Alternative Financing Methods (Reverse Mergers)

Companies can raise capital in one of two ways: debt and equity. The difference between these two methods is how ownership is transferred. Business owners give up a percentage of ownership with an equity funding. Equity funding can include but is not limited to: Family, Friends, and Fools; Angel investment; Venture Capital; Private Equity. Unfortunately, there is much competition for these sources, thus creating an opportunity for alternative financing methods for cash flow or to get your venture off the ground.

The most liquid form of raising equity is via the stock market. However, this requires registering for a public listing of a company, usually via an initial Public Offering ("IPO"). An IPO is an extensive and expensive process. Some companies who wish to bypass this process opt for a Reverse Merger.

A reverse merger happens when a publicly trading company merges with a private company and the private company survives; the private company occupies and operates in the publicly traded company's legal shell (a public shell company is a non-operating public company; a company registered, and filing periodic reports under, the Securities Exchange Act of###-###-#### the "34 Act"). Typically, Public Shells are listed on the NASDAQ Small Cap Market, the NASDAQ Bulletin Board or the Pink Sheets).

A reverse triangular merger is the most common form of reverse merger. With this structure, the public shell company creates a subsidiary company which then merges with the private company. Shareholders exchange their shares in the private company for those in the public company, and the private company is now a wholly owned subsidiary.

With a reverse triangular merger, it is usually easier to obtain consent from company shareholders because the new subsidiary company has only one shareholder; the public share company. Structuring a reverse merger in this way allows the public company to avoid the Securities Exchange Act's proxy requirements for mergers.

The private company takes over controlling ownership of the stock of the public company and management of the company, usually changing the company's name to its own and changing the stock symbol. It is not necessary for both companies to be in the same business; in fact, usually they are in very different businesses.

Public Shells can exist in three possible forms: (1) A Public Shell could be a start-up company that never achieved significant revenues. This category generally includes companies with uninspired business ideas and models that have failed to achieve profitability. Normally, these companies have a rather short business history and have never acquired or managed substantial assets. These companies are still listed on an exchange but have fallen out of favor with investors. Their stock prices have declined, and they struggle to keep afloat;

(2) A former operating company that went out of business or sold all of its operations. This form spans the business spectrum, including any company whose management and major shareholders decided at some point to sell all assets but keep the company’s 34 Act registration alive to pursue a possible lucrative reverse shell merger. Generally, these companies have a long business history and have owned substantial assets at some point in their history;

(3) A company that was specifically formed and registered for the purpose of being sold in a reverse shell merger. These companies do not have any business history and have never acquired any assets.

Advantages of going public via a reverse merger into a Public Shell: • Businesses can use a reverse merger to get listed on an exchange quickly. No underwriter is needed to go public through a reverse shell merger; they don’t need to seek out investment banks or go through lengthy due process periods; • The legal requirements are usually less stringent; • The public company already has an active shareholder base, which makes future equity capital easier; • Reverse mergers are considered less risky than enduring the IPO process. Not every IPO is successful and can result in being delisted; • In theory, reverse mergers create instant liquidity. Shares of public companies are traded on exchanges, which makes access available to a broader group of investors; • It’s easier for companies to offer stock to retain top talent. They can offer stock options and warrants, too; • The stock of a company has value. This could be used as an exchange during acquisitions and future mergers; • The public companies chosen for the merger are usually companies that suffered losses. These losses can generally be used to offset income in future periods, which lowers the tax base of the combined company.

Disadvantages of going public via a reverse merger into a Public Shell: • Complete (and expensive) financial disclosure is required for publicly-held companies under the 34 Act; • There are substantially higher costs of regulatory compliance for the audit, legal and investor relations work; • Owners of the Private Company give up some equity percentage in the merger (usually between 15% and 20%); • Management must devote additional time to public company activities; • Additional company visibility brings a higher level of liability exposure; • Getting listed as a private company doesn’t guarantee success. For instance, if a stock’s price falls below a certain threshold on the New York Stock Exchange, it risks being delisted. Each exchange has different requirements for staying compliant; • Stock exchanges charge its members fees for staying listed. These fees are usually significant; • Public companies are at risk for increased jeopardy. The increased exposure and opportunity of a public company comes with a higher risk to management and the Board with severe civil and criminal penalties for regulatory mistakes and non-compliance.

It takes real money to do a reverse merger. Most public shells do not come with any money. The cost of the shell, plus the cost of navigating the process, can add up to a half-million dollars or more, depending on the shell company. This approach is thus not viable for a private company without any money. In addition, it is expensive to maintain the public entity post merger; to follow generally accepted accounting, reporting, and audit procedures. It is estimated that maintenance costs could be up to $2.5M a year.