The Risky Shortcut to Going Public: Reverse takeovers can plunge unwary businesses into stock schemes or crushing financial burdens.

Even in these difficult economic times, private companies want to become public. The reasons for going public are sound – and appealing. Once a company is public it can use its stock as currency to make meaningful acquisitions and grow exponentially. It also can use securities and stock options to attract, assemble, and reward an experienced management team. And public companies generally have an easier time raising money; experienced investors tend to be more comfortable when they have an “exit strategy.” As an added benefit, shareholders can gauge the value of their investment by tracking the stock’s market price. In other words, being public is a reasonable goal. Becoming public, however, can present myriad problems. Initial public offerings, which dominated a bubbling marketplace just a few years ago, have become a rarity. Underwriters, who once vied with one another to take every fledgling company public, are now reluctant to raise money for even the most promising ventures. IPOs have become the exception, forcing companies to look elsewhere for a gateway to the public marketplace. For some, that search has led to a process called a “reverse-merger.” In a reverse-merger, a private company becomes public by merging with, and gaining control of, a public “shell” corporation. The shell has no operating business, no revenues, and no cash, but it has one very significant asset – it is already public. In some instances, the shell never engaged in business; it was formed by stock promoters or speculators as a non-operating vessel, whose only mission was to search for a viable merger candidate. In other cases, the shell is the remnant of a failed business, or an earlier, aborted reverse-merger. Reverse-mergers have become increasingly popular in recent years since they allow a private company to become public instantly. That sounds enticing, but other factors can leave that company longing for a return to its private life. All too often, reverse-mergers are utilized as part of stock manipulation schemes that exploit legitimate private companies and defraud the public. Shell Games The individuals who control the shell have one compelling agenda; they want to increase the value of their investment. As a means toward that goal, they seek a viable, or at least credible, private company that can be merged with the shell. Theoretically, the postmerger public company will be more appealing to investors. After all, the former shell now will have an operating business. Unfortunately, this can lead to abuse. Unscrupulous stock promoters often try to accelerate this process by manipulating the stock through “pump-and-dump” schemes. “Pump-and-dump” schemes are orchestrated by shady promoters on behalf of individuals who have accumulated large, “free trading,” stock positions in the newly merged company. “Free trading” shares are those that can be sold immediately because they have been registered, or are exempt from registration. The sellers may include the promoters themselves, people who acquired shares when the shell first was formed, private investors (including off-shore companies) who accumulated shares in advance of the merger, and consultants and finders who were issued stock in return for bringing about the merger. They are poised to sell as soon as a market develops for their shares. Once the private company agrees to merge, stock promoters, who may have no connection to the company’s management, arrange for an intensive publicity campaign that is calculated to generate interest in the stock. They may issue press releases extolling the prospects of the merger, or pay so-called analysts to recommend the stock. They use the Internet to spread the word, sending e-mails to hundreds of thousands of potential investors. All too often, these promotional materials include misleading, exaggerated information. If the “pump-and-dump” scheme is working, this wave of publicity creates a “buzz” about the company and leads to higher share prices. As those prices increase, the promoters and their associates dump their stock, at enormous profits. Then, as the overblown promises fail to materialize, stock prices decline, often precipitously. When the pump-and-dump is over, the promoters are long gone but the company is left with angry shareholders and a sullied reputation. It also may face an inquiry from securities regulators who want to hold someone accountable for the manipulation. Management may have played no role in the deceptive campaign, but it is likely to be tainted by the association and impeded in its efforts to establish a credible business. Of course, not all reverse-mergers lead to that worst-case scenario. There have been some notable success stories. In 1970, Ted Turner used a reverse-merger with Rice Broadcasting to create Turner Broadcasting. More recently, in 1996, Muriel Siebert took her brokerage firm public through a reverse-merger with a failed furniture company. Their good fortune makes the process quite tempting, despite the risks. These examples indicate that reverse-mergers can prove successful. Unfortunately, for every such triumph there are dozens of failures; Wall Street is littered with their remnants. If a private company is intrigued by the prospect of a reverse-merger, it should proceed with care, conduct exhaustive due diligence, and be ready to withdraw from the process at any time. Advantages of a Reverse-Merger To begin, management should consider the following advantages and disadvantages of a reverse-merger. Reverse-mergers are fast and cost effective. An