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Ground Floor -- Going Up!

Friends are always asking me: "So what's it like writing for the Fool?" And I'm not going to kid you -- this is a great gig. Not just because I get to make a living by doing what I love, writing about stocks, but because in response to what I write, I so often get to exchange ideas with fellow investors (Hi, there!) who read what I write.

Take last week, for instance. In response to one of my articles, a Fool reader dropped me a note asking for my take on a couple of small biotech start-ups. In an effort to protect the innocent, I'll fudge both the reader's identity and the specific stocks inquired about here … but the gist of the inquiry went like this:

What do you think about:

  1. Geron (Nasdaq: GERN  )
  2. MannKind (Nasdaq: MNKD  )
  3. Dendreon (Nasdaq: DNDN  )
  4. All of the above?

Will they thrive? Will they even survive?

To which I gave the following, admittedly unsatisfying answer: I do not know.

Educated ignorance
Will Dendreon discover the silver bullet that cures cancer forevermore, or MannKind eliminate the scourge of diabetes? Will Geron gift mankind with the secret of eternal life? Maybe they will, and maybe they won't. But agnostic as I am on their prospects, I'm convinced to the point of certainty of one thing:

You won't make a profit on it if they do.

Potential versus profits
Upon receiving this disappointing news, my correspondent posed me the most common question asked about start-ups like the three named above: "But what about the potential? Even Microsoft (Nasdaq: MSFT  ) was an upstart once upon a time. If I buy these stocks, and they strike it big, won't that make me a millionaire?"

Problem is, when searching for a company with the potential to become "the next Microsoft," your first step should be to identify a company like Microsoft. One that, even early in its days on the public markets, demonstrated an ability to earn a profit and support its own business. Right now, none of the three biotechs named up above can claim that. Far from earning a profit, they barely even have revenues.

Sure, one day, stem cells could revolutionize health care. And it's a theoretical possibility that a century from now, "MannKind" or "Dendreon" could rank right up there with Pfizer (NYSE: PFE  ) as one of the giants of health care. But between now and then, these companies face the daily dilemma of how to keep their businesses running while they move toward fulfilling their potential.

You see, just like you and me, companies have bills to pay. Lease payments to make on their factories. Electric bills that come every month. Employees who would, given their druthers, really enjoy cashing a paycheck every once in a while. But in order to meet these obligations, a company really has only three choices:

First, it can produce products and sell them for a profit. (For that, you need revenues -- see above.)

Second, it can take on debt. (For which, as a general rule, lenders generally like to receive interest payments. See above again.)

Or, lacking products to sell, or the ability to pay interest when due, a company can resort to selling the one thing that costs it nothing to produce, yet still brings cash in the door: Shares.

"And the first shall be last …"
And there's the rub. So many start-ups get caught up in this catch-22 that it's become a cliche. Faced with a choice between admitting they cannot pay their bills and closing up shop, or selling shares to raise the cash they need to keep running, these companies make the logical decision: If investors are willing to give them more money, the companies are happy to take it.

And the problem doesn't even lie with the investors who help out companies in a crunch. To the contrary, in a "buyer's market" for shares in cash-strapped companies, they often make out like bandits, picking up shares for a song -- shares that earlier investors had paid through the nose for, in a scramble to "get in on the ground floor." But it's precisely these early investors -- investors like my Foolish correspondent -- for whom I feel sorry. Because with every round of additional capital raised, and every new batch of shares issued, their ownership stake in the company shrinks just that much more.

Foolish takeaway: The dilution solution is no solution at all
Selling shares to raise cash to keep the business running -- stock dilution -- ranks among the most common attributes of unprofitable start-ups. Over the past five years, investors in Geron have seen their stake in the company diluted by 67%. Dendreon shareholders' stake in their company has been cut almost in half as dilution rocketed to 96%. MannKind investors fared worst of all -- diluted by more than 240%!

But they're not the only ones. Even such supposedly "profitable" firms as Suntech Power (NYSE: STP  ) have shown themselves incapable of generating the kind of free cash flow necessary to avoid taking the stock dilution route.

The sad fact is that these companies probably shouldn't have "gone public" in the first place. Investing in unprofitable start-ups, knowing full well that you're likely to get diluted (or ante up yourself for additional shares to avoid dilution) multiple times, has historically been the province of deep-pocketed angel investors, venture capitalists, and the investment arms of bankers like Goldman Sachs (NYSE: GS  ) -- not individual investors like you and me.

