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Investment Banking
Reverse-Mergers: A Growth Industry
US capital markets are still the most desirable goal
for companies in China and companies in any of the emerging markets across
the globe. While there is fierce competition between the off-shore hedge
funds, the Euro pension plans and the Sovereign Wealth Funds to find profitable
long term investments in energy, commodities, infrastructure and
IT/telecommunications, there are many businesses - retail, manufacturing,
services - from start-ups to mid-market (between USD$100 million and USD$500
million in revenues) that are looking to find strategic partners and access
the 'traditional' capital markets as a publicly-listed company.
Canada's exchanges, the London, Singapore and Hong Kong exchanges all are
seeing growth in the number of new listings through IPOs. The China Exchanges
- Shenzhen and Shanghai - had more than 20 IPOs in 1Q 2008 raising US$7.8
billion. The Shanghai Exchange trailed only the NYSE in IPO capital raised
(US$64B NYSE vs. US$54B Shanghai) in 2007. Granted there was the mega-IPO
of CITIC in China (US$5.4B) while the NYSE had two mega-IPOs - VISA (US$7.98B)
and Blackstone (US$4.13).
The capital flows are also large as the number of mergers and acquisitions
that existing listed companies are completing with strategic partners in
China, India, Latin America and the central European states are also increasing.
The announcement (May 14, 2008) of Carlyle's agreement with the Province
of Shandong (2nd largest industrial base in China with nearly 15% GDP growth
year over year 2006 /2005) also indicates that the US capital markets remain
in demand inside China. The "first-look" agreement will provide Carlyle with
a pipeline of China-based companies that are looking for foreign investors
and seeking to expand their markets outside of China.
One of the most attractive routes to the capital markets, however, remains
the Reverse-Merger with a US based public company. That attractiveness has
as much to do with status and brand recognition of the US stock exchanges
as it does with the terms of the offer sheets and the breadth of financial
services that are available. The current generation of entrepreneurs in China
also have numerous ties to the US as they brought their US graduate degrees,
internship experiences and relationships back to their mainland business
relationships and ambitions.
The New York Stock Exchange (NYSE Euronext) remains the most recognizable
and one of the few luxury brands in the financial world for entrepreneurs
and enterprises. The London Stock Exchange, arguably, has a similar global
cachet, as do several investment banks such as Goldman Sachs Group, Inc.,
Lehman Brothers Holdings, Merrill Lynch and Credit Suisse.
The NYSE listing is still viewed as achieving global status - competitive
success, financial strength and membership in an exclusive club of global
business leaders.
While the number of companies on US stock exchanges that have progressed
from a small public Pink Sheet company (non-reporting) or Over-the-Counter
Bulletin Board (OTC BB) listing of its shares onto the Nasdaq trading system,
graduating to listing requirements for the specialist-run American Stock
Exchange and finally onto the "Big Board" NYSE is limited - American Oriental
BioEngineering - NYSE:AOB is one of the few to complete that journey - the
trail is there to follow.
The flow of companies from China seeking to complete that listing journey
in the US capital markets - from reverse-merger to the NYSE - has been steadily
growing over the past decade with some pauses as economic cycles, China's
regulatory changes on investment flows into the country, and marketing efforts
by non-US exchanges and capital markets notably the London AIM, the Hong
Kong, and the Singapore exchanges and the expansion of the Shenzhen exchange,
have been distractions.
That flow of companies seeking a reverse-merger with a US listed company
is also a very attractive source of revenues for US investment banking firms
- particularly to the smaller and mid-size firms that have over the past
five years felt the more severe economic climate and faced competition from
the larger firms' encroachment into the mid-market as those larger firms
move to capture clients earlier in the development cycle.
Recently, the smaller firms have also faced higher costs of regulatory oversight
that made revenues and profits harder to achieve - just as the financing
markets closed their doors from the "sub-prime" lending crisis and the huge
financial derivates markets losses that were being realized.
Within that landscape - the flow of companies entering the US capital markets
is still strong. The US based firms ready to provide the advisory, legal,
accounting and regulatory services for those companies are competing for
those client-companies.
In my ongoing discussions with executives of companies that are considering
converting from private ownership to public ownership using the 'reverse-merger'
process - also termed a 'reverse takeover' (RTO), and with executives of
companies that became public through that 'reverse-merger' process, among
the major topics that get probed and referenced more frequently are "Stigma",
"Dormancy" and "After-Market Support".
