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MONEY

Back-Door IPOs

How to go public by merging with a shell company.
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When was the last time you bought a book that was printed and distributed by its author instead of an established publishing house? Probably never. Such vanity publications may satisfy a writer's yen for publication, but they don't necessarily earn him any readers or royalties.

It's been pretty much the same story for companies that go public by merging with a shell -- or nonoperating -- public company. These are private companies that are usually too small, too unprofitable, or just too unappealing to sell their shares in an initial public offering. By marrying a shell, in what's called a reverse merger, such enterprises can truthfully call themselves public companies. But they don't necessarily reap all the goodies that traditionally go along with being public -- lots of investors, liquidity, and, most important, lots of cash.

Worse still, reverse mergers can be dangerous. Unscrupulous shell owners have found it easy to manipulate the stock prices both before and after a merger in regional penny-stock markets such as Denver, Salt Lake City, Phoenix, and Miami. The Securities and Exchange Commission's task force on penny-stock fraud is concerned enough about such cases that it may propose a new disclosure rule this fall, according to Joseph Goldstein, associate director of the SEC's enforcement division and head of the task force.

With so much going against it, who would want to go for the reverse merger? People like Cor Bregman and Bill Christensen, a 40-year-old former insurance executive and a 30-year-old onetime McDonald's store manager who teamed up to found Oasis Laundries Inc., in San Jose, Calif. They need the cash that they hope their recent reverse merger will bring in. And they feel that being able to say that Oasis is a public company is just too important to put off.

That's because for Oasis, image matters almost as much as substance. After combing national and trade magazines for new business ideas, Christensen hit upon his concept for an upscale chain of coin-operated laundries in early 1986. They'd be clean and spacious; they'd be equipped with large-screen televisions; they'd provide drop-off service, snacks such as burritos and bagels, and some would even have tanning booths. Oasis's slogan: "The World's Most Entertaining Way to Wash."

Now it doesn't much matter to the people who wash their clothes at Oasis's laundries that the company is public. But it matters a lot to potential franchisees. They don't want to invest the $300,000 or so that it costs for an Oasis turnkey operation unless they think Oasis itself is a solid, ongoing enterprise. With its ambitious site-construction program, Oasis also needs to impress others in northern California. "It gives you a lot more clout with developers to say that you're a public company," Christensen asserts. "It really improves your stature in the community."

The reverse merger also looked as if it would raise more money with less loss of control than other financing techniques. Not that Oasis, which lost $569,216 on revenues of $1.2 million last year, had access to every alternative. "The launderette is not the most exciting thing for a lot of venture capitalists here in Silicon Valley," Bregman observes dryly.

Finding the right shell is probably the trickiest part of a reverse merger. Like any prospective new home, it has to be clean. A shell that once operated a business may have lawsuits or other liabilities hanging over it. Just as important, the shell's current ownership must be clear-cut. Undisclosed shareholders or control positions -- held under different names, for example -- could be angling for a way to unload shares after the merger in a way that could hurt the company's share price, or worse, its reputation.

Oasis turned to a business consulting firm, which presented it with three candidates before chief financial officer David Lieberman found one he liked: Washington Consolidated Acquisitions Inc. WCA was incorporated in Nevada in 1987 for the express purpose of finding a mate. The shares of such shells are typically sold to the public for a very low price. Because the shell's shareholders have no idea what they're investing in -- it all depends on what the shell later acquires -- such shells are called blind pools.

Often the shell's shares are sold, as WCA's were, with warrants attached. The right to buy more stock later on, after the shell finds a tenant, gives the shell investors a chance to make more money. More important, though, warrants that are exercised bring cash into the postmerger company.

WCA's warrants, and its $30,000 in cash, were key features for Oasis. Here's how the merger worked. Technically speaking, WCA acquired Oasis and then changed its name to Oasis Laundries Inc. Before the merger, WCA shareholders owned 100% of WCA and warrants giving them the right to buy 1.2 million more shares in the future. Now, WCA shareholders own just 4% of Oasis Laundries and hold warrants for 1.9 million shares. Oasis management and its directors own about 65%, and other Oasis shareholders own the remaining 31% of the company.

Creating that distribution of ownership required quite a bit of financial restructuring before the merger could take place. Oasis split its stock in order to increase the number of shares outstanding. And WCA had to reverse-split its stock to shrink its share count. Oasis required WCA to further reduce its outstanding shares by asking one large shareholder to cancel the majority of his stock. In exchange, Oasis gave him warrants for 700,000 shares. If all the warrants are exercised, which may not happen until July 1991, Oasis will net $4.25 million. The total cost of raising that money and going public: some $85,000 in accounting and legal costs, 4% in equity -- and another 8% of equity that will go to the consulting firm if the warrants are exercised.

That could be a great deal -- if the money comes in. Right now, the outlook for the exercise of Oasis's warrants is uncertain. Shareholders won't exercise them, obviously, unless its stock price goes up. Thus far Oasis's outside consultant has been slow to promote the stock through presentations to brokers around the country -- a key element in building up a stock price. CFO Lieberman may be forced to shoulder more of such activity himself. Moreover, it's tough to gain a loyal following when your stock is so thinly traded. Because of the way that the company went public, nearly 98% of Oasis's 8.4 million outstanding shares are "restricted securities." They can't be sold within the next two years unless they are registered with the SEC.

But Oasis is doing the most important thing it can to push its stock price up -- it's growing. First-quarter revenues increased 543%, to $677,893, though it continued to lose money. The company is also attracting more franchisees. By mid-1988 Oasis had sold only 3 franchises. A year later it had commitments for 26 stores. Finally, Oasis is broadening the appeal of its shares by applying for a listing with the National Association of Securities Dealers.

As far as Bregman is concerned, the reverse merger isn't a backdoor route to being public. It's just a way to bypass all the financial intermediaries who usually get to pass judgment on new companies. "The reverse merger lets the public play the role of the venture capitalist," he says. Now, he and Christensen have to make sure that Oasis does well enough to allow the public to play the role of the successful investor, too.

* * *

PLAYING THE SHELL GAME

Tips on avoiding pink-sheet pitfalls

Merging with a shell company may make you a public company in name, but not necessarily in spirit. You'll have to work much harder both to enjoy the benefits of public life and to sidestep the pitfalls of the loosely regulated penny-stock market. Here are some tips on how to proceed:

* Don't depend on the kindness of strangers. The most important part of your investigation of a shell is making sure that the company's major shareholders are reputable, their intentions honorable, and their stock holdings fully disclosed. Otherwise, you might find yourself in the unhappy position of being vulnerable to stock-price manipulation after the merger. "The people who run the private company can't control what the other people do with the stock, so you really have to know who you're dealing with," explains Joseph Goldstein, an associate director at the Securities and Exchange Commission.

* Find a shell collector. The advisers and consultants who will find a shell company for you may not provide other necessary services. Look for someone whose deals are seasoned enough to provide a good yardstick: did the adviser help the postmerger company promote its stock? Did advice on structuring the deal ultimately result in the warrants being exercised? Did the adviser get paid when the deal was done, or later, when its money-raising features proved successful?

* Leave footprints on the pink sheets. Have a plan for broadening the appeal and tradability of your stock beyond the thinly traded pink-sheet stocks. Meet the qualifications and then apply for a listing with the National Association of Securities Dealers. Grow your company and turn a profit. Consider a reverse-stock split to shrink share count, which in turn may have greater appeal to institutional investors.

Last updated: Sep 1, 1989




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