Among the things resource investors fear the most—or should fear the most—is shareholder dilution. That’s why my due diligence always includes a look at a company’s share capital structure.

It goes like this…

Moosepasture Exploration Co. has a bunch of moose pasture in Canada to explore, but no revenue. It starts out with a very clean, tight share structure, say 10 million shares, a million options, no warrants, and $2 million in cash. The shares trade for $1. Let’s also say management is wise and frugal and don’t blow it all on fancy office space, but spend most of it peeling back the moose moss to look at the rocks underneath.

Then what happens?

If they’re lucky, they find some encouraging indications of valuable minerals under the moss. But now they only have $1 million left, and it’s going to cost at least twice as much to drill the project and give their potential discovery a good test.

If they’re not so lucky—which would be completely normal—they still spent $1 million and are no better off than before. But they don’t want to keep exploring without topping up the treasury, because the worst time to go to the markets for money is when you desperately need it.

Either way, they need to raise more money. Borrowing it when they have no income and no guarantee of success would be insane, so they have to issue new shares in a private placement. It’s like an IPO, except that it’s not initial. And it’s called private because it’s done directly between the company and qualified investors, not via the stock exchange.

So let’s say they were lucky and the stock is up to $1.30 when they go to the market for money. They offer a private placement with five million units at $1.25. To sweeten the deal and make sure they raise all the money they can while the stock is up (and they still don’t have an actual deposit in hand), the units include a share and a full warrant, good for two years, exercisable at $1.50.

The offering is a success. The company now has 15 million shares issued and outstanding. It’s 21 million fully diluted—counting the five million warrants and the one million options.

That’s fine, but the ownership of the initial shareholders is diluted by 50% more shares being issued.

This usually happens every year or two, until the exploration company makes a discovery or goes out of business. Some years are luckier than others, enabling the company to raise more money with minimal dilution. Some years, a company can deliver great results on the ground, but the markets are down, and it’s forced to issue more shares at lower prices. That creates more dilution, despite excellent, value-adding work. Unless shareholders participate in every private placement along the way to maintain ownership, their share of whatever gets discovered is decreased every time the company raises money.

It’s a tough business.

And as bad as that is, it’s just the beginning. In the unlikely event that Moosepasture Exploration discovers a deposit worth mining—and starting from scratch, it really is unlikely—a lot more dilution will be required to finance building the mine.

Let’s say that Moosepasture has been exceptionally lucky and gone from peeling back moose moss to delivering a deposit ready for mine construction in five years. That took a lot of drilling, metallurgical studies, engineering studies, and such. All of this had to be paid for, necessitating more dilution along the way. The company now has 100 million shares issued, 50 million warrants and options out at various prices, and $10 million in the bank. The deposit has $1 billion in net present value, so it was worth it—but it’s going to cost $500 million to build.

Now here’s where it gets really interesting.

If all this work discovering and defining real value in the ground happens when markets are rising, the stock could be way up. Maybe even 10x over its initial trading price. The original shareholders may have been diluted in their ownership of the project, but they aren’t complaining.

But suppose the markets rose and fell during that time, as they often do. The stock could be trading back at $1 again. Management may feel great: they made a billion-dollar discovery and their company went from $10 million in valuation to $100 million (100M x $1). Bully for them. But it hasn’t benefited the original shareholders at all. Not only have they made no money via share price appreciation, they own 1/10 as much of the company as they did at the start.

And now Moosepasture needs to raise $500 million to build the mine. If that’s done by issuing shares, everyone faces more direct dilution. If it’s done via debt, the lender will usually require a hedge as collateral, meaning a certain portion of production at a fixed low price—and that too is a form of dilution.

I’m not trying to depress anyone with this litany of dilution. I am trying to make sure everyone understands that it’s an inescapable part of the exploration business.

An astute thinker here might challenge me on that and say that a large, profitable mining company can pay for exploration out of pocket. If they issue no shares, there’s no dilution. That’s true as far as it goes. But exploration is uncertain and expensive. It’s the easiest cost to cut when markets turn down—which they often do. It’s rare for a big company to make a grassroots discovery and take it all the way to production. They often end up buying smaller exploration companies that make great discoveries. That use of capital reduces the amount that can be paid out to shareholders as dividends or put to other uses, and also represents a form of dilution. And even when all goes well, these companies are too big for a billion-dollar discovery to move their share prices much.

There really is no escape.

So it’s wrong-headed to oppose all dilution. The question to ask when management of a company we own says they want to raise money is: “What do we get for the dilution?” The value added needs to exceed what we lose to dilution.

Suppose, in our Moosepasture example, we can finance the mine build for 50% more dilution in shares and the rest in dilution-minimizing debt. What we get for that is transitioning from spending money on a theoretical asset in the ground to a cash-flowing asset that builds shareholder equity. Assuming the mine lives up to expectations, that’s a good deal.

Or, suppose we’re looking into the share structure of a company we’re considering buying. The question then becomes: “What did we get for the dilution?”

If the company has a lot of shares issued and no flagship asset, it’s a red flag, at the very least. It’s potentially a big problem, because it makes it hard to raise money on good terms. Worse for new shareholders is that there are a lot of old shareholders with large amounts of cheap stock in hand who will often dump their shares every time the price tries to rally.

But a lot of shares issued is not by itself a red flag. A company may have a lot of shares issued for good reason—like acquiring another company with great assets by issuing stock.

It’s even possible for a very low number of shares issued to be a red flag. If a company has been around for a long time and has few shares out, there’s probably a rollback in its history. At some point, there were probably so many shares issued that (as per the above) it was difficult to advance. So they consolidated shares, issuing one new share for every 5 or 10 old shares. Sometimes this is necessary, but it’s almost always a sign that something went wrong, or someone made bad decisions. It’s best to make sure whatever happened has been corrected before taking a chance—and even then, there’s a good chance that the now massively diluted shareholders from before the consolidation will dump shares, keeping share prices under downward pressure for a long time.

How much is too much?

There’s no rule written in stone, but in general, here’s how I look at it:

At the end of the day, it’s all about cost and use of capital. Shareholder dilution throughout the exploration process is inevitable, but it can be kept to a minimum. One should always ask what one is getting or has gotten in exchange.

Let me put it this way: when I look into a company’s share structure, it tells me a story. It can tell me when management is effective, successful, and looking out for shareholders.

Or it can tell me the opposite.

Caveat emptor,

Wednesday, November 28, 3:49pm, EST, 2018