Reverse Mergers

And Other Alternatives to Traditional IPOs

David N. Feldman

• Éditeur: Bloomberg Press
• Année: 2010
• ISBN:
  9780470885499
• Édition: 2
• Sujet: Negocios y empresa
• Sous-sujet: Fusiones y adquisiciones

In good markets or bad, reverse mergers play a key role for companies that want to avoid the IPO route for going public. Since the successful first edition of Reverse Mergers was published in 2006, the economic and regulatory landscape has changed. Executives, owners, lawyers, accountants, professional investors, regulators, and others need to know what those changes mean for reverse mergers. Reverse-merger expert David Feldman gives an overview of the most important changes since the previous edition was published: new SEC regulations, the changing nature of SPACs (Special-Purpose Acquisition Company), and the emergence of new instruments called WRASPs (WestPark Alternative Senior Exchange Process). The book includes a new chapter on China, and the "Experts Speak" chapter features all new interviewees. David Feldman is one of the country's leading experts on reverse mergers, self-filings, and other alternatives to IPOs. His firm has guided hundreds of companies on going public, advising them on structure and mechanics, financing, due diligence, regulatory issues, and more.

CHAPTER 1

Why Go Public?

Before deciding how to go public, a company must decide whether to go public. As I often tell my clients, if you can benefit from being public, and can bear the costs of becoming so, you should seriously consider it, regardless of your stage of development.

Advantages of Being Public

In general, there are five major advantages to being public: easier access to capital, greater liquidity, ability to grow through acquisitions or strategic partnerships, ability to use stock options to attract and retain senior executives, and increased shareholder confidence in management.

Access to Capital

It is easier for public companies to raise money than it is for private companies. Regardless of the merits of any specific private company, public companies have five characteristics that make them more attractive to investors than private companies.

First, by law public companies must disclose their financial results (good or bad) and other material developments to the U.S. Securities and Exchange Commission (SEC) and the public regularly and in great detail. Disclosure requirements build investor confidence because it is harder for a public company to hide problems than it is for a private one to do so.

The second major benefit to investors is that there are more opportunities for a public company to create liquidity for their investment. This increases a public company’s access to capital. Those who invest in private companies always worry about the “exit strategy” and look for companies that wish to be sold or to go public eventually. If a company is already public, it significantly enhances the investor’s ability to exit. The fact that a public company’s stock can be traded creates liquidity because an investor can sell the stock in the public markets. The fact that one can trade a public company’s stock creates liquidity because an investor can sell the stock in the public markets. Typically, public company investors obtain the ability to sell their shares publicly within three to five months after their investment. At worst, they must wait six months after investing in a company that has not been a shell company for the past six months, or at most one year following most reverse mergers. This is significantly faster than the three to five years a venture capitalist generally expects to wait for an investment to pay off.

The third major benefit to a company that completes a financing as a public company rather than a private one is that it is not bound by the restrictions and covenants that private equity or venture capital investors customarily require. Venture capitalists view themselves as management’s partners, and require veto power on many different aspects of decision making in a company. In general, once a company is public, investors stop demanding these powers. Thus, even if a private company is able to attract private equity investors, it still may want to consider going public, because private investment in public equity (PIPE) investors or others who finance public companies generally put fewer restrictions on the company’s activities, decision making, and so on.

The fourth advantage of seeking financing after going public is valuation. The markets judge shares in a public company to be worth roughly twice as much as shares of similarly situated private companies. When a financing takes place as part of the going-public event itself, the value of the company before the investment (known as the “pre-money value”) is almost always materially higher than the value a private equity investor would place on the same company. This makes perfect sense when one considers that investors place a premium on liquidity.

Even though it is easier for public companies to raise money than private ones, this is not a sufficient reason for going public, as many companies who go public solely to obtain one round of financing learn to their dismay. Companies that follow this path frequently regret the decision; many, in fact, end up going private again. Companies that make the most out of being public also make use of some or all of the following benefits.

Liquidity

Liquidity gives all investors the opportunity to enhance their exit strategy by being able to turn their investments into cash. New investors are not the only ones who want to be able to exit. Sometimes one of the main reasons for bringing a private company public is so company founders, former investors, and senior executives holding stock positions can take money out of the business without selling the company outright or losing practical control. There are as many reasons owners might want cash as there are owners.

