The Rule 415 Conundrum- We Await the SEC...

In recent interpretations, staff members of the Securities and Exchange Commission’s Division of Corporation Finance for the first time have been advising small public issuers (the almost 10,000 companies with less than $75 million in public trading stock) that they must limit the percentage of their company that may be registered to increase their float.

These “resale registrations,” typically permitting stock of former private equity investors to become tradable, according to the staff are really indirect public offerings by the company if the percentage is too high. Therefore, they say, the registration must be transformed into a “direct” public offering, which in almost all circumstances for these small companies is unachievable. While I respectfully disagree with the legal interpretation, that analysis can be saved for the legal journals.

I do need, however, to discuss what this will bring about. This interpretation (of Rule 415 under the Securities Act of 1933) likely will have the impact of effectively shutting down all financing opportunities for these small companies, any one of which could be the next Microsoft, Yahoo or Amgen. If private equity or so-called PIPE (private investment in public equity) investors are unable to achieve liquidity soon after their investment, most will simply not invest, or at best will substantially increase their price to do so to account for the additional risk.

There are those within the SEC who contend that these smaller companies should not be public. I could not disagree more strongly. One example: Advanced Cell Therapeutics, which managed to raise funds in a PIPE to support its research on extracting stem cells from fetuses without damaging the fetus. There is no other potential source of financing for a company like this other than a PIPE investor.

In biotechnology in particular, the question should not be whether the company is big enough to be public, but rather whether it can benefit from being publicly held. Easier access to large pools of capital is a major benefit to being public. If a small public company can raise money through PIPEs, the next cancer cure or Alzheimer’s treatment could be the result.

Reverse mergers also will be significantly impacted. After a merger, most shares in the company are “restricted” and cannot be sold unless the holder waits at least a year or registration is possible. And investors in what was the shell must have their shares registered – they cannot even sell after holding a year or two or even more. By limiting the amount to be registered to a very small amount (recently we have heard the desire of the staff to limit registration to 30% of shares held by nonaffiliates, a very small amount following most reverse mergers), the ability of these companies to benefit from going public through this popular and legitimate technique would decrease dramatically.

I implore the SEC’s Commissioners and Division of Corporation Finance, as well as the Congressional committees providing oversight, to show their support of entrepreneurs and small businesses when they seek to access public markets, and provide clear and unequivocal guidance as to how to provide liquidity for investors in these companies in a manner that is realistic, meaningful and balancing all interests, rather than overreacting to those few who abuse the system.

Allowing continued growth in the $25 billion a year PIPE market, the only source of capital for very small companies to support their efforts to achieve their goals, can provide the opportunity for inventors, entrepreneurs and visionaries to achieve their version of the American dream. We hope the SEC will recognize the value of these companies and not cause thousands of companies to stop in their tracks and fail simply because their regulations made capital unavailable.

Looking for Mr. Good Guy

Some people only view reverse mergers with an eye on the negatives – the "bad guys" and unsavory who exist in all corners of Wall Street but are associated frequently with reverse mergers. As I discuss in my new book Reverse Mergers, there are 11 signs to look for when trying to make sure a shell player or investment banker is legitimate:

• No Compensation – Principals, officers and directors of the shell should not be compensated for performing their functions.
  
  
• No Unnecessary Expenses – A shell should not need to pay rent or hire a public relations firm.
  
  
• Limited Fundraising (if any) at Reasonable Valuations – Any monies raised should be at a fair valuation and should be used solely to keep paying lawyers and auditors for SEC filings and related expenses (which should not exceed $25k-$30k per year).
  
  
• The Right Type of Shell – The shell should either have been a true, legitimate former operating business that was not intended to be stripped out of the shell or cease business, or was formed as a shell under Rule 419 or as a Form 10-SB shell.
  
  
• No “Bad Boy” History – Deal players should have nothing in their background, even if long ago, indicating criminal behavior, regulatory problems or a propensity to being involved in lawsuits.
  
  
• Proper Insider Reporting & Trading – The control shareholders and officers have not traded heavily in the stock, have fully reported their ownership and trading activity, and there is no indication of trading leading up to the announcement of a deal.
  
