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of record to mean what is known as “actual benefi cial owners,” but also increasing the number of shareholders one must have to avoid being able to use the simple Form 15 fi ling to go private. This inclusion of benefi cial owners would encompass “street name” holders and not just those holding physical stock certifi cates. It is not clear whether the full SEC will adopt this or any other of the committee’s recommendations.
In analyzing this issue, on the one hand, most everyone agrees that tying the availability of the simple fi ling to only those with physical stock certifi cates makes no sense: the rule is anachronistic and stems from a time when every shareholder held a stock certifi cate. In an era of elec- tronic trading, it makes more sense to make the fi ling available based on the number of “benefi cial owners”—including all those with shares held in street name. However, many—myself included—have urged the SEC to increase the maximum number of shareholders a company can have and still go private relatively easily.
In some few cases, such as in a reverse merger of a Chinese company I was recently involved with, there is no current need for fi nancing. There may be a plan to raise money at some point in the future, but it is not required at the time of the reverse merger.
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venture capitalist knew that the investment bank could raise multiple rounds of fi nancing going forward, which would be essential to the company’s achiev- ing its business plan. The venture capitalist also knew that the valuation the company received from an investment bank was likely to be higher than a valuation from a private equity fi rm. All of this would be good for the venture capitalist and his interest in the company.
The investment bank was excited to get involved. They realized the most attractive way to raise money was for the company to become pub- lic. They consulted with advisers, including my law fi rm. The venture capitalist was clearly nervous about taking the reverse merger route. In- deed, while most of Wall Street has learned the value of this technique, the private equity and venture capital communities still remain somewhat skeptical and steeped in attitudes of the past (this was in 2003).
Thus, I found myself in the large conference room of a major law fi rm explaining the basics of reverse mergers to one of the fi rm’s partners and the venture capitalist. My client was there as well, and of course helped fi ll in some of the details of the fi nancing.
Recognizing that forming a new shell for the deal would take a few months and require substantial disclosure if a specifi c transaction was planned, the fi rst step was for the investment bank to acquire an already existing public shell. They saw the benefi ts of acquiring the shell fi rst rather than negotiat- ing the reverse merger directly with the then-owners of the shell.
At that time, in early 2004, shells were readily available. The particular public shell they looked at, which was trading on the OTC Bulletin Board, cost about $450,000 (cheap by today’s standards), plus a percentage of the deal going forward. Our client proceeded to purchase nearly a 90 percent interest in the shell, then immediately commenced negotiations with the venture capitalist and the company to complete both the reverse merger and the fi nancing.
At this point, it is important to note a little known aspect of reverse merger fi nancings. That is, if an investment bank or source of money also provides the public shell for the deal, it obtains an additional interest in the merged company simply for having provided the shell. In this case, at the end of the deal, our client’s $450,000 investment in the shell turned into almost $1.5 million in value upon the closing of the reverse merger and fi nancing only a few short months later.
It is considered both customary and appropriate in the reverse merger business to pay a fee to a shell’s broker and, therefore, most private compa- nies allow the investment bank or provider of the shell this extra interest.
Some companies believe, however, it is a form of double-dipping when an investment bank earns fees on raising money as well as receiving an inter- est in the company for having provided the shell. I believe it is more than
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appropriate to receive these two forms of compensation because they are provided for separate sets of services, one for raising money and the other for providing a shell.
When a company balks at the additional compensation, however, there is still an advantage to the bank. Since it purchased the shell for cash as an investment, there is a tax benefi t even to taking some of the fees for raising money by retaining its equity interest in the shell. In other words, if the bank were to receive warrants to purchase a 3 percent interest in the com- pany as part of its compensation for raising money, it might be satisfi ed retaining an extra 3 percent through ownership in the shell. Thus, when it sells the interest later, it is taxed at more favorable capital gains rates rather than as ordinary income, which typically involves higher rates.
In general, though, banks supplying shells retain less of the overall post-merger entity if they also receive fees for raising money. Where a con- cern exists as to whether a bank has a confl ict of interest raising money and also retaining an interest in the post-merger entity, it is not uncommon to obtain a fairness opinion from a valuation fi rm or investment bank. This third-party, theoretically objective opinion about the fairness of the trans- action from a fi nancial point of view helps assure the bank, the boards, and the shareholders that all parties were treated appropriately.
The two main purposes of obtaining such an opinion are (1) to confi rm that the transaction is fair, and (2) to provide something of an insurance pol- icy to the board of the shell. If the board has a fairness opinion in hand, it is much harder for shareholders to bring an action to challenge the valuation.
