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Understanding The Details Of Axion's Reverse Split Proposal

|Includes:Axion Power International, Inc. (AXPW)

On Wednesday afternoon Axion Power International (NASDAQ:AXPW) filed a preliminary "Notice of Consent Solicitation" with the Securities and Exchange Commission that describes a plan to ask its stockholders to authorize the board of directors to implement a reverse split in a range of not less than 1 for 20 and not more than 1 for 50 at any time prior to December 31, 2014 without further stockholder action. Since this is an important proposal, emotions are running high, fears are running deep and the entire process is a mystery to most investors, I prepared this discussion to highlight the issues and offer a back-stage view of a very complex process that's an essential element in the maturation of every public company; a process that I think is long overdue.

The proposal described in the preliminary Notice of Consent Solicitation will:

  1. Authorize the board of directors to implement a reverse split of not less than 1 for 20 and not more than 1 for 50 without further stockholder approval; and
  2. Leave Axion's authorized capital stock unchanged at 350 million shares of common stock and 12.5 million shares of preferred stock.

The stated goals of the proposal are to:

  1. Facilitate the negotiation and closing of a financing transaction that will be required before year end; and
  2. Facilitate an upgrade of Axion's trading market from the OTC Bulletin Board to the Nasdaq Stock Market.

It's an ambitious plan with a lot of moving pieces that stockholders need to understand before making a decision.

Preliminary disclosure

Readers should understand that in the fall of 2003, a partner and I controlled a public shell that ultimately merged with Axion Power Corporation to form Axion Power International. When I negotiated the reverse merger my most important concern was the market where the combined companies would trade. While I knew the combined companies would have to start trading on the OTCBB because of the transaction structure, my primary goal was to get Axion off the OTCBB and onto a national exchange as quickly as possible. The reason is simple. The OTC market is a financial ghetto where nasty characters lurk in every back alley and shadow. It's a great place to learn street smarts, but life in the national market suburbs is far more comfortable, safe and secure.

The process should have been completed in 2004, but litigation that was filed within a couple months after the reverse merger disrupted certain soft third party financing commitments that were at the heart of the original plan. Since there was no way to unscramble the eggs, my only options were to walk away from a busted deal or go to work and do it the hard way. I chose the more difficult path, but the greatest frustration of my career is that the decisions stockholders are facing today should have been resolved a decade ago and baseless litigation from dishonest characters we couldn't control screwed up our carefully conceived plans.

My view of dilution

The first topic I want to touch on is the dreaded D word - dilution. I've spent my whole career working with entrepreneurs who have great potential but don't have enough money to realize that potential. The entrepreneurs, quite rationally, want to keep as much of the upside as possible. Their prospective investors, on the other hand, know that the business potential can't be realized unless they step up new cash and if things go badly they'll eat the lion's share of the loss. Those two differing and entirely rational perspectives create incredible tension. Bringing the parties to a reasonable middle ground where the entrepreneurs and the investors both get a fair share of the unrealized value is the heart of the deal, the region where I've always earned a living.

A harsh reality that most public company stockholders never understand is that they became members of the entrepreneur class when they bought their first share of stock. From that point forward, their interests were diametrically opposed to the interests of the investor class; the people who need to write new checks to help their enterprise realize its potential.

Over the years I've gotten pretty jaded on the topic of dilution. An entrepreneur starts with a collection of bricks, sticks, mortar and widgets that have an ascertainable value, and a far fuzzier "unrealized business potential" that can be quite high if things go well and quite low if things go poorly. In the context of a public company like Axion, the spread between the equity that appears on the balance sheet (~$10 million) and the market capitalization (~$30 million) is the market's best current estimate of the intrinsic value of that unrealized business potential.

When an investor comes along and invests $10 million in a company, his new cash increases the aggregate value of the bricks, sticks, mortar and widgets by $10 million. It also increases the intrinsic value of the unrealized business potential because the entrepreneur has $10 million more that can be used to turn ambition into reality. The increase in the value of the unrealized business potential isn't always proportional, but it's usually pretty darned close.

Stockholders tend to think in terms of a pie and assume that selling a piece of their pie to a new investor somehow decreases their retained value. The reality is the cash paid by the new investor usually makes the pie bigger. It increases the value of the bricks, sticks, mortar and widgets by an amount equal to the new cash. It also increases the value of the unrealized business potential by providing new resources that allow the entrepreneur to move closer to his goal.