  
• No Inordinate Time Pressure – Everyone wants deals done quickly, but a legitimate player understands the need for a private company to do its due diligence and negotiate the merger properly.
  
  
• Backing Up Reps & Warranties – Good guys will at least discuss the possibility of personal guaranties or holdbacks to back up representations and warranties
  
  
• Good Advisors – Ideally the deal involves well-respected and well-known attorneys, auditors and investment bankers
  
  
• Due Diligence – An investment banker will insist on proper due diligence before completing the transaction
  
  
• Broker-Dealer Registration – Ideally, if the bank involved is raising money, then they should be an NASD-registered broker-dealer.
  

About the Book: Reverse Mergers

My book Reverse Mergers: Taking a Company Public Without an IPO was published in September. Here is the description from the publisher:

Berkshire Hathaway, Turner Broadcasting System, Texas Instruments, Tandy Corporation, Occidental Petroleum, Muriel Siebert & Co., Blockbuster Entertainment, and the New York Stock Exchange all went public without doing initial public offerings. They did so by means of the reverse merger—a method by which a private company buys a majority stake in a public one and thereby becomes public itself.

Reverse mergers are far more versatile than IPOs. A great number of companies in a wide variety of situations can use the technique successfully. Reverse mergers are particularly advantageous to smaller companies, many of which are cut out of the IPO market because they do not meet the restrictive criteria set by investment banks.

Written for private company CEOs, CFOs, and the investment bankers, lawyers, and accountants who advise them, this book is the first to explain how reverse mergers work, from both a business and a legal perspective. Topics covered include: the pros and cons of going public, deal structures and mechanics, financing, winning market support, best (and worst) practices, due diligence, the regulatory regime, working with companies outside the United States (especially in China), specified purpose acquisition companies (SPACs), and Form 10-SB shells. Anyone interested in the capital markets will want to understand this valuable technique.

Praise for the book:

"With this book--the first of its kind--David Feldman has created an invaluable guide to the varied and increasingly complex world of going public. It is essential for any investment banker, lawyer, accountant, or private company that is seeking a rational alternative to an IPO."
--Timothy J. Keating
President, Keating Investments, LLC

"Reverse mergers have been growing rapidly, especially after the SEC’s recent ruling to improve disclosure and legitimacy in these transactions. And I can think of no one better to write the first book on this subject than David Feldman, the clear leader in the field."
--Lady Judge, formerly Barbara S. Thomas
Deputy Chairman, UK Financial Reporting Council and former SEC Commissioner

"David Feldman, a true pioneer and leader in the legal community, translates reverse mergers into plain English that is easy to read and understand."
--Nimish P. Patel, Esq.,
Managing Partner, Richardson & Patel, LLP

You can buy the book at these locations:

• Amazon.com
• BN.com
• Bloomberg Press

Frequently Asked Questions

What is a reverse merger?
A reverse merger is an alternative to a traditional initial public offering (IPO) for a company desiring to have its stock become publicly traded. In a reverse merger, the owners of a private company acquire control of a dormant public one, called a “shell,” and complete a business combination with it. When the merger is complete, the private company becomes public and its stock can be publicly traded in its own right.

What is a “public shell”?
A “public shell” or “shell company” is a public company that has no or nominal assets (other than cash) and minimal, if any, day-to-day business operations. It may be the remnant of a bankrupt or sold organization or specially formed for the purpose of combining with a private company.

Why should I use a reverse merger rather than an IPO (Initial Public Offering)?
Reverse mergers have a number of benefits over IPO’s. For example, they tend to have lower costs, less required management attention, much shorter process times, and less dilution, which allows a private company’s management, founders, and prior investors to retain a greater percentage ownership of their company after going public. In addition, reverse mergers are not market-sensitive. Therefore, they are not dependent on the unpredictable IPO window “openings” or on underwriters and initial market prices on the particular day of trading.

What kind of companies are the reverse merger appropriate for?
Any company at any stage of development that can benefit from being publicly held and bear the costs of doing so should consider all methods of going public, including a reverse merger. In 2006, the average market capitalization of companies completing reverse mergers was a little over $50 million. Industries vary and tend to match whatever sectors are popular on Wall Street at the time.

