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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