The entrepreneur class always gives up a slice of the pie when new money comes to the table, but the total weight of the pie usually increases by an amount that's equal to or greater than the weight the new investor brought to the table. In the business world a big pie has a greater chance of success than a small one. Given a choice between owning 100% of a 3 pound pie and owning 50% of a 6 pound pie, I'll take the half pie every time because my chances of success are better.

I frequently quip that every bartender knows you don't dilute a beer by adding a shot of whisky. As long as the new investors increase the intrinsic value of the business the entrepreneur class benefits from new financing transactions. It does not suffer dilution.

How credible investors think

In the preliminary disclosure I spoke of the OTC markets as a financial ghetto. While that may strike some as an exaggeration it really isn't. The SEC is extremely wary of small companies that trade on the OTC markets because it knows that dishonest promoters are more common in the ghetto than they are in the suburbs. It also knows that shady characters who lurk in alleyways and shadows are more than happy to victimize the honest residents.

While the suburbs are filled with financial institutions that have open airy lobbies and friendly personal bankers, the only financial institutions you'll find in the ghetto are heavily fortified check-cashing joints, pawnshops and loan sharks. When you live in the ghetto convincing a credible investor that he wants to do business with you is a long hard uphill battle. If you want to be taken seriously by the boys in mid-town and the suburbs, moving to a better neighborhood must be part of your overall plan, and the sooner the better.

How funds are organized

Investment funds come in two basic flavors. The mainstream investment funds are a lot like mainstream bankers who want to do business in mid-town and the suburbs. They're incredibly risk-averse and usually have strict provisions in their bylaws and other corporate documents that prohibit investments in the ghetto. The rest are the "special situations" funds that run the check-cashing joints, pawnshops and loan sharks. It's not unusual for a major fund family to have a combination of mainstream and special situations funds, but the funds that are organized to do business in the ghetto are much tougher beasts than the mainstream funds.

Most funds that aren't specifically organized for special situations investing have ironclad rules against buying shares of companies that aren't listed in a national exchange. In addition to their ironclad rules, many have detailed policies that are almost as inflexible. It's not at all unusual for a fund to have a minimum price requirement of $5, $10 or even $20. Unfortunately, the most stable and reliable funds, the guys you really want as investors, are the hardest to please.

Over the last thirty years I've attended more financial pitch presentations than I can count. The easiest presentations are ones where a company that's listed on a national exchange wants to raise more money. The second easiest presentations are the ones where a privately held company wants to raise money from investors who are willing to do a deep due diligence dive into their business fundamentals and deal terms. The hardest presentations in the world are the ones for public companies that still live in the ghetto. If your business card shows that you live in the wrong neighborhood the meetings are hard to come by and if you do make it past the reception desk the first question on everybody's lips is "How and when are you going to move out of that crappy and dangerous neighborhood?"

What it takes to get a NASDAQ listing

NASDAQ has two market tiers that are potential fits for Axion - the Capital Market and the more prestigious Global Market. It's third tier, the Global Select Market, is reserved for very large issuers and will be out of Axion's reach for at least a few years. While NASDAQ publishes a detailed list of initial listing requirements for each market tier, the key financial requirements for Axion's proposed application are as follows:

 

Global

Capital

 

Market

Market

Stockholders equity - or -

$30 million

$5 million

Market capitalization

$75 million

$50 million

and

   

Minimum bid price - or -

$4

$4

Minimum closing price

 

$2

Click to enlarge

While the NASDAQ will consider planned financing transactions when determining whether a company meets the stockholders equity and market capitalization standards, the major hook is a requirement that a company like Axion that wants to upgrade from the OTCBB <edit> in reliance on the Market capitalization standards <edit> must meet the Market capitalization and Minimum price requirements for 90 consecutive trading days before filing an application. Since there are 20 to 22 trading days in the average month we're currently on the cusp of the price evaluation period for a September market upgrade.

NASDAQ will consider trading prior to a reverse split as solid evidence that the price will hold, but they also tend to like some headroom because they worry about post reverse price declines like everybody else. So its not unusual for a stock that's been trading at $.20 before a reverse split to use a larger ratio than 1 for 20 to give everybody confidence that the price will hold.

Authorized capital

The concept of authorized capital is the bane of every securities lawyer because it's a throwback to another time when corporations had a handful of shareholders who actively participated in the business. It makes a world of sense in closely held companies where individual stockholders participate in management decisions and day-to-day operations but it makes no sense in the context of a public company where the biggest holders own 2% or 3% of the outstanding stock.

Every time a company goes to its stockholders to request an increase in the authorized capital the knee-jerk response is the same. Holders who own an insignificant stake suddenly find themselves overcome by paranoia that the people who manage the business will change established behavior patterns and begin to carelessly issue new shares or greedily line their own pockets.

