Reverse merger specialist Nimish Patel discusses the lucrative practice of reverse merger transactions, how his firm advises and structures deals with clients, and what attorneys should be aware of before entering the reverse merger practice area.
After the panel, Mr. Patel discussed his niche practice in reverse merger transactions from a law firm business perspective. Reverse merger transactions are gaining popularity with small businesses as a way to attract private capital investment. Attorneys seeking to practice in this space should first understand the legal complexities, requisite industry knowledge, and potential risks associated with this emerging and lucrative practice area.
An Evolving Practice
In the late 1990s, Mr. Patel's firm was doing a lot work with companies that were getting funded by Silicon Valley venture capital firms. With the exception of two publicly traded companies, his client list was primarily made up private companies seeking venture capital.
"In 2000, it was like someone turned off the lights," Patel recalls as he describes the VC market for small businesses. "We either had to evolve or close down. Immediately, we noticed that the emerging trend was liquidity. Liquidity was governing capital transactions. So we did our first PIPE transaction in 2000 and it worked out well."
PIPE stands for Private Investment in Public Equity. PIPE funds are investor groups that invest privately in companies that are publicly traded or required to go public. In these unique circumstances, where receiving capital is a conditioned on going public, the reverse merger has become "a weapon of choice to attract the financing."
"Our first PIPE client was a company that was pre-revenue and couldn't attract any venture capital. They did a reverse merger and got $2 million in financing and they were able to launch a product from that point forward. From then on, we became specialists in the areas of reverse mergers and capital raising transactions."
Today, the firm of Richardson & Patel handles the SEC work for over 120 public companies. "We're 40 attorneys and we are consistently ranked in the top 10 of all firms representing companies engaging in PIPE transactions. And we're competing against law firms that have several hundred to several thousand attorneys. So for us to do that much volume tells you how active we are in this space."
What do you tell your clients about the advantages of being a publicly traded company?
"There are many reasons to go public. Capital raising is just one of them. As a public company, you now have the ability to use your stock as a currency for M&A transactions. Instead of spending $5M in an all cash acquisition, you can now do it for $6M where $4M is in stock and $2M is in cash. Now all of a sudden, the company has an additional $3M in cash that they can deploy for working capital. So the valuations are better for the seller as well as for the buyer because they can use their stock as a currency."
Another reason to go public is employment stock options. "You can tie employees or key executives to certain benchmarks and give them an opportunity to see that their work has a certain benefit that's translated into a dollar amount that they can easily compute by looking up the stock quote on Yahoo! or other financial service websites."Going public also has estate planning benefits. "If you own 100% of a company and you want to sell a piece of it, it's very difficult to do it as a private company. For instance, very few investors want to be a minority (10%) shareholder of a privately held company. But if you're a publicly-traded company, selling 10% of your existing stock allows you to retain control of your business. You've got investors who don't want to have a controlling interest and just want to be passive investors. So, for estate planning or simply being able to cash out some of your investment that you've put into your company, the reverse merger going public transaction is a great way to do it."
What kind of companies should consider the reverse merger?
"Any company in the right space at the right time should take advantage of the reverse merger. Timing is everything in the capital markets. If you happen to be in a business that is getting a lot of attention from Wall Street, you can ride that momentum just when it's peaking because that's when you get the best valuation."
"There are investors for almost every business. So even if you're not in the "hot" businesses, you still have a better chance of finding someone if you're offering that investor the opportunity of liquidity."
"We have taken a lot of pre-revenue companies public. They may be in their third or fourth round of financing and they are up against a "down round" - where their earlier investors paid more money for shares than what the new investors are willing to pay. So, if this is not in the interest of their existing shareholders, they evaluate going public through a reverse merger. Because you are offering liquidity, the valuations tend to be a lot higher. So, startups that have a good, viable business plan have the ability to do reverse merger."
What would you tell a small technology startup that wanted to do a reverse merger?
"I get this question all the time by clients. The first thing I do is list off all the bad reasons why not to do it and disclose all the costs and burdens of being public. If they understand all the reasons and appreciate all the costs associated with it and if they can then articulate to me why they should do it, then that's when we would engage in the reverse merger. It's not for everyone. There are times when people want to do it for the wrong reasons - ego over business. It's glamorous to be associated with a publicly-traded company, but the cost with being public could be the death nail for some of these companies if they're not going public for the right reasons."
