Startups and businesses with limited cash looking to go public are understandably very money-conscious and want to use the most cost-effective route. The survival and/or further development of their business may depend on getting access to capital raised through the public marketplace and managing the process without breaking the bank.
Reverse Mergers have long been considered one of the most cost-effective and fastest ways to go public, but is it really the best option?
The truth is that there are lots of myths and misinformation in the marketplace about Reverse Mergers. Let’s review some of them.
Myth #1: Reverse Mergers are the cheapest way to go public
Yes, it is possible to find publicly traded shells for sale to use as a public vehicle for a Reverse Merger, but existing shells come with lots of risks that, in the long run, could lead to exorbitant costs and even the loss of your business.
The cheaper the shell, the more risk. The biggest risks are:
- Skeletons in the closet. If the shell has a bad history, including bad actors, control disputes, stock promotions, and offshore stockholders, it may be too tainted. Those past frauds often follow the shell and lead to problems in the future, so much so that the SEC regularly addresses the risks associated with shell companies as Reverse Merger candidates.
- Good luck with FINRA. A big part of any Reverse Merger is converting the old shell into a new shell that properly represents your business. But if the shell is full of red flags, getting FINRA to approve any corporate actions, such as a name change or reverse split to clean up the share structure, could prove impossible. In this case, the money saved by locating a public shell is going to backfire and cost your business in other ways, including its public image.
- Toxic debt situations. One of the biggest mistakes companies going public through Reverse Mergers make is not vetting the shell properly and entering into a toxic situation due to existing debt. Often, these types of shells contain the worst kinds of debt with the most toxic and harmful terms of conversion. You could quickly find all of your value sucked out of the shell because of dilution caused by existing debt holders.
- Shell owners are wolves. These shells are often associated with questionable characters who make a living peddling public shells and use them for their own self-enrichment. In many cases, they hijack abandoned shells through custodianship petitions or purchase damaged shells for next to nothing, then flip the shells to unsuspecting business owners looking for a cheap option to go public. They tout the shells as a lifeline for your business and even offer you consulting and access to capital for your business through various agreements. Often, those agreements are one-sided and only meant to put your company in a vulnerable, no-win position that could ultimately end up costing you your business.
- Unforeseen expenses. Cheap shells are often behind on their filings – some haven’t done public disclosures in years. By purchasing the shell, you’ll be on the hook to get the shell back current with its public disclosures. Without doing so, future corporate actions will be impossible, and with changes in rule 15c-211 due to take effect on September 28, 2021, you could end up losing the quotation of your stock, making the shell virtually worthless. Getting the shell back current with its disclosure requirements and local filing requirements at the secretary of state will cost several thousands of dollars that you may not have anticipated.
- Limited source of capital. Non-SEC reporting shells provide almost no value as a source to raise capital for your business. As a former shell company, the issuer is not eligible to use Rule 144 to create “free trading” stock. The only kind of funding you’ll be able to find is using unsavory sources that have no problem with skirting the rules and working with unregistered stock. Unregistered stock sales could get you in trouble with the regulators and put you at risk of litigation. To get legitimate funding, using equity as a source of capital, you’ll need to file a registration statement.
Myth #2: Reverse Mergers are faster
Part of going public through a reverse merger is changing the name of the shell to match your business operations. Any respectable business wants its customers to identify the services or products offered with the company’s name. It is a vital step to maximize the future success of your business.
But before any name change or other corporate action can be approved, the shell will have to bring its disclosures up-to-date to get approval from FINRA. The process of updating public information and submitting public disclosures to get a stop sign shell changed to pink current status can take months, assuming that all the data and information from prior management is even attainable. Then the corporate action will have to be approved by FINRA per Rule 6490, which can take months of back and forth to satisfy FINRA’s concerns.
The unanticipated costs and unexpected time lost could have been avoided by doing a Direct Public Offering.
Myth #3: Reverse Mergers allow easy access to capital
This couldn’t be further from the truth.
A Reverse Merger is not a capital-raising transaction, and a company engaging in a Reverse Merger cannot issue or receive “free trading” shares unless the shares are registered with the SEC. Reverse Mergers do not create liquidity and may, in fact, permanently destroy any chance of obtaining liquidity. Issuers engaging in Reverse Mergers often undergo name changes and stock splits, which both FINRA and DTC review. Upon this review, many Reverse Merger issuers find they lose DTC eligibility, and their securities have DTC chills and global locks. Without DTC eligibility, a company can’t establish liquidity in its securities.
Myth #4: A Reverse Merger can be a stepping stone to the NASDAQ or NYSE
Again, this is completely false.
Putting the strict listing requirements aside, only SEC reporting companies can be listed on an exchange. Pink sheet shells are not eligible. You’d first have to register with the SEC, which could have been accomplished by going public through a Direct Public Offering. If your goal is to up list to an exchange, going through a Reverse Merger becomes a complete waste of time and money. Not only did you purchase a shell full of risks and bad history, but you have also put yourself several steps behind where you could have started and handicapped yourself by merging into a shell with an unfavorable share structure.
The Direct Public Offering Solution
For small companies who will be unable to locate underwriters for an IPO, the Direct Public Offering can result in an issuer having a ticker in less time than a Reverse Merger requires (if done properly) and for less than half the cost. In a Direct Public Offering, 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 reviewing 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. The issuer can then apply for its ticker symbol and trade if it meets FINRA’s requirements.
FINRA requires that the issuer have at least 35 shareholders who hold either registered shares or, with respect to Pink Sheet listed issuers, shares that have been held by non-affiliate investors for twelve months. These shares in the aggregate should represent at least 10% of the issuer’s outstanding securities and are often referred to as the “Float.” A market maker must sponsor and file the issuer’s Form 211 with FINRA. After this, FINRA conducts a review and may provide 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.
Conclusion
Any private company going public should proceed with caution when considering engaging in a Reverse Merger. Similarly, investors should proceed with caution when considering whether to invest in Reverse Merger Companies. Many Reverse Merger issuers either fail or struggle to remain viable. In light of these considerations, private companies should consult a qualified and independent securities attorney to perform thorough research and due diligence before engaging in a Reverse Merger.
To the extent that a private company is willing to expend the time and resources to become public, it should do so properly by filing a registration statement with the SEC and conducting an underwritten or Direct Public Offering and avoid the growing risks and new requirements involving Reverse Merger transactions and public shell companies.
For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email at info@securitieslawyer101.com or visit www.securitieslawyer101.com. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
Hamilton & Associates | Securities Lawyers
Brenda Hamilton, Securities Attorney
101 Plaza Real South, Suite 202 North
Boca Raton, Florida 33432
Telephone: (561) 416-8956
Facsimile: (561) 416-2855