Selling Micro Caps to Reverse into Public Shell Companies – Snake Oil?

Selling Micro Caps to Reverse into Public Shell Companies – Snake Oil?

I recently saw an article saying, “Reverse Mergers are more Popular than Ever.” The author was extolling the virtues of such transactions for MicroCap Stocks. However, this solution I rarely find delivers as promised,  in many cases, is more of a poison chalice.

 

How it works

A private entity reverses into a public shell company to go public. The shareholders in the private corporation exchange their shares for the public company’s shares. The number of shares issued to the private company gives its shareholders control over a majority of the stock of the shell, and so they are running the public company.

The legal structure for this type of merger is called a “reverse triangular merger.” The process of a reverse triangular merger is:

  1. The public shell company creates a subsidiary entity.
  2. The newly formed subsidiary merges into the private company that is buying the shell.
  3. The newly formed subsidiary has now disappeared, so the private company becomes a subsidiary of the shell company.

Using a reverse triangular merger avoids the shareholder approval process usually required for acquisitions. The deal requires shareholder approval – the shareholders of the private company and shareholder of the new subsidiary entity. However, the only shareholder of the new subsidiary is its parent company.

The process is beneficial because there is no change in control of the private company, and the private company continues to operate as a going concern; thus, preventing any potential damage to the business from loss of contracts if either of those events were to occur.

However, a reverse merger still requires the filing of a Form 8-K with the SEC, which requires much of same the information found in an initial public offering prospectus.

 

The Case for Reversing into a Public Shell

The of advantages with a reverse merger are:

  • Speed. A reverse merger takes just a few months.

  • Time commitment. A reverse merger requires far less effort than an initial public offering, allowing the management team to continue to focus on the business.

  • Timing. As this is a discussion about Micro Caps, raising cash is not a likely scenario, so that a reverse merger can take place regardless of stock market conditions.

  • Tradable currency. As a public company, it is easier for a corporation to use its stock for acquisitions. Also, the value of its stock is theoretically more certain and realizes a higher multiple, increasing the company’s value.

  • Liquidity. Sometimes the existing shareholders of a private company favor the reverse merger path to have an exit for selling their shares. Especially in cases where the shareholders are unable to sell their shares to the company or other shareholders, and the majority of shareholders don’t want to sell the company.

  • Stock options. As a public company, stock options are more valuable to recipients and so can be used to incentivize management and employees. If the option holders elect to exercise their options, they can then sell the shares to the general public rather than having the company have to buy them.

 

The Problems of Reversing into a Public Shell

The disadvantages are:

  • Cash. Since we are discussing Micro Caps, an IPO is not a possibility. Thus, the company will not be able to raise money through the reverse.

  • Cost and Loss of Value. While the reverse merger typically is cheaper than an IPO, there is still considerable ongoing expenditure to meet the requirements of being public. An active business can expect to at least $500,000 a year on auditors, attorneys, SOX compliance, filing fees, investor relations, etc. which are required by being public. Also, assuming the company is trading on an 8x multiple and has a tax rate of 35%, this will reduce the value of the company by $1.8MM

  • Prior life. Following the Great Recession, there is currently a glut of failed dot-com shells on the US and Canadian Shell markets. Unless the Buyer is very familiar with the Principals and previous business involved, bear in mind the words from Lost in Space – “Danger, Will Robinson!” Without spending a small fortune and investing vast amounts of time, it is almost impossible to find all their contracts and obligations, as well as the legal actions, launched them. As such, there will always be questions about what you are buying. Also, many of these companies have a terrible will with existing stockholders, and a bad reputation is hard to shake.

  • Liabilities. Not all shell companies are actual shells. In additional to unresolved litigation and disgruntled shareholders, as mentioned above, many have undisclosed financial obligations and regulatory history that will not go away after the reverse merger. Sellers of shell companies often are economical with the truth, the problems, or potential problems with the company. On completion of the transaction, the sellers have little incentive to solve these issues, leaving litigation as the only remedy, and an imperfect solution it is. Acquiring only a shell that has been inactive for several years can ameliorate this risk.

  • Stock price. When a company does a reverse merger, many of the existing shareholders seek to exit. However, all these selling shareholders put downward pressure on the stock price since there are now more sellers than buyers. A falling stock price reduces the effectiveness of stock options issued to employees and increases the dilution of the existing shareholders if they plan to use the stock for acquisitions.

  • Thinly traded. Usually, there is only a minimal amount of trading volume in the stock of a public shell company. Immediately following the reverse merger, only the shares held by the original shell shareholders are tradable, as no other shares are registered with the SEC yet. Building trading volume takes time, an active public relations and investor relations campaign, as well as the registration of additional stock. Besides, if the market capitalization of the company is below a certain threshold, no analysts will follow it, and most mutual funds cannot buy it. The lack of analyst coverage and fund demand will reduce interest in the company further.

Finally, thinly trade shares are volatile, and the price will tend to move a great deal on any sizable order. However, any untoward movement in the stock price could lead to class action litigation, and the costs of fighting these lawsuits can be substantial.

As can be seen, there are significant issues with public shell companies that should keep companies from buying them. In particular:

  • The annual cost of being a public company – which should prevent any micro-cap from considering this path, and

  • Being a thinly-traded stock – this offsets the main reason for being a public tradable stock.

