Private companies seeking investment capital to launch products, fuel R&D, or simply sustain business operations may want to consider a reverse merger as a way to attract financing. Recently approved SEC proposals may also benefit smaller public companies by providing a more favorable regulatory environment for those involved in the capital formation process.
Traditionally, small private companies seeking to attract investment capital would either engage in private rounds of financing or go public through an initial public offering (IPO). While these fundraising vehicles have worked well in the past, they are no longer as viable for small businesses under current economic conditions. There is, however, a little-known funding vehicle that is gaining popularity with small businesses: The Reverse Merger.
Reverse Merger Transactions
A reverse merger is a transaction by which a private company merges with an existing, publicly-traded shell. At the consummation of the merger, several things occur: 1) the private company merges into the public shell, and the post merged entity is a publicly traded company; 2) the private company's management retains controlling interest in the post-merged entity; and 3) the money from investors is put into the company, and investors receive shares in the post-merged public entity providing them with a clear exit strategy.
History of Reverse Mergers
Although these capital raising transactions have not enjoyed widespread recognition, reverse mergers have been around for a long time. For example, Occidental Petroleum (OXY), which trades on the NYSE and has a little under $50 billion in market cap, was a reverse merger from the 1950s.
Prior to 1999, the reverse merger had somewhat of a bad reputation, which partially contributed to the transaction's underutilization. In the past, reverse merger transactions were considerably unregulated, and only minimal disclosures were required. As a result, reverse mergers were used in scams in which investors lost substantial amounts of money. The term "pump and dump," as applied to questionable securities investments, evolved from pre-1999 reverse mergers.
Since 1999, however, the SEC has established new rules regulating reverse mergers that have brought integrity to the transactions. Most notably, all post-merged companies that trade on the OTC Bulletin Board are required to file Forms 10K and 10Q disclosures and audited financial statements each year. These are the same filing obligations requirement of large public corporations that are listed on the NYSE or NASDAQ.
The heightened transparency of reverse merger transactions has enabled viable due diligence by small businesses as well as investors. Viable due diligence, in turn, has established the credibility and attractiveness of the reverse merger transaction as an integral part of fundraising.
Current Market Conditions Favoring Reverse Merger Transactions
As of 2007, the once robust market for private financing, fueled primarily by venture capital (VC), has undergone a significant reduction. Today, only a select few of the vast number of small companies receive VC money.
Alternatively, accessing public capital markets through an IPO is increasingly difficult for small businesses. Currently, valuations of small private companies without a proven track record do not make sense for the investment banks that manage IPOs. Private companies that do not raise more than $75 million in revenue have a difficult time finding an investment banker that will do an IPO. Additionally, the IPO process has always involved a large amount of time, expense and regulatory uncertainty.
One result of the dotcom bubble of the late 1990s is that liquidity now rules capital markets. Liquidity is the ability to convert an investment to cash. Prospective investors are no longer willing to wait three to seven years for possible liquidity, either through an IPO or M&A transaction. Instead, they want the certainty that if they invest, they at least have the option to liquidate within a year if they choose to do so.
Nimish Patel, a lawyer specializing in reverse mergers at Richardson & Patel LLP, believes that the opportunity for liquidity has driven what is known as the Private Investment in Public Equity or "PIPEs" market.
The PIPEs market is made up of many different funds, some of which have made a lot of money over the last five to seven years and are now looking to reinvest. Traditionally, PIPE funds invested only in public companies, because these public entities already had a history of reporting and SEC compliance. However, as these funds now have a tremendous amount of money to deploy, they have started looking at companies that are still private in order to get a good return for their investment. The condition is that the private company has to do a reverse merger in order to get the funding from the PIPE fund. According to Patel, "This is how reverse mergers became 'mainstream' as a weapon of choice to attract PIPE financing."
Burdens and Risks of Reverse Merger
There are certain burdens and risks associated with reverse merger transactions.
