Alternatives to an IPO – Reverse Mergers

This primer on how to reverse mergers was written as a chapter in the book called Where's the Money. I wrote the book under agreement with its' authors Dwayne Moyers and Art Beroff and with Entrepreneur Media, Inc.

David R. Evanson

Where’s the Money?, Fall, 1999

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

Appropriate For: Reverse mergers are appropriate for companies which do not need capital quickly, and which will experience enough growth to reach a size and scale where they can succeed as a public entity. Minimum sales and earnings to reach [italicize reach] this plateau would be $20 million and $2 million, respectively.

Supply: There are thousands and thousands of dormant public companies, sometimes calledshells which 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 which do not need capital quickly. Not that reverse mergers take long to consummate. But consummating the initial transaction is usually just the halfway point. Once public, a company generally still has to find capital. Also, this financing technique works better for companies which will experience substantial enough growth to develop into a “real” public company.

Cost: Expensive. Compared to a conventional initial public offering, fees and expenses are not that high for a reverse merger. Deals can be completed for between $50,000 and $100,000 which might be 25% of the out of pocket costs that come with a full-blown IPO. In the process of doing the deal however, the acquiring company might give up 10% to 20% of its equity. This is very [italicize very] expensive. After all, it means a company is surrendering ownership just for the priviledge of being public. More equity will likely disappear when the company actually raises money.

Ease of Acquisition: Difficult, but not as difficult as a conventional initial public offering. Perhaps the most challenging aspect of a reverse merger is trying to create a real trading market for the companyzzs shares once the deal is done.

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

Though initial public offerings are perhaps the most sought after form of financing, the fact is surprisingly few companies can ever hope to successfully negotiate their way through the tortuous process.

This truth leads to a nasty little Catch-22. Many promising small companies cannot get funding because they are private. However, without funding, they canzzt ever hope to grow to the size and scale where they could go public.


Shop Talk: Investorzzs frequently talk about “exit strategies.” This is a fancy reference to cashing out. Specifically, once an investor puts money into a company, they want to know how they can get their money back out at a profit.


Why is being a private company anathema to the capital formation process? Because many investors believe that even if the company does well, without an exit strategy for the investors to get their money out of the company, they will never realize a substantial return on their investment. There might be some merit to this thinking. However, the other side of the coin is that the company which is patiently [italicize patiently] funded so that it is able to realize its true potential, will have numerous options for rewarding its shareholders.


Donzzt Forget: A reverse merger is not an end in and of itself. It is a technique or tool, which makes a company more financeable.


Perhaps the highest and best use of a reverse merger was made by LVA Group.

The companyzzs founder Dr. Jerry Stephens already had a profitable hospital management business. But he saw an opportunity in free-standing centers offering laser refractive eye surgery to correct myopia, also known as nearsightedness. However the process not yet approved and was awaiting the nod from the FDA. “The U.S. was a multi-billion dollar market,” according to Stephens.

To get ready, the company laid plans for financing the roll-out of centers in the United States and bought part of a laser surgery center in Toronto, where the process was already legal.

Considering financing alternatives, Stephens beleived he could cobble together an IPO, but concluded that it was highly unlikely for a new and untested concept. What if the FDA approval was delayed?

But with a reverse merger, Stephens only had to convince the controlling shareholder of a public shell that the reward was worth the risk. And the controlling shareholder of shell company which Stephens was talking with happened to agree.

In the resulting deal, Stephens bought stock in the shell company in exchange for LVA Groupzzs assets. At the end of the day Stephens had a majority position in the shell company, and the shell company had the operating assets of his company. The public company then changed itzzs name to LVA-Vision to reflect the deal and the future course of the business.

Two months after the deal, the FDA approved the laser refractive procedure used by LVA, and Stephens was off and running. Almost immediately Stephens raised nearly $500,000 privately. He also used his publicly traded common stock to buy the remaining interest in the Toronto facility. The provate capital he raised, combined with favorable lease terms on surgical laser equipment helped Stephens roll out seven new surgery centers in the South and Midwest. After a brief honeymoon on Nasdaq’s Bulletin Board, LVA Vision moved up to Nasdaqzzs SmallCap.

In a climaxing deal LVA used its stock to purchase a chain of refractive surgery centers from another company. To acquire the company, LVA issued several million of its own sharesand in return got the other companyzzs 19 wholly owned and operated refractive surgery centers around the country. As a final bonus, the company that LVA bought had $10 million in the bank when the deal was inked.

Today, LVA Vision is the largest provider of vision treatment procedures in the United States.

Here are some of the primary benefits entrepreneurs and their companies can reap with a reverse merger transaction.

– Reverse mergers are impervious to market conditions. Conventional IPOs are risky for companies to undertake because the deal depends on market conditions over which senior management has absolutely no control. That is, if the market is off, the underwriter may pull the the offering. The market doesnzzt even need to plunge wholesale. If a company in registration participates in an industry thatzzs making unfavorable headlines, investors may shy away from the deal, causing it to run out of gas on the runway.

But with a reverse merger, the deal rests on whether or not the people that control the shell like the private company and desire to be acquired by it. Market conditions have almost no bearing on the situation.

