Moving forward in reverse

The reverse merger was originally developed as a faster, less expensive alternative to the traditional IPO process, and purportedly provides greater access to capital markets, increases the company's visibility, and offers the opportunity to utilize stock to make acquisitions.

Essentially,

in a reverse merger, a privately held company buys a publicly traded, but usually dormant, company. By doing so, the private company becomes public. The public company purchased is usually called a "shell." Shell companies used in reverse mergers are usually one of two types. The first is a failed public company that remains to be sold in order to recoup some of the costs of the failed business. Often, these shells have the potential for hidden liabilities, lawsuits, or other problems. The second type of shell is created for the specific purpose of being sold as a shell in a reverse merger. The second type typically carries less liability than the first.

Whenever the topic of reverse mergers comes up, two success stories seem to come to mind - Ted Turner's reverse merger with Rice Broadcasting in 1970, which grew into Turner Broadcasting, and the 1950 reverse merger which grew into Occidental Petroleum. Are these the only two notable reverse mergers in the last 50 years? With approximately 500 reverse mergers happening every year, this certainly begs the question, are reverse mergers actually beneficial to the private companies engaged in them? Do they really become successful at creating stock holder value through this process?

The traditional IPO process exists for a reason. It may be a difficult and expensive one, but it serves a purpose: To allow only those companies that are stcturally and financially secure to enter into the public market. Taking a huge leap into the public trading abyss leaves the unprepared company gasping for air and rarely, it seems, are they able to maintain any value or increase value significantly. In a study by RCW Mirus from 1999-2001, out of 46 firms engaged in a reverse merger, only four were able to increase their stock price over a period of two years after going public, and all four remained penny stocks.

The Good

There are several pluses of engaging in a reverse merger over the traditional IPO. Two of the most important reasons, given the volatility of the economy and the speed at which technology changes, are time and money. To raise enough capital through a traditional IPO would cost $3 million to $5 million in underwriting fees and take more than a year. The whole environment could change by then.

Other pros for conducting a reverse merger include tax benefits and the added value they bring to a company. Many shell companies have tax loss carry forwards, which means future income may be sheltered from income taxes. While IPOs can be withdrawn by underwriters because an industry is getting hammered in the stock market, a reverse merger simply needs two willing and able partners. In addition, "Reverse mergers allow companies to tap into the action quickly. Not only do they get the benefits of being public without all the expense of an IPO, but reverse mergers also give companies greater access to needed capital," states Eric Stevenson, president of Axiom Capital Corp. based in Tempe, Arizona.

The Bad

While there are specific benefits of a reverse merger over the traditional IPO, there are some liabilities in choosing this method of going public. In many cases, the defunct public company may have hidden liabilities, such as pending litigation or badly damaged balance sheets. It could take more than a year to clean up the shell by bringing reporting status up to date, and settling any existing claims against the shell company. You're buying someone else's failure and there often is more due diligence required than in a typical merger. Creditors may also appear after the merger and demand payment.

An unsavory reputation also haunts reverse mergers. Shady stock promoters often hype the stocks, and then sell them off in what is called a "pump and dump" scheme. Reverse mergers can also backfire easily if the shareholders of the shell company dump the securities post merger and devalue the stock price.

Another major roadblock is usually the management of the public company, which may be reluctant to relinquish control of their company under the terms that appear an admission of defeat, writes Stacy Mosher of The Daily Deal.

The Trend

Reverse mergers flourished in the early 1980's, and again in the mid-1990's and have come under increased scrutiny of the SEC since then. Regardless, reverse mergers are making a comeback with a new twist. According to DoneDeals there were 24 reverse mergers in the first ten months of 2001, a significant increase from 17 in year 2000 and 4 in year 1999.

in the past, reverse mergers were made between a public shell and a private company in a totally unrelated line of business. The latest trend, especially among biotech nology companies, is for a struggling but operational public company to be taken over by a stronger private company in the same sector. Mark Simon of investment banker Robertson Stephens Inc. states, "A company that has gone public prematurely may find it advantageous to merger with a private company with similar products in a more advanced stage of development."

As a results reverse mergers are on the rise, time and money being the biggest players. But, for those companies looking to do a reverse mergers it may be in their best interest to first do their due diligence.

Source: DoneDeals, Computerworld News, Entrepreneur.com, TheDailyDeal.com, CFO.com, RCW Mirus

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John Nidecker

Contributing Editor