From the June 1999 issue of Entrepreneur

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

This truth leads to a nasty Catch-22. Many promising small companies cannot obtain funding because they are private. However, without funding, they can't hope to grow to the size that would allow them to go public.

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 to get their money out, they'll 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 a patiently funded company that realizes its true potential has numerous options for rewarding its shareholders.

If you're convinced going public is the best way to find the funding you need, there's an alternative to the typical IPO that's less burdensome and may be equally lucrative: a reverse merger. In a reverse merger, a private company acquires an already public, though typically dormant, company and becomes public as a result. Though completing a reverse merger is only the first step in receiving funding as a public company, it can lay the groundwork for substantial capital growth.


Art Beroff co-writes Entrepreneur's "Raising Money" column. Dwayne Moyers is the founder of Cummer Moyer Securities investment brokerage and management company. He has advised numerous emerging companies on financing strategies and options.

Backward Bonus

Following are some of the primary benefits you can reap with a reverse merger:

  • Imperviousness to market conditions: Conventional IPOs are risky for companies to undertake because the deals depend on market conditions over which you have no control. If the market is off, the underwriter may pull the offering. The market doesn't even need to plunge wholesale. If a company seeking an IPO is in an industry that's 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 the shell company likes your company enough to be acquired by it. Market conditions have almost no bearing.

  • Compressed timetable: Regular IPOs can drag on for a year or more from when the idea pops into your head until you actually get a check. Unfortunately, when a company transitions from an entrepreneurial venture to a real public company fit for outside ownership, senior management's time is at its most valuable. Spending it in seemingly endless meetings and drafting sessions can have a disastrous effect on the growth the offering is predicated on and even nullify it. In addition, during the many months it takes to put together an IPO, market conditions can deteriorate, closing the IPO window on a company. By contrast, 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 bring the deal to the closing table, the costs increase. A reverse merger, however, can be done for only $50,000 to $100,000.
  • Corporate tax shelter: Many shell companies have what's known as a tax-loss carry forward. This means losses incurred in previous years can be applied to income in future years. When this occurs, future income is sheltered from income taxes. There's a better-than-average chance the shell you meet will offer this opportunity. (As discussed in the next section, however, the shell company's history can rub off on you, which turns out to be one of the biggest drawbacks to reverse mergers.)
  • More ways to raise money: The primary reason to do a reverse merger is the greater number of financing options that become available to companies once they have gone public. These include:

1. The issuance of additional shares in a secondary offering.

2. Exercise of warrants. Warrants are options that give the holder the right to purchase additional shares in a company at a predetermined price. 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.

3. Private offerings. Many more investors will step up to the plate for a private offering of shares once they know there's 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 . . . that's a different story. If it succeeds, there's a greater likelihood of developing a market for its common stock that accurately represents the company and lets investors sell their shares.

The Drawbacks

Reverse mergers aren't 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 for a few reasons. First, most reverse mergers start with dormant public companies. Usually 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. Furthermore, the chances of some irregularity occurring in the trading, most likely unknown to the company, are high. That's because most reverse transactions initially trade on the Pink Sheets or the OTC Bulletin Board, the least regulated tiers of the market.
  • Unknown shareholders: At the end of the day, the private company that acquires a public one is left with an unfamiliar shareholder base with which it has had no previous interaction. These shareholders can place a significant downward pressure on the company's stock by continually selling their shares as a new trading market develops. Also, creditors or other parties that suffered in the past because of the failures of the predecessor company can come out of the woodwork and make claims against the new management.
  • Indirect route to capital: Reverse mergers represent a way to open avenues to financing for a company without actually financing it. Though they are theoretically quick and easy, like any securities transaction, reverse mergers contain enough wrinkles to draw out the process. But in most instances, just consummating the reverse merger transaction is only the halfway point in a company's pilgrimage to growth capital. When it's done, the company must still go out and beat the bushes for the cash it needs.
  • Difficulty becoming a real public company: An exciting private company may have taken control of a dormant public company, but that doesn't necessarily mean other investors will sit up and take notice. In fact, the only investors who tend to care about the change of control are those who invested in the original company. Often their interest is mercenary: They simply want to know when the new company will succeed to the point where they can recoup their money.