 

© 2015 Marc Borrelli All Rights Reserved

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Having represented many clients with selling their businesses, raising capital, or entering into joint ventures, the issue of Non-Disclosure Agreements (“NDA”) always arises. The primary focus of clients is on ensuring that the NDA is as secure as possible and often such that no reasonable party would agree to it. Thus, I find my job is to help them understand what is commercially reasonable, and more importantly, to work with them to understand who is the other party executing the NDA.

Most sales of small companies these days in the US are to Private Equity Groups, and so many people become complacent about understanding who the other party is. If the other party is not someone that is known, far more work needs to be done to understand:

  • Who is the other party is;

  • Where are they located;

  • What you each have; and

  • How much you share.

Failure to do this potentially exposes you to the “Achilles Heel” of the NDA.

First of all, if there is a breach of the NDA, most NDAs allow for injunctive relief, which is obtainable in the US, so damage within the US may be limited. However, if you want more than injunctive relief in the US, the areas of concerns are:

 

Who?

Who is the company? A Fortune 500 Company, some sizeable foreign company that you have never heard of, but there is information on or some company that for which there is no information? Many people don’t look at who is executing the agreement if they believe the person they are dealing with is with XYZ Corporation that they know.

However, if the entity executing the NDA is a single purpose subsidiary of XYZ, does it have any capital? Is XYZ a party to the transaction? Finally, there are cases in some developing markets, especially China, where government entities own many companies, i.e., the People’s Liberation Army owns many Chinese businesses, and thus for all practical purposes, these are immune from any claims.

Recently I came across a situation where ABC, a US company, found that their confidential information was being used against them by Z, a subsidiary of Company Y in China. ABC had executed an NDA with X, a Singaporean special purpose subsidiary of Y with no assets. Also, there was a Letter of Intent with T, a US subsidiary of Y, which also had no assets. As a result, there were no identifiable assets to go against, and to win in China would be hard.

 

Where?

If the NDA is with a non-US company, you may have issues in bringing a claim. While the NDA may provide that the venue and choice of law are your home state, the other party has to be served and appeared in federal or that state’s court. If the other party is not in the US, it may be challenging to serve even them because they may not exist, or the address/agent provided doesn’t exist. If you can’t serve them, a proceeding may be complicated.

Assuming you serve them, and they fail to appear, you should win in court. However, even if you do, you may not be able to enforce any claims because their courts will not recognize the US court’s decision. In some countries I have dealt with, judges have not recognized contractual agreements because “times have changed.” Not all countries have a judicial system like ours with precedent and some predictability.

Even if governmental agencies don’t own these companies, in some countries, if well-connected business people and politicians do, that may have the same result. Bringing any claims against a company owned by such a businessman or politician may result in you, your company, or employees being harassed or imprisoned on some charge in these countries, i.e., China and Russia.

 

How Much Has Each Party?

1. What Assets do They Have?

If it is a single purpose entity with no assets, even if you bring the claim and win, there are no assets to pay monetary damages. Injunctive relief is all you have. That may not fix any damage done to your brand or pay for all the litigation. Even if they have assets, if there are superior claims on those assets, i.e., bank liens, that can rank above your claim, you could win but still receive no monetary damages.

Finally, if they are a large company with deep pockets, they may fight you in court with a full army of in-house and third-party lawyers. Besides, even if they lose, they may be willing to fight through many appeals. The purpose is to wear down a smaller company just by having more resources.

2.  What Assets do You Have?

While many client’s businesses are profitable and have value, the company may not have the financial wherewithal to fund litigation, especially international litigation. To fight a company in the US that is determined to protect its image on an NDA could cost $0.5MM and more. Many small companies don’t have that amount of excess cash to put towards litigation. Besides, not only is there the cost of the lawsuit but the disruption to the business. Discovery, depositions, etc. can absorb large amounts of time and resources from a small company causing it to lose its way or position and thus value.

3.  What Loss have You Experienced?

Raising this issue causes an angry response from many clients? The value of the business, which they may think, is very high, has now suffered a loss in value. As with all litigation, you must demonstrate the damage. If there is a $XMM offer from a buyer who immediately reduces the offer to $YMM quickly on finding out about the breach, then the loss is $(X – Y)MM. However, in all other situations proving the quantum of the damage is much more complicated. Experts are required to determine your loss, which also increases the costs of litigation. The other side will also have their experts to prove no loss in value and show where your experts are wrong. Finally, the winner and amount of the win are never guaranteed when walking into a court, no matter what you think.

 

How Much Information Do You Share

While you are going to discuss your business, the products, customers, and opportunities, I think it is advisable to be economical with some of that information. Give the other party enough for them to make a decision and be interested. However, many owners are so proud and excited about their business, with good reason; they cannot help themselves from disclosing how they do everything. While some of this information may be a trade secret, it may not have been protected as such or may be more difficult to claim such in litigation. If the other party knows how you do everything, they may decide they can duplicate your business using your processes but not using your technology or approaching your customers. They do this; it may be much hard to identify and protect.

Thus, be careful with your NDAs by knowing:

  • Who you are dealing with;

  • Where are they located;

  • What they have;

  • Know what you can do if they breach; and

  • Let your advisor help you control the information flow.

 

© 2015 Marc Borrelli All Rights Reserved

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