The Ugly Duckling Turns Into A Swan – Wall Street Searches for New Revenue Streams

Why Reverse Mergers Make Sense & What to Look for Before You Leap In…

My First Prospectus – Back in 1992, a document was dropped on my desk. The front page said “Preliminary Prospectus”, “Kaliningrad Fund”. Under the name in big bold letters it read “AN INVESTMENT IN THE SECURITIES OFFERED HEREBY IS SPECULATIVE AND INVOLVES A HIGH DEGREE OF RISK”. As I started to read, every page was worse than the next. 

I wondered what this Company did. It had no revenues, no business and only $10,000 in the bank. I found out that a family friend, the former Secretary of State, General Alexander M. Haig, had been asked to be the Chairman of the Board of this new venture which involved acquiring businesses in the former communist bloc.

They were raising $10 million dollars with little or no money in the bank and no operations.  I was intrigued and called the lawyer on the back of the document and two months later I put together my first $1 million and launched my first public company.  Little did I know at the time, that my attorney had attempted to play investment banker and had convinced me of a terrible structure.  I had launched a best-efforts, mini-maxi, blind pool offering. When I tell this story now (to those in the investment banking world), I always get a laugh. Knowing what I know now, I realized that it could not have been any worse.

The Evolution of the Reverse Merger – It took me years to get my first public company (The Czech Fund) off the ground after the less than perfect start.  After “going effective” through the Securities and Exchange Commission process, then raising some more capital,  and then listing my stock on the over-the-counter exchange (which is a regulatory process all in itself), my company started to make acquisitions. My experience in the reverse merger business was born.

In those days, on Wall Street, the idea of a being involved with a reverse merger was like Paris Hilton shopping at a Kmart. It was beneath them. Despite this fact, many prominent companies have been built via the reverse merger. My favorite would be a little company in Omaha by the name of Berkshire Hathaway, run by a wily old man you may have heard of, Warren Buffet.  That’s right, in 1963, Buffett took over a small company that was the result of a merger between Berkshire Fine Spinning Associates Inc., a milling company, and Hathaway Manufacturing Company, a furniture maker. After Warren Buffett took control of Berkshire Hathaway, the company operated in dual roles. First, it maintained its core business of textiles, but secondly, Buffett gradually began to use the public company as an investment vehicle. In 1967, Buffett turned the company’s eyes towards the insurance business, negotiating the purchase of two Nebraska companies, National Indemnity and National Fire and Marine Insurance. While Buffet kept the core furniture business alive until 1985, Berkshire Hathaway had already been transformed into the vast financial powerhouse that has made Buffet the richest man in the world.

Unfortunately, for every great example there are 100 bad ones, and in the reverse merger world, it’s sometimes shady on both sides of the street.  I have seen my share of scoundrels and just when I think I have seen it all, I am astonished again. All that being said, the reverse merger world has changed for the better, mostly in part to the age of the internet and its fast access to information as well as many reforms that the regulators have put in place that prevent the chicanery that was prevalent in the past.
These changes coupled with the virtual demise of the small cap broker dealer and its IPO business has made the reverse merger more commonplace. Ten years ago, the number of attorneys I spoke with who knew the art of the reverse merger was 1 in 20. Now-a-days, most securities attorneys are well versed and in many larger firms, there is a specialized practice dedicated to this niche.  A good site to go to for specific legal information on reverse mergers is David Feldman’s blog site: Even the auditors have gotten up-to-speed and the Big 4 (Ernst & Young, Price Waterhouse, Deloitte and KPMG) now partake in reverse mergers.

Now the large investment banks are getting into the act. I was recently in the offices of a large investment bank, meeting with some of the bankers on a transaction we had done. After discussing the topic at hand, the conversation switched to reverse mergers. I was curious why they wanted to know so much about the process. They were asking questions like what did I pay for a shell, how much did I retain, how did I value the deal, etc. I couldn’t help but ask why all the questions. The answer was that the bank was buying their first shell and wanted to get my opinion if they were getting a fair deal. Turns out, they realized that for companies under the $200milllion market cap, it’s hard to do an IPO anymore. And that raising capital privately was too costly. More importantly, the fees that can be charged are not as regulated, unlike a traditional IPO, where the NASD caps the fee.

