How-To Buy An Existing Business: Reverse Merger

Take your private company public the easy way by purchasing a dormant, public company.

Definition or Explanation: A privately held company acquires a publicly traded, but usually dormant, company. By doing so, the private company becomes public.

Appropriate For: Reverse mergers are appropriate for companies that don’t need capital quickly and that will experience enough growth to reach a size and scale at which they can succeed as a public entity. Minimum sales and earnings to reach this plateau are $20 million and $2 million, respectively.

Supply: There are thousands of dormant public companies, sometimes called shells, that might be viable merger candidates. By becoming public, a company becomes a more attractive investment opportunity to a wider range of investors. The supply of equity capital is more abundant for public companies than for private ones.

Best Use: Reverse mergers can be used to finance anything from product development to working capital needs. However, they work best for companies that don’t need capital quickly. Not that reverse mergers take long to consummate, but the initial transaction is usually just the halfway point. Once public, a company generally must still find capital. Also, this financing technique works better for companies that will experience substantial enough growth to develop into a real public company.

Cost: Expensive. Compared with a conventional initial public offering (IPO), however, fees and expenses are not that high for a reverse merger. Deals can be completed for $100,000, which might be 25 percent of the out-of-pocket costs that come with a full-blown IPO, but fees can reach $400,000. In the process of making the deal, however, the acquiring company might give up 10 percent to 20 percent of its equity. This is very expensive. After all, it means a company is surrendering ownership just for the privilege of being public. More equity will probably disappear when the company actually raises money.

Ease of Acquisition: Difficult but not as difficult as a conventional IPO. Perhaps the most challenging aspect of a reverse merger is trying to create a real trading market for the company’s shares once the deal is done.

Range of Funds Typically Available: $500,000 and greater.

First Steps
If a reverse merger sounds like a good idea to you, here are the steps you need to take:

 

  • Find a shell company. You can find one by contacting the usual suspects. As a first stop, ask an attorney. Every metropolitan area has a law firm with a securities practice. Often, these firms have a dormant public company sitting on one of the partners’ bookshelves.Another alternative is an accountant. People who control shell companies tend to keep the financial statements, such as they are, up to date. This brings accountants into the loop. Like attorneys, they know where the bodies are.Another source is financing consultants. In fact, many actually have a couple of shell corporations and, upon request, can manufacture a clean public shell. A made-to-order shell without the baggage of a business failure in its background can sometimes be the way to go.

    But there’s often a cost involved. That is, you will most likely end up with the financing consultants as minority shareholders in the new company, holding between 2 percent and 5 percent. However, in almost any reverse merger transaction, the principals of the shell company keep a small equity position in the company going forward. This surrender of equity is simply a cost of doing business.

  • Devise your financing strategy. A reverse merger is an indirect route to raising capital. Entrepreneurs must first consider how additional capital will be raised after the deal is done.Remember, a public company can issue and exercise warrants. Some public shell companies already have warrants issued and outstanding; some have previously registered the underlying common stock shares with the Securities and Exchange Commission—which is a significant benefit. This is much easier and much more valuable to a company that wants to raise capital with warrants. If the newly public company must create and issue warrants, the road to getting them exercised will be trickier but still possible. In short, exercising warrants where the underlying common shares are not registered requires the assistance of a brokerage firm and must occur in a state where there is no registration requirement for issuance of shares of up to $1 million.If you are going the private-offering route (i.e., an offering sold to select individuals rather than through a sale directly to the public at large), the deal must be carefully structured. Specifically, the amount of stock owned by investors that the new owners do not know and cannot influence must be diminished so that a stable quote can be established. Usually, this is done by reducing the percentage of the total number of shares these investors own. By doing so, as an added incentive, the private investors can be offered stock at a discount to the market price.
  • Clean up your act. Unfortunately, there’s a stigma attached to reverse mergers. LVA-Vision, a company that owns free-standing centers offering laser refractive eye surgery, founder Jerry Stephens, who used the technique to brilliant effect, said that although it worked for his company, “there’s definitely another side to these deals. If it wasn’t for my long-standing reputation in the medical community, our deal might have been perceived differently.” Largely, the bad rap stems from the fact that reverse mergers are not understood, Stephens says.Entrepreneurs contemplating such a transaction can and should take steps to elevate the profile of their “new” company. Specifically:1. Hire a national accounting firm.
      One of the reasons the Big Four fees are high is because they inspire a lot of comfort among investors, traders, and regulators. If you saved a lot on fees at the front end, this might be worth investing in on the back end.

2. Hire a prestigious law firm. It’s almost a certainty that the attorney who initially helps you with your reverse merger transaction–if he or she is an expert in these kinds of deals–will not be with a prestigious downtown law firm. However, after the offering is completed, you should consider retaining one of these firms. Why? When deciding whether to get involved in your offering, many investors and brokers will judge your firm by the company it keeps. An unknown law firm makes a neutral-to-negative impression. But a well-known and powerful law firm sends an unmistakable message.

Start with a clean shell. As was mentioned, many shells are created for the express purpose of merging with a private company. These shells have no predecessor entities and, as a result, little baggage in the way of a business failure or other skeletons in the closets.

Check your greed. “Greed is Good”–the great rallying cry of the 1980s, popularized by the Hollywood oily takeover artist Gordon Gekko in the movie Wall Street–doesn’t apply with a reverse merger. It’s possible to structure a reverse merger so that at the end of the day, the public owns 2 percent of the company and the remaining 98 percent is controlled by the owners of the private company that acquired the shell. Unfortunately, there’s almost no incentive for any other investors to become involved if the only people who truly benefit are the insiders. The lesson is, if you plan to involve the public with the intention of engaging in a truly symbiotic relationship, you simply must leave some value on the table.

 

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Costa Kapothanasis

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