The challenge in this situation is to avoid a great wave of share sales by company insiders. There are two reasons for this. First, if too many insiders sell out, those who built the company in the past will lose the incentives that would encourage them to continue building the company in the future. Second, Wall Street notices when insiders are selling out. Generally, a wave of insider sales discourages outsiders from investing in a company. Therefore, a company should consult its advisers and design an appropriate, rewarding, but measured selling plan.

For example, a former client took his company public through a reverse merger. Shortly thereafter, the company founder actively began to sell his stock. He sold nearly $5 million worth of stock before the price began to drop precipitously. This caused prospective investors to lose interest in the company. Today the company is out of business and in bankruptcy. This is also the type of situation that leads to SEC investigations of investors’ activities.

Another client took a more circumspect approach, with great success. He restricted when, in what amount, and how often insiders could sell their shares. He meticulously consulted with legal counsel before each such insider sale to determine whether there was a risk of insider trading. Today, the company is growing, its stock price is rising steadily, and the founders have been able to sell enough stock, slowly and deliberately, to begin to realize their exit strategies.

PRACTICE TIP

To senior executives of newly public companies: don’t get greedy.

Growth Through Acquisitions or Strategic Partnerships

The second most popular reason for going public (after the need to raise capital) is to pursue a strategy of growth through acquisition, joint venture, or strategic partnership. As noted above, investors are more willing to provide financing to a public company, even when the purpose of the financing is to fund acquisitions. In addition, a public company often can use stock as currency or “scrip” in the package of consideration to be provided to a company it is acquiring or collaborating with. Indeed, sometimes the only consideration given is stock.

In general, the value of the stock provided exceeds the agreed-upon value of the transaction because there is some risk the stock will drop in value down the road. In other words, if a company is to be acquired for $20 million, including $10 million in cash, a seller may demand the balance to be equal to $12 million or $13 million in stock to offset the risk of stock price volatility. Public buyers generally are willing to be flexible in this regard, as purchasing with stock circumvents the need to raise cash for the purchase. It also allows a company to retain its cash for other purposes such as reserves.

Stock Options for Executives

Many companies have difficulty attracting talented senior management. Public companies have an advantage over private ones in the competition for top people because they can offer stock options and other equity incentives—the “brass ring” of affiliation with a public company—as part of the compensation package. Frequently, compensation for top executives at public companies seems exorbitantly high. However, the fine print often reveals that the vast bulk of a multimillion-dollar compensation package comes not in the form of wages, but in the form of stock or stock options. (Stock options aren’t just for high-ranking executives. Many stories have been written about the millionaire secretaries at Microsoft, eBay, Google and other companies.)

Private companies also have the option of setting up stock option plans; however, the problem, as with all investments involving private companies, is liquidity. Private company executives know that they cannot make money from owning stock unless there is some form of liquidity event. The company must go public, be sold, or initiate a major dividend distribution to turn shares into cash. Stock options in a public company are much more versatile and, therefore, more valuable.

Options are attractive to those who lead public companies because they align management’s incentives with company performance as judged by the market. Option holders are highly motivated to build the company’s success so that its stock price will go up. The vesting process, whereby options become available based on an executive’s time with the company, encourages a long-term commitment. I know many senior executives who stay with a company longer than planned simply to ensure that their options vest.

Confidence in Management

Because of SEC disclosure requirements, shareholders of public companies feel more confident that the actions of management and the operation of the company will be transparent. The SEC requires reporting companies to reveal financial results regularly (providing explanations of period-to-period changes), including executive compensation, related party transactions, material contracts, liquidity, capital resources, and the like. Public companies create this stream of information as required by SEC rules, and the result is to help shareholders feel knowledgeable about the company’s operations and challenges.

On the other hand, state laws generally limit the type and quantity of information that a shareholder of a private company may obtain. Rarely can a shareholder legally obtain a financial statement and a list of shareholders more than once a year. Some states require a shareholder to show cause or even bring a court proceeding before obtaining this or other information. Investors in private companies typically negotiate broader and more frequent information delivery, but still find extracting pertinent information to be a constant challenge.

That being said, it must be remembered that even public company filings can be misleading or fraudulent. The lessons of Enron, WorldCom and others are relatively recent and will linger. Nonetheless, private companies still have greater incentives to play games than do public ones. After all, the public company that plays fast and loose with disclosure requirements risks SEC investigation, criminal prosecution, and class action lawsuits.

