Funding: Confirmation Bias, History, Skin in the Game

How do small companies and mid tiers fund themselves? This is a key question for companies which don't have significant cash flow from production. Thinking about an exploration or development company, typically they invest capital in order to create value within an asset and actually there's no real cash flow coming out until the production phase.

The production phase is so far down the track that it could be months, years or even decades before that happens. Therefore, when considering investing in a company without cash flow, you have to be comfortable with how that company is going to fund itself in the period from now to exit or from now to production. These smaller companies, the junior sector, are in the exciting developmental stage of their assets, often going through exploration.

Of course the reward is that during this period, you can get multiple returns on your investment. You can get the two baggers up to the five baggers or the 10 baggers. The risk is they go bust and you lose your money. You lose your investment. Indeed, if you look at the share price performance of most junior exploration companies, what you see is a skewed bell curve where the share price rises, peaks and falls with a long tail off to the right. Effectively, this represents the generation of some good exploration targets in the early days,

followed by some initially positive results, and then the grim reality that few of the initial exploration success stories actually make it into an economic deposit.

Companies have to issue more shares to self-fund, and without that rarest of things - a company making asset - what one has is ongoing dilution, chopping and changing between projects, and a long, unexciting tail to the share price.

If you take a slightly less risky approach, you can invest in a company which has already identified an asset with economic potential, where the first phase of exploration has already been completed. And I refer you back to the Lausanne curve to put yourself in context. But at this stage of development or this stage of the asset in the Lausanne curve, what the company is trying to do now is to establish a realistic net present value or NPV for a project and to hunt down or walk down the discount that is being applied to that asset at that particular time. Put another way an NPV is a theoretical financial value but there are a host of other risks that need to be included in the analysis, such as market volatility, permitting risk, and most pertinently when it comes to the junior end of the industry, funding and execution risk.

In short, the market applies a haircut to the NPV. And the investment case is predicated on the discount to NPV gradually being chipped away or eroded as key milestones are met. Feasibility study? Check.

Full suite of permits and licenses from the authorities to allow development? Check. Funding strategy that doesn't wipe out equity investors. Check.

Successful construction on time and on budget. Hardly ever happens, but “check” anyway.

And then startup and commissioning without any nasty surprises. Again, pretty rare, but “check”.

Each successful step reduces risk and should lead to a re-rating. Assets sitting in juniors at the study phase are likely to be trading at something like 0.3 to 0.4 times NAV or NPV, rising to 0.7 times NPV when funding and permissions are in place. And when a project is successfully commissioned without blowing up the capital structure, then the market finally gives the project full value. Overall, the share price performance may be less spectacular than enjoying the wild ride of a bonanza exploration discovery, but if you select your commodity, your team, the jurisdiction and the project properly, then you should still get a very healthy return on your investment. These kinds of return profiles such as de-risking from 0.3 NPV to 0.7 NPV, or shooting for a 10-bagger in a discovery, are key factors when it comes to funding.

Clearly the primary way that a junior company raises money is by issuing stock, and the institutions or brokers that cornerstone a capital raise want to be sure that the issue is properly priced so that their share price goes up, not down, after issuance. Conversely shareholders typically want to issue capital at a higher price so that the original shareholders, the founders of the company, don't get diluted too much. Which means that there's a degree of tension in the pricing as investors typically want a lower entry point and existing shareholders typically want a higher pricing price.

What often happens therefore is that the management teams start banging the drum hard before rattling the tin, just like a good busker does in a crowded street market. Watch out for this if you're a retail investor and ask yourself is this a fundamental rise in share price or is it a result of a short-term marketing push? And there are other reasons for a sudden share price rise that should make investors wary. Your antennae should be twitching if there's a sudden rush of interest as a commodity comes into vogue. You have to ask yourself is this move based on something fundamental or is this perhaps a little bit choppy?

By studying the trend of a share price over the longer term, the fundamentals of the story tend to come through and the share price will settle down to trend levels or more realistic levels. Buyer beware, don't go chasing sudden price rises. There's always time. Take a deep breath, exercise prudence when the temptation arises to rush into a hot stock, either when it recently has had a large move upwards or when you know that they're doing a big marketing push with a view to an “opportunistic” capital raise. Often one of the best things to do as an investor is to sit back and wait for things to settle down and to really see how this company is funded and backed and is going to perform.

Another general observation for a retail investor is that there's always a knowledge gap. No matter how the market is trying to be transparent, no matter how the regulators are trying to ensure that everyone gets access to the same information, there's a cascading flow of information from the CEO outwards. And the closer you are to the heart of things, the more you will know. Typically, this means that retail investors get pretty much the worst information out there. They are often privy to less information than institutions. Certainly, advisors and brokers know more about what's going on within the company.