– Compressed timetable. Regular initial public offerings can drag on for a year or more, between when the idea pops into the chief executivezzs head until he or she actually gets a check. Unfortunately, when a company is making the transition from an entrepreneurial venture to a real public company fit for outside ownership, senior managementzzs time is at its most valuable. Time spent in seemingly endless meetings and drafting sessions can have disastrous effects, and even nullify the growth upon which the offering is predicated. In addition, during the many months it takes to put together an IPO, market conditions can deteriorate, closing the “IPO window” on a company.


A Good Deal: Even if the market crashes while you are working on your reverse merge, it probably wonzzt kill your deal. For the shell company, with few assets and little or no story to tell, a good merger is good news and worth pursuing, no matter what market conditions are.


By contrast, conditions permitting — which means among other things, two extremely interested and willing parties — a reverse merger can be completed in 45 days.

– Reduced expenses. For a real IPO, it can cost as much as $200,000 just to get a preliminary prospectus on the street. To actually get the deal to the closing table, the costs increase. A reverse merger however, can be done for $50,000 to $100,000.

– Corporate income tax shelter. Many shell companies have what is known as a tax loss carryforward. What this means is that a loss incurred in prior years can be applied to income in furture years. When this occurs, the future income is sheltered [italicize sheltered] from income taxes. Since most active public companies become dormant public companies through a string of losses, or at least one large one, therezzs a better than average chance the shell you meet will offer this opportunity.

(As discussed in the next section however, the shell companyzzs previous history can rub off on you, which turns out to be one of the biggest drawbacks of reverse mergers.)


Donzzt Forget: In addition to fees, a reverse mergers will also cost you precious points of equity in your company. The shareholders of the public company get a stake, and the deal makers who control the shell get a stake as well.


– More Ways to Raise Money. The primary reason to do a reverse merger to begin with is the greater number of financing options which become available to companies once they are public. Some of these include:

• The issuance of additional shares in a secondary offering. • Exercise of warrants. Warrants are options, which give the holder the right to purchase additional shares in a company at predetermined prices. When many shareholders with warrants, which a public company can easily issue, exercise their option to purchase additional shares, the company receives an infusion of capital as shown above.

Theoretical Exercise of Warrants to Raise
$2.4 million For a Newly Public Company

• Private Offerings. Many, many more investors will step up to the plate for a private offering of shares, once they know there is some sort of mechanism in place for them to resell their shares if the company succeeds. Most investors realize that even a successful company may not be able to go public if market conditions are off. But a company that is already public . . . thatzzs a different story. If it succeeds, the likelihood of developing a market for its common stock that accurately values the company and allows the investor to sell their shares, is much much better.

Reverse mergers arenzzt for everyone however. There are several drawbacks to this financing technique. Among the disadvantages:

– Image. Reverse mergers have accumulated their share of controversy over the years. There are several reasons for this. First, most reverse mergers start with dormant public companies. Most of the time, they fell into dormancy because of failure in their line of business. As a result, there may be an angry group of shareholders somewhere in the deal. Second, the chances of some irregularity occurring in the trading, most likely unknown to the company, are high with reverse mergers. The reason is most reverse transactions initially trade on the Pink Sheets or the Bulletin Board, the least regulated tiers of the market.

– Unknown shareholders. At the end of the day, the private company which acquires a public one, is left with a shareholder base it does not know, and has no pervious interaction with. These shareholders can place significant downward pressure on a companyzzs stock by continually selling their shares as a new trading market develops. Also, creditors, or other parties which suffered by the failure of the predecessor company, can start to come out of the woodwork, and make claims against the new management.

– Indirect route to capital. Reverse mergers represent a way to make a company financeable not necessarily finance it per se. Though they are theoretically quick and easy, like any securities transaction, reverse mergers contain enough wrinkles to make the process drawn out and lengthy. But in most instances, just consummating the reverse merger transaction is only the halfway point in a companyzzs pilgrimage to growth capital. When itzzs done, the company still has to go out and beat the bushes for the cash they need.

– Difficult to become a real public company. Despite the fact that an exciting private company has taken over control of dormant public company doesnzzt mean other investors will sit up and take notice. In fact, the only investors who tend to care about the change in control are the one who invested in the original company. Oftentimes, their interest is mercenary: they simply want to know when the new company will succeed to the point where they can get their money back.

As a result of this relative obscurity, most reverse mergers find their stock doesnzzt trade much. Moreover, company executives and principals find they have a hard time attracting investors to their stock to create the kind of trading and liquidity which is the benchmark of a real public company.


In the diagram above the hypothetical public company has 1 million common shares outstanding prior to any sort of transaction with a private company. Of these 1 million shares, 500,000 are owned by public investors and 500,000 are owned by the person or persons which control the public company. Once a deal is struck for the private company to acquire the public one, herezzs how it might be consummated in a three step process:

1. The public company issues 9 million shares of common stock to the person or persons who own the private company. Now what is the ownership structure of the public company? There are now 10 million shares outstanding. Of these, 9 million or 90% of the company is held by the owner of the private company. Another 500,000 shares, or 5% ownership of the company, are held by the person or person who controlled the public company. And the public investors, hold the other 500,000 shares or 5% of the company. Note that prior to merger, the public owned 50% of the public company, but after the merger they owned just 5%.