It is not unusual for a senior executive of a public company to ask my firm to figure out how not to disclose something, which is almost always something bad. Even when disclosure is not mandatory, when the decision is on or even near the borderline, we usually take the view that disclosure is recommended. (We don’t recommend it in every case. For example, the departure, of a CEO’s longtime personal assistant generally would not need to be disclosed. However, the departure of a director certainly would.)

Disadvantages of Being Public

There are five well-recognized disadvantages of being public: pressure to please Wall Street by emphasizing short-term results; mandatory public disclosure of company information, which makes “warts” hard to hide; vulnerability to fraud (even after Sarbanes-Oxley); higher annual expenses, because of the costs of fulfilling SEC reporting and auditing requirements; and vulnerability to lawsuits.

Emphasis on Short-Term Results

If a public company is lucky enough to be covered by Wall Street analysts, the pressure to please “the Street” is intense and constant. Every quarter, the question on analysts’ minds is whether the company will meet or beat expectations in the market.

There is a healthy aspect to this because management must keep its eye on stated goals. The negative, of course, is that short-term results become more important than the long-term goals every company must pursue in order to build shareholder value.

A public company must concentrate both on making wise decisions and on how those decisions will be perceived by analysts. This can cause problems. Say a company with a strong cash position decides to spend a portion on long-term capital expenditures. Some Wall Streeters will see the long-term benefit—but some will simply see the erosion of cash reserves. Another example: If the underwriters in an initial public offering (IPO) did not insist that the company shed an early-stage or R&D opportunity and that opportunity continues to drain cash, Wall Street may not respond kindly. Additionally, investments in systems, real estate, or overhead in anticipation of future business may be negatively received.

Conflicts also arise when companies “do the right thing.” I make financial decisions in the course of running my law firm based on my business philosophy of doing right by my vendors, my clients, and my staff. This may mean, for example, keeping problem employees on if I feel they are working diligently to correct their deficiencies. It may mean a larger raise for an employee who is going through tough times, getting married, or experiencing unusual personal circumstances. Or it may mean cutting a client’s fee, even when he does not request it, if I feel that we may have spent too much time on something. If my firm were public, I would feel more pressure to base my decisions on the smartest financial strategy, regardless of whether or not I was doing the right thing.

Public Disclosure

Earlier I described some of the advantages of the public disclosure of financial results, executive compensation, and the like. However, public disclosure is not always beneficial. All of a company’s problems have to be revealed, without delay. If its financial statements are being restated, or the company loses a major customer, or an executive has strong personal or family ties to a major vendor, the public will find out immediately.

Disclosure requirements also make it more difficult to keep important information away from competitors. I had a public client, since sold, whose business primarily involved obtaining military contracts. SEC rules require that major new contracts must be filed and disclosed. Unfortunately, one contract included a copy of the company’s original bid, which was very specific and detailed regarding pricing and other terms.

The company challenged the filing requirements on the grounds that the original bid was confidential. Unfortunately, the SEC ruled that the contract must be disclosed, confidential bid and all—and the company’s competitors were able to obtain this information on the SEC’s Web site with a few mouse clicks. Granted, the information was also obtainable with a Freedom of Information Act (FOIA) request (which was the reason the SEC deemed it not confidential). However, the process of obtaining information through FOIA is more cumbersome, and our client’s competitors generally do not seek information in that manner.

The other side of public disclosure is that good news travels fast. When positive things are happening at a company, press releases and SEC filings help promote the company’s success.

PRACTICE TIP

In deciding what to disclose, be consistent, and as quick and determined to disclose the bad...

Table des matières

• Praise
• Title Page
• Copyright Page
• Dedication
• Table of Figures
• Acknowledgements
• Introduction
• CHAPTER 1 - Why Go Public?
• PART ONE - THE BUSINESS OF REVERSE MERGERS
• PART TWO - LEGAL ISSUES AND TRAPS FOR THE UNWARY
• PART THREE - OTHER WAYS TO GO PUBLIC, MANUFACTURING SHELLS, AND CURRENT TRENDS
• GLOSSARY
• INDEX
• ABOUT THE AUTHORS
• ABOUT BLOOMBERG