IPO can be an expensive, time-consuming process, involving significant legal fees, accounting costs, filing fees, and underwriting expenses. Before the company can go public, a registration statement including audited financial statements must be filed with the SEC and various state securities offices. The SEC will review the registration statement, ask questions about the company and its management, and almost always require changes. The process can take months. The reverse-merger process does not require either a registration statement or SEC approval. The agreement is reflected in far less detailed documents that address the reverse-merger process but rarely offer much insight into the business of the private company. Audited financial statements may be delayed until long after the deal is completed. Legal and accounting fees can be kept to a minimum. As a result, the process may take only a few weeks. Reverse mergers require little public disclosure. An IPO registration statement contains detailed information about the company’s history, plans, management, and financial condition. The company must explain the risks it faces and how it plans to use the money that is raised. It also is required to disclose whether any of its directors, officers, or major stockholders has had previous legal or regulatory problems. IPOs are designed to expose every material skeleton in the corporate closet that could have an impact on an investor’s decision to buy shares. A reverse-merger can be completed without any of this disclosure. Private companies can avoid disclosure about their management and controlling shareholders. They do not even have to identify those individuals. While the public shell is obligated to file a Form 8-K with the SEC disclosing the merger, it can describe the transaction in broad strokes. The private company does not incur high investment banking fees. Since the reverse-merger does not involve an underwriter, the private company will not incur investment banking and offering fees. Instead, it may owe finder’s fees to the people who arranged the transaction. These, however, are often paid in securities rather than cash. Disadvantages of a Reverse Merger The private company does not raise any money by going public. In an IPO, a company raises cash for operations by selling stock to the public. At the end of the day it has secured funding to develop its business plan and pay expenses. In a reverse-merger, a private company becomes public without selling shares, and therefore without raising cash. Unless the private company already has adequate capital, in which case it would be less likely to pursue a reverse-merger, it still must identify future sources of funding. For the reasons discussed below, that may not be easy. The company does not develop a relationship with underwriters. The brokerage firm that underwrites an IPO generally becomes the public company’s principal supporter. It has a vested interest in doing so; the brokerage firm and its clients now own shares in the new public company. In addition, the underwriter usually will become a principal market maker for the company. These factors increase the possibility that the brokerage firm will help the company in the future by raising additional money, preparing research reports, and developing and maintaining a market for the stock. Reverse-mergers do not foster such relationships. Reputable brokerage firms are wary of reverse-mergers because they cannot easily determine who owns and controls the outstanding stock. They know, however, that those shares may be held by promoters, speculators, or former insiders at the shell, all of whom may dump them without notice, adversely affecting stock prices. Consequently, after a reverse-merger is completed, the surviving company may have a difficult time developing an investment banking relationship with an established brokerage firm. Without that connection, it will be difficult to raise funds. Limited disclosure means limited information. Reduced disclosure is a double-edged sword. It permits a private company to conceal details, but leaves investors in the dark. Thoughtful investors want detailed information about a company. The veil of secrecy that surrounds a reverse-merger allows undesirable individuals, including those with a history of regulatory problems, to remain as significant shareholders of the surviving company. Their association with the company can taint its future prospects. Shares are concentrated in a few hands. The shell and its successor tend to be controlled by a few major shareholders. That increases the possibility for manipulation. In an IPO, the company’s shares are distributed to the public, creating a broad market that is more likely to respond to overall market conditions as well as business developments. Share prices are low and markets are thin. Companies that go public through reverse-mergers tend to trade at low prices, in part because they lack support from a major brokerage firm or recognized analysts, but also because shares are not widely held. Trading is dominated by a few small brokerage firms that often have ties to the promoters who formed the shell or orchestrated the merger. The surviving company seldom qualifies for a major stock exchange. In order to be listed on the New York Stock Exchange, the American Stock Exchange, and Nasdaq, a company must demonstrate that it has sufficient assets and net worth to qualify for the listing. Even the Nasdaq SmallCap Market requires that the listed entity have stockholders’ equity of $5 million, listed securities with a market value of $50 million, or net income of $750,000 in two of the last three fiscal