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What are the risks to consider if directors hold a significant proportion of the issued shares and buying steadily with the chief executive holding over 30% plus options on another 33% exercisable above the current price?

You also mentioned in your question that the company was trading on a low PE ratio and was rather small with a capitalisation of $15 million.

Before looking at the risks, let us consider what might be good about the situation.

It is generally thought to be a sign of confidence by the management if they are buying shares in their own company. Clearly, there is a suggestion that they have faith in its prospects and think that it is currently cheap in relation to those prospects.

It is also considered to be a positive if the management have a significant proportion of their own wealth invested in the company because they will tend to be trying that much harder to make the business succeed than they might if they were only dependent on the business for a salary.

The existence of options that are exercisable at a high price is also generally considered to be a positive in that the management has a strong incentive to make the business succeed in order to get the share price above the option exercise price.

Now let us consider the risks.

Whenever a large proportion of the shares is in the hands of a small number of shareholders, who are not active traders, there can be a liquidity problem. With a large company, where there are hundreds of millions of shares issued, there may still be plenty of shares being traded all the time. However, with a small company like this one, it could be a problem. That does not mean that it is, though. You would have to look at the volumes going through the market and continue to monitor it as the situation changes with respect to the proportion of the issued capital accumulated by management.

The next issue is control. Where a small number of directors, or in this case potentially the managing director alone, have over 50% of the shares, they can vote who they like on to or off the board and exercise control over all decisions made by the company. There are laws against them victimising minority shareholders, but unless it is blatant or the minority shareholders have the wherewithal to take them to court, it may be difficult to do much about it. I suggest you read some of Pierpont's columns on these situations on www.pierpont.com.au

Just as worrying as oppression of minority shareholders is that the directors have no opposition to keep a check on them when they have a majority of the shares. A managing director with 63% of the shares, as you postulate could occur, could surround himself or herself with directors that only say "oui" and never "non" to the MD's ideas. They might not oppress minorities intentionally, but with nobody to query decisions, they could make many mistakes in running the business. There is no law against incompetence. Negligence, fraud, etc, yes, but stupidity is still not a crime.

It is also possible, of course, that the directors are trying to run the price up to the option exercise price. They would have to be careful of the laws dealing with insider trading and market manipulation.

What you should be looking to research is:

1. Is the profit real operating results, or has there been some accounting trickery, non operating profits, one-off situations and so on? Look for operating cash flow as well as profits. Be very wary of transactions with directors or their associates.

2. What are the prospects for the business? Look more for sound operating history than promises and blue sky.

3. What is the track record of the directors and management?

4. How is the market valuing similar businesses? If the company has a low PE ratio, there could be a very good reason - that suggests that the market doubts that the earnings will be repeated.

In general terms, small companies are more risky in many ways than large companies. They are often available at low PE ratios as a discount for this risk.

The golden rule always applies - if a situation looks too good to be true, it usually is. However, there are situations where the market gets it wrong - not many, but they come along from time to time and often in bear markets where an industry sector is out of favour.

Because of the risks, you should be looking for a big margin of safety. Unless you are absolutely sure you know enough to assess these situations, you should never put more than a small part of your investment capital into them. You can always increase your commitment if the situation confirms your assumptions. Otherwise, leave them to those who know what they are doing and look for easier situations.

I must stress that this answer does not relate to any specific company, but is of a strictly general nature. I have no idea what company you are asking about or whether it is a real or simply hypothetical situation.

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