Bear Scratching Head

Where does stock come from?

Most investors don’t know the answer, and many who do still don’t fully understand the process. This is an especially important question to ask when dealing with OTC stocks.

Once shares have been issued by the company, they may only be deposited into the market after they have been registered, unless they are exempt from registration under Rule 144. Most of the shares traded in major markets (AMEX, NASD, NYSE) were registered, but most of the shares traded in the OTC were not registered. Most OTC shares were initially deposited using an exemption offered by Rule 144.

What is Rule 144?

In short, it is an SEC Regulation which states that you may legally deposit shares of  a public company’s restricted stock after a one year holding period. If that stock is a fully reporting company, shares may be eligible for deposit in as little as 6 months. As registration statements are complicated, costly, and must go through an extensive SEC filing and review process (which takes several months), they are generally avoided whenever possible. Without a registration statement, you will only find evidence of the shares issued by reading the company’s filings. For companies who don’t fully report, it can be impossible to identify exactly how many shares are currently in the market.

Venture capital firms understand this and are often happy to purchase shares of 144 stock at a discount, typically 50% below the current bid price. Shares of 144 stock are commonly issued in exchange for services as well. As a company’s stock is it’s currency, any time they can issue stock in lieu of cash, why wouldn’t they?

Why don’t more people invest in 144 stock?

It’s not as simple as it sounds. To begin with, unless the company is fully reporting and the stock’s share price is over $1, no discount broker will allow you to deposit the shares. This leaves a small group of full-service retail broker-dealers, also known as 5% brokers, who regularly deal in this type of stock.

Prior to depositing shares, a legal opinion must be issued by an SEC attorney ($200 – $500) stating that the shares are eligible for deposit, and then various other fees ($1,000 – $1,500) must be paid to the broker-dealer and their clearing firm at the time of deposit. The entire process takes 2 – 4 weeks to complete, and the cost averages around $1,600 per deposit.

There are rules regarding how and why a company may issue 144 stock, and investment in unregistered shares may never be solicited, so public companies are approached by venture capital firms instead. Smaller investors who are already shareholders may contact a company too. If the company needs additional investment, unregistered shares can usually be purchased at a deep discount to market.

There are also rules regarding who may purchase shares of 144 stock, and being an accredited investor (worth over $1Mil) is a primary requirement. That said, every rule has exceptions, and there are various ways in which smaller investors may also obtain shares of 144 stock.

Because of the lengthy holding period, investing in 144 stock is much riskier than buying shares in the open market. However, because of the deep discounts, 144 transactions can be incredibly profitable. If the company was legitimately undervalued at the time of investment, it is not uncommon for venture capital firms to see returns of more than 1,000% on these types of transactions.