Even some private equity players have gotten into the game. KKR’s announcement in July, that it was completing an Alternative Public Offering (APO), a fancy name for a reverse merger, helped lend even more credibility to the process.  My friend Andre Peschong, who writes at his blog site explains the merits of that particular transaction.

The meeting I had with those Wall Street investment bankers was three months ago. Today, I suspect that their need to generate business and complete transactions for the investment banks is at dire levels. Perhaps the reverse merger will help fill the void that has been lost in the traditional IPO business for the larger banks. Perhaps the “Ugly Ducking” of the investment banking world has turned into the “Swan”.

Are You Ready and If So, What To Look For – In all the years of doing deals, as simple as it sounds, I have found there is really only one main ingredient that one should first consider when undertaking the reverse merger process. That main ingredient is summed up as follows: is the Company that you are taking public ready to go public?

For the longest time, the reverse merger playground has been littered with small and micro cap development stage companies. As an entrepreneur, I applaud the risk taking and I feel that everyone should have right to build their businesses as they see fit.  But the likelihood of failure is already great for any small private business. Adding the layer of being public, with its added costs and responsibilities, is in most cases too much to bear.  I know, I did it. And, as one old partner once told me, “we died and thousand deaths” during the process. So if you are a company considering going public via reverse or a “deal guy” considering doing a reverse, ask yourself the hard question: are you ready?

If you are considering getting into the reverse merger world, I would suggest that you consider my five point checklist as you start to evaluate deals. 

  1. Back to Basics – Are we there yet? My kids ask me this every time we get in the car. And it’s the first thing I look for now when I consider a company. Are they making money?  How is their cash flow? Build it and they will come was great mantra for a baseball movie, but when this is your game plan in the public markets, one wrong move and you’re dead.
  2. Bet on the Jockey, Not the Horse – After I get comfortable with financials, I listen to the CEO make their pitch. I am always weary of those CEO’s that want to do too much outside their core business. The best ones know what they do well and want to expand on that. Also, make sure the CEO and key management has “skin” in the game (more below). 
  3. Double Check The Auditors – I have learned the hard way one too many times, that when you are public, the only real professional that can do shareholders harm are the auditors. The lawyers for the most part are interchangeable and are relatively abundant to choose from. But the wrong auditor can really set your company back.  And don’t be fooled with the “larger-is-better” philosophy. I almost got delisted once from NASDAQ when a nationally recognized auditing firm’s domestic partner got into a fight their international partner and we got caught in the middle. I have also had companies’ auditors that have had little or no experience in reverse merger work. When the SEC reviews the filings and asks the Company to make a change in the financials, the auditors are so scared to “restate” that they dig in their heels.  I have also seen companies who fire their auditor, then the same auditor pulls their opinion and renders the historical financial statements useless. In one case, a company was in the middle of a financing and this killed the deal and almost the Company.
  4. Get Funded From the Start– This is one of the most crucial steps to a successful reverse. It’s just too hard and takes too much time to complete a reverse and then go out and raise capital. The stock is illiquid, there is no registration statement that has been declared effective with the SEC and the investors almost always want to structure the deal their way, which may cause the Company to have to redo their capital structure. A simultaneous reverse-financing is the only way to go (the caveat being that the company got funded prior to the reverse).
  5. It Takes Two Years to Become and Overnight Success – Wall Street is full of the quick buck artists. The fact is, it takes time to go from private company, through reverse to liquidity in the marketplace. During this time, besides building the business, the Company should have three goals: a) Obtain a national market listing for its common stock, b) hire reputable investor relations firms, and c) actively promote the Company at various banking conferences and road shows. In several of the most recent deals that I have been a part of, getting the stock listed is part of the merger conditions, as is the hiring of the IR firm. In fact, management shares and investor funds are escrowed to highlight the importance of these issues. In several of the recent reverses, foreign management has been required to visit the US quarterly for road shows with US investors. From an investor standpoint, the “claw back” is also a vital tool in making sure the management lives up to its expectations. Like an old friend of mine likes to say “I have never seen a bad pro forma”. There is nothing wrong with being an optimist. But if management doesn’t make the money it projected, then they should give back some of their stock. Add a management lock-up of their shares for two years and investors should have some comfort that they are betting on a jockey that it’s aligned with their interests.
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