The reverse merger process is basically an acquisition by a public company
of a private company, however, the management and business of the public
company usually give up control and end that business, if it has not already
ceased to operate, and the public company becomes the acquired private company
and its business operations - with the owners and management of the former
private company in control. More simply described - The private company and
its management team steps into the shoes of the public company and its management
team.
The advantages of an RTO as a process to take a private company public are
the time frame and certainty with which the private company's management
team and their business become a public company - a process than can take
a few months - and the lesser fees and charges than a private company could
incur if it became a public company through an Initial Public Offering (IPO)
process.
The IPO has underwriter and sponsor fees that the RTO does not include, and
there are decision points that are market driven and market timed that determine
the valuations, the date of the going public event, including the possibility
that after all of the process is done and expenses incurred, the event may
not happen should the underwriters and sponsors decide to postpone it or
cancel it.
Because the reverse-merger process has been attractive to smaller companies
looking to gain the advantages of being a public company - being more competitive
in dealing with partners and clients and having more channels for funding
and financing are especially attractive - and the market conditions for IPOs
have been less favorable over the past three years since the 'dot-com' crashes,
the reverse-merger scene has been very active.
While there are many examples of companies that have succeeded as public
companies that started their public lifecycles through the reverse merger
process, there are many examples of companies that have not been successful.
There are many causes that can be attributed to a reverse merger that failed
- but there are patterns that can be discerned with certain originators and
promoters whose track records are littered with the dead and the terminally
ill companies they have mentored.
There are also competent originators and promoters who have seen the supply
of private companies seeking a public entity expand greatly - causing more
companies that are less suited or less ready for the public arena to go through
the reverse-merger process. These 'not-ready-for prime-time' companies also
add to the failed or floundering numbers within the reverse-merger universe.
STIGMA
Q: Is there a stigma attached to a company that became a public entity through
the reverse-merger process?
A: Whether the process has been an IPO, a reverse merger, or as a spin-off
from a public entity - it is the fundamental soundness of the business and
its management that ultimately determines success or failure.
A private company that has a certain level of maturity in its management,
a demonstrably sound if not fully proven business strategy, and traction
with its partners and its clients within its markets, with revenues and profits
or near term predictable profits with a level of confidence that becomes
public through a 'reverse-merger' transaction with a public entity that has
undergone full due diligence with professional and experienced legal, accounting,
regulatory and transactional reviews, that was appropriately valued and for
which a capital funding and financing plan was developed and executed, and
the reverse-merger process and ongoing capital funding included sufficient
market liquidity that was accessible by its full universe of investors ---
No, there is no stigma.
There is no stigma because this company will more likely be successful as
a company and that success will translate into Value Creation for its
shareholders. Value Creation for its shareholders will mean that the process
by which it became a public entity - 'reverse-merger' or IPO or as a spin-off
from a public entity, etc. - won't matter.
DORMANCY
Q: A public company that has been dormant for two years is a good candidate
to be a "shell" for a reverse-merger.
A: Dormancy is in the eye of the beholder. The duration of dormancy is just
one part of the legal due diligence process. Alone, dormancy does not in
and of itself answer any questions as to the suitability or legality of a
company as a participant -good or bad - in the 'reverse-merger' process.
There are fifty state jurisdictions in the United States. There is a Federal
system of courts with various jurisdictions as well. There are county
jurisdictions which determine the location of the repositories of legal
proceedings within the states. There are Districts within the Federal Courts
system and layers of Federal Courts as well that also determine the location
of the repositories of legal proceedings within those districts.
The location of files and information may be in archives or in the court
records offices. Judgments and legal processes to execute and collect monies
due under a judgment may be processed in a different court, and those records
and archives may be in the court records offices, or in the administrative
clerks offices with or adjoining the land records of that particular jurisdiction
(since impeding the transfer of land is one way to get paid under a judgment).
The information systems of those various repositories are not necessarily
linked, nor fully electronically accessible, nor complete in detail. There
is no one stop shop to access to determine if a company is or has been a
party to litigation, much less whether or not it has an outstanding judgment
against it. There is no automatic process to even limit the field of inquiry
as to which courts and which jurisdictions are applicable.
