Reverse Merger: A Rational Alternative to an IPO? Timothy J. Keating and Rick M. Schweiger

Transcription

1 The 2004 IPO results are in. Reverse Merger: A Rational Alternative to an IPO? Timothy J. Keating and Rick M. Schweiger In 2004, there were 249 traditional initial public offerings (IPOs) raising a total of $48 billion, or an average IPO of $192 million. Of these, only 11 IPOs raised under $25 million, not a surprise since the IPO market is dominated by the largest, tier one investment banking firms. In today s market, a micro-cap company attempting to go public via the traditional IPO faces long odds in being successful, a phenomenon we call the IPO void. The IPO process can, in many cases, take nearly a year to get through SEC registration, with no certainty of the deal ultimately being priced, costing a company a significant amount of money and commitment of resources. But now, more than ever, the micro-cap IPO candidate has a rational alternative, a well-structured reverse merger. Reverse merger as a means to access capital. One alternative to an IPO is the reverse merger, where a private company merges into a publicly traded, reporting company with no assets or liabilities. For years, this type of transaction has been roundly criticized. First, there has been a focus on the fact that the process itself does not raise capital. Second, there is the specter of contingent liabilities and skeletons in the closet, which may surface after the completion of the merger. And third, the total cost of the transaction plus the ongoing costs of being public may outweigh the originally perceived benefits of the transaction. But for the small, emerging growth company ready and able to meet the increasing regulatory burdens and costs of the post-sarbanes-oxley environment, more immediate and superior access to the capital markets will and should be the mandate. While the IPO market has improved over the last two years, financings of private investments in public equities (commonly known as PIPEs ) have experienced rapid growth. According to Sagient Research, there were a total of 1,269 PIPEs raising $15.5 billion in 2004, up from 710 PIPEs raising $12.3 billion in 2002, representing increases of 79% in terms of number of deals and 26% in capital raised, respectively. This dynamic and ever more aggressive market is now, more than ever, poised to fill the capital markets void for private companies that have obtained a U.S. listing through the reverse merger. This will be especially true for those private companies truly focused on creating liquidity and realizing enhanced value for its stockholders. Liquidity is virtuous. Liquidity is so important in the capital markets that investors generally attach a valuation premium of 100% or more for publicly traded companies compared to private companies

2 with the same financial metrics.. In the parlance of corporate finance, this valuation premium results in a lower cost of capital for public issuers. The reason a liquidity premium exists is straight forward: investors are willing to pay up for the ability to sell stock quickly, even if they do not use that ability. In addition to higher valuations, the other principal benefits that public companies enjoy include: (i) creation of a stock currency to fund acquisitions; (ii) liquidity for investors and minority stockholders; (iii) equity-based compensation for management and employees; and (iv) a foundation providing for superior access to capital for future financing activities. Today s real news for micro-cap companies is that the IPO void can be overcome through the combination of a properly structured reverse merger and PIPE financing. Even better news, these companies, in short order, can realize the liquidity premium in the trading market with proper focus and discipline. Although many factors will play a role in the reverse merger success, here are some key considerations. Good shells versus clean shells. In many reverse merger transactions, attention seems to be focused much more on the public shell, rather than on the private operating company. It is the latter that will ultimately determine the success of the public company. The misplaced attention on the public shell is difficult to explain, but we suggest other than a shell emerging from bankruptcy, no public shell is truly clean. So let s look for the good shell. Public companies which have been inactive or dormant for several years and which have operated in less regulated industries (e.g. business services as opposed to mining operations) can mitigate the anxiety of unknown and contingent liabilities. Also, there appears to be an increasing trend in active business spin-off transactions leaving a public shell. Caution is required on two fronts first, improperly structured spin-offs do not always relieve the public shell from the active business liabilities and, second, SEC regulatory interpretations may frustrate the overall spin-off objectives. Due diligence should be focused on the individual officers, directors and principals, with background checks being conducted if suspicions arise. Also consider the turnover in, and experience and reputation of, the public shell s accountants, lawyers and transfer agents. An often-overlooked area is the size and quality of the public stockholder base, i.e., the number of round lot holders, especially where the public company is looking to elevate to a NASDAQ or AMEX listing. The market tends to favor public shells that are Section 12(g) reporting companies, current in their reporting under the Securities Exchange Act of 1934 (Exchange Act), and quoted on the Over-the-Counter Bulletin Board. An extremely limited number of public shell companies may also have some cash in them for use as initial seed capital for the transaction. Beauty is in the eye of the private company. 2

