Copyright (c) 2012 Hamilton & Associates Securites Lawyers
Traditionally, private companies become publicly traded by registering an offering under the Securities Act of 1933, as amended. Another method for private companies to obtain public company status is through a Reverse Merger ("Reverse Merger") with a public shell company.In a Reverse Merger, a private operating company or its business operations are acquired by or merges into a publicly traded Shell Company ("Public Shell"), often inactive with negligible operations and assets. Reverse Mergers can be structured a variety of ways but the end goal is the same - to take a private company or its operations public.
In a Reverse Merger, several things typically occur occur:
i. the private company merges into the Public Shell, and the post reverse merger entity is a publicly traded company;
ii. the private company's controlling shareholders and management obtain control of the post-merged entity; and
iii. the post reverse merger entity changes its name to that selected by the private company.
Despite success stories touted by shell brokers, reverse mergers involve a significant amount of legal and compliance risk. Additiionally, if proper due diligence is not conducted and the reverse merger transaction is not properly structured, the post reverse merger company can end up a private company, with public company reporting requirements and expenses.
In addition to the traditional reverse merger risks including SEC investigations or violations, undisclosed liabilities, litigation and potential litigation, companies now face increased compliance costs and regulation. Private companies are learning the hard way that it is easier and more cost effective to simply file a Registration Statement with the SEC and complete a direct public offering ("DPO") than to encounter the uncertainty and risks inherent in Reverse Merger transactions.
The Myths.
There are many misconceptions about reverse mergers that shell brokers use to entice private companies into purchasing a public shell company including but not limited to those set forth below.
Reverse Mergers are Inexpensive and Fast.
Stock promoters often compare the price of an initial public offering with that of a Reverse Merger. This is misleading because with an IPO, a company pays an underwriter to sell securities to the public and develop an active market after the company becomes public. A Reverse Merger is not a capital raising transaction. A private company can go public and file their own Registration Statement for a cost of between $35,000 and $100,000. A public shell for a Reverse Merger can cost as much as $450,000 and 5% of the Shell Company's outstanding securities. In addition to the time it takes to perform due diligence, negotiate the Reverse Merger agreement, and close the Reverse Merger, recent SEC and FINRA requirements eliminate the timeliness benefit of the Reverse Merger. Recently passed Rule 6490, requires that corporate acts frequently associated with Reverse Mergers obtain FINRA approval before effectiveness. This approval takes approximately a month to obtain.
Reverse Mergers require minimal disclosure.
In 2005, new rules were adopted that require former Shell Companies to file "Form 10 Information" with the SEC within four business days after completion of a Reverse Merger. This information is substantially equivalent to that found in the Registration and requires comprehensive disclosure of the company's business plan, risk factors, financial condition, management, properties, and audited financial statements.
Reverse Mergers allow easy access to capital.
A Reverse Merger is not a capital raising transaction and a company engaging in a Reverse Merger cannot receive "free trading" shares. The only way for a company engaging in a Reverse Merger to receive free trading shares or proceeds from the sale of free trading shares is by filing a Registration Statement with the SEC.
Reverse Mergers Create Easy Liquidity.
Not only do reverse mergers not create easy liquidity, they often destroy any chance of obtaining liquidity. Companies engaging in Reverse Mergers often undergo corporate changes, such as a name change or stock split. These corporate corporate changes can cause delays of months for companies applying for DTC-eligibility. Further, after Reverse Mergers companies with DTC eligibility often find their securities subject to DTC chills and global locks. Without electronic trading capability, it is impossible for a company to establish liquidity in its securities.
Reverse Mergers allow for easy migration onto NASDAQ, or NYSE or AMEX.
In November of 2011, the SEC approved new Nasdaq, NYSE, and NYSE Amex rules that impose more stringent listing requirements for companies that become public through a Reverse Merger. These rules prohibit a Reverse Merger company from applying to list until it has completed a one-year "seasoning period" by trading in the U.S. over-the-counter market or on another regulated U.S. or foreign exchange following the Reverse Merger, and filed all required reports with the Commission, including audited financial statements. The company must also maintain a minimum share price of $2.00 to $4.00 for at least 30 of the 60 trading days, immediately prior to its listing application.
Use of Rule 144 for Reverse Merger Companies
Most reverse mergers involve inactive or dormant companies known as Shell Companies. A "Shell Company" is defined as a company with no or nominal assets or assets consisting of cash and cash equivalents. In February of 2008, the SEC passed new rules that require holders of companies that go public in Reverse Merger transactions with Shell Companies, be unable to resell their shares in reliance upon Rule 144, until the issuer of the securities has ceased to be a shell and at least one year has elapsed from the time the issuer filed current Form 10 Information with the SEC reflecting its non-shell status.
Form S-8.
Registration of securities on Form S-8 is a short-form registration statement that is available to register securities offered to employees and consultants under benefit plans under limited circumstances. Because a registration statement on Form S-8 is effective upon filing, it offers benefits to issuers, most significantly, that an S-8 registration statement becomes effective upon filing and the shares registered may be issued without a restrictive legend. On July 15, 2005, the SEC amended Form S-8 to prohibit its use by companies that are Shell companies.
The Direct Public Offering Solution
For small companies who will be unable to locate underwriters for an IPO, the direct public offering ("DPO") is an appealing option which can result in an issuer having a ticker in as little as 90 days for less than 1/4 of the cost of a typical reverse merger. In a DPO, the issuer files a registration statement with the SEC, typically on Form S-1 that registers shares from the issuer's treasury or shares held by its existing shareholders.
After the issuer files the registration statement it is then subject to review by the SEC. After review of the registration statement the SEC may render comments which the issuer will address by filing amendments to its registration statement. When all of the SEC comments have been answered to the satisfaction of the SEC, it will declare the registration statement effective. Once the registration statement is declared effective, the issuer may sell the registered securities to investors without the use of an underwriter. Upon effectiveness of a registration statement which registers shares held by existing shareholders, the issuer can file its Form 211 if it meets FINRA's requirements.
FINRA requires the issuers to locate a sponsoring market maker to file a Form 211 ("211"). For issuers who are non-reporting, audited financial statements are not required in order to file a 211. After the sponsoring market maker files a 211, FINRA reviews the 211 and provides comments for the sponsor to address. Upon receipt of confirmation that all comments have been answered satisfactorily, a ticker symbol is assigned and the issuers' securities are publicly traded.
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