I last wrote about Organovo Holdings (ONVO) on July 24th. Since my last article, there have been several new developments, which further reinforce the short thesis on the stock. The stock has continued to fall as expected.
First, the S3 registration statement for up to $100 million of new shares and/or warrants has now become effective. Some individuals had previously taken comfort that no offering would be impending because the S3 was not yet effective. It is now the case that Organovo is free to issue up to $100 million of equity securities at any time.
Second, I have uncovered an undisclosed legal action against Organovo by their own investment banker, Spencer Trask Ventures ("STV"). The initial arbitration filing was submitted on June 27th, when STV demanded compensation, which is now valued at around $28 million. Under the terms of the original Placement Agency Agreement, Organovo had agreed to binding arbitration. However, on June 28th, Organovo filed in New York Civil Supreme Court to attempt to fight the arbitration.
There have now been a flurry of arguments and counter arguments in New York Civil Supreme Court during the months of June and July.
One issue is that this may prove to be a significant financial issue for Organovo. But as a totally separate issue, this is already a significant disclosure problem for Organovo investors.
None of this has been disclosed to investors, including in the S3 registration statement, which just became effective a few days ago.
Before getting into these issues, there are a few preliminary points that deserve to be made.
Following my article, Seeking Alpha contributor Jason Napodano wrote a forceful rebuttal to my article. It was his 4th bullish article on Organovo in less than 1 year.
In his article, Mr. Napodano makes it clear that the points in my article are either entirely irrelevant or else downright inaccurate. The author supports these statements with a mix of facts, opinions and anonymous postings from a Yahoo message board.
There are now three main issues, which investors need to resolve for themselves.
- How much (if any) of the 32 million share overhang is currently depressing the share price?
- How much (if any) equity is Organovo likely to issue under the recent S3 registration statement?
- How much (if any) revenue is Organovo likely to generate in the next 1, 5 and 10 years?
Clearly, I disagree with Mr. Napodano on each of these points.
A substantial overhang pressing on the share price from the 32 million shares from 2012 is evidenced by the fact that Organovo still filed a subsequent prospectus on these shares. Once the overhang is fully removed, there will not be additional prospectuses.
Organovo is likely to complete a very large financing under the $100 million S3 sooner rather than later. It has been less than one year since the company deliberately reduced the exercise price of the existing $1.00 warrants to just 80 cents in order to get money in the door at that price. We can also see from the STV lawsuit that Organovo tried to incentivize STV to exercise by reducing the strike price to just 60 cents. This means that Organovo was attempting to issue new shares at a price of just 60 cents as recently as February / March.
For revenue, Organovo may have some prospects with liver cell modules at sometime in 2014. But we have been given no indication of the certainty or the amounts, which may be involved. The key point here is that the hype surrounding Organovo is in connection with the 3D printing of human organs. Not even the most bullish authors expect to see manufactured human organ revenues any time in the foreseeable future. Instead, we will continue to see small amounts of revenue from grants and research collaborations. Historically these have typically been in the range of six figure amounts.
In the meantime, we can see that Organovo has been successful in two areas:
- selling stock to investors at $1.00 (or below)
- elevating its share price to above $6.00
The company has recently been sporting a fully diluted market cap of nearly half a billion dollars, despite the following financial metrics:
- lifetime revenues of just a few million dollars (coming from grants and research)
- non cash assets (including all intellectual property) of less than $2 million
Metrics like these do not justify a market cap anywhere near half a billion dollars.
A very small but vocal minority of readers continues to post their emotional comments below these articles. However, a much larger (and silent) majority chooses to express their views by selling their stock rather than typing up rabid comments.
Prior to my article, the stock was hitting $7.70 in pre-market trading. Following my article the stock fell to $6.50.
It is now the case that all investors have the benefit of full information from these various articles and comments and the share price continues to slide rather than recover any lost ground. Following his article on Organovo, Mr. Napodano left a subsequent comment stating that he believes that "fair value" for the stock is around $4.00-5.00 - an additional decline of as much as 20% from the current level. In the near term, I would agree with this statement, which is why I continue to be short the stock. Although any potential equity offering could potentially push the share price even lower.
