Put It In Reverse

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.

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This article was originally published in the June 1999 print edition of Entrepreneur with the headline: Put It In Reverse.

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