years. Few companies that go through reverse-mergers can meet these requirements. If they could, they probably would pursue an IPO instead. As a result, most reverse-merger companies are traded on the Over-the-Counter Bulletin Board or the Pink Sheets, markets that are far less regulated and therefore subject to considerably more abuse. This fact alone will impede the company’s ability to raise money from credible, legitimate sources. Guarding Against a Scam Any private company that is considering a reverse-merger should balance these considerations and perform adequate due diligence to avoid becoming an unwitting pawn in a pump-and-dump scheme or other stock scam. The due diligence process is critical to that assessment, and should require, at a minimum, the following inquiries: Who will own the stock? Once the reverse-merger is concluded, the private company will hold a majority of the outstanding shares, but it is still important to know who owns the balance of the stock. Are the remaining shares controlled by a handful of promoters and private investors who may seek the first opportunity to dump their holdings? That sets the stage for a potential pump-and-dump that can taint the company’s reputation, adversely affect its ability to raise money, and depress its stock price going forward. Does the shell have outstanding liabilities? The private company probably is resigned to the fact that it will not inherit any liquid assets from the shell. Liabilities are quite a different matter. It is important to check for outstanding liens, judgments, and contractual obligations that diminish the value of the shell and could become an ongoing burden for the surviving company. Who controls the shell? The identity of the shell’s officers, directors and management team will go a long way toward revealing their motivation. Is the shell owned and operated by a group of stockbrokers, promoters, and speculators? Have they led other shell companies through reverse-mergers? Do they have a history of profiting from pump-and-dump campaigns? If so, it is important to look at the fate of those earlier deals. Insist on full disclosure. If offshore corporations control large blocks of stock, find out who owns those companies and how they obtained their holdings. Check out the regulatory history of the shell’s owners and management team. Do not simply rely on information provided by the shell. Use other resources, including the Internet, to conduct a thorough investigation. Then decide whether you want your company to be associated with those people in the minds of investors and regulators. Beware of convertible securities Find out exactly how many shares are outstanding and their terms. Be certain that all preferred stock is accounted for, and that it cannot be converted into common shares in the future. Preferred stock can be given “super conversion” rights that allow the holders to exchange them for a far greater number of common shares-such as permitting the preferred to be converted into common at a rate of 10-to-1, or even 100-to-1. Convertible debentures can serve the same purpose. If such convertible securities remain outstanding after the merger, they may allow the former owners and promoters of the shell to regain control. Limiting the Risks If the private company is determined to proceed with the reverse-merger, it should take steps to limit the potential for disaster. Start by insisting that all existing shareholders sign a lockup letter that prevents them from selling shares for at least one year after the merger is completed. That way the surviving company will have an opportunity to establish a credible, stable market position. The lockup also will smoke out scam artists who may be planning to pump, dump, and run. The postmerger corporate structure should be clear and unequivocal. All officers, directors, and employees of the shell should be required to resign as soon as the merger is concluded. All existing employment and consulting agreements should be cancelled, effective immediately, together with all outstanding stock options. The new company does not want to be surprised by a knock on its door from a former officer demanding more stock or compensation. As the reverse-merger moves forward, the private company must insist on controlling the flow of information. No press releases or public statements should be issued without the prior approval of the private entity. That will reduce the opportunity for someone to exploit the pending merger by issuing exaggerated and misleading information. If promoters or so-called stock analysts begin to publicize the merger in violation of this understanding, the private company would be well advised to abandon the deal. In a similar vein, the private company should monitor carefully the trading pattern for the public shares during the period before the merger is completed. Any unusual activity should be noted, and, where possible, tracked, to determine whether an inside party is manipulating the market. Whenever possible, the private company should identify and meet with the public company’s major market makers. There is no substitute for effective due diligence. A reverse-merger can be a valuable opportunity to enter the public market, but it also can produce an ongoing quagmire. Private companies would be well advised to err on the side of caution. If it looks wrong, or feels wrong, or simply smells wrong, act judiciously and just walk away. Hartley Bernstein is editor and founder of StockPatrol.com, which performs in-depth investigations of publicly held companies for both corporations and individuals. Copyright 2003 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com