In terms of burdens, the private company immediately inherits the public shell's reporting obligations. Companies that go through a reverse merger have to file all SEC reports, just like any company that went through a traditional IPO. The post-merged entity will have to file annual reports on Form 10K and audited financial statements according to GAAP every year. It also has to file three quarterly statements every year. Any time the company has a shareholders meeting, it has to file a proxy statement, and whenever "insiders" (officers, directors, 10% shareholders) buy and sell their company's securities, they have to file certain forms with the SEC. A public company's reporting obligations can be quite expensive.
The liabilities of the shell company also pose a significant risk in reverse merger transactions. Due diligence on the shell is very important because the small business will inherit all of its liabilities, disclosed and undisclosed. Liabilities, such as pending or threatened litigation, contractual disputes, and adverse tax consequences are just a few of the things that may arise. These dangers can be mitigated by indemnification for undisclosed liabilities, or pledging certain stock for a period of time until the statute of limitation expires. However, the private business can never have a 100% guarantee that nothing unknown will arise from the shell's past.
Benefits of Going Public via Reverse Merger
With an IPO, a company raises money and goes public. With a reverse merger coupled with a PIPE transaction, a company raises money and goes public. One difference between these vehicles is that the reverse merger transaction does not implicate as many of the SEC rules and approvals to complete.
Because of fewer SEC hurdles, a reverse merger can be done more quickly than an IPO. Theoretically, the reverse merger transaction itself can be done in thirty days or less, assuming the company is ready with its audited financials, has identified the shell, and is structured for the transaction. IPOs, on the other hand, can take an average of 6 to 9 months to complete.
There is also a definite certainty associated with a reverse merger transactions compared to the uncertainties associated with IPOs, such as market conditions, finding investors, and the time it takes to clear the SEC's comments. Because a reverse merger is essentially a contract between the operating company and the private company, the material terms are already known before the transaction takes place. If a private company does a financing as part of the reverse merger, the terms of the investor financing are already structured, so the company knows: a) exactly how much dilution it going to have; and b) the price at which it will issue securities. These two concepts are largely speculative in an IPO process.
SEC Rules Benefiting Reverse Mergers
On May 23, 2007, the SEC announced six proposed measures that would impact small public companies by providing a more favorable regulatory environment for those involved in the capital formation process. As small business issuers are typically the ones that engage in reverse mergers, these proposed rule changes would result in greater incentives for going public by way of reverse merger.
One noteworthy SEC proposed rule change is to Rule 144, which would reduce the minimum holding time on the sale of restricted securities. Under the current Rule 144, when the issuer or company issues restricted securities, the investor who purchased those securities has to wait a minimum of one year before reselling the shares. The current proposed rule is designed to shorten that period from one year to six months.
Such a change encourages investment in small public companies that have engaged in reverse merger transactions, as a reduction in the waiting time increases the investor pool. Theoretically, an investor could invest in a reverse merged company and have liquidity in six months. This change may also encourage more companies to attract capital by going public instead of staying private.
Another significant change proposed by the SEC is one impacting Form S3. The S3 is a "short form" registration statement used when public companies are trying to raise money. The form is about 15-20 pages long, and the legal, accounting and management time is considerably less than that required by Forms S1 and SB2.
Under current SEC rules, large public companies are entitled to use Form S3. Small Business Issuers, currently defined as public companies with less than $25 million in public float (all the shares not held by officers, directors and affiliates of the company), are not permitted to use the S3, even though they have the same filing obligations as large companies. They must use Form S1 or SB2.
The S3 proposals would allow small business issuers to use short form registration. The changes would also expand the definition of "Small Business Issuers" to any company with less than $75 million in public float. In sum, a public company with less than $75 million in public float will be eligible for the streamlined disclosures under the proposal.
One caveat is that companies engaging in reverse merger must wait one year before they are eligible to use Form S3.
David Feldman, an attorney with Feldman Weinstein & Smith, believes there is a good chance the SEC rule change proposals will pass sometime near the end of 2007.
Small private companies seeking investment capital should carefully consider through competent counsel whether a reverse merger serves their needs. If the burdens, costs and liabilities of going public are fully appreciated and understood, a small business may be able to use the reverse merger as a way to obtain PIPE financing in an otherwise unwelcoming investment capital market. Finally, the recently proposed SEC rule changes may also provide a more favorable regulatory environment for post-merged entities that qualify as small business issuers.