2. The 9 million shares of common stock is usually issurd to the shareholders of the private company in exchange for something. In most reverse merger transactions, the private company: a) contributes all of its assets to the public company; b) issues shares of its own to the public company or c) buys the shares outright from the public company at a nominal price.

3. The public company then changes its name, usually to the name used by the private company, to reflect the change in it business.


If a reverse merger still sounds like a good idea to you, here are the teps you need to take.

– Find a shell company. You can find a shell company through the usual suspects. As a first stop, ask an attorney. Every metropolitan area has a law firm with a securities practice. Many times these firms have a dormant public company literally sitting on one of the partnerzzs 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 the attorneys, they know where the bodies are too.

Another source are financing consultants. In fact, many financing consultants actually have a couple of shell corporations, and upon request, can manufacture a clean public shell. Made to order shells, without the baggage of a business failure in its background can sometimes be the way to go.


Shop Talk: The controlling shareholders of a shell corporation will most likely insist on owning a small stake in the deal going forward. This “trailing interest” is simply a cost of doing business.


But, therezzs often a cost involved. That is, you will most likely end up with the financing consultants as minority shareholders in the new company holding somewhere between 2 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. Therefore this surrender of equity is simply a cost of doing business.

– Devise your financing strategy. As mentioned several times already in this chapter, a reverse merger is an indirect route to raising capital. Entrepreneurs must consider first how additional capital will be raised after the deal is done.

As mentioned above, a public company can issue and exercise warrants. Some public shell companies already have warrants issued and outstanding which have the underlying common stock shares registered with the Securities and Exchange Commission. This is much easier, and much more valuable to a company which wants to raise capital with warrants. If the newly public company has to create and issue warrants, the road to getting them exercised will be trickier, but still possible. In short, to exercise warrants where the underlying common shares are not registered, the exercise will require the assistance of a brokerage firm, and will have to occur in a state where there is no registration requirement for issuance of shares of to $1 million.

If you are going the private offering, i.e., an offering sold to select individuals rather than through a sale directly to the public at large, then 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 which these investors own (See Sidebar Above, The Mechanics of a Reverse Merger) By doing so, the private investors can be offered stock at a discount to the market price as an added incentive.

For example, if the the stock is $7.00, the private offering is offers investors common stock at $5.00. This incentive evaportes when sell orders flood the market, and the market price of the stock drops to $5.00.

Of course, a smart investor knows they canzzt simply load up on $5.00 stock in a private placement and turn around and sell it out on the public market at $7.00. There simply isnzzt that many buyers to support that kind of selling. But the point is, itzzs much easier to sell common stock to investors at $5.00 in a private offering when the market price is $7.00 as opposed to trying to sell common stock privately at $5.00 what the market price is $4.00.

– Clean up your act. Unfortunately, therezz a stigma attached to reverse mergers. LVA-Visionzzs Stephens, who used the technique to brilliant effect, said that although it worked for his company, “therezzs definitely, another side to these deals. If it wasnzzt for my longstanding reputation in the medial community, our deal might have been perceived differently.” Largely, the bad rap stems from the fact that reverse mergers are not understood says Stephens.


Donzzt Forget: If you need all the bells and whistles of a true public company, you can spend as much time and money on the back end of reverse merger as you would on the front end of a conventional initial public offering.


Accordingly entrepreneurs contemplating such a transaction, can and should take steps to elevate the profile of their “new” company. Specifically:

• Hire a national accounting firm. One of the reasons the “big five” fees are high, is because they inspire alot 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.

• Hire a prestigious law firm. Itzzs almost a certainty that the attorney who helps you with your reverse merger transaction, if he or she is an expert in the process, will not be with a prestigious downtown law firm. And though you may be reluctant to switch from a competent and trusted counselor after the deal is over, for the sake of the company an its credibility, it might be good idea. When deciding whether or not 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 mentioned, there are many shells which 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. The great rallying cry of the 1980s popularized by the Hollywoodzzs oily takeover artist, Gordon Gekko, “Greed is good,” doesnzzt quite apply with a reverse merger. Itzzs possible to structure a reverse merger, so that at the end of the day, the public owns 2% of the company, and the remaining 98% is controlled by the owners of the private company which acquired the shell. Unfortunately, therezzs almost no incentive for any other investors to get involved if the only people who truly benefit are the insiders. The lesson is, if you are going to get the public involved with the intention of engaging in a truly symbiotic relationship, youzzve simply got to leave some value on the table.

In many ways the reputation of reverse mergers is similar to the notoriety which junk bonds had during the 1980s. Junk was used by corporate raiders to buy companies and break them up. But junk bonds also nurtured an entire generation of exciting growth companies and made a material and profound impact on the economy in terms of wealth and employment.

Remember, reverse mergers are simply a technique. The ultimate goodness or badness of the deal depends on how wisely it is deployed.


Taking Action: Start calling attorneys and accountants and ask them if they are aware of a clean shell company. You should locate something in less than 10 calls.


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