Reverse Mergers Can Help Attain Liquidity, Growth and Capital Goals

California CPA magazine: January/February 2008

Ron Stone, CPA

Small and mid-size companies under $50 million in revenues often seek growth capital at certain stages of their development. A strong established com-pany with solid financial statements and a good earnings history is a good candi-date for standard bank financing at competitive rates.

Many companies that may have tremendous potential, however, do not qualify for standard bank financing and must find alternative financing vehicles. Such companies may be able to access the necessary capital by going public via a reverse merger into a public shell.

Pros/Cons of Going Public

A publicly traded company provides the following benefits:

Liquidity for investors: Publicly traded securities enable investors to decide when to divest their holdings. However, there has to be significant investor interest and trading volume in the aftermarket to achieve liquidity.

Acquisition Capital: The value of publicly traded stock is easily ascertainable and thus can be used as currency to purchase other companies. However, when you use stock in such a manner, that stock is restricted under SEC rules 144 and 415.

Higher Valuations: Publicly traded companies usually sell at a premium to private companies. The arbitrage between public and private often creates opportunities for aquisitions.

Greater Access to Capital Markets: Growing companies often look for growth capital. Public companies have greater access to capital on the open market, as they are more attractive to institutional investors than private companies.

Retention of Staff: provide incentives for employees and create shared goals between management and employees.

Prestige: Officers of publicly traded companies have increased prestige in their communities. (This is often a driving force in choosing to go public.)

Operating as a publicly traded company also presents certain challenges:
Less Confidentiality: For many owners, this is the most difficult obstacle to overcome. A public company must disclose all material information for the benefit of investors. Once available to the investment community, this information, both finan-cial and operational, is also available to the company’s competitors.

Burdensome Reporting Requirements: A public company is required to make quarterly reports to the SEC, have its financial statements audited once a year and make disclosures if any “news” events occur during the reporting periods. This process is cum-bersome and costly. Alternatively, many
U.S. companies file with foreign exchanges, like London’s Alternative Investment Market, which is less burdensome from a regulatory perspective.

Ownership Dilution: A reverse merger requires the owner of a private company to sell a percentage of his company to either the investment bankers or shell owner. Any investment component to the transaction will also dilute the owner’s share.

Greater Liability: In addition to the ordinary liabilities any company faces, public companies face an added burden of potential officers and directors liability and earning surprises can lead to exposure to shareholders you don’t know. A public company may be perceived as having deeper pockets than the same company held privately, possibly creating a stronger litigation incentive.

Increased Expenses: Administrative costs increase for a public company: Legal and accounting expenses could double; as the company retains an investor relations firm and institutes a 404 plan (SOX), internal staffing requirements increase as do the costs associated with outside special consultants.

Once a company determines that the advantages of becoming publicly traded company outweigh the disadvantages, it must undertake an analysis of the methods used to go public.

An IPO is the preferred mode for larger companies, but it is generally less attractive for smaller companies because an IPO is more complex, time-consuming and expensive than a reverse merger. With a reverse merger, a company will likely be required to provide only two years of audited financial statements; the com-pany’s “story” is not needed; and the professional fees are significantly lower than those for an IPO.

Smaller companies face difficulty finding investment bankers willing to underwrite their deal. Investment bankers typically work with larger, more established companies in more complex transactions. Therefore, small and mid-sized companies seeking access to public markets should consider the alternative—a reverse merger.

The Process

Once a company decides to proceed with a reverse merger, it must identify the public “shell” company into which it will merge. This shell is a legal entity that is ideally devoid of assets and liabilities and listed on a stock exchange.

It is critical that a due diligence review be conducted with respect to the proposed shell to uncover any hidden liabilities, assure proper legal structure and reveal information on the existing stockholders. Since the shell is used merely as the vehicle for the operating company to gain publicly traded shares, any hidden liabilities related to the shell will haunt the “new” public operating company after the deal is completed.

Purchasing a shell with audited financial statements can minimize the risk.

The legal structure of the proposed shell also must be analyzed to ensure that it is suitable for the proposed merger. Part of this analysis should include an investigation into the business philoso-phy of the shareholder base of the shell. As the new operating company begins to succeed, ideally the stock price should increase.

If existing shareholders seek a quick profit, the selling pressure on the stock may depress the share price, making it more difficult to acquire other companies and for new cash investors to liquidate their positions. Lock-up agreements with existing shareholders can address this problem. And, generally, restrictions on the use of your stock under SEC rules must also be considered.

The shell company then changes its name to the operating com-pany’s name. The acquiring company becomes liquidated into the acquired company, but it has mostly new ownership and a new name (i.e., “Newco”). After the merger, Newco will file a registra-tion statement notifying the SEC of the merger and registering the new shares for sale. SEC Rule 415 limits the initial registration of Newco shares to between 30 percent and 35 percent of the total outstanding shares.

Once the stock is registered, Newco should hire an investment relations firm to market the securities. Unlike an IPO, which involves significant investment market maker coverage and market-ing of the company and its stock, a reverse merger is generally achieved with less publicity.

A reverse merger is often followed by a private investment in a public entity (PIPE), a vehicle through which investors add capital to the new entity. These investors generally desire short investment holding periods and require a viable market to liquidate their posi-tion at some future time. Subsequent to the reverse merger, the shell company issues additional shares of its stock to PIPE investors and the operating company. In effect, a company undertaking a reverse merger is responsible for marketing its own stock. An investment relations firm can help market the stock and ensure an active and stable market for the company’s stock, one of the chief requirements of PIPE investors. PIPE investors look for stocks with a stable market, which provide liquidity so they can sell all or part of their investment without damaging Newco’s market value.

For the company seeking increased access to capital markets and an exit strategy for investors, going public is worth considering. Smaller private companies should consider the advantages of the reverse merger method of going public, which may help them meet their liquidity, growth and capital goals.

Working in Reverse

Here are some high-profile and successful reverse mergers:

Armand Hammer, world renowned oil magnate and industrialist, is generally credited with having invented the reverse merger. In the 1950s, Hammer invested in a shell company into which he merged multi decade winner Occidental Petroleum.
In 1970 Ted Turner completed a reverse merger with Rice Broadcasting, which went on to become Turner Broadcasting.
In 1996, Muriel Siebert, renown as the first woman member of the New York Stock Exchange, took her brokerage firm public by reverse merging with J. Michaels, a defunct Brooklyn Furniture company.
Rare Medium merged with a lackluster refrigeration com-pany and changed the entire business. This was a $2 stock in 1998 which found its way over $90 in 2000.
Acclaim Entertainment merged into non-operating Tele-Communications Inc in 1994.

Ron Stone, CPAis a principal of Profit Planners West, a consulting firm for small and mid-size public companies and those companies interested in becoming public companies. You can reach him at rstone@profitplanners.com.