Each state has its own Statute of Limitations on the time periods under which
various types and causes of litigation are allowed - or extinguished. In
general, these periods can run from four or six years for various contracts
to ten years or more. If there has been litigation and a judgment was entered
against a party, even a default judgment, that judgment, which may have a
monetary or other penalty, can be enforceable for ten to twenty years, and
renewable for additional periods of time, if not satisfied. If the claims
were for injuries and minors were involved, the time limits may be extended
dozens of years until the victim is of legal age or beyond.
There are Federal Statutes of Limitations with varying survival periods of
causes of action and enforceability of judgments.
The numbers and types of parties who interact with a company, its officers
and directors, its salesmen, its products, its resellers, its manufacturers,
its banks and lenders, and the possibilities for legal actions that have
already begun, finished or which still have a time period under which they
can be filed and prosecuted - are not easy questions to answer much less
quantify when the number of jurisdictions and the numbers of such parties
are combined.
Q: Does a company that has been dormant for two years offer any insight into
the legal obligations it may have outstanding, or the legal obligations it
may be subject to over the next decade?
A: NO.
Add to that mix, that there may be disgruntled shareholders - or others -
who did not previously want to spend the money to litigate with the dormant
company since winning a judgment did not mean they would ultimately be able
to collect on their claim. Also, for companies that are not robust, the threat
that a lawsuit will force the company into bankruptcy can also forestall
legal creditors and other litigants from pursuing their claims.
A dormant company that suddenly has assets, a business and a future is a
much more desirable target from whom those past injuries can be compensated.
'Dormant' is not in any way a determinant of the legal efficacy of a public
company as a "shell" candidate for a 'reverse-merger' process. If the dormancy
extends to its accounting and regulatory filings, it is a non-candidate or
a candidate that will require a lot of massage and fees to get into a current
and reporting status and potentially useful in the 'reverse-merger' process.
View "Reverse-Mergers: Stigma, Dormancy (Part I)" posted on March 7th, 2005
single page format
AFTER-MARKET SUPPORT
The "after-market" is generally understood to designate the time period after
the reverse-merger transaction has occurred and the "old" public company
has become the "new" public company with - commonly - a new management team
(the former private company's management and owners now being in control
of the public vehicle) and in practically all instances the company undergoes
a simultaneous name change. The name change is indicative of the change in
company strategy and direction, the removal of any legacy businesses and
operations, and a new 'start' under a completely new identity. In some instances,
the identity of the former private company is part of that new name.
One of the benefits of the reverse-merger process is the shareholder universe
that the 'new company' inherits from the 'shell' and the addition of new
shareholders being the investors and partners in the former private company
who have converted those interests into shares of the public vehicle at the
time of the reverse-merger transaction. There may also be new shareholders
through fees paid for financing or options to purchase shares that were exercised
as part of the financing and funding, if any, that was also part of the
reverse-merger transaction. Combined, these shareholders hold the keys to
the future success of the company as a publicly traded entity.
To some of the participants in the reverse-merger transaction, the transaction
itself is the end-point. It is an opportunity to cash-out and pay-off debts
that the private company may have accrued, and give investors in the private
company some exit for their interests in the private company. The legacy
shareholders from the 'shell' company may also see the transaction as an
opportunity to cash out shares that had little or no value, or had seen no
appreciation in value, while tied to the former business and operations of
the public company prior to the reverse-merger transaction.
Obviously, having several hands full of sellers is not in the best interests
of the long term value of those shares - unless the new management team and
principals have a game plan in place and ready to implement as part of the
reverse-merger transaction itself. In fact, the planning for the market for
those available shares of the new public entity should have been part of
the overall planning process for the reverse-merger itself. The size of the
public float, the price-points and market capitalization of the company,
the relationships of share price and market cap to revenues and earnings,
as well as how those rank with respect to the peers and competitors of the
new business - are not issues to be added to the agenda after the reverse-merger
has closed.
For the success of failure of a company as measured by its share value and
the demand for its shares in the open market - this after-market time period
is actually the meaningful and critical 'in-market' time period. This 'in-market'
timeframe determines how successful the company will be immediately after
the reverse-merger transaction has closed, how successful it will be as it
looks to grow through acquisitions, and how successful it will be as it looks
to grow through financing and through follow-on offerings of equity.
Even though these events may be two, three or five years away, the management
team and advisors that set the table for the 'in-market' timeframe with liquidity
planning and valuation planning will benefit themselves and their shareholders
- and future shareholders and constituents - the most.
David W. Alvey, Executive Editor - DiplomaticPlanet.net
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Reverse-Mergers: A Growth Industry