An undisclosed legal action
In its past financings, Organovo used the services of Spencer Trask Ventures for raising what now totals roughly $28 million in proceeds from stock and warrants. As of March, Organovo had $15 million in cash remaining.
The lead individual involved was Adam K Stern, a Managing Director with STV. Mr. Stern also became a Director of Organovo.
According to the terms of the Private Placement Agreement, Organovo would pay to STV a cash fee equal to 10% of the proceeds along with "agent warrants" ($1.00 strike price, 5-year maturity) equal to 20% of the stock issuable to investors. There was also an 18-month "tail" provision allowing for additional fees to be payable to STV based on subsequent capital raises. A key point of contention in the current lawsuit is that it was agreed that STV would be appointed as an exclusive Warrant Solicitation Agent at least 20 days prior to any notice of redemption. Organovo agreed to not contact any of the investors introduced on STV's proprietary investor list.
In 2012, Organovo Director Stern left Spencer Trask and went to Aegis Capital. Shortly thereafter, the arbitration suit states that Organovo began the warrant solicitation to raise new money from STV customers. But instead of using (or even notifying) STV, Organovo used Mr. Stern's new firm, Aegis.
In total, Organovo raised $14.8 million through the warrant exercises. In fact, Organovo lowered the exercise price on warrants to just 80 cents in order to raise new money at that level.
STV did not find out about any of this until it became public information through Organovo filings.
STV and Organovo are now in a protracted legal battle in which STV is demanding the disgorgement (and payment) of $14.8 million along with $1.3 million in cash fees and the issuance of 2.9 million warrants owed. The warrants alone would currently be worth around $12 million. Total consideration is therefore now in the area of $28 million.
During 2013, and after the warrant transactions conducted via Aegis, Organovo and STV began negotiating a Warrant Agreement, which would arrange for payment of compensation to STV. A second draft of the Warrant Agreement was also provided.
On March 1st, Spencer Trask's attorneys sent an email to Organovo CEO Keith Murphy rescinding the proposed agreement. A copy of the rescind email can be found here.
Following the rescinding, Organovo still sent small payments to STV, however these payments totaled just $115,000, instead of the much larger sum demanded by STV.
Section 13 of the Placement Agency Agreement states (in ALL CAPS) that any "dispute, claim or controversy" which arises with respect to this agreement will be submitted to Judicial Arbitration and Mediation Services Inc. ("JAMS") in the State of New York.
STV filed for arbitration on June 27th.
The next day, on June 28th, Organovo filed to fight the move for arbitration, stating that the Warrant Solicitation Agreement voided both the compensation earned by STV as well as the need for arbitration.
As is often the case, many dirty secrets get spilled out in lawsuits. Organovo reveals that it had already agreed to pay to STV $23 million in exchange for helping Organovo raise just $15 million in proceeds. The need to pay such a fee is staggering in and of itself.
The lawsuits also reveal that Organovo was willing to lower the strike price on STV's warrants to just 60 cents, in order to raise equity at that level. This was not in the distant past. This was in February / March.
Both of these facts speak loudly to the fact that Organovo has always been eager to issue equity at just about any price, no matter how low. The company has virtually no non-cash assets and continues to generate only minimal and non-commercial revenues. So getting money at any price may well be the best strategy.
But it also reconfirms my suspicion that if the company is eager to issue substantial equity for just pennies, then it will likely be a very large issuer of equity with the price sitting at just over $5.00. A normal discount for an equity offering like this would be around 20%, meaning that an offering would likely take place at around $4.00. One would also expect heavy warrant coverage once again. The stock price would then react accordingly.
Investors now need to ask themselves two very important questions:
First, how much of the $28 million in demanded compensation will Organovo end up paying to Spencer Trask ?
Second, why are investors hearing about a potential $28 million legal liability from me, rather than from Organovo in an 8K or S3 legal disclosure ?
