2010.24 Going public via a reverse merger; one investment banker’s perspective
A reverse merger into a shell company (a back door IPO) is essentially the acquisition of a non-operating public company by a private company, with the public company surviving. The shareholders of the private company gain control of the public company by merging their company into the public shell and receiving shares in the public shell as their merger consideration. The public company is called a “shell” because there is nothing inside – it’s typically not an operating company at the time of the transaction. The private company shareholders obtain the majority of the shares and board control; the private company’s name is usually adopted.
The process is often marketed as taking only a few weeks (much quicker than a traditional IPO) and avoiding a related lengthy and expensive SEC review – should the shell already be registered with the SEC.
Armand Hammer is generally credited with inventing the reverse merger in the 1950s when he invested in a shell company then merged Occidental Petroleum into it. In 1970 Ted Turner completed a reverse merger with Rice Broadcasting, later named Turner Broadcasting. In our just issued In Reel Time newsletter we discuss Image Metrics’ recent reverse merger transaction and related fundraising – and point out that the company is growing at an impressive rate.
I don’t generally like this form of transaction. Doing an Internet search before writing this post I read a lot of positive articles and I’m skeptical of the authors’ objectivity. Are those web sites listing “liquidity” as a benefit because they are touting reverse mergers? Going to Googlefinance.com I was able to find numerous such companies with an average trading volume of zero shares – hardly liquidity.
To be fair, a reverse merger can be a cheaper and faster way to go public. You can often bundle it with a fund raising, lock up shareholders (so they don’t dump shares into the liquidity you might get) and cash out minority investors who need to sell. Theoretically, you can use the “public” shares as acquisition currency after you complete the transaction. And, if the business performs well you will have a higher price, liquidity and perhaps even an institutional following. In the late 1990’s I worked with Richard Rosenblatt and his company iMall, which he was later able to sell for almost $600 million to Excite@Home. The reverse merger structure worked for him, early on and when iMall was suffering growing pains. But Richard, co-founder of Demand Media and seller of over $1.3 billion in Internet company value, is not your average CEO.
What I’ve seen more often is an increased burden for management from the demands of being public. Below a certain market cap institutions can’t or won’t buy company shares so investment banks aren’t motivated to make a market or initiate research coverage. As a result, shares trade thinly. Financing is tough – the participants in such transactions tend to litter their deals with warrants and dilutive and contingent terms (should the company not meet certain performance criteria). Since the initial “shell” company often failed, a stigma can linger. Unlike with an IPO no large chunk of raised funds necessarily accompanies this route to becoming public (which can justify the increased scrutiny, cost and burden of being public).
Is it the structure that I don’t like or the reality that many companies who use it have few alternatives? Both. I’m a huge believer in taking money when you can…until doing so becomes too cumbersome, dilutive or difficult (for example, high debt burdens that are impossible to meet). But alternative methods are alternative for a reason; they’re often marketed with much hype but don’t deliver as promised. In the right situation (see my examples above) a sophisticated and well counseled management team can benefit from such a transaction. As a lawyer by training – though not current practice – I would counsel that the shareholders’ goals need to be clearly defined and match the transaction structure chosen. A transaction structure should be valued based on whether or not it is used correctly; structure alone is inherently neutral.
Most of all, I have reservations about the promises made to those looking for a solution to the difficult realities of raising money. This structure rarely solves a company’s short term capital needs. Being public – in and of itself – does not ease fundraising woes UNLESS your company performs at an exceptional level. But then, public or not, you’ll be able to raise money.
Please feel free to follow up with me personally for insights more tailored to your own company’s status at jones@hadleypartners.com.
