May 01, 2015
Article by Jeffrey Zudeck, Partner-in-Charge, Philadelphia Region, "Microcaps: Understand the Risks and Reap the Rewards," Featured in The Metropolitan Corporate Counsel
Whether you're an issuer or an investor, playing in the microcap arena can be riskier than with other forms of investment, at times significantly so. Many microcap stocks are traded over the counter, directly between brokers and dealers. As they are not often the focus of concentrated market interest, only a small number of shares are traded at any one time, and prices tend to be low because of the low demand. In addition, unlike microcap stocks that are not exchange-traded, they do not have to meet the strict listing standards designed to protect investors, and due to the relative anonymity of these stocks, investment researchers follow them less closely and file reports about them less frequently than their larger counterparts. The SEC has stepped in to address this, requiring microcap stocks with more than 500 investors or with $10 million or more in assets or that post their price quotes on the OTC Bulletin Board to file reports with the agency, detailing the stock's financial condition. But certain microcap stocks are considered risky investments for reasons apart from their place in the regulatory framework. Often, for new companies with no established history of success and with products or services that are in the infant stage, the likelihood of their success is difficult to gauge. In addition, the paucity of public information increases the risk of corporate fraud.
The tradeoff, of course, can be summed up in a Wall Street axiom: "The higher the risk, the greater the reward." With many microcap stock prices low and the companies small, tremendous room exists for growth and robust returns.Understanding the Differences
It is important to understand what is meant by the terms microcap, small-cap and penny stock. The definitions of small-cap and microcap stocks are connected to the value of their market capitalization. Penny stocks, on the other hand, are defined by their per-share price.
- Small-Cap Stocks: The definition of a small-cap stock varies among the rating agencies and numerous brokerage houses. Generally, it relates to a company with a market capitalization of less than $1 billion. Historically, these companies have focused on the delivery of services and products to niche markets or emerging industries where substantial growth in demand is expected.
- Microcap Stocks: The SEC has indicated that the term microcap stock applies to those companies with low or "micro" capitalizations (i.e., meaning the total value of the company's stock). Depending on who you're talking to, there are many different market caps used to define what a microcap stock is. Generally speaking, companies with market capitalizations of less than $500 million are defined as microcap.
- Penny Stocks: The SEC has noted that the term penny stock generally refers to a security issued by a very small company that trades at less than $5 per share. Smaller start-up-type companies typically issue penny stocks - many of which may be thinly capitalized. These are often traded infrequently and, as a result, their true value may be unknown.