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01 Dec A Few Reverse Merger Myths

The reverse merger industry is full of charlatans pushing unneeded and unnecessary products and services on the unwary. Those on the outside of the knowledge loop are often taken advantage of and pigeonholed into deals that may not fit well with their corporate growth strategy. It is therefore essential to understand at least a few of the typical myths associated with the micro-cap markets so they can be avoided when working with someone in the industry who claims to have an understanding on how things work.

 Myth 1: Reverse Mergers are Quick and Cheap

Comparing the price of a reverse merger to an initial public offering or IPO is wholly an unfair comparison for several reasons. First, the underwriter in an IPO scenario is paid to help develop a viable market for the company stock once the shares are readily trading. In contrast, a reverse merger is typically not a capital raising event unless a PIPE is simultaneously executed. It is true that with a self-filing a company can typically go public for between $35K and $100K. However, it’s not nearly as cheap if you want a public shell that is immediately available with trading shares. The cost in this instance will typically range from $350K to $450K. In addition, somewhere around 5% of the company’s stock will likely be exacted in the deal to ensure some public float. Third, when it comes to timing reverse mergers aren’t always lickety-split. Negotiations, public shell company due diligence, deal closing and completing all FINRA and SEC requirements can significantly slow any speed-to-market advantage a reverse merger holds over an IPO. In particular, new rule changes as of 2005 put more pressure on Form 10 shells contemplating the completion of a reverse merger. More information including comprehensive info on financial condition of the firm, general and specific risk factors, properties and financial statement audits are now required. It’s ultimately good for investors, but slows the overall process for a reverse merger.

Prior to some such rule changes, companies contemplating a reverse merger could wait as long as seventy-five days after the completion of a deal before disclosing anything material in the transaction. Now the requirement is four days. In addition, new FINRA approval requirements with Rule 6490 can take as long as 30 days or more to complete.

Certainly, reverse mergers and self-filings are still faster and cheaper than an IPO, but the picture is often painted as being more rosey on the surface than reality would dictate. Breaking through the proverbial “critical path” in the process in a timely manner requires expertise to ensure rapid completion.

Myth 2: Reverse Mergers Can Be Completed with Little to No Disclosure

As discussed briefly above, disclosure requirements for such transactions have become more stringent, especially as fraud in the micro-cap markets has forced many a hand. A registration statement is now required for reverse merger deals which includes everything from the business plan, risk factors and audited financial statements. Such disclosures ensure the company truly is public as its information is completely transparent and available publicly. Gone are the days of gray sheets and yellow sheet stocks. This is one of the main reasons we steer clear of pink sheets. We like disclosure because investors like disclosure. Enough said.

Myth 3: Reverse Mergers are Liquid 

Public companies are liquid, but many are less liquid than you think. In a reverse merger, unless there is a separate capital raising event, the company cannot issue/receive free trading shares, unless said shares have been registered with Securities and Exchange Commission. Establishing  a liquid, trading market for a company’s stock requires promoters, peddlers and market makers and investors/buyers willing to buy and sell. In an IPO, the underwriters typically fulfill the role–in some cases in an unnatural way that protects the company’s stock from tanking at IPO. It can even be worse if nefarious actions cause a lock on DTC eligibility of the stock as such can freeze any chance of the company creating a liquid market for its shares.

A reverse merger scenario is altogether different. Immediately liquidity is less likely. For the truly legit company that can make a name for itself overtime, a reverse merger can create just as much liquidity as an IPO, but winning that type of market support doesn’t happen overnight like an Alibaba IPO. It takes time to win that type of support. Berkshire Hathaway is a great example of that. If you have existing parties, shareholders or networks related to the business that could pony-up as shareholders to the new public company, then you’ll likely have the beginnings of a public market of trading stock for the business. Otherwise, massive appeal is not likely to occur overnight.

Myth 4: Migration to NASDAQ or NYSE is Simple

Larger exchanges always hold more stringent rules and listing requirements, particularly for those who’ve obtained public status through a process other than an IPO. In fact, in 2011 the larger stock exchanges changed the seasoning period for a reverse merger that intends to transition to the larger exchanges to one year. In addition, the company also must have maintained a share price of between $2 and $4 for a minimum of one half of the last two months. In other words, former shell shareholders are unable to rely on Rule 144 for selling their shares until the reverse merger has “seasoned” on the OTC for at least one year. That is, the filed Form 10 info must have been completed at least one year prior to the current date before the company can go public on a higher exchange.

In addition, the SEC changed Form S-8 requirements in 2005 to exclude companies that go public by reverse merger. This type of short form registration statement allows certain shares to be issued that may not have been registered as long as specific conditions are met.

These are only of the few characteristics about reverse mergers that may ultimately turn-off both shareholders and management. It’s interesting because in many cases, I actually end up being the bearer of bad news. Many folks who want to go public shouldn’t. But, with what I’ve discussed above, there are always many more options for solid companies looking to public, rather than the rag-tag startup that wants to go public with no revenue.

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Nate Nead
Nate Nead is a licensed investment banker and Principal at Deal Capital Partners, LLC which includes InvestmentBank.com and Crowdfund.co. Nate works works with middle-market corporate clients looking to acquire, sell, divest or raise growth capital from qualified buyers and institutional investors. He is the chief evangelist of the company's growing digital investment banking platform. Reliance Worldwide Investments, LLC a member of FINRA and SIPC and registered with the SEC and MSRB. Nate resides in Seattle, Washington.