One must be very cautious when engaging a provider of a fairness opinion. In one case, a client owned a shell that was to merge. He sought a fairness opinion from a Midwest investment bank. The bank was hired, asked no questions, did no due diligence, got a check, and about two weeks later issued its opinion. Since the shell was traded on Nasdaq, a proxy was required to approve the deal. Only when the SEC insisted on much greater disclosure about the fairness opinion and how the invest- ment bank did its analysis did the client feel forced to fi re the original provider and engage another valuation expert who took six weeks, exam- ined everything including comparable deals, and issued a well-researched, thorough, and insightful opinion.
When done right, the fairness opinion can provide some useful guid- ance. In fact, on at least one occasion a valuation expert was able to con- vince a client to change aspects of a deal to bring it more solidly into the realm of fairness.
Now, to get back to the biotechnology example: My investment bank client could not have completed its negotiations with the biotech compa- ny before acquiring the shell, as the $450,000 value of the shell at purchase
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would then come into question, given the value it achieved upon closing.
In other words, the difference between the $450,000 purchase cost and the $1.5 million value on closing would be more suspect if the deal were prearranged prior to our client’s acquisition of the shell. By purchasing the shell without any certainty as to whether the deal would proceed, our cli- ent had a strong argument that the $450,000 value was appropriate at the time of purchase. It felt the acquisition of the shell was worthwhile in any event, because if the biotech deal had not happened, it could have used the shell for another deal.
The next step was for the investment bank to work with the private company and the shell (i.e., itself as the owner of the shell) to craft both merger agreements and offering materials for the fi nancing, while simul- taneously working on due diligence reviews. Luckily, the client had com- pleted a thorough due diligence review of the shell before its purchase, so it could focus on the private biotech company, the value of its patents, status of clinical trials, its fi nancial results, and so on.
The most important step was yet to come, namely, valuing the com- pany for purposes of the PIPE investment.
Many investors and investment banks have little experience with in- vestments to be made at the same time a company becomes public through a reverse merger. They are accustomed to evaluating investments in private companies and investments in public companies, not investments that are hybrids of the two.
Several factors must be taken into consideration. First, different meth- ods are used to value private and public companies. A private company often is valued for private equity purposes based upon not only its histori- cal performance, but also its anticipated growth. Investors in a publicly trading company, however, typically value their investment based on the trading price of the stock, which may or may not incorporate growth po- tential in it. This usually results in a higher valuation being placed on a public company than on a similarly situated private one.
When a company goes from private to public with an IPO, the expec- tation is that the stock will sell at or above the IPO price as soon as the stock starts trading. But a company that starts trading shares after a reverse merger is in a somewhat different situation because its shares are not im- mediately tradable. This means the valuation has to take into account the anticipated delay between initial investment and liquidity.
Clients can approach these dilemmas in different ways. This particular client took a middle-way approach, essentially splitting the difference be- tween a private and public company valuation, still coming in well below what the company’s value was hoped to be once it began trading in a few months. The “public venture capital” concept was thereby further refi ned
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by our client. But the venture capitalist was still happy, as this valuation far exceeded his last round of fi nancing and, in fact, exceeded what he had hoped to obtain if another private equity round did take place.
Having completed the valuation analysis, at this point our client learned that a reverse merger fi nancing, even structured as a PIPE, was different from a typical PIPE. Most PIPEs are completed with companies that have been public for a while. Their public SEC fi lings are scrutinized as the primary form of due diligence. Documentation with the investors consists of a purchase agreement and a few collateral agreements which are basically in industry customary form, with not much to negotiate in most deals. The tough decision is typically for the investor to simply decide whether or not to go forward with a deal; most everything else becomes rather routine with the attorneys and deal professionals at the bank.
As a brief aside, I do not wish in any way to downplay the hard work of lawyers involved in PIPE fi nancings (especially my partners Joe Smith and Rob Charron, who together completed more PIPE deals representing inves- tors than any other law fi rm in each of the last three years). There is much negotiation that often takes place in completing PIPE deals with seemingly endless conference calls. In addition, the regulatory climate is complex and deal structures continue to evolve, requiring that attorneys adapt and adjust.
As the PIPE market has become more competitive, companies rais- ing money have exacted more concessions from investors, changing the dynamics somewhat and making the process less and less routine. But it is true that many deals are relatively straightforward (as are most venture capital and private equity transactions) if for no other reason than the golden rule of fi nance: “He who has the gold makes the rules.” Investors declare the documents are in the form they require, and accept very few changes. This makes the lawyers’ work a bit less onerous once solid deal forms are developed and become industry standard.