Do all reverse merged companies trade in stock exchanges?
"Initially, the stock of most companies coming out of a successful reverse merger will trade on the OTC Bulletin Board. Hopefully, within a year or so, they will graduate to an exchange, like NASDAQ of the AMEX. But the baseline trading platform is usually the Bulletin Board, or sometimes a step below in what's known as the Pink Sheet." Not a lot of investors feel comfortable with Pink Sheet companies, so the majority of deals are done on the Bulletin Board."
What is the risk level for attorneys practicing in this area?
"The reverse merger field is still a high-risk area. By just dabbling in it part time could get you into a lot of trouble. You need to be aware of all the current rules associated with reverse merger - and there are a lot of rules! If you're not familiar with how these rules work, and you dismiss a particular area, clients could come back and say, 'You didn't tell me about the tax consequences of this transaction. Had I known, I wouldn't have engaged in this transaction. I'm suing for malpractice and failure to advise.'"
"Reverse merger is a difficult area to practice in unless you have qualified attorneys who have been doing this for a long time and have seen a lot of these issues arise. That's just on the law side."
"Then there's the practical business application. If you haven't done a lot of these deals, you don't know how to negotiate the terms for your client. For example, the value of a shell has risen to about a million dollars. If you don't know this, you may give up too much of your client's company when it comes to pricing. On top of the law, you have to know the current business trends as well."
Which laws are implicated in reverse merger transactions?
"There's no statute that has a heading called "Reverse Merger" which outlines all the things you need to do, unfortunately. Federal corporate securities law, state securities law, accounting issues, tax issues, corporate law - they all converge at once in a reverse merger. It's a group of rules and regulations at the SEC and the state level that you need to know how each works."
Here is just a sample of the legal requirements:
- A reverse merger requires a definitive agreement that contractually describes the stock exchange between the shareholders of the private company and the publicly traded company. Usually the transaction is structured as a tax-free reorganization.
- Because you're communicating with shareholders of a publicly-traded shell, you have to file a proxy with the SEC, but which is governed by state corporate law in which the publicly traded company is incorporated in.
- Accounting rules - 2 or 3 years of audited financial statements that must be filed 4 days after the reverse merger takes place. Only when this is completed should they sign the definitive agreement - otherwise they will merge into the shell and immediately become delinquent and they will then have merged into a worthless shell, in essence.
How many attorneys do you need for a reverse merger?
"Our firm is very unique. Usually large law firms play in this field. The solo attorneys don't have enough bandwidth or talent pool to take on these kinds of deals. You need more than 1 attorney, but you don't necessarily need 100 attorneys, to do these types of deals. We have about 40 attorneys - it's all we specialize in. We fill a niche that's underserved and we're able to do quite well."
What are the typical billable hourly rates in the reverse merger practice area?
"Reverse merger transactions are a good practice area for lawyers in that the fees are very lucrative. You can command a high billable rate -- in the $500-700 per hour range for partners. Boutique lawyers usually get $200-300 per hour, but because of the complex nature of reverse mergers, the market rate is significantly higher."
How do you structure your fee agreements with clients?
"Small business issuers are our clients. They're very entrepreneurial and we have to be just as entrepreneurial to represent them. Many times you don't have the luxury of charging the full $75,000 to $100,000 that it takes to do the legal work as an upfront retainer. It would be ideal if we could get $20,000 as a retainer, which we would bill against our hourly rates and get the remaining amount paid when the deal closes."
"A lot of these clients know that the money will come as soon as the reverse merger transaction is completed, and they are more than willing to compensate you for taking the deferment of payment. My firm does this. We have the ability to ask for a lower retainer amount, then we can bill the higher hourly rates for doing so."
"What's even better is taking equity in the company as partial payment of our legal fees. We're one of the very few law firms that do that, and that's how we've built our firm. Right now, 30% of our revenues is generated from the equity that we take from our clients. Unlike the 'Wilson Sonsini' model from the dotcom days, we like to take equity in publicly traded companies. Just like investors, we also like to see a clearly defined exit strategy or liquidity for the stock that we own. Our clients love it, because any dollar they don't have to use to pay legal fees is a dollar they can use for working capital and to develop their business. And, yes, issuing stock is a financing cost, but for an early-stage company, that is something they are willing to trade off by paying equity versus cash."