By John Paris
Williams Mullen

The phone rings. The client asks: “John, what do you think about us merging into a public shell?” I shudder. “Don’t even think about it.”

If not for recent developments, this article would end here.

But I’m still writing. Why? Against my better judgment, I’ve found myself thinking harder about the advice I’ve given over my career.

Old habits die hard. Who would want to go public other than through the traditional IPO process? Who would want to pay the increased accounting, legal, and other expenses required of a public company if they don’t have to?

Who would go public without the revenue, the first class investment banking firm, or the sufficient visibility on future revenue streams and profitability required of successful public companies?

Who would want their company’s valuation tied to a stock price that’s beyond their control? Who would want the only material public stockholders being high risk traders and shorts? Who would want to risk becoming the prototypical “public orphan?”

What is a reverse merger?
Throughout my career, the answer to these questions has been “no one.” Sure, many of my clients have been approached by, yes, charlatans, who sold the reverse merger product.

“Financing is much easier to come by when you’re public,” they say.

“You can use your stock as currency to acquire complementary businesses.”

“The market will understand your business model better than private sources do.” I’ve heard it all from reverse merger proponents, typically smaller “investment bankers” or “consultants” who are paid to structure these transactions. I’ve rejected their proposals out of hand.

But, I’m getting ahead of myself. What is a “reverse merger” into a “public shell?” It’s when a private company is acquired by a public “shell” company that is current in its SEC filings even though it no longer has a business – no business, that is, except for the “business” of being public.

After failure, these companies continue to report the status of their “non-operations” with the SEC on a periodic basis hoping that a private company will pay those who have kept it public the $500,000 to $1 million routinely paid to merge with the shell.

After the reverse merger
After the “reverse merger”, the public “shell” becomes a public version of the private company and the shell issues such a large number of shares to the private company that the private company owners end up owning most of the shell’s stock.

Reverse mergers, or “alternative public offerings” (the politically correct term now being used) do offer timing and cost advantages over a traditional initial public offering. In a traditional IPO, the private company engages investment bankers, prepares a registration statement, files it with the SEC, replies to the “comments” of the SEC staff, and when it believes it’s close to getting those comments cleared, begins to meet with potential investors hoping to convince them to buy their stock.

If all goes as planned, and market conditions don’t change, some two to five months after the filing of the registration statement with the SEC, the company sells stock to the new investors and “goes public.”

In a reverse merger, the company “goes public” at the closing of the merger. Stock of the shell held by former owners of the failed company is immediately available for trading, allowing for the possibility of a market being created in the stock. Often stock held by owners of the private company is available for trading as well.

Principal advantage
The principal advantage of the historical reverse merger is that a private company becomes “public” without first being required to clear the SEC’s comments, a strategy that saves the private company time and money. They have also been known to feed the ego of an entrepreneur who believes being public is important to her company’s success.

A relatively recent development adds spice to the alternative public offering product.

Smaller IPOS less common
In the aftermath of the dot.com fiasco, smaller IPOs have become uncommon. In 2007, the average amount raised in public offerings was $262 million. That’s amount RAISED. The market for smaller traditional public offerings raising $10 - $50 million is nearly non-existent.

Reverse mergers have benefited, indirectly, from the prevalence of PIPE transactions. Many smaller public companies needing capital have turned to these “Private Investment into Public Equity” transactions in which investors, typically hedge funds, invest money on a discounted (to the current market price of the stock) basis in privately placed securities.

These investors require the public company to then register those shares with the SEC so they can sell them into the market some two to five months after acquiring them and profit from at least a pricing arbitrage, if not from an increase in the share price that often follows a funding event.

Although the SEC is concerned that the risks associated with purchasing the stock eventually sold by these hedge funds may be difficult for Mom and Pop to understand, the prevalence of PIPEs has caused the SEC to pass rules that provide the public companies guidance on how to best disclose these transactions, which share attributes of reverse mergers.

New rules change things
Under the new rules, any private company merging with a shell company must file a report with the SEC within four days after the closing of the reverse merger containing all of the material textual and financial information required to be disclosed by any public company.

This is a much shorter time period than required in past relatively unregulated reverse mergers. While a “hassle” for the new company, the rules require private companies to be better prepared for the job of being public than in the past.

Whether right or wrong, these new rules, and the scarcity of small traditional IPOs, have made the process of doing a reverse merger more appealing, predictable and acceptable.

This predictability has lead to a new, more commonly used form of reverse merger, the FUNDED reverse merger. Reverse merger consultants now sell the same old reverse merger product with a key fundamental advantage.

Under this product, hedge funds invest funds at the closing of the merger as they do in PIPE deals. This gives the merged company the cash they need BEFORE they go through the SEC comment clearing process. Often, this funding offers cash at prices not available to the company in the private markets.

Raised profile
The availability of funding at the beginning rather than the end of the SEC process has raised the profile of reverse mergers. Many profitable Chinese companies seeking U.S capital, whose executives are not psychologically burdened by the “taint” of reverse mergers, have chosen to become public through this process.

They like being able to raise cash immediately rather than accepting the delay inherent in the traditional IPO process. Take a look at CAAS, HOGS, and WATG. All could have gone public the “normal way” but chose an alternative public offering instead.

The principal reason I’m seeing reverse mergers in a different light is the availability of funding that may not be available privately. Many life science companies (MITI; CYCC) have taken this path. So have other companies that are willing to bear the heavy burdens of being public mentioned above.

The hedge funds, looking for at least a quick profit arbitrage, make the difference. A year and a half ago, I never would have recommended this path. Being public is expensive and inappropriate for most private companies.

But an old dog can learn new tricks. The current version of the old reverse merger technique is an option worth at least considering for private companies in search of capital. There, shudder-free, I said it.