Advantages and Disadvantages of Reverse Mergers of Technology Companies

A reverse merger is a process in which a privately-held company can go public without the high expense and complexities of a traditional initial public offering (IPO).

In a reverse merger, a private company merges with a publicly-listed company.

The publicly-traded entity is sometimes a business that failed. Or it may have been formed as a “blind pool company” or “capital pool company” by its founders. This is a company with no operations or revenues. It was founded for the sole purpose of searching for viable businesses that it can acquire.

The public company is sometimes referred to as a shell corporation.

The privately-held company merges with the public company and obtains a majority of its publicly-traded stock. Sometimes the merged entity’s business name will be changed. The new shareholders then appoint and elect a new management team and board of directors.

REVERSE MERGERS OF TECHNOLOGY COMPANIES

Product obsolescence is a big issue for technology companies. Technology products can become obsolete very quickly. Speed-to-market is something technology entrepreneurs talk about constantly. If a company goes to market first, they enjoy a first-mover advantage, and quickly secure significant market share.

Products need to be developed and brought to market quickly to enjoy this first-mover’s advantage. As such, capital required to build these products needs to be secured as quickly as possible. For this reason, reverse mergers are very popular with privately-held technology companies that seek to go public quickly and inexpensively.

The merged publicly-traded entity has access to the public capital markets for funding. The stock of this new company can be used to raise further capital or acquire other technology businesses.

ADVANTAGES OF A REVERSE MERGER

Access to capital markets

A reverse merger enables a private company to access the public capital markets in a relatively short time-frame. Becoming a public company increases the visibility of the business within the investment community.

The private entity goes public but doesn’t raise capital in a reverse merger. In order to raise capital, a secondary offering is executed after the merger is completed. It is generally easier for a public company to raise capital at a higher valuation due to the liquidity of its stock than it is for a private company.

The secondary offering can be a private placement offered by the new merged public company. This is referred to as a private investment in public equity or PIPE deal. It is the selling of shares in a public company to private investors. This is different from a public offering of shares on a stock exchange.

One of the benefits of a PIPE deal is that it provides investors with the opportunity to acquire a large stock position at a fixed or variable price without pushing up the price of the stock as could happen with public open market purchases.

Shareholder base

The public corporation will already have a base of shareholders sufficient to meet the 300-shareholder requirement for admission to quote on stock exchanges like NASDAQ. If the business doesn’t meet the NASDAQ eligibility requirements, it can be listed over-the-counter (OTC).

The private company doesn’t have to go on a road show to pitch its business plan to investors as in a traditional IPO in order to attract investors.

Some exchanges such as Toronto Stock Exchange (TSX) Venture Exchange actively encourage reverse merger transactions under special programs such as the TSX Capital Pool Company Program.

Lower Costs

Going public through a reverse merger allows a private company to go public typically at a lower cost and with less stock dilution than through an IPO. Traditional IPO transaction fees can be millions of dollars.

The transaction costs are much lower in a reverse merger than in an IPO for the following reasons:

– The private company does not typically require underwriters or broker-dealers to execute the transaction. These services are costly during a traditional IPO process.

– There is no road show. Therefore, all the costs associated with a road show including hiring advisors to prepare the business for the strict pre-IPO examination process, preparing a prospectus, and travel & entertainment expenses are absent.

Liquidity

Shares of privately-held businesses are highly illiquid. Hence going public is the Holy Grail for most entrepreneurs. The shareholders of the private company give their illiquid shares in return for the liquid shares of the publicly-traded company.

Liquid stock provides more options when planning to offer compensation packages to key employees.

In addition, through a reverse merger, there can often be less dilution of ownership control for the private company’s shareholders.

Higher Profile and Visibility

A private company can raise its profile and credibility by going public. It may become much easier to attract, incentivize, and retain talent with creative stock option plans.

The availability of company information disseminated in the public domain may attract press coverage that was previously unavailable as a private entity.

Acquisition Capital

The new public company’s stock can be used to make acquisitions of other businesses.

For technology companies that want to grow fast, acquiring talent, technology, or even entire businesses is vital.

DISADVANTAGES OF A REVERSE MERGER

Liabilities in a “dirty” shell corporation

Most reverse mergers involve a nice “clean” shell corporation. This is a capital pool company with no operating history, a little cash on its books, and little to no assets or liabilities. This scenario presents very little risk to the investors of the private company seeking to merge with the publicly-traded shell corporation.

However, sometimes the shell corporation may have had some past operating history. It may be a little dirty. Many shell companies failed or voluntarily abandoned a line of business. The shell may have open lawsuits involving shareholders, employees, customers, or vendors.

Without proper due diligence, it would be very risky for investors to merge with such an entity. By receiving the shares of the dirty shell, these investors also receive its liabilities.

Raising Capital

One of the primary benefits of going public for any company is the ability to raise capital during the IPO process.

In a reverse merger, the company does not actually raise capital. Shares of the private company are simply exchanged for shares of the public company. In order to raise capital, a secondary offering is required.

In some instances, the secondary PIPE offering can dilute existing shareholders’ equity positions heavily. Some of the terms of a PIPE deal are designed to be as attractive as possible to new private investors. The seller may sometimes agree to provide the private investors with downside protection.

One common downside protection tool is that private investors receive more shares as compensation if the share price falls below a specific minimum level. If this happens, these new investors receive more shares for free, which further dilutes the original shareholders who didn’t receive these guarantees.

For a technology entrepreneur who wants to control his business, this is not an ideal scenario.

Transaction Costs & Public Company Costs

The transaction costs of a reverse merger are lower than a traditional IPO. But it’s expensive to execute a reverse merger relative to raising capital from, say, a venture capital fund or via a private placement.

A reverse merger transaction can cost from $100,000 to $500,000.

Moreover, there are ongoing costs of being a public company. Public companies are required to file quarterly and annual reports and meet stringent accounting standards. Small private companies often lack the infrastructure and back-office capabilities to support these requirements.

In addition to the reverse merger transaction costs, the company has to plan for the additional capital expenditures required to set up the infrastructure to meet the regulatory and financial requirements.

Higher visibility may not materialize

Whether you’re selling a physical product or a service, if buyers don’t know you exist, your business will fail. The same applies to selling stock in a company to the investment community.

Most analysts ignore small cap companies with penny stocks. These are companies with a stock price under $5. As such, the hope that going public will increase the company’s visibility very often doesn’t materialize.

The company may end up as a penny stock with low trading volume and little to no visibility with large institutional investors that are needed to move a stock price higher.

For a technology entrepreneur, the low stock price means he has no currency to acquire talent, technology, or businesses.

Credibility from underwriters

During a traditional IPO process, the calibre of investment banks and underwriters selected adds credibility to the business. A top tier investment bank leading the IPO instills confidence in retail and institutional investors.

Top tier investment banks perform strict due diligence on the companies that they bring to market to ensure that these companies looking to go public are ready to be public.

As such, from the very beginning, institutional investors pay attention to the company. This visibility moves the stock price higher in the secondary markets after the IPO.

ALTERNATIVES

It is important to hire competent advisors to carefully assess the costs and benefits of executing a reverse merger to achieve your business objectives.

In some cases, it may be best to explore alternatives. It can make more sense to remain a private company and raise capital in a private placement. Or it could be better to seek to merge with another privately-held company to create a stronger business first, and go public in the future.

Explore all your options and decide whether to reverse merge or not to reverse merge.

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