Back to our example and the unique features of PIPEs completed con- temporaneously with reverse mergers. The fi rst question that was unique to the reverse merger context (and that had to be answered) was: Do the PIPE investors put their money into the private company just before the reverse merger, or directly into the former shell at the same moment as the merger? Logically one would think investing directly in the shell makes sense, since ultimately shares of the shell would be issued to all those who previously owned shares in the private biotech company.
In this case (and many others we have dealt with, but by no means all), the investment bank chose to have investors put their money into the biotech company one moment before completion of the merger. The reason was purely psychological. The bank felt that it would be too con- fusing to explain to investors that they are investing in a “shell,” even if
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the investment happens at the same time. In other words, it did not want the front of the offering document booklet to say “Shell Co.” Instead the bankers wanted it to say, “Biotech Co.” In recent transactions, this has been changing, and more deals are being structured as purchases of secu- rities of the shell itself upon closing the merger.
In this case, the decision to invest in the private company created some problems, none of which was insurmountable. First, it meant that, techni- cally, the PIPE investors had to be part of the process by which all share- holders of the biotech company had to vote to approve the reverse merger.
This was easy enough to deal with by incorporating into the subscription materials a consent to the transaction. We might have been able to seek shareholder approval of the merger prior to completion of the PIPE invest- ment, which would not then require their approval. But we did not see the need to risk investor ire for not having had the chance to participate in the decision-making process.
Second, administratively, investing directly in the biotech company added a step of actually issuing PIPE investors’ shares of the biotech com- pany, then immediately exchanging them upon the merger for shares of the shell. This also was not a big deal, just a bit of a hassle.
The next challenge related to the lack of information. As noted above, in a typical PIPE, straightforward stock purchase agreements are used instead of a full disclosure document, often called a “private placement memorandum (PPM).” It is more common to use a full PPM for an in- vestment bank–led raise for a private company. Sometimes a PPM is used in a private offering for a public company, but this document is usually a bare-bones “wraparound document” that includes a description of the offering, unique risk factors relating to the offering, all wrapped around copies of the company’s public fi lings.
In this case, and in most cases we have encountered, the investment bank decided to complete a full PPM for the PIPE investors putting money into the biotech company upon its merger with the shell. This way inves- tors would receive full information concerning the company to be merged, and the bank would be shielded from a liability standpoint from sugges- tions that investors were not fully informed of the risks of the investment.
This intelligent decision from a liability point of view caused a fairly signifi cant delay in the deal since the lawyers and accountants took a sur- prisingly long time to agree on the disclosure language. The old adage
“too many cooks spoil the broth” took on real meaning as it simply took time to get all the various players to respond to each successive draft of the PPM. At the same time, the parties were working on due diligence and completing a merger agreement and SEC fi ling under Section 14(f ) of the Exchange Act, which related to the anticipated change of directors.
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PRACTICE TIP
A PPM is a good idea when completing a PIPE contemporane- ously with a reverse merger.
There is also an advantage to the existence of the PPM under the new SEC rule requiring a Form 8-K fi ling with substantial disclosure about the private company immediately following the merger. That is, the PPM can be used as the basis for this fi ling, which is essentially a PPM on steroids.
Many components of a PPM are taken right from a typical full offering prospectus, which the 8-K will effectively mirror. Thus, some of the antici- pated delays in deals relating to the new rule will be signifi cantly reduced to the extent a PPM is already being prepared.
The last challenge in our biotech example involved when to disclose the existence of the placement agent raising the money. Under SEC rules, engaging a placement agent to help raise money is generally considered a material contract, requiring a fi ling with the SEC and disclosure of the contract with the agent. But in this case, it was the private company engaging the agent. Also in this case, the public shell had disclosed that it was entering into the transaction with the private company. Therefore, a determination was made that it was prudent for the shell to disclose that the private company with which it might merge had engaged a placement agent.
The problem then is avoiding a determination that the public dis- closure of the offering and the agent might cause a loss of its “private offering” exemption, which depends on avoiding what is known as general solicitation. Under Regulation D, to be discussed in more de- tail later, to ensure that an offering remains private, the company must avoid advertising and other activities deemed general solicitation. Dis- closing the agreement with the placement agent might be deemed to be such a type of solicitation; however, an SEC rule known as Rule 135 provides guidance as to how to disclose the existence of a placement agent and a pending private placement without triggering a general so- licitation concern, and we followed that rule in making the disclosure.
The key, believe it or not, is to disclose everything without actually disclosing the name of the placement agent itself.
PRACTICE TIP
When in doubt, disclose the engagement of a placement agent—
but watch out for accidental general solicitation when undertak- ing a private offering.