News
Corporate
Feb. 27, 2002
Given IPO Downturn, Reverse Mergers Can Be an Alternative
Focus Column - By Stephen P. Milner - Last year was not a banner year for the initial public offering market. And, unfortunately, the beginning of 2002 does not appear to be much better. Quite clearly, underwriters have become less willing to proceed with initial public offerings given the current condition of the stock market. As a result, many businesses that seek the benefits of being a public company will do so by way of a reverse merger.
Focus Column
By Stephen P. Milner
Last year was not a banner year for the initial public offering market. And, unfortunately, the beginning of 2002 does not appear to be much better. Quite clearly, underwriters have become less willing to proceed with initial public offerings given the current condition of the stock market. As a result, many businesses that seek the benefits of being a public company will do so by way of a reverse merger.
In a classic reverse merger, a privately owned operating company is "acquired" by a dormant publicly traded company. The dormant public company often is called the "shell," since it usually has few, if any, assets. Because of its size, a shell probably will not be listed on a national stock exchange (although it may have been at one time); instead, its stock may be quoted on the National Association of Securities Dealers' Over-the-Counter Bulletin Board or, in some cases, only on the "pink sheets."
Once the reverse merger is accomplished, the former owners of the private company will control the public company. Usually, the public company's name is changed to reflect the identity of the private company.
The original owners of the public company typically will retain between 3 percent and 15 percent of the merged company. The amount of stock that the original public shareholders are able to retain will depend on a number of factors, including the value of the private company, the assets of the shell (if any), any cash consideration paid by the private company to either the shell (often in order to "clean it up") or the public shareholders, and the compliance and "cleanliness" of the shell.
For example, in the case of a good shell, a speculative e-commerce business that contributes little or no cash consideration likely will have to give up a larger percentage of equity to the original public shareholders. By contrast, a company that provides significant cash consideration or has a clear demonstrative value likely will give up less equity to the original public shareholders.
Although the equity given to the original public shareholders may have a substantial value, private companies that seek a public shell see significant benefits over an initial public offering. Some companies seek shells because a reverse merger is typically a much quicker method of becoming public than an initial public offering.
In many cases, private companies have some sort of financing arrangement that is dependent on them being a public company or otherwise requires them to be such. (For example, many German companies seek American public shells because it is so difficult to go public in Germany, yet their German investors are more attracted to public companies.)
Some private companies seek public shells because it is a more cost-effective way to become public. In fact, the benchmark for the value of the shell should be whether it would be less costly to go public by way of a securities offering. If the answer is yes, then most likely the asking price of the shell is too high.
The most common reason that companies seek to become public by way of a reverse merger is that they are unable to find an underwriter for their stock. This could be because of a variety of reasons, even in a healthy stock market. Perhaps the company is too small, or perhaps it is still in the development stage.
Unlike an initial public offering, however, a reverse merger does not raise money because the private company is, in effect, the buyer. Instead, the merged company often plans a secondary offering some time shortly after the merger. Of course, the success of the offering will depend on the success of the company and market conditions. Further, unlike with an initial public offering, the company usually does not accomplish liquidity simply by becoming public, because the shells often do not have market makers or a national securities listing.
Choosing a shell can be a difficult task. First and foremost, the shell must be "clean." In other words, the shell should be free from any liabilities or contingent liabilities. Next, in order to accomplish the intended result, the shell should be a publicly reporting company under the Securities Exchange Act of 1934. Third, the shell should be current with its filings with the Securities and Exchange Commission.
The price that a shell can demand will depend on the assurances that can be given with respect to its compliance and "cleanliness." In the case of shells that are compliant with the SEC, those that were legitimate operating companies that have not gone through bankruptcy proceedings will receive the largest premiums. Of course, the guarantee against contingent liabilities is only as good as the due diligence on the shell.
At the bottom are the so-called "blank check" companies. These companies typically were never operating businesses and were formed primarily, if not solely, to locate a merger partner that is an operating business. In 1992, the SEC adopted Rule 419, which tightened regulations on these companies because the SEC perceived them to be used for fraudulent purposes. In addition, a majority of states restrict or prohibit the registration and sale of stock by such entities within their borders.
Some of the best shells available in today's market come from companies in Chapter 11 bankruptcy proceedings. In many cases, these shells come from once viable operating companies that are reasonably current with their SEC filings. The reverse merger is accomplished effectively through the confirmation of a plan of reorganization. Accordingly, the stock structure, public float, etc., can be adjusted by a judicial order.
Most important, Section 1141(d) of the Bankruptcy Code provides that the confirmation of the plan discharges the debtor (i.e., the public company) from debts that are not set forth in the plan. As such, the confirmation of a Chapter 11 plan is the best way to guarantee that a company is free from contingent liabilities.