3 No single factor is more important to a reverse merger s success than the management team and its ability to execute on its business plan and strategy. Unfortunately, the management team will be immediately stretched, or need to be extended, as it must now manage its core operating business and the business of being public. With reverse merger transactions capable of being completed in a relatively short, 60 to 90 day time frame, management must begin to implement its public company best practices before the reverse merger is even completed. Some of the more important areas include understanding SEC accounting rules affecting the company, structuring and evaluating PIPE financing plans, implementing corporate governance matters, obtaining D&O insurance, and complying with the now infamous Section 404 internal controls assessment under Sarbanes-Oxley. While these public company burdens may seem daunting, these challenges are being faced by all micro-cap and small-cap companies in the market place. The good news is that an expanding network of outside consultants and advisors can provide the experience and guidance to tackle the regulatory maze. Transaction considerations. No transaction is the same. But with reverse mergers, there are a number of recurring issues both simple and complex that deserve special attention by legal practitioners. Here are some lessons learned: The reverse merger world is quite dynamic with numerous finders, advisors and consultants acting as intermediaries in the deal. When dealing with intermediaries, be sure they are registered broker-dealers with reverse merger and securities business experience. Unregistered brokers may create unintended risks under the Exchange Act. The key economic terms are generally the amount of cash required to be paid by the private company and the amount of equity retained by the public company stockholders. Issues to consider: Are the shell principals bringing more than just a public vehicle, e.g., transaction experience, ability to assist in capital raising, market-making and interest in assisting in after market support activities? What is the public float in the company going to be following the transaction? Shell principals have a vested interest in these matters and should be willing to align their interests with the interests of the private company stockholders. Transactions typically take the form of either a triangular merger or a share exchange. Important issues to be considered in the structuring include public stockholder approval requirements and taxes. If possible, the transaction should be designed to avoid stockholder approval at the public company level even if a controlling stake can provide consent without meeting. Where filing of either a proxy or information statement is required under the Exchange Act, delays and costs can be incurred. But even where stockholder approval is not required, 3

4 reporting companies must file and mail a stockholder notice of change in control in a timely manner under SEC Rule 14f-1. In most cases, the public company s issuance of restricted stock in the reverse merger transaction should be exempt from registration under the Securities Act of 1933 (Securities Act). However, where there are a large number of stockholders in the private company, extra care must be taken to assure availability of an exemption under Regulation D (mainly, no more than 35 non-accredited investors and re-certification of accredited investor status). If an exemption is not available, an S-4 registration statement may be required as part of the transaction, again adding time and expense to the transaction. No transaction should be closed without the certainty that the private company can deliver the audited and interim financials statements required by the SEC rules for acquired businesses. This is especially important since the reverse merger transaction will generally be treated as a recapitalization for accounting purposes, meaning the private company financial statements will become the financial statements for the ongoing public entity. Although current SEC regulations only require that audited private company financial statements be filed within 75 days of the closing, as a business matter, and especially where PIPE financing is being provided at closing, acceptable audited financial statements of the private company should be required as a condition of closing. This practice is consistent with recently proposed SEC regulations which, if adopted, will require that audited financials statements and Form 10 type disclosure on the public company be filed within four days after closing. These proposed regulations will likely be adopted in some form, possibly as soon as Q PIPE financing is widely available for the right private company seeking to complete a reverse merger. But like any financing, do not expect the fact that being public means there will be any less diligence. The prospective issuer must be prepared to defend business model assumptions and be ready to show that management is dedicated (and qualified) to operate a public company in today s current regulatory storm. On the investor side, after market success will largely depend on obtaining quality financing, that is from institutional PIPE investors that look at the fundamentals and are patient money, as opposed to hedge fund arbitrageurs attempting to simply capture the discount in actively traded issues. The sweet smell of after market success. Today, public issuers under $100 million in market capitalization have two businesses: managing their core operations and managing the business of being public. Consider these sobering facts with respect to being public today: There were more than 15,000 U.S. public companies in Today, there are fewer than 11,000. 4

5 7,000 of those 11,000 public companies trade on either the OTC Bulletin Board or the Pink Sheets. Most brokerage firms prohibit their brokers from recommending a stock to a client unless it is traded on either NASDAQ or a listed exchange, and has a stock price of at least $5. Approximately 90% of all public companies trade for under $5. A successful after market program is a critical ongoing part of the business of being public. It requires not only the production of high quality content, but also a wellconceived strategy for distribution. Quality independent research is a cornerstone of building interest in the stock. The pyramid below highlights some of the key elements in an after market support program that are necessary to realize the liquidity premium. Conclusion Any issuer that wants to go public and that can successfully complete an IPO should do so. However, the market for small IPOs is effectively shut. Although 2004 was the best year for IPOs in four years, only 11 companies raised $25 million or less through an IPO. A well-structured reverse merger combined with PIPE financing can be a rational alternative to an IPO. Undoubtedly, the most important consideration is to begin the process by selecting experienced and knowledgeable advisors that can assist in shell 5

6 selection and review, transaction structuring, capital formation, national exchange listings and after market support. Timothy J. Keating is the founding Partner and President of Keating Investments, LLC, a Colorado registered investment advisor and broker-dealer founded in Previously, he held senior management positions in the equity and equity derivative departments of Bear Stearns, Nomura and Kidder, Peabody in both London and New York. He is a 1985 cum laude graduate of Harvard College with an A.B. in economics. tk@keatinginvestments.com Rick M. Schweiger is a Partner in Keating Investments and has over 20 years experience advising managing middle market companies on investment banking, financial, legal, strategic, transactional and operations matters. He is a 1982 magna cum laude graduate of the University of Notre Dame, BBA, Accounting; 1985 magna cum laude graduate of Marquette University Law School; and 1988 graduate of the New York University Law School, LLM, Taxation. rs@keatinginvestments.com Keating Investments, LLC is the parent company of Keating Securities, LLC, a brokerdealer and NASD member specializing in reverse mergers. Web site: 6