Reverse mergers in perspective
Commercializing a new product or service in the real world is an arduous and time-consuming task. Successes are rare and often take decades to make themselves evident.
Reverse merger stock promotions, in sharp contrast, are far easier. It is very simple to achieve 8 and 9 figure fortunes in the space of just a year or two.
Step one is to acquire the busted shell of a defunct company. Step two is to complete a reverse merger and inject some token amount of assets. Step three is to change the name. Step four is to heavily promote the story.
A few years ago, when China was hot, it was possible to create $500 million dollars by simply creating a reverse merger with the "China" in the name. Hundreds of these companies were uplisted to the NYSE and NASDAQ. Before that, when solar was hot, there were numerous half billion-dollar companies created just by having some hint of a solar business. Prior to that adding ".com" to a company's name would often create similar valuations for reverse mergers. But in the end, when these companies failed to produce profits, we saw them ultimately plunge to the pennies.
As noted in "Get Rich or Die Tryin'," there are two kinds of investors in these promotions. The "Get Rich" crowd gets in early at very low prices.
It is important to note that the Get Rich crowd has no intention of waiting for the product to be an ultimate commercial success. Instead, they cash out when the promotion of the stock and the story hits a peak.
Many authors (such as Mr. Napodano) have clearly expressed their views that the early investors in Organovo have already sold their stock - well before any commercial success is even close. They had no intention of waiting around for real world success because they were simply playing a stock promotion - not a product.
I agree that these investors will sell well before commercialization. But I also believe that they would be smart enough to wait for the price and liquidity, which is provided by the uplisting. This is why I believe that they are selling now.
Early investors cannot sell unless someone else is doing the buying. Likewise, investors who buy these stocks should be aware that every time they buy, it is the result of someone else being eager to sell. This is where the Die Tryin' crowd comes in.
It is well known that institutions tend to steer clear of reverse merger promotions. As a result, reverse mergers rely heavily on promotion to retail investors.
For example, Organovo has made ample use of a service called RetailInvestorConferences.com.
Retail investors can often take comfort from various sources of "validation" which may not be appropriate.
For example, some investors believe that an uplisting to the NASDAQ or the NYSE is reflective of some sort of judgment on the investment merits of a stock. This is quite clearly not the case.
In recent years, there were hundreds of Chinese reverse mergers which uplisted to the NYSE and the NASDAQ. It was ultimately uncovered that many of these companies were empty shell frauds with virtually no assets or employees. Most of these companies were delisted to the pink sheets just as quickly. Taking any confidence from the uplisting was clearly a mistake.
The only point I am trying to make is that an uplisting will improve liquidity, but does not have any implication for the investment merits of a company. Note: I am not making any suggestion that Organovo is a fraud.
Likewise, many investors assume that obtaining a research grant is also validation of the long-term potential of a company. Sometimes this can be the case. But we can also see that the list of non-productive research grants is very long and very large.
Examples include a $3 million federal grant to study the game World of Warcraft and a $2.6 million program to teach Chinese prostitutes to drink responsibly.
My point is not to suggest that Organovo's grants are without merit. Instead, my point is to suggest that obtaining a few million in grant money is a very common occurrence for many creative ventures in the US.
So far, Organovo has not achieved any meaningful degree of commercial success. But the stock promotion has been extremely successful.
Despite minimal assets and revenues, the company has been able to briefly exceed half a billion dollars in market cap. The recent rise briefly put the value of CEO Keith Murphy's stock at nearly $40 million in a very short time since coming public.
Fortunes like this often take decades to achieve when one is dependent upon the actual commercial success of a product. But with reverse merger stocks, they often take just a year or two.
Ultimately, Organovo may end up being the reverse merger that transforms the nature of medicine as we know it. If so, it will end up being worth many billions of dollars.
On the other hand, if Organovo fails, someone will come along, acquire the defunct shell and start over with a new billion-dollar reverse merger idea. The name will be changed and so on.
Fortunately we are all able to come to our own investment conclusions with respect to these divergent potential outcomes and we are all able to act accordingly.
I am short Organovo.