Reverse Mergers + PIPEs:The New Small-Cap IPO Reprinted and updated from PIPEs: Revised and Updated Edition-A Gui de to Private Investments in Public Equi ty (Bloomberg Press, 2005)
| Author | David N. Feldman |
| Pages | 06 |
By David N. Feldman 1
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Blockbuster Entertainment, Occidental Petroleum, Turner Broadcasting, Tandy Corp. (Radio Shack), Texas Instruments, and Muriel Siebert are just a few wellknown companies that went public through a "reverse merger." To the uninitiated, a reverse merger is a deceptively simple concept. Instead of pursuing a traditional initial public offering ("IPO") utilizing an investment bank serving as underwriter, a company arranges for its stock to be publicly traded following a merger or similar transaction with a publicly held "shell" company. The public shell has no business other than to look for a private company with which to merge. Upon completion of the merger, the private company is publicly held instantly. The process is generally quicker, cheaper, simpler, less dilutive, and less risky than an IPO, but has its own unique risks and challenges. Reverse mergers are typically complex transactions with traps into which even experienced practitioners with limited knowledge of this technique can easily fall. When done right however, these hidden dangers can be avoided, and the transaction can proceed quickly and smoothly.
In the last several years, investors and investment bankers have discovered the reverse merger-with the "pile on" mentality that is common in any Wall Street trend. In this case, however, there are good reasons for reverse mergers and private investments in public equities ("PIPEs") to come together. In particular, investors in PIPE transactions have been extremely active in the reverse merger space. Why have reverse mergers suddenly become so popular and legitimate? The short answer is, it has not been sudden, but rather an evolution that has taken about a dozen years. Most recently, however, a confluence of factors has caused this market to really take off. Since 2001, the initial public offering market has been effectively shut down for all but the largest private companies, making a reverse merger more attractive to middle-market businesses. In addition, the private equity markets for growing private companies have been soft at best, making it tougher to stay private if large amounts of capital are needed for growth. The PIPE market has been experiencing tremendous growth and creating more potential benefit to being a public company if access to the capital markets is important. Also, until recently, the mergers and acquisitions market had been very weak-and still remains so for many companies-therefore limiting the exit options that entrepreneurs and investors have had.
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An additional factor is a recent change in the PIPE market. In the past, PIPE investors were more interested in short-term liquidity and arbitrage in their investments, but typically they did not look at companies in detail beyond trading volume. Because of Securities and Exchange Commission ("SEC") scrutiny and issuer concerns, PIPE investments now more closely resemble "true" longer-term investments. Investors conduct due diligence, meet with management, take more warrants to benefit from a stock's upside, and generally are more willing to wait for a larger return. As a result, PIPE investors are more active in pursuing investments in reverse mergers, where liquidity will probably take a little longer, but where a greater upside exists. This, combined with the increased competitiveness for deals, has shown PIPE investors and investment banks the benefits of what is sometimes called "public venture capital." The most recent positive development in this area has come from the regulators. In April 2004, the SEC proposed a new regulation requiring a significant increase in the amount of disclosure immediately following most reverse mergers. This new regulation was approved in June 2005 and became effective in November 2005. This helped improve the reliability and acceptability of these transactions. In its adopting release, in part resulting from strong encouragement from the private sector (including this writer), the SEC declared that it acknowledges the legitimate use of the reverse merger technique. This is a major development. Given the history of abuse accompanying reverse mergers, it is very helpful that the SEC is prepared to encourage their proper use while continuing to penalize their abusers.
A public shell is basically a publicly listed company with little or no assets or liabilities. Shells formed from scratch specifically to engage in a merger or acquisition are called "blank check companies," whereas shells resulting from the sale or liquidation of an operating public company are called "public shells." In either case, the industry tends to use the terms shell or public shell to refer to either a public shell or blank check company. In its 2005 rulemaking, the SEC defined shell company as a public reporting company with only nominal assets (other than cash) and operations. Some shells have cash in them that will be used to entice a private company to merge while others do not. The most valuable shells are the so-called reporting companies-those obligated to file periodic and other reports with the SEC. Shells that trade on the Over the Counter ("OTC") Bulletin Board are more valuable than those trading on the Pink Sheets. Some do not trade at all but may still have value if they are reporting and have a shareholder base. A few shells trade on the NASDAQ and American Stock Exchange.
A reverse merger is a method by which a private company merges with a shell and becomes public without a traditional public offering. The private company's shareholders generally receive between 65% and 95% of the public shell's stock. Four factors tend to affect this valuation:
This is primarily dependent on how recently an operating business existed in the shell.
A start-up will retain less of the merged company than a sales-generating company with $1 million in earnings.
The value of the shell will improve if those managing the shell have reputable backgrounds.
In general, a direct merger between a public shell and a private company requires shareholder approval of both companies. In the case of a public reporting company, this requires the expensive and time-consuming process of preparing, filing, mailing, and seeking SEC approval of a somewhat complicated proxy statement. One way around this is through a reverse triangular merger. In this transaction, the public shell creates a wholly owned Page 37 subsidiary. That subsidiary merges into the private company. Shares of the private company are exchanged for shares of the public shell. As a result, the subsidiary disappears, and the private company becomes a wholly owned subsidiary of the shell, with the owners of the formerly private company owning the majority of the shares of the shell following the deal's closing.
One major advantage of this structure is that as an entity, the operating business remains intact. If it has valuable vendor numbers with customers, they do not need to be changed. Bank accounts, employer identification numbers, and virtually all contracts (even leases) remain the same because only...
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