Success in reverse: reverse mergers can help attain liquidity, growth and capital goals

California CPA, Jan-Feb, 2008 by Ron Stone

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

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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 acquisitions.

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: Employee stock option plans 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 financial 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 cumbersome and costly. Alternatively, many U.S. companies file with foreign exchanges, like London's Alternative Investment Market, which is less burden-some 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 company'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.