Several years ago whilst working with an investment group we were offered an opportunity to acquire shares through a private placement in a listed lithium junior mining company. The company had undertaken various feasibility studies and needed to raise capital to bring certain growth milestones to fruition to fund working capital. At the time, the lithium carbonate price was depressed, various government EV mandates had not come into effect, and we felt the investment thesis for the investment didn’t warrant making the investment.
As things would turn out, not much long after we considered the investment, beginning in 2021 the lithium cycle turned dramatically, demand for lithium deposits exploded, the price for lithium carbonate peaked at over $90,000 per ton in November 2021 from around $13,000 per ton, and a rush of previously interested but cautious buyers flooded in, with the top bidder eventually paying hundreds of millions of dollars to acquire the mine from the company. The investment would have resulted in a near 10x multiple of investment inside of three years.
The lesson piqued an interest in private placements, and how to negotiate them, so I was fortunate to came across a speech by the renowned resources investor Rick Rule, formerly President and CEO of Sprott US Holdings Inc, and a master of negotiating private placements.
What is a private placement? A private placement is an issuance of debt of equity securities directly from companies treasuries to investors, usually sophisticated private or institutional investors, rather than going through public offering. The advantages of private placements to companies are that funds can often be raised much more quickly than through public offerings because of less regulation in the process.
What are the advantages of private placements to investors?
- They are negotiated transactions directly with the issuer – an investor negotiating a placement investment is not buying shares in the company in the secondaries market, which would mean they could be competing with themselves, and possibly paying a higher price, particularly in less liquid companies. The investor can therefore negotiate preferential terms, and if not agreed to, walk away.
- Shorter time-frame – A company undertaking a private placement usually needs the money for a specific “catalytic event”, which will, if successful, change the fortunes of the company for the better in a relatively short period of time. Once the funding has been deployed, the results are usually evident, and if successful, will create shareholder value, and lead to an increase in the share price. This compares with buying shares in the secondaries market, where the funds goes to a selling shareholder rather than to the company’s treasury, and usually having a longer timeframe to see results.
- Warrants – If negotiated effectively, warrants can be issued alongside private placements. A warrant is like an option, where the holder of the warrant has the right but not the obligation to purchase more shares at a fixed strike price at some point in the future. The reason why warrants are usually negotiated alongside placements, is that by funding the placement, an investor is taking a lot of asymmetric financial risk, which could result in downside only to the investor, or significant upside for all shareholders. In return for taking on this this additional asymmetric risk, it is wise for the investor to negotiate a warrant to give him the option to acquire additional shares in the company, at a fixed strike price, thus “having an opportunity to buy the shares twice”.
Rick’s Rules for negotiating placements
- No warrant, no money – a warrant should always come with a placement, otherwise Rick advises to walk away from the deal. The upside reward is not high enough to benefit from the potential downside risk.
- Match time horizon on warrants to management share option schemes – management often don’t like warrants, because they see them as dilutive. However, as Rick points out, management share option schemes are also dilutive. The longer the time horizon the warrant is valid for, the better. At a minimum, therefore, the time period for which warrants are valid for, should match the time period of management’s share option time periods. A clever tactic to use when management say they do all the work, is that funding provided to the company is working 7 days a week, whereas management only usually work 5 days a week!
- Changes in warrant strike prices should move with employee share options – if a market is depressed, and management want to lower the strike price on their shares, then the same logic should apply to strike prices on warrants.
- Invest when capital is scarce – don’t invest when there is a craze, like when the lithium price went from $13k to $90k per ton during 2021-2023. Invest when markets are depressed since this is when market participants are scared, and when the best deals are done.
The why, what, how, who, and when of negotiating a private placement
- Why does the company need the capital? Which is linked to;
- What is the “unanswered question” that management need an answer to. What are management trying to find an answer to, which if achieved, will benefit the company? How long until the company will know when it has answered the question?
- How – how much money is required to answer the “unanswered question” and how will the proceeds be used? If a company needs $5m over 18 months for the project, but overheads are $2m per year, then the company needs $8m not $5m ($5m for the project and $3m to fund overheads for 18 months). Only do a placement if the company has all the money required to do the project.
- Who – who is going to implement the project and what have they done/achieved in the past? How specific is the expertise needed to supply the task at hand? Does the company have the requisite skills and expertise to handle the invested capital? If a company is developing a lithium project in Zambia, is there someone who has specific experience in similar lithium projects and in a similar developing country?
- When – When will the company know if it has succeeded or failed. What can go wrong, and how will management know if things are going wrong? What is the pivot if things go wrong? Rick cites an example from a project where management raised $10m for a drilling project, and spent the full $10m, even though they knew early on that the project had gone wrong, thus wasting precious capital.
Ultimately, the best placements are done when the following conditions are in place:
- There is a clear question to be answered, which will result in a catalytic event that will benefit the company
- The funds raised via placement will be sufficient to answer the unanswered question
- The duration of the project is well understood with well documented milestones
- There is a strong management team in place with sufficient experience to execute the task at hand
- Appropriate risk mitigation techniques in place in case things go wrong or the project does not turn out as expected
- Capital is scarce, giving the investor an upper hand in negotiations
- A warrant comes with the placement to enable the investor the ability to “buy twice” at the same price, with duration and strike prices aligned to the share option schemes enjoyed by management.