Bankrupt public companies also may offer other significant benefits. First, depending on how long the company has been in bankruptcy and its position in the market before it filed for bankruptcy, its market makers still may be in place. Again, access to market makers is one of the primary benefits sought by companies interested in reverse mergers.
Second, the Bankruptcy Code has certain pre-emptions over federal securities laws. Most notably, Section 1145(a) of the Bankruptcy Code provides an exemption from the registration and prospectus delivery requirements of the securities acts (and equivalent state securities and "blue-sky" laws) where new securities of the reorganized debtor are exchanged for pre-Chapter 11 securities pursuant to the confirmed plan of reorganization.
Finally, as part of the plan of reorganization, creditors of the bankrupt shell likely will become shareholders of the new public company. After all, these creditors hope to recover some of their losses though the value of their shares in the new company. Assuming these former creditors still hold their shares at the time of a secondary offering (which is usually the case), market makers often tout the names of these "shareholders" to generate interest in the offering.
With all shells, the price that they can demand depends on the level of compliance with the SEC. In other words, are they current with their filings? The quarterly filings (10-Qs) only need to be reviewed by a certified public accountant firm and are relatively easy and inexpensive to file. The annual reports (10-Ks) need to be accompanied by an audit by a qualified certified public accountant firm.
Shells that are not current with their 10-Ks and need to be audited typically demand less in the market because of the cost and time of bringing them into compliance. Form 8-K is used to make a filing with the SEC regarding the reverse merger transaction.
As a final note, in evaluating a reverse merger, a company should make sure that it has a qualified certified public accountant to perform the future audits and review the necessary SEC filings. Companies should not assume that their existing auditors can, or will, perform the audit. Many national accounting firms are reluctant to audit Over-the-Counter companies. Conversely, many local certified public accountant firms are not qualified to conduct public company audits.
With the right shell, a private company can become public more quickly and cheaply than by an initial public offering. For those companies unable to locate an underwriter to take them public, a reverse merger may be their only option. While a reverse merger is not a money-raising vehicle, it can be a road to one. For owners of a shell, the reverse merger offers a chance for meaningful equity in a substantive operating company. And, for those unfortunate owners and creditors of a bankrupt company, a reverse merger with a private company may be the best and last opportunity for partial recovery of their claims.
Stephen P. Milner, an attorney and certified public accountant, is managing partner of Squar, Milner Reehl & Williamson, a certified public accountant and financial advisory firm in Newport Beach.
By Stephen P. Milner
Last year was not a banner year for the initial public offering market. And, unfortunately, the beginning of 2002 does not appear to be much better. Quite clearly, underwriters have become less willing to proceed with initial public offerings given the current condition of the stock market. As a result, many businesses that seek the benefits of being a public company will do so by way of a reverse merger.
In a classic reverse merger, a privately owned operating company is "acquired" by a dormant publicly traded company. The dormant public company often is called the "shell," since it usually has few, if any, assets. Because of its size, a shell probably will not be listed on a national stock exchange (although it may have been at one time); instead, its stock may be quoted on the National Association of Securities Dealers' Over-the-Counter Bulletin Board or, in some cases, only on the "pink sheets."
Once the reverse merger is accomplished, the former owners of the private company will control the public company. Usually, the public company's name is changed to reflect the identity of the private company.
The original owners of the public company typically will retain between 3 percent and 15 percent of the merged company. The amount of stock that the original public shareholders are able to retain will depend on a number of factors, including the value of the private company, the assets of the shell (if any), any cash consideration paid by the private company to either the shell (often in order to "clean it up") or the public shareholders, and the compliance and "cleanliness" of the shell.
For example, in the case of a good shell, a speculative e-commerce business that contributes little or no cash consideration likely will have to give up a larger percentage of equity to the original public shareholders. By contrast, a company that provides significant cash consideration or has a clear demonstrative value likely will give up less equity to the original public shareholders.
Although the equity given to the original public shareholders may have a substantial value, private companies that seek a public shell see significant benefits over an initial public offering. Some companies seek shells because a reverse merger is typically a much quicker method of becoming public than an initial public offering.
In many cases, private companies have some sort of financing arrangement that is dependent on them being a public company or otherwise requires them to be such. (For example, many German companies seek American public shells because it is so difficult to go public in Germany, yet their German investors are more attracted to public companies.)
Some private companies seek public shells because it is a more cost-effective way to become public. In fact, the benchmark for the value of the shell should be whether it would be less costly to go public by way of a securities offering. If the answer is yes, then most likely the asking price of the shell is too high.
The most common reason that companies seek to become public by way of a reverse merger is that they are unable to find an underwriter for their stock. This could be because of a variety of reasons, even in a healthy stock market. Perhaps the company is too small, or perhaps it is still in the development stage.
