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 an October 2005
CFO magazine article covering reverse
mergers.
In-practice
capital: Going around Banks
by
Constance Gustke
Small
companies are finding more alternative
routes to fresh capital. But all of
them could prove to be dead ends.
Growing up is hard to do. Quintessence
Photonics had no trouble attracting
venture capital when it started in the
"optoelectronics" business, which combines
laser and semiconductor technology to
cut and join metal. But finding funds
for its next stage of growth wasn't
easy. "The terms on follow-on venture
capital rounds were too restrictive
and much more onerous than funding from
other sources," says co-founder George
Lintz. And an initial public offering
for a research-intensive outfit that
has yet to make a profit isn't an option
these days.
So Lintz instead is contemplating a
reverse merger, in which a private company
in need of capital sells itself to a
publicly traded "shell"-a company with
few if any assets besides its Securities
and Exchange Commission registration
statement. If successful, Lintz expects
his firm to gather more capital than
it could through an IPO, and he hopes
for "the potential of higher valuations
sooner." The fact that Quintessence
won't have to pay an underwriting fee
to a banker doesn't hurt.
The company considered another detour
around bankers: the so-called pink sheets
(see "Weighing Transparency", next page).
That means paying a broker-dealer to
sell stock in the company through other
market markers alone-that is, without
the help of the public price quotation
a stock exchange listing provides. This
approach is more viable today, thanks
to the development of the Electronic
Quotation Service, which handles bid
and ask prices via the Internet. Still,
Lintz is pursing a reverse merger because
exchanges provide more liquidity.
GAINING TRACTION
Quintessence isn't alone. More companies
in its position are seeking alternatives
to traditional routes to capital. Increasingly
abandoned by venture capital firms more
interested in taking public companies
private, and ignored by banks that won't
lower IPO underwriting fees, more small
private firms are casting their lot
with shell companies. Through mid-September,
103 reverse mergers were completed,
compared with 114 for all of 2004, according
to Reverse Merger Report. "There's
no question that reverse mergers have
blossomed," says David Feldman, a managing
partner at New York law firm Feldman
Weinstein LLP.
And higher-profile deals, including
the acquisition of Archipelago Holdings
by the New York Stock Exchange, increasingly
use the technique, so that their size,
once typically no greater than $10 million,
now sometimes approaches $100 million.
Bigger deals, however, usually require
the help of investment banks to serve
as brokers, which raises the cost. Yet
they still typically amount to less
than half as much as the standard 7
percent levy for underwriting an IPO.
Reverse mergers aren't without problems.
For one thing, finding a "clean" shell
can be daunting. Lintz assigned a team
of lawyers to investigate one candidate.
"If we end up merging with an unsuitable
partner, that can make or break our
company," he says. "There's a lot of
due diligence". Even so, reverse mergers
remain cheaper and faster than IPOs.
A $30 million reverse merger can cost
$75,000, compared with at least $200,000
for a similarly sized IPO. And a reverse
merger can be done in a few days versus
a minimum of several weeks for an IPO.
The SEC also has cracked down on fraud
in this arena. Previously, all the SEC
required a shell to do was file a registration
statement. That lack of disclosure made
such deals susceptible to "pump and
dump" schemes in which promoters talked
up shell stock values by touting a merger
with a private firm and then dumped
their own shares before the merged firm's
low value became obvious (see "Honest
Shell Games?", CFO, April). And even
if a partner is legitimate, a private
firm that goes this route could still
find itself with unwanted liabilities.
"You want to make sure there are no
skeletons in the shell," says Randy
Rock, a partner at Andersen Partners
in New York.
Under a new rule, shell companies must
file information on their operating
business with the SEC within days of
merging. "Now, companies must be as
prepared as if they were going public,"
observes Charles Weinstein, a managing
partner at accounting firm Eisner LIP
in New York, so "reverse mergers have
less stigma" than they once did.
CONFIDENCE COUNTER
Yet another alternative may be preferable
to both the pink sheets and reverse
mergers: heading directly to electronic
over-the-counter (OTC) markets, known
as bulletin boards, which require full
SEC reporting. "There's more transparency
there," says Rick Schweiger, a partner
at investment banker Keating Investments
LLC in Denver. However, companies raising
capital in OTC markets must already
have at least 40 shareholders, so this
approach is best suited to small but
established companies.
Bob MacDonald, CEO of Ovation Products
Corp., which makes water purification
technology, set his sights on the OTC
bulletin board after his company raised
$10 million in private financing, but
failed to get follow-on VC funding (despite
11 patents). He says on OTC listing
"reflects a higher level" of investor
confidence than the pink sheets do and
would cost his company about $200,000
less than the $400,000 (not including
legal fees) for a shell. However, with
fewer than the minimum number of shareholders
required, the Nashua, New Hampshire-based
firm will have to go the pink sheet
route until more shareholders come aboard,
he says.
Even less-expensive reverse mergers
with good partners aren't problem-free.
There's no analyst coverage, road show,
or hoopla to sustain a company's stock
price and help it raise more capital
from the public down the road. "It's
a very quiet way of going public", says
Weinstein. That's why it's often just
a first step to a private offering for
additional capital, typically through
a so-called PIPE (private investment
in public enterprise) transaction. Quintessence's
Lintz notes that a PIPE would likely
close simultaneously with his company's
reverse merger. Yet PIPE transactions
aren't without woes, either (see "The
Pipes Are Flowing", CFO, November 2004.
The bottom line: the alternatives to
VC firms and investment bankers are
growing more viable, but none are yet
free of serious drawbacks, CFO.
Weighing Transparency
Going public via pink sheets remains
a controversial option. The lack of
Securities and Exchange Commission reporting
requirements means little regulatory
burden for companies, but it also makes
investors wary of abuse. As a consequence,
companies in need of capital tend to
shy away. Yet not everyone considers
pink sheets a less attractive option
for raising capital compared with reverse
mergers. Anthony Loumidis, CFO of American
Distributed Generation Inc, a privately
held firm that provides electricity,
heating, and cooling systems, sees pink
sheets as more viable than they used
to be. That's why he hopes to raise
as much as $10 million through them
within a year. He believes that the
"games people used to play with prices",
which created huge spreads are disappearing
without SEC intervention, simply because
bid and ask prices are more widely available
thanks to the Internet.
