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Reverse Mergers


Reverse merger is a way for a private company to get public without the nasty details of an SEC S-1 filing and an underwriting by investment bankers. To start, the private company's management or investors locate an already public 'shell company.' A shell company is one that is nominally public, usually listed in the NASD OTC bulletin board or 'pink sheets', but that is pretty much dormant. It will likely have no remaining employees and maybe no management, and it will have ceased any business activities. A 'clean' shell company will also have little or no outstanding debt, will have kept its regulatory filings up to date, the stock will be listed at pennies per share, and majority control will be in the hands of relatively few shareholders.

The object of the exercise is for this moribund, but public, shell company to acquire the assets of the private company. This will done by a stock swap. First, the owners of the private company must get the controlling shareholders of the shell to agree to the transaction. Often, the shell has already been groomed for such a transaction by a broker and the agreement is in hand. Next, the investors of the private company buys an overwhelming majority of the shell shares for a nominal amount and/or the shell shareholders vote to authorize the issuance of a new large and highly dilutive block of shares. Finally, the large block of shell company shares that is now controlled by the private company investors are swapped for the shares of the private company, thereby acquiring it. The shell company now owns the assets and ongoing business of the private company, including its name, which it usually assumes. The investors in the private company are now the controllers of the shell, and they have the ability to market their shares on the exchange where it is listed, often free of items like lockup and standoff agreements.

So why is this approach to liquidity generally denigrated, given that it is perfectly legal? There are a number of reasons, some of them historical.

First, although the quality of dilience by investment bankers and IPO buyers obviously deteriorated during the height of the boom, the need to issue an S-1 and shop the new issue around to investors does create some level of accountability and diligence in the process of a new issue. There is no such apparatus in the case of a reverse merger. The 'purchase' of the private company usually falls within the normal business discretion of the shell company. The transaction must be reported to regulators, but the buyer of the shares of the post-merger company shouldn't be assuming that the business has been vetted in any meaningful sense.

Second, though the shares of the merged company are publicly tradeable, they are also rather illiquid. The shares in the hands of the private company's investors are a large majority of the company, the float is thin, and the shell company was last known to the market as a moribund establishment in another market. Analysts and business writers gave up on it long ago. To get anyone onto the buy side of a transaction in its shares, the company has to go out and market its new identity, and get some attention. Again, this is something done by the underwriter as part of a normal IPO, now it must be shouldered by the company instead. It is this process that has led to the historical abuse of reverse merger which makes it a black sheep: It's a perfect setup for a 'pump and dump' stock scam. Take a stock that has been trading for pennies, merge it into a business that has at least the facade of respectability and a presence in a market that is perceived as hot, sell off as many of your shares as possible, and make a run for the border before the price drops dramatically.

Third, you'll notice that the reverse merger transaction doesn't actually bring any new capital into the combined entity. Other than getting liquid, the purpose of a public offering is to raise capital for the growth of the company. The reverse doesn't raise new money, it consumes it, in the form of fees, share purchases, and marketing of the company's stock. The post-merger entity might be public, but it may be weakened in the process.

Nonetheless, the reverse is sometimes better than nothing, and for sure there is a supply of useable shell companies amongst the detritus of the Internet bubble. A private company in a market that is perceived as hot may try this approach to get liquid. If you're an investor considering buying shares resulting from these or other reverse mergers, dig more deeply than your normal practice. Don't assume the SEC or investment bankers have been there ahead of you - they probably have not.

 

Author: Tim Oren

 

 

 
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