Unlike an initial public offering, however, a reverse merger does not raise money because the private company is, in effect, the buyer. Instead, the merged company often plans a secondary offering some time shortly after the merger. Of course, the success of the offering will depend on the success of the company and market conditions. Further, unlike with an initial public offering, the company usually does not accomplish liquidity simply by becoming public, because the shells often do not have market makers or a national securities listing.
Choosing a shell can be a difficult task. First and foremost, the shell must be "clean." In other words, the shell should be free from any liabilities or contingent liabilities. Next, in order to accomplish the intended result, the shell should be a publicly reporting company under the Securities Exchange Act of 1934. Third, the shell should be current with its filings with the Securities and Exchange Commission.
The price that a shell can demand will depend on the assurances that can be given with respect to its compliance and "cleanliness." In the case of shells that are compliant with the SEC, those that were legitimate operating companies that have not gone through bankruptcy proceedings will receive the largest premiums. Of course, the guarantee against contingent liabilities is only as good as the due diligence on the shell.
At the bottom are the so-called "blank check" companies. These companies typically were never operating businesses and were formed primarily, if not solely, to locate a merger partner that is an operating business. In 1992, the SEC adopted Rule 419, which tightened regulations on these companies because the SEC perceived them to be used for fraudulent purposes. In addition, a majority of states restrict or prohibit the registration and sale of stock by such entities within their borders.
Some of the best shells available in today's market come from companies in Chapter 11 bankruptcy proceedings. In many cases, these shells come from once viable operating companies that are reasonably current with their SEC filings. The reverse merger is accomplished effectively through the confirmation of a plan of reorganization. Accordingly, the stock structure, public float, etc., can be adjusted by a judicial order.
Most important, Section 1141(d) of the Bankruptcy Code provides that the confirmation of the plan discharges the debtor (i.e., the public company) from debts that are not set forth in the plan. As such, the confirmation of a Chapter 11 plan is the best way to guarantee that a company is free from contingent liabilities.
Bankrupt public companies also may offer other significant benefits. First, depending on how long the company has been in bankruptcy and its position in the market before it filed for bankruptcy, its market makers still may be in place. Again, access to market makers is one of the primary benefits sought by companies interested in reverse mergers.
Second, the Bankruptcy Code has certain pre-emptions over federal securities laws. Most notably, Section 1145(a) of the Bankruptcy Code provides an exemption from the registration and prospectus delivery requirements of the securities acts (and equivalent state securities and "blue-sky" laws) where new securities of the reorganized debtor are exchanged for pre-Chapter 11 securities pursuant to the confirmed plan of reorganization.
Finally, as part of the plan of reorganization, creditors of the bankrupt shell likely will become shareholders of the new public company. After all, these creditors hope to recover some of their losses though the value of their shares in the new company. Assuming these former creditors still hold their shares at the time of a secondary offering (which is usually the case), market makers often tout the names of these "shareholders" to generate interest in the offering.
With all shells, the price that they can demand depends on the level of compliance with the SEC. In other words, are they current with their filings? The quarterly filings (10-Qs) only need to be reviewed by a certified public accountant firm and are relatively easy and inexpensive to file. The annual reports (10-Ks) need to be accompanied by an audit by a qualified certified public accountant firm.
Shells that are not current with their 10-Ks and need to be audited typically demand less in the market because of the cost and time of bringing them into compliance. Form 8-K is used to make a filing with the SEC regarding the reverse merger transaction.
As a final note, in evaluating a reverse merger, a company should make sure that it has a qualified certified public accountant to perform the future audits and review the necessary SEC filings. Companies should not assume that their existing auditors can, or will, perform the audit. Many national accounting firms are reluctant to audit Over-the-Counter companies. Conversely, many local certified public accountant firms are not qualified to conduct public company audits.
With the right shell, a private company can become public more quickly and cheaply than by an initial public offering. For those companies unable to locate an underwriter to take them public, a reverse merger may be their only option. While a reverse merger is not a money-raising vehicle, it can be a road to one. For owners of a shell, the reverse merger offers a chance for meaningful equity in a substantive operating company. And, for those unfortunate owners and creditors of a bankrupt company, a reverse merger with a private company may be the best and last opportunity for partial recovery of their claims.
Stephen P. Milner, an attorney and certified public accountant, is managing partner of Squar, Milner Reehl & Williamson, a certified public accountant and financial advisory firm in Newport Beach.
#337629
Columnist
Daily Journal Staff Writer
For reprint rights or to order a copy of your photo:
Email
Jeremy_Ellis@dailyjournal.com
for prices.
Direct dial: 213-229-5424
Send a letter to the editor:
Email: letters@dailyjournal.com