David Feldman's book, Reverse Mergers: Taking a Company
Public Without an IPO, now in its third printing, was published in 2006
by Bloomberg Press (available on http://www.amazon.com).
View David Feldman's reverse merger blog at www.reversemergerblog.com.
Joseph Smith and David Feldman are coauthors of PIPES:
Revised and Updated Edition - A Guide to Private Investments in Public Equity
(Bloomberg Press, 2005) available on http://www.amazon.com.
In the News
David
Feldman is quoted in the April 2005
issue of CFO Magazine in an overview
of reverse mergers.
Honest
Shell Games?
There
was no road show, no banker, and no
under-writer when Cyberkinetics Neurotechnology
Systems Inc. went public last October.
And no initial public offering, for
that matter. Instead, the Foxborough,
Massachusetts, medical-device company
merged with an existing shell company:
Vancouver, Canada-based Trafalgar Ventures
Inc, registered in Nevada in 2002 for
the purpose of mining copper, nickel,
and platinum.
Cyberkinetics, which develops interfaces
between computers and the human brain,
is widely regarded as a well-run, respected
young company, even if its combination
with Trafalgar could have given some
investors pause or shivers. (Trafalgar's
original Securities and Exchange Commission
filing noted that "to date, we have
not conducted any exploration activities.")
But Cyberkinetics is far from alone
in choosing a "reverse merger" into
a shell as its way of taking itself
public. In January, Worcester, Massachusetts,
biotech firm Advanced Cell Technology
Inc. merged with Two Moon Kachinas Corp.,
a four-year old Utah firm created to
sell wooden Hopi Indian statues over
the Internet. (Like Cyberkinetics, ACT
kept its old name after the merger.)
And some investment bankers think that
reverse merging into a shell, whose
main asset is its preexisting SEC registration,
may well be on the upswing.
Companies engaging in this special type
of merger, however, must look beyond
the taint of boiler-room scams once
associated with shells-still hardly
free of scandalous connections today.
And they must proceed cautiously. Fraudulent
or suspect shells "come up on a weekly
basis," says one official at the SEC,
which just last April proposed rules
to further crack down on the use of
shell companies in "pump-and-dump" stock
schemes. (In one common scam, penny-stock
promoters may pump up shell stock values
by touting a merger with a private company,
then dump their own shares before the
merged company's low value becomes obvious.)
At the same time that the SEC proposed
restrictions on shells, however, the
agency also indirectly acknowledged
that such mergers are and can be used
as legitimate tools. "If people can
legally do these deals by reverse mergers
and not defraud anybody, we don't have
any objection," says the commission
official.
THE NEW SMALL-CAP IPO
"A shell is a vehicle. It can be used
properly, it can be used improperly,"
says Cyberkinetics CEO Tim Surgenor,
who believes that whatever stigma is
still associated with past abuses hasn't
been a detriment to his company. IPO
s were also abused," he notes.
Basically, there are two kinds of shells:
those truly designed to be operating
companies, and the so-called blank-chek
variety, created expressly to take a
private company public via merger. However,
the line between the two types can be
thin. It often seems impossible to tell
whether a shells stated business plan
is simply a front--in other words, a
blank check in disguise. (While investors
in a newly merged onetime shell may
not care how serious its original plan
was, disguised blank checks often have
been used by promoters to lure unsophisticated
early investors into shady business
schemes.)
For Cyberkinetics, the main concern
was finding a "clean" shell, without
pre-existing liabilities, shell-company
officials with an unsavory past, or
share-holders who might be upset by
a change in direction of the firm. An
outside investor found the Trafalgar
shell, Surgenor says, and investors
with an interest in Cyberkinetics then
put up $700,000 to buy control of Trafalgar.
"The horror stories about investors
who don't know what they own do not
apply here," he says, estimating that
"95 percent" of the new Cyberkinetics
shareholders "already knew who we were."
Mark Carthy, who Oxford Bioscience Partners
is Cyberkinetics main venture investor,
says Cyberkinetics benefited from Trafalgar's
having little or no operating history
of its own. "Sometimes it is better
to be totally clean and not have any
operations than worry about what liabilities
the company had incurred before." He
adds that going public in this manner
"was more work than I expected."