Take the escalator to the second floor
If all of this sounds a little disheartening, and you're beginning to think that trying to "get in on the ground floor" is hopeless … well, there is an alternative: Take the escalator to the second floor, and enter there. Because while markets are rife with profitless wonders offering you the chance to get in early -- and lose big -- there are plenty of stocks that really do offer Microsoft-like profit potential. Companies boasting:

  • minimal debt (or no debt at all!) ...
  • plenty of the free cash flow necessary to fund their operations ...
  • and market caps small enough to allow for boundless growth and plentiful profits.

At Motley Fool Hidden Gems, it's our mission in life to discover these companies and reveal them to you. Join us.

Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. Check out his other holdings here, and his active CAPS recommendations here. The Motley Fool has a disclosure policy.

Microsoft and Pfizer are Motley Fool Inside Value selections. Suntech Power Holdings is a Motley Fool Rule Breakers pick. Motley Fool Options has recommended a diagonal call position on Microsoft.

Read/Post Comments (8) | Recommend This Article (36)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 02, 2010, at 4:51 PM, getrickqk wrote:

    Your article proved that you can write about something that you don't really know much about.

    You're not agnostic about Dendreon, you don't know anything. Are you suggesting, if I buy Dendreon today, I will surely would not make any money even on the event of an FDA approval for Provenge? All you Fools contributors and writers have been negative about Dendreon and have been wrong so far, how can I believe you now?

  • Report this Comment On February 02, 2010, at 7:42 PM, tkell31 wrote:

    Why do so many people insist on responding like a giant a$$? His point was clear, you must not be smart enough to figure it out, but let me summarize:

    Investing early in unprofitable small caps ultimately leads to devaluing of your investment both by a drop in stock price and further by dilution. Yes, you may be smart enough to pick the one that will take off, but for the most part you are going to lose money by default.

  • Report this Comment On February 03, 2010, at 12:38 AM, masterN17 wrote:

    "Why do so many people insist on responding like a giant a$$?"

    I believe it is called the Greater Internet F---wad Theory.

    Normal Person + Anonymity + Audience = Total F---wad.

  • Report this Comment On February 03, 2010, at 12:38 AM, masterN17 wrote:

    I personally think there is a valuable takeaway from this article. Thanks Rich.

  • Report this Comment On February 03, 2010, at 12:46 PM, PatF wrote:

    I think the analogy with Microsoft is false. Microsoft never had to (a) run clinical trials to see if it's product was safe and effective and (b) write extensive reports to have the product approved by the FDA. (I suppose you could make a lot of jokes about what would have happened if Microsoft had to be run through the FDA mill.)

    Oh. Full disclosure. I own both MSFT and DNDN.

    As a matter of fact, I bought DNDN on March 9 of last year at $2.93 per share. It's nice to know I have not made any money on it.

  • Report this Comment On February 03, 2010, at 4:50 PM, enginear wrote:

    Buying (virtually) anything march 9 of last year made you a killing. Not 1000% maybe, but still...

    Microsoft is a bad example though. It was on the second floor when it went public - had been successfully selling software for quite a while (I still have an early catalog of theirs from 1981 - very interesting). Different business model, and very different startup costs, regulatory requirements, and on an on. It also became a very tall building! 10th floor would have been fine.

    The main point is good though - it's a long shot, especially for those of us that don't understand what goes on when baking soda and vinegar are mixed. Good scientists don't necessarily make good businesses.

  • Report this Comment On February 04, 2010, at 3:45 PM, jhalgren wrote:

    Last night on Nightly Business Review, PBS, Hilary Kramer said the largest investment in her portfolio is DNDN! So she's either an Angel for Denderon or a fool? Which category do you thinks she fits?

  • Report this Comment On February 05, 2010, at 7:39 PM, esuresh12 wrote:

    Hi Rich, you might argue that you are writing this article in good faith for the people who are regular investors. But my question is that do you have even looked at what a company like dandreon is doing. They have proven in phase 3 trial that it extends life in prostate cancer (end stage) by anotoher 4-5 months. That too without much side effects. And look at this, this works completely on the body's own immune system. This is a new kind of medicine, that uses body's own immune system. This is a kind of company that has pioneered a new way to concure diseases. Most of all why you are thrashing the stocks that offer hope to patients and their relatives who are desperately looking for ways to increase life span and while reducing mysery. It is really sad that motley fool coming up with an article that has done no study whatsoever on the stocks they are talking low. Also, it is really sad that motley fool is also joining the group of hedge fund criminals in talking low about this company

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