In today’s market, the road to an IPO is long and laborious. Tired of the wait, the management teams of some private entities are resuscitating their dreams of going public by negotiating a reverse merger, which offers a faster route to listing. At the same time, near-dead public companies are coming back to life in a bear market by merging the core businesses of these private entities. It sounds like a win-win situation for both corporate shells and private companies – but what IR professionals and CEOs of these formerly private bodies are realizing is that reverse mergers require a lot of due diligence in order for the newly created entity to prosper.
The process typically involves private firms and corporate shells, drawn together by a mutual desire to reverse merge. Management teams of these companies sometimes meet through internet message boards where executives discuss their search for a merger mate. A typical posting from a corporate shell features the number of shares outstanding and the trading status of an available but unnamed public company, for instance. Alternatively, either party might seek an advisor to introduce it to a suitable merger candidate. After a brief courtship (including negotiations and due diligence), the merger is consummated and a new public company is born.
Resuscitating a shell
Public companies involved in these deals usually don’t have an active business or viable business plan – hence the term ‘shell.’ They could be regular public companies that have either ‘gone bust, bankrupt or been sold so there is no active business going on,’ says David Feldman, managing partner of New York-based law firm Feldman Weinstein. He points out that as long as someone continues to file with the SEC, the shell is public from a legal standpoint.
Corporate shells are occasionally listed on the Nasdaq but more often trade by appointment on the OTC Bulletin Board or on the ‘pink sheets,’ which is where companies that don’t meet the minimum criteria for trading on major exchanges and the OTC are listed. But some don’t trade at all.
Whether the shell suffered a near-death experience in the public market or had its assets stripped out through a debt restructuring, a reverse merger can provide a fresh start. Essentially, the core business of a private company energizes the shell and the newly created entity lists under a different name and trading symbol.
A new management team gets to run the public company while the owners of the original shell get a new opportunity to make money. Shareholders traditionally trade their stake in the shell for a percentage – typically 10 percent – of the new, public company that emerges, often as a subsidiary of the shell. Sometimes shareholders also get a cash success fee at closing.
The private firms that merge with these shells are usually micro-cap companies that have been excluded from the IPO process, or turned off by it. Their management team seeks a fast, backdoor hook-up to the capital markets by merging into an existing public company. They don’t have millions of dollars to spend pursuing an IPO – but they do want the benefits of listing.
Risk versus reward
While a reverse merger sounds like a storybook wedding, it’s crucial that the management teams and IR professionals of these private companies look closely before saying ‘I do’. A hasty union with a public company could result in important issues – like a shell’s hidden liabilities – being overlooked.
It wasn’t just biopharmaceutical expertise that led Atlanta-based Nova BioGenetics’ management team to focus on identifying a ‘clean’ public shell. ‘Our biggest concern was finding a clean company that we could take over that had no debt issues or lawsuits,’ explains Todd Smith, head of investor relations for Nova BioGenetics.
After investigating ten possible partners, Nova BioGenetics acquired a controlling interest in publicly traded Healthcare Network Solutions through a reverse merger in August this year. Management didn’t care about the shell’s line of business because it wasn’t functioning anyway, notes Smith.
As Feldman notes, when a private company takes over a public company shell it also inherits any bad news lurking in that company’s past. Ironically, a bankrupt company could be a good catch. According to Feldman the best kind of shell is one that’s been through bankruptcy because, as he notes, ‘At least you know all of its debts have been sorted out. However, bankruptcy doesn’t take care of everything.’
Blank checks
One of Feldman’s clients, Dennis Depenbusch, chairman and CEO of newly public Catalyst Lighting Group, took his time choosing a reverse merger partner, because he didn’t want to have to worry about ‘any skeletons in the closet’ when merging with a corporate shell.
Initially, he looked at a number of non-operating shells and blank-check companies – non-trading public entities specifically created to merge with an operating business – on the internet before deciding he needed an expert’s opinion. To help him through the process, Depenbusch hired Colorado-based Keating Investments, an investment bank specializing in reverse mergers. After careful deliberation with his newly appointed advisor, Depenbusch ended up going the blank-check route.
Timothy Keating, president of Keating Investments, takes no official position on whether reverse mergers are better with shells (which take 30-60 days to complete) or with blank checks (which take about 180 days). A client’s needs determine that choice, he says. ‘There’s a misperception that shells have lots of cash,’ explains Keating. Many private companies think they can ‘dial up the internet and find a shell with $3-5 mn in cash, submit their business plan and that’s the end of it,’ he adds. ‘But in reality, that is not the case.’
Reverse IR
Lacking the initial glitz of an IPO, companies going public through reverse mergers do need to work harder to get their IR program rolling. ‘You never quite know what is going to happen [with a reverse merger],’ points out one US-based executive currently contemplating such a transaction. If a languishing stock reinvents itself and rises a little because of the reverse merger, some shareholders looking for short-term gain might bail out, for example.
By reverse merging with an already listed company, it was easier for Nova BioGenetics to begin trading. However, as Smith notes, ‘most of the shares are closely held and so no-one is selling.’ Consequently, the company’s IR program is proceeding slowly.
Catalyst Lighting is not yet trading but is expected to start soon. The company has filed a registration statement in connection with a proposed public offering of 1.2 mn shares at $2.50 per share.
With help from an IR firm, Halliburton Investor Relations, Catalyst Lighting’s management team has started planning its IR program. ‘If you really want your company to be valued more appropriately in the market, you need to be proactive,’ says Geralyn DeBusk, executive vice president of Halliburton.
She says the company’s IR program will be very targeted. Investors purchase at various growth levels, reach their goals and then may want to move out, she explains. So identifying the right mix of prospective holders for Catalyst is an ongoing project.
While a reverse merger may enable a small company to go public faster, the company still has to prove it can withstand the test of time. ‘There is a very well-defined segment of people who are interested specifically in micro-cap stocks and what those people need to see are several quarters of consistent growth,’ says Keating. ‘In addition to demonstrating both top and bottom line growth, [companies need to] execute their business plan and show that they have a viable business model.’
The bottom line with a reverse merger is the same as that of taking a company public – you must be diligent and patient throughout the process. ‘Don’t think that any number of press releases with hype are going to accomplish the difficult task of generating return on shareholder capital,’ sums up Keating. ‘There are no shortcuts.’
Blank checks’ bad rap
Floating false rumors to send stock prices soaring was among the practices that gave blank-check companies a level of notoriety many years ago. ‘There was a lot of abuse,’ comments David Feldman, managing partner of Feldman Weinstein. But after the SEC came out with Rule 419 in 1992, as Feldman says, ‘a lot of the bad guys disappeared.’ What Rule 419 did was to put significant restrictions on blank checks. Until it took effect, there was a significant ‘taint’ associated with these blank-check transactions.
The SEC’s web site defines a blank-check corporation as ‘a development stage company that has no specific business plan or purpose and has indicated its business plan is to engage in a merger or acquisition.’ However, the regulator also goes on to warn that ‘these very small companies typically involve speculative investments and often fall within the SEC’s definition of penny stocks or are considered micro-cap stocks.’ So caveat emptor.