Still, such "back-door registrations"
can reward companies like Cyberkinetics,
which is conducting a clinical trial
in which quadriplegics are implanted
with devices that help them manipulate
computers. Says Surgenor: "We got lots
of press and won lots of awards none
of which can benefit you if you're private."
But such recognition can be invaluable
to public companies, with their access
to the larger universe of investors.
Just one month after its merger, Cyberkinetics
raised $6 million in capital through
a private investment in public equity
(PIPE). One week before it became a
public company, ACT closed on a placement
of Series A preferred stock and warrants
that generated some $8 million, and
converted the shares to common to the
merger. (ACT is involved in applying
human embryonic stem-cell research to
the study of regenerative medicine.)
Further, hedge funds--another fast growing
source of private equity--are more likely
to provide financing to companies with
listed securities.
"It's the new small-cap IPO--a reverse
merger and a PIPE," says David Feldman,
managing partner of New York-based Feldman
Weinstein LIP, which has represented
many companies in such transactions.
He prefers blank-check shells, a preference
that sends a message that "we are doing
it the honest way." Specifically, he
adds, he avoids shells designed with
"creative business plans."
FUNDING THE NEXT STEP
While venture capital and other forms
of private equity are poring into companies
at high levels lately, little of that
funding has been directed to relatively
successful small companies that need,
say, less than $30 million for their
growth plans. And, of course, because
of their small size, they find the traditional
IPO route all but closed to them.
"Companies at an inflection point can't
really wait six months to go through
painstaking due diligence with venture
capital firms," says investment banker
Randy Rock, a partner at New York based
G.C. Andersen Partners LLC. Ironically,
the very fact that these companies are
generating returns may turn off VCs
who desire the bigger payoffs associated
with brand-new start ups.
Traditionally, next-step capital for
such companies has come from small institutional
investors in Europe or the United States.
But the costly and complex valuations
required in both places have all but
wiped out this avenue of funding. In
Europe, self-imposed requirements for
pre-investment valuations went largely
ignored for years, but European boards
are no longer so cavalier about their
potential liability if investors challenge
a redemption price. In the United States,
meanwhile, investment fund managers
say regulatory audits and subsequent
negotiations with the SEC have resulted
in investment firms being required to
mark-to-market such investments at least
quarterly.
"If a small company needs less than
$20 million, it's in no-man's land,"
sys Anthony Loumidis, CFO of privately
held American Distributed Generation
Inc. The Waltham, Massachusetts-based
company provides electricity, heating,
and cooling systems, and has $13 million
in annual revenues. The company ran
into this funding block several times
in seeking $3 million to $10 million
from institutional investors representing
mutual funds and hedge funds. "Investors
didn't want to bother hiring an independent
firm to value our company on a quarterly
or monthly basis," he says.
"I think you are going to see more and
more companies going through a nontraditional
process, because the IPO process is
so expensive," predicts Surgenor of
Cyberkinetics. The company's vice president
of finance, Kimi Iguchi, who joined
at the time of the merger, is now applying
to switch the company's stock to the
American Stock Exchange from Nasdaq's
over-the-counter bulletin board. Going
public through a reverse merger, says
Feldman, can cost as little as $250,000
in expenses (not including the cost
of acquiring the shell), and usually
is accompanied by a PIPE that covers
the costs. Most small companies
taking that route end up on the OTC
Bulletin Board, which has fewer exchange-driven
regulations than the New York Stock
Exchange, Nasdaq, or Amex.
Such companies also are so small that
Sarbanes-Oxley regulatory burdens don't
pose the same disincentives that they
pose for larger companies. "Assuredly,
there are incremental costs," says Andersen's
Rock, "but they are outweighed by the
ability to get capital." As for the
stigma associated with shells, recent
SEC regulation has reduced it significantly.
In the past, "whenever anybody walked
in talking about reverse mergers, I'd
throw them out of my office," says Rock.
Now it may be the best source of funding."
Perhaps. But one SEC official, noting
the limitations of the recent rule-making
cautions companies considering a reverse
merger: "Be very careful who you deal
with, because there is still a lot of
fraud going on in this space."