As a result of their relative obscurity, most reverse mergers find that their stock doesn't trade much. Moreover, company executives and principals have a hard time attracting enough investors to their stock to create the kind of trading and liquidity that is the benchmark of a conventional public company.

Gearing Up

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

1.Find a shell company. 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.

Financing consultants may also be a good source. In fact, many actually have a couple 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. You'll 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. Therefore, this surrender of equity is simply a cost of doing business.

2.Devise your financing strategy. As we've mentioned, 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.

As was mentioned previously, a public company can issue and exercise warrants. Some public shell companies already have warrants issued and outstanding and 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 total.

If you're 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.

For example, if the stock costs $7, private investors are offered the opportunity to purchase common stock at $5. This incentive evaporates when sell orders flood the market and the market price of the stock drops to $5.

Of course, smart investors know they can't simply load up on $5 stock in a private placement and turn around and sell it on the public market at $7. There simply aren't that many buyers to support that kind of selling. But the point is that it's much easier to sell common stock to investors at $5 in a private offering when the market price is $7 than it is to sell common stock privately at $5 when the market price is $4.

3.Clean up your act. Unfortunately, there's a stigma attached to reverse mergers. LCA-Vision's Stephen N. Joffe, who used the technique to brilliant effect (see "A Case In Point," page 144), says that although reverse mergers 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:

  • Hire a national accounting firm. One of the reasons the Big Five 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.
  • 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.

4.Check your greed. The great rallying cry of the 1980s, popularized by the oily Hollywood takeover artist Gordon Gekko, "Greed is good," doesn't apply with a reverse merger. It's possible to structure a reverse merger so 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.

In many ways, the reputation of reverse mergers is similar to the notoriety 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 had a material and profound impact on the economy in terms of wealth and employment.

Remember, a reverse merger is simply a technique. The ultimate quality of the deal depends on how wisely it is deployed.

Flip Side

Perhaps the best use of a reverse merger was made by LCA-Vision Inc. The company's founder, Stephen N. Joffe, already had a profitable hospital-based management business. But he saw an opportunity in freestanding centers offering laser refractive eye surgery, a procedure that corrects nearsightedness. The process for the surgery was awaiting FDA approval, so the company laid plans for financing the rollout 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, Joffe believed he could cobble together an IPO, but he concluded it was highly unlikely for a new and untested concept. He didn't think there would be much problem convincing an underwriter of the business's potential, but could an underwriter convince other investors? What if FDA approval was delayed?

Next Joffe considered a reverse merger. For this type of arrangement, he only had to convince the controlling shareholder of a public shell that the reward was worth the risk. And the controlling shareholder of a shell company Joffe was talking with happened to agree.

In the resulting deal, Joffe bought stock in the shell company in exchange for LCA-Vision's assets. At the end of the day, Joffe had a majority position in the shell company, and the shell company had the operating assets of his company.

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

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

The Scoop

Reverse merger defined: A privately held company acquires a publicly traded, but usually dormant, company. By doing so, the private company becomes public.

Appropriate for: Companies that don't need capital quickly and 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 mil-lion, 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 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 com-panies 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, but compared with a conventional initial public offering, fees and expenses are not that high for a reverse merger. Deals can be completed for $50,000 to $100,000, which might be 25 percent of the out-of-pocket costs that would come with a full-blown IPO. 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.

A Good Deal

Even if the market crashes while you're working on your reverse merger, it probably won't 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.

This excerpt was reprinted from Where's The Money? (Entrepreneur Media Inc., ©1999), by Art Beroff and Dwayne Moyers. To obtain a copy, visit your local bookstore or our Web site at http://www.entrepreneurmag.com

Contact Source

LCA-Vision Inc., 7840 Montgomery Rd., Cincinnati, OH 45236, (513) 792-9292