad dilution. What it means is that shares were issued at a poor return to the current shareholders. The current investors, only Sam in this case, is now left “worse off”.
Here is where a death spiral starts for many, but not all, companies that dilute…
Well it turns out that ten dollars didn’t go very far, all I did was pay off some administrative fees and was only able to get half of the equipment I need for the hot dog stand. Seems like I should have held out for a better deal, right? But how could I? I had my accountant and attorney sending me collections notices. I did what I had to do to keep the ship sailing!
It’s okay, I know my idea is still great, but now I need more cash. I convinced grandma to buy 50 shares for ten dollars, maybe I can convince someone to buy 200 shares for 20 dollars. I’m diluting, but hey my dream is coming alive. And maybe I’ll even be able to pay my rent from those 20 dollars of capital. So, not only was I getting a terrible deal for my new shares, but I also couldn’t even invest it back into the business properly. And on and on it goes…
Good vs. Bad Dilution – Investor’s Perspective
As an investor, you many times have the luxury of sitting back and watching these two scenarios above unfold. That guy in the first good dilution scenario seemed to have his priorities straight. He knew exactly by how much he should dilute, how much capital he needed to raise, and now the business has a fighting chance to take off. Maybe I’ll win big, maybe I’ll lose, but I’ll put my money on that horse.
That same investor could also read a company’s typo-infested unaudited financial report posted to OTCMarkets with a great big SHELL RISK on the company profile and notice things that look like the bad dilution scenario. The company is consistently selling shares well below the market price, convertible notes go unpaid, and conversions happen at an 80% discount to the market, and what does the company have to show for the money? Absolutely nothing! Some joker is just paying Garbage Accounting Group LLC for their accounting work and then paying themselves a few hundred thousand dollars a year. The money isn’t being reinvested, just spent on nothing that builds shareholder value.
The key when it comes to dilution then is two-fold. First, is the company (mostly) able to raise capital at a price to the current shareholders that you think is fair? Second, is the company effectively reinvesting the money? If you answer “yes” to both of those questions, then you have likely drastically increased your probability of investing in a winner. Remember, going from a probability of 0.001% to 1%, for example, is still a drastic increase!
Your primary risk then becomes, does the product, service, etc. work, or does it not work? It stops becoming as much of a financial issue as it does become a question of “Does the business model make sense to me?” If you answer “yes” to that, then you should get excited about the company. Again, it doesn’t mean it will be a winner, but you should only invest in something you personally believe in.
Now that we have the basics down, where does AITX fit into all of this? Recall our key questions: 1. Does the company effectively raise capital? 2. Does the company reinvest the money properly into future revenue generating activities (R&D, sales, etc.).
I don’t think it’s relevant to talk about AITX’s early years now. Many past activities or financing choices, such as convertible debt issued, common stock issued, preferred shares issued, whatever, have already happened. If you invested early and are upset at a choice, or where the stock price is, that is now irrelevant to our current question of “is AITX performing good or bad dilution now?” We can only look at the company’s choices from right now and into the future.
With that in mind, let’s get into our two questions on good vs. bad dilution from above.
AITX’s Capital Raising – Is it Effective?
Right now, AITX’s primary method of raising new capital is through two ways, but from the same investors.
The first way is new share issuances and the S-3 shelf registration, see my prior article on the evolution of capital raising for more detail. This is the exact same scenario as above with Sam and his grandma. The second way is through warrants, which is just a call option to purchase more shares at a price well above the current market price.
This then begs the question, are these issuances at a fair value? In my opinion, yes. AITX is issuing new shares at a price that is at a slight discount to the market price, sort of like a bulk discount. AITX clearly believes the market price is approximately a fair price for its stock, and so do investors. As for the warrants, without getting into an option valuation model, these warrants are smart for current investors. The company gets upfront cash for the warrants, and the new investors only make money if the stock price exceeds the exercise price, which is currently well above the market price.
AITX’s current capital raising choices lead us to the scenario of: “either everyone’s getting rich, or nobody’s getting rich.” As opposed to: “the new investor is getting rich, and I’m holding on for dear life to keep this company afloat.”
Therefore, in my opinion we have answered the first question, AITX is raising capital at a fair price for current investors.
Does AITX Effectively Reinvest?
This is a bit more of a subjective point, so I must leave that to the reader. However, my two cents are as follows. See below some recent AITX financials.
We are currently seeing strong revenue growth from the company, strong spend in R&D, and a build out of their salesforce (included in general and administrative). Albeit, the company is nowhere near profitable right now. However, we are seeing them spend money on activities that could potentially lead to revenue growing at a higher rate than costs, leading to a potential profit. They aren’t just blowing money on silly third-party expenses like accountants and professional fees, or just paying themselves. See my article linked below on growth and scale for more on that.
A great litmus test for me personally with AITX, when compared to other penny stocks, is how “real” their business is. It might sound stupid, but with so many penny stocks there’s barely any information or tangible evidence of a company out there. No facilities, no actual products, and vague business plans.
With AITX, you can see the end products that AITX spent their money on from dilution, you can even go see their facility in Detroit! They have several product lines, real sales and sales growth, and actual products visible out in the wild. You can flip through the fact sheets for their products (ROSA, ROAMEO, whatever) and think for yourself if you believe in the products. It’s all there for you to see. That’s better than probably 95% of all penny stocks on the market. There is so much information on AITX for you to make an informed decision on the business. This is not a penny stock where the money goes into a black hole, and you have no clue what ever came of it.
So you as the reader need to ask yourself then, if you believe the dilution is good and the money is effectively reinvested, do you believe in the business model? Research the company’s products, understand the business, think about the security industry and how it could, or couldn’t be, disrupted by what AITX is doing. If at the end of all of that, you truly believe in the business model, then this is a company you should get very excited about. I am long, so obviously I am.
However, if you don’t believe in AITX, then don’t invest. You should never, ever, invest in something you don’t believe in! If you want to pass on AITX, it’s okay.
To sum this all up concisely, good dilution is capital raised at a fair price to current shareholders which is effectively reinvested in the business. Bad dilution is capital raised at a poor price to current shareholders which is (typically) not effectively reinvested in the business. Remember, dilution can be good! Would you rather have 10% of a failed company, or 0.01% of Amazon (that’s about $175 million right now by the way).
For AITX, I’ve laid out my case as to why I believe their current dilution is good and healthy for the growth of the business. It is at a fair price, in my opinion, and being effectively reinvested into the business. This then leads us to the question of, “Do you think additional capital and the current management will make this business model work?” If you answer yes to that question, then you should feel good about the investment whether it ends up working out or not. If you truly can’t answer yes to that question, then it’s time to move onto the next one!
So whenever you see someone on Twitter banging their keyboard about dilution, take a deep breath and do some research into how much capital the company received for said dilution, where the money is spent, and the company’s expected return on that invested capital. It might be good dilution, it might be bad dilution, but not all dilution is bad.
For further reading and AITX analysis, check out all of my articles HERE as well as in the sidebar.
DISCLAIMER – I CURRENTLY HOLD A LONG POSITION IN $AITX. THIS ARTICLE IS NOT FINANCIAL ADVICE AND IS INTENDED ONLY FOR EDUCATIONAL PURPOSES.