What are the general steps to complete a reverse merger?
(1) Find a shell company. There are hundreds of dormant public companies available. You can also ask corporate law firms, accountants, or financial consultants.
(2) Develop a financial strategy for raising additional capital contemporaneous with or after the deal.
(3) Hire a law firm and accounting firm. There are a myriad of SEC rules, forms to fill out, legal documents, confusing numbers, and steps you will need help with.
(4) Complete the transaction and trade shares. Shares of the private company are traded for shares of the public company and typically the private company continues its existence as a wholly owned subsidiary of the former shell.

What are the financial requirements before getting into a reverse merger?
At least two years of audited financial information (three years for larger companies) must be filed a few days after a merger with a shell that is fully SEC reporting. Thus, hopefully the company has been run in that two-year period with the expectation of going public, minimizing related party transactions, resolving litigation, etc. In addition, you also should make sure you have a strong marketing and financial strategy for raising capital after the reverse merger is completed.

Which shell should I choose?
A “clean” shell, or a company with well-kept, organized records and no history of unsavory activity. Shells are valued on this, as well as whether or not its stock is trading, whether or not it is fully SEC reporting, and the size of its shareholder base.

What problems should I be wary of in a reverse merger?
First, make sure that going public is right for your company, and that your financial plan is well designed in raising capital and market support after the deal is done. Be wary of “messy” or “dirty” shells that may have shady activity and disorganized record keeping. Make sure you conduct thorough due diligence in reviewing all financial documents, old contracts, SEC filings, and stock issuances.

What is Sarbanes-Oxley?
This is an Act of Congress passed in 2002 as a response to the alleged malfeasance at Enron, WorldCom, and the many other companies caught up in accounting and related scandals. The Sarbanes-Oxley Act (or SOX) requires CEO’s to personally certify to the best of their knowledge that the financial statements in their company’s public filings are materially correct. SOX also established a very short reporting time for insiders. In addition, companies are now required to establish and maintain internal financial controls not therefore required.

What is Rule 144?
Rule 144 allows public resale of restricted and control securities purchased privately on a number of conditions, including the following:
-The securities are held for 1 year before resale.
-There is adequate current information about the issuer of the securities for the public.
-The number of shares sold during any three-month period in the second year after acquisition does not exceed the greater of 1% of the outstanding shares of the same class being sold, or if the class is listed on a stock exchange or quoted on NASDAQ, the greater of 1% or the average reported weekly trading volume during the four weeks preceding the filing a notice of the sale on Form 144
-A notice with the SEC on Form 144 is filed.

What is SEC Form 10?
This form is for registration of a class of securities with the SEC. It requires certain business and financial information about the issuer. Some shell companies, often called "virgin shells," go public through filing of Form 10. Form 10 is also used by public companies seeking to become subject to the SEC reporting requiremetns with out a traditional IPO or a merger with a shell company.

What is Rule 419?
This SEC rule was created in 1992 in order to prevent fraud and severely restrict "blank check" companies (those with no business plan or whose business plan is to aquire another business) seeking to conduct an IPO raising less than $5 million dollars. These restrictions include the following:
-All capital raised in separate escrow accounts
-An 18 month time limit to find a deal and close it
-All of stock of shell in escrow not tradable beforehand
-Formal shareholder and investor approval beforehand

How long does a reverse merger take?
Depending on the financing involved, a reverse merger can take place in a matter of weeks or up to three or four months. IPO’s typically take six to twelve months.

How much does the reverse merger usually cost?
Most reverse mergers can be completed for under $1 million (this includes the cost of acquiring a public shell). Costs depend on the cost of the shell and whether or not the private company has already completed proper audits of its financial statements. I have seen transactions costing less than $200,000, and this is not unusual.

Are there other options to going public?
Yes, these options include IPO’s, self-filings (process of going public by voluntarily following the same rules and filing the same documents that public companies follow), SPAC’s (set up with a clean public shell where the management team looks for a target to acquire), and merging with Form 10 or “virgin shells” (a blank check company is created and voluntarily reports to teh SEC, the shell that is created is a clean non-trading shell).