The Pitfalls of Being an OTC Public Company

Title III CrowdfundingThe SEC’s Division of Economic and Risk Analysis (DERA) recently issued a paper about over-the-counter stocks, i.e., stocks of publicly traded companies that are not listed on a national securities exchange like the New York Stock Exchange or Nasdaq. While the main subject of the paper is on the inadvisability of individual investors purchasing OTC stocks, my focus here, briefly addressed in the paper, is on whether the companies themselves should consider transactions that result in them having OTC stock. For example, companies that are not in a position to complete a traditional IPO may be able to go public via a backdoor method such as merger with a SPAC or a reverse merger.

For these companies, the usual plan is not to remain an OTC company forever, with thinly traded stock and low institutional ownership. Rather, the hope is that, with the capital usually raised concurrently with the transaction that made the company public, it can successfully execute its business plan such that it can meet the listing standards for admission on the NYSE or Nasdaq at a later date. However, this scenario rarely plays out in practice. Studies cited in the DERA paper find that, over a nine-year period, less than 9% of OTC companies became listed on an exchange, and even those that do have a poor average investment return.

Accordingly, any company planning to go public by alternative means has to consider the possibility of remaining in OTC status indefinitely. There are some advantages to being public. It may be easier to attract employees with equity compensation packages, since there is an easier path to eventually selling shares than would be the case with a private company. Also, public company stock can be used to acquire other companies (though a target company may be skeptical about receiving OTC stock). Finally, there are forms of financing like PIPEs that are available only to public companies (though the terms of those transactions are not necessarily any more company-favorable than investments that private companies can secure).

The obvious disadvantage of being public is the need to prepare public filings required by the Securities Exchange Act of 1934. (There is the possibility of not making these filings, for companies traded via the OTC Markets Group, previously known as the Pink Sheets, but the prospects for those companies are even more dicey than the ones traded on the OTCBB.) While the disclosure requirements are more lenient for smaller reporting companies (as defined by the SEC) that aren’t exchange-listed, it still requires a significant annual outlay for qualified corporate counsel and outside auditors, in addition to the salaries of internal personnel who can handle these matters.

There may be situations where voluntarily becoming an OTC company makes sense, but companies should be clear-eyed about the likelihood of success and the costs before proceeding.