I've never seen that happen in real life because managers know they'll be sued for that kind of behavior and they'll almost certainly lose. There are occasional abuses in closely held companies and even companies that trade on the OTC markets, but once a company graduates to a national exchange like the NASDAQ the potential for the kind of malfeasance stockholders fear most effectively disappears.

If we consider Axion's current capital structure, there are 350 million authorized shares and 221 million shares outstanding in mid-April. By the time you reserve about 30 million shares for future issuance under warrants, stock options and convertible securities that only leaves 100 million shares of wiggle room for the board.

I don't have the foggiest idea of the amount Axion will need to raise in this next round or what the use of proceeds might be. My fondest hope is that it will need a good deal more than $10 million of survival money. Since I can't begin to estimate the amount of cash that might be needed I can't have any firm conviction that 100 million pre-split shares will be enough to get the company where it needs to be. I've never had a good outcome when I tried to empower with one hand and hobble with the other.

Corporate governance

In order for a public company to upgrade its market listing from the OTC to the NASDAQ it must:

  1. Make its annual and interim reports available to shareholders, either by mail or electronically through the company's website;
  2. Have a majority of independent directors;
  3. Have an audit committee consisting solely of independent directors who also satisfy the requirements of SEC Rule 10A-3 and who can read and understand fundamental financial statements. The audit committee must have at least three members. One member of the audit committee must have experience that results in the individual's financial sophistication;
  4. Have a compensation committee consisting solely of independent directors and having at least two members. In addition, Rule 5605(d)(2)(NYSE:A) includes an additional independence test for compensation committee members. The compensation committee must determine, or recommend to the full board for determination, the compensation of the chief executive officer and all other executive officers;
  5. Adopt a code of conduct applicable to all directors, officers and employees.
  6. Hold an annual meeting of shareholders no later than one year after the end of its fiscal year;
  7. Solicit proxies for all shareholder meetings;
  8. Provide for a quorum of not less than 33 1/3% of the outstanding shares of it voting stock for any meeting of the holders of its common stock;
  9. Conduct appropriate review and oversight of all related party transactions for potential conflict of interest situations; and
  10. Obtain shareholder approval of certain issuances of securities, including:
  • Acquisitions where the issuance equals 20% or more of the pre-transaction outstanding shares …
  • Issuances resulting in a change of control
  • Equity compensation
  • Private placements where the issuance equals 20% or more of the pre-transaction outstanding shares at a price less than the greater of book or market value.

Axion already complies with most of these rules because they're just good corporate governance. But without the protections the NASDAQ requirements provide for stockholders, it's easy for a management team to get mugged or worse by a special situations investor that says, "Take it or leave it."

Offering price discounts

Institutional investors usually expect a discount from the quoted market price of a security because their risk profile is very different from the street investor who can typically sell his entire position in within a few days if he changes his mind. Responsible large investors know that they can't account for more than 5% to 10% of sell-side volume without distorting the market. There's also a strong theoretical basis for the position that a new investor who writes a check to a company to is creating new value for the company and its existing stockholders while an investor who buys shares in the open market creates no new value.

In general the magnitude of the discount demanded by prospective investors is directly related to the market where the underlying stock trades. Investors fear stocks that trade in the OTC ghetto and they demand deeper discounts when buying shares. As companies move up the market tiers through the NASDAQ Capital Market and Global Market, the discount demands get less severe. By the time a company makes it to the NASDAQ Global Select Market, it can usually sell shares without any discounts.

The recent follow-on offerings by Capstone Turbine (NASDAQ:CPST), Plug Power (NASDAQ:PLUG) and ZBB Energy (ZBB) are all fairly typical. The companies took haircuts of 15% to 20% in connection with the deals, but it was nowhere near the 40% to 60% discounts you see when OTC companies sell shares to special situations investors.

What it takes to bring it all together

In the final analysis an outfit like Axion has to negotiate with NASDAQ to find out what it will take to satisfy their staff and then negotiate with the investors to find out what it will take to satisfy them. Until you know the answers to those questions, pulling a reverse split number out of thin air and implementing it is a great way to find out that somebody you were depending on is shaking his head and saying "not good enough."

The Notice of Consent Solicitation talks about a range of 1 for 20 to 1 for 50 because that's what management needs to find a clean path through the negotiations. It could act unilaterally, but that would be a very foolish thing to do.

Disclosure: I am long AXPW.

Stocks: AXPW