Board members will often know more than the buyers and the key brokers, although this of course does depend on communication lines. And finally, senior management are privy to the most information. As an external investor dealing with publicly disseminated information, all of this can make your decision making quite difficult. You can build up your trust in your company. In the spokespeople from the company, you've got to start off without trust and verify from there. Doubt and double check.

It is why it is so useful having the long form interviews with Crux Investor when Matt asks difficult questions. Seeing how a senior executive deals with an unscripted question is particularly revealing and useful for investors.

A quick word on confirmation bias. It is of course important to be aware of confirmation bias. As humans we are always looking for things that we want to be true and we try to confirm the views that we already hold. But let's bring it back to what does this mean for the funding of a company. It's crucial that a company is well funded.

If your company is cheap you may think that it has a really good asset but its share price and market capitalisation is very low relative to the reporting value of the asset. There are probably good reasons for why it is cheap and just because it is cheap does not mean that it is good value. It probably means that there are risks that you haven't thought about and timelines and how the company gets funded is often a key oversight. There are some well established playbooks in the resources sector that seem to play out in slow motion.

And with time, you'll get to learn the signals, which are often there very early on. Those signals will indicate how things will turn out in one, two, three or more years. Let's have a quick look at the funding history because this is relevant. So when you look at the funding history, my aim is to highlight and spot these early warnings or indeed these attraction signals because let's not be too negative here. If they've got a good funding history, it can actually be a positive for the stock as well.

So, let's specifically on funding look at the many indicators. And perhaps the first thing to look at is what is this funding history? It's always worth checking to see who owns stock in the company and at what price did they get that position. For example, if it's been private for a long time and then it comes to a market at a much higher price than the price at which it raised money during the private rounds, you need to question, will there be a wave of selling as perhaps bulls take advantage of this sudden liquidity event?

In an extremely well-managed exercise, in an extremely well managed company, anybody who wants to sell at the higher price will have been mopped up pre IPO, but I've only seen that once or twice in my experience. Typically what happens is that it comes out at a higher price than the IPO and these shares get met by some early selling as people crystallise their gains and the share price pulls back, it settles down and eventually a new trading range is established and the share price gets back on track. It's not good practice but it happens a lot.

And this is perhaps not so relevant to retail investors because there's less opportunity for engagement in IPOs, but it's still worth considering because if you do hear about a new IPO coming to market, you may want to sit back and wait and just let things settle down before

jumping in. Another key factor that's worth considering when it comes to funding is skin in the game because many people have strong views on this. And as a general rule, most people like to see management with skin in the game. From my perspective, it's not quite as simple as that.

The management team that founded the company, that started it or found the project and run it, they've got a particular skill set and they might be just the right people to pick up the asset in a difficult jurisdiction such as Central Asia or Africa or South America or in the frozen expanses of Northern Canada. The specific kind of person who can pick up the asset and identify the opportunity might not be the right person to take the asset forward or at least not be the right person to take it beyond a certain point. At some point, you need to hire people with different skill sets to do the next phase of the job.

You might need to pay a professional to get the job done well. I think it's slightly strange that the resources sector puts so much emphasis on this guy's not taking any salary and he's got skin on the game. I don't think there are many other businesses in the world where you'd be able to attract a good professional and say, we're not going to pay you, or you have to invest heavily in this business, have no salary and also expect that this person is a professional who's going to do the job properly.

You know, there's a conflict in my mind between professional and amateur. Clearly you don't want people to come in on a huge salary who've got no downside. There has to be some ratchet and that's the way I like to see it. Fair pay with a reward on success and a track record of delivery. What's less encouraging is when you see founding directors with large positions who are not prepared to let go of control, who are not paying anybody because they don't want to see any dilution. The company's not going to grow, it's not going to move on. Or people coming in on a huge salary and actually their salary is so large that it doesn't really matter to them whether they succeed or fail. Hence getting the G&A right, the general aspects of the company, right in a small company, it's really important.

I would urge every investor to look at the reports of a company, the financial statements and look at the remuneration and ownership of stock. It can be really revealing and the professionals on a decent salary don't always need to be big owners of the company. There are many companies where I think actually that's just taking the mickey, that's really not good enough and that's a good enough sign for me not to want to get involved in that company.

But I wouldn't say that having skin in the game is an easy thing to analyse and I wouldn't base an investment decision purely on whether one guy has skin in the game or not. You've got a question, is it a fair package and particularly is this company properly set up to make a successful future for itself?

Thank you.