As explained earlier, a very common mistake is for a company to pursue a reverse merger when its only goal is obtaining one round of fi nancing immediately—or the hope of a round to come later—without the con- comitant analysis of whether the company can otherwise benefi t from being public (see Chapter 1). This shortsightedness can have unfortunate consequences. Here are two quick examples (some names and details are changed for obvious reasons):
A private company had a very exciting patent relating to certain enter- tainment technology. It had completed a small private placement to pay for additional research and development. A larger round was needed, and a group of investors agreed to provide $10 million as long as the company went public through a reverse merger.
The merger was completed, and the intention was to use the $10 mil- lion to help the company reach the point at which it could sell the product under development. As it turned out, more research was needed, the com- pany was unable to raise additional fi nancing, and consequently it went out of business. Since then, the resulting public shell has been merged with a different company, and the shares I received as part of my compen- sation have been reverse split from the 50,000 I held at a value of $2 per share to about 450 shares I now hold of a company trading at about $0.05 per share. As my accountant would say, “a good write-off.”
In this case, the mistake was going public too early. The company was many months away from a commercial product. (This would have been unremarkable had the company been in the biotechnology industry, an industry that expects new companies to languish for years in prerevenue stages.) But, by its own industry standards, it took too long to get going.
Investors got spooked and were unwilling to provide additional fi nancing.
This company went public because it wanted the $10 million and going public was a condition set by the investors.
Source: TKTK
PRACTICE TIP
Going public solely to raise one round of fi nancing when a com- pany sees no other benefi ts to being public almost always turns out to be a fl awed strategy.
In addition, this company never made the effort to run itself like a public company. During my nine-month tenure as counsel (after which I resigned), the company went through three different chief fi nancial offi - cers. The CFOs never had second-level assistants, who are almost essential for a public company in the post-SOX environment. The well-intentioned chief executive offi cer was constantly traveling, trying to cut deals. Ob- taining due diligence when we got started was like pulling teeth.
The second example involves a company that completed a reverse merger several years ago with the expectation of obtaining fi nancing soon after the deal was done. The company, which was breaking even on about
$15 million in sales, had a plan to benefi t from being public by making acquisitions in its business, which relates indirectly to the sports industry.
But it needed fi nancing to pay for going public, as well as for searching for targets to acquire.
The investment bank it worked with provided the shell with which the company merged. The investment bank expected to raise funds after the merger, but for various reasons the fi nancing was never completed. The banker would probably say that certain things in the company changed or were different than expected. The company would probably say that noth- ing was so different as to impair the ability to raise money.
In any event, the company did obtain some additional funds through traditional PIPE investors, but only enough to stay in business, which, by the way, is growing. As with so many businesses, however, while pur- chase orders and receivables grow, cash fl ow remains very tight. The man- agement team is extremely dedicated and has worked hard to cut costs.
Unfortunately, the difference between making and losing money in this company is represented by the combination of the costs of being public and the increasing cost of servicing the company’s debt.
The company made several mistakes. First, because fi nancing was es- sential, it should have arranged for it concurrently with the reverse merger.
Second, when needed fi nancing was not available, management probably should have considered returning to private status (which would not have been diffi cult in this case) at least for a short time so they could regroup and earn some money. Here’s how they might have accomplished this.
Under current SEC rules, any reporting company with fewer than three hundred shareholders of record can voluntarily “deregister” itself as a public
Source: TKTK
company, stop fi ling periodic reports, and have no further obligation to do so through a simple fi ling known as Form 15. A holder of record is one that actually holds a physical stock certifi cate. Many shareholders hold their shares in “street name,” which means they own shares through an electronic entry at their broker, and therefore, all such street name shareholders count together as one shareholder. Thus, many public companies, some fairly large, have fewer than three hundred shareholders of record.
A company with more than three hundred shareholders of record must go through one of several complex fi lings in order to go private.
It can effect a massive reverse stock split, cashing out investors who end up with less than one full share to reduce its number of shareholders to below three hundred. It can sell off its business to a related party, leaving behind the public shell to be used again. Or it can simply ask the share- holders to vote to “go private.” In any of these cases, either state law or the SEC or both require shareholder approval, a full proxy, and often a related fi ling known as Schedule 13E-3, which describes in excruciating detail the plan for going private.
The ins and outs of going and staying private are of interest to growing numbers of companies. First, there are those who in the past several years have chosen to go private rather than comply with the onerous require- ments of Sarbanes-Oxley. Then there are those like the company described above. Under current rules, keeping the number of shareholders of record below three hundred provides important fl exibility and usually is not that diffi cult to do.
There is one additional challenge to going private, one that the client mentioned above faces. That is, PIPE investors generally require that, for as long as they own shares, the company will retain its status as a reporting company and use its best efforts to maintain its exchange listing. Thus, any going private event results in a default in most PIPEs.
Several years ago, a client helped raise money in a private placement for a public company. There was no specifi c covenant to stay public; however, the company had a contractual obligation to register our client’s inves- tors’ shares so they could become tradable, which never happened. The company fi led to go private the “simple way,” by fi ling Form 15, a declara- tion that a company has fewer than three hundred shareholders of record.
My client and his investors sued, and won a settlement that returned the money invested in a combination of cash and tradable stock of another company.
One last note on going private. In 2005, the SEC formed the Advisory Committee on Smaller Public Companies, which I testifi ed before in June 2005. In April 2006, the committee submitted its fi nal recommendations, which included amending SEC rule 12g5-1 to interpret the words held
Source: TKTK
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.