Capital: Shell Game
Decorize Inc., a home-furnishings importer, went public with a listing on the over-the-counter bulletin board on July 5, 2001 -- just 16 months after CEO Jon Baker cofounded the company in his horse barn in Springfield, Mo. The whole process cost $100,000. In December, Baker, 49, applied for the company to make the leap to the American Stock Exchange, which -- with its more rigorous listing requirements -- would increase the likelihood that investment firms like Merrill Lynch and Morgan Stanley would recommend the company's stock to their institutional and individual clients. Three months later, on March 5, Baker walked into his office and found the Amex approval letter waiting for him. "Getting on the Amex, that changes the world for us," says Baker.
The route that Baker took to the public markets was not new, but it was controversial: he went public by a reverse merger -- that is, he backed into a nonoperating public company, or a "shell." The shell he chose, called Guidelocator.com Inc., had been created for the express purpose of being acquired by a small, fast-growing private company that wanted to go public sans the hassles and costs of an initial public offering.
Entities like Guidelocator are called "blank-check companies" or "blind pools." But a shell may also be a public company that has ceased operations. Because of the dot-com bust, says Lawrence Kaplan, CEO of investment-banking firm G-V Capital Corp., in Melville, N.Y., scores of companies down to their last $4 million are languishing on the exchanges. There are also many that raised $10 million or $20 million but realize they'd be better off private, so they want to sell their public presence.
Mention reverse mergers to investment professionals, and you'll get one of two reactions: they're either enthusiastically for or rabidly against them. Detractors like Todd McMahon, a managing director at RCW Mirus Inc., an investment-banking firm in Boston, say the process is like "trying to lose weight without diet and exercise." Reverse mergers, claim the naysayers, give you none of the advantages of an IPO -- such as the road-show exposure, the credibility that comes from being associated with a leading underwriter, and true liquidity -- but entail all the risks. The most typical problem is negligible share prices. Indeed, RCW Mirus's research, which tracked 46 companies that had gone public by means of reverse mergers, found that from 1999 to 2001 the stock of those companies declined by 67%. During the same time period, the S&P SmallCap index increased by some 15%. "An IPO is a vetting process -- institutional investors, asset managers, and larger retail banks assess a company's viability as a publicly traded company," says McMahon. "If a company isn't suited to going public by the normal route, there's no reason to think that capital will be attracted to that same company if it goes public through the back door."
There have been horror stories. "In the 1980s there were lots of bad guys engaged in blind pools and shells," says David Feldman, a partner at the New York City law firm of Feldman Weinstein. "For a while the Wall Street cockroaches resided there."
Some unsuspecting companies have merged with shells that have financial liabilities, pending shareholder or patent litigation, or angry former employees. "If you combine a viable company with the skeletons of the past, the skeletons reappear," says Timothy J. Keating, president of the Denver-based broker-dealer firm Keating Investments, which specializes in reverse mergers.
Other small private companies simply aren't ready to be public. "The vast majority [of reverse mergers] are crash and burns," says McMahon, citing as an example a southern California search-engine developer called Diamond Hitts Production Inc. that went public by means of a reverse merger in 1999 and by February 2001 was trading at 4¢ a share.
But there's another side to the story -- one highlighted by reverse-merger successes like Turner Broadcasting and Occidental Petroleum. Advocates like Feldman see reverse mergers, done properly, as a "terrific vehicle for companies that can benefit from being public in an environment where there are no IPOs." Like, say, now. Just 10 companies went public from January 1 to March 1, 2002; in all of 2001, there were 96 IPOs, compared with a high of 871 in 1996.
Companies can benefit from the chance to attract institutional and individual investors through brokerage houses that recommend their stock; capital-raising options such as secondary public offerings; stock with which to make acquisitions and attract top management talent; and liquidity. Reverse mergers are quick, taking no more than three months to complete, compared with as much as a year for a typical IPO. They're cheap, costing about $150,000 in legal and accounting fees as opposed to $1 million or $2 million in expenses for an IPO.
The truth about the strategy, of course, lies between the two extremes. Even advocates agree that reverse mergers are only a stepping stone. "You haven't pulled a rabbit out of a hat," says Keating. "Once you become public, you still have to go through the process of building investor relations and a shareholder base."
From 1990 through 2001 there were, on average, 14 reverse mergers a year in the United States, according to Thomson Financial. That indicates that reverse mergers are for only the brave few. And a substantial percentage won't make it in the public marketplace, because many companies that go public by reverse mergers don't meet certain standards of success: for example, having a unique business model, an experienced management team, and revenues of at least $3 million at the time the company goes public. (See "Shell I or Shan't I?" below.)
According to Jon Baker, Decorize had already met most of those criteria when two deal makers separately pitched the idea of taking the company public by a reverse merger. Baker -- who with a partner had launched Decorize with $2 million from friends -- chose the one who had already taken seven early-stage companies public by the reverse route and who made a point of supporting the companies once they became public. In addition, the man, who requested anonymity, personally invested $980,000 in Decorize (for a 10% equity stake).
For its part, Decorize has been doing everything possible to make its public status work. The company became profitable in early 2002. Its stock served as part of the purchase price of two home-accessories companies that it acquired last year. In part because of the acquisitions, the business's revenues have soared from $284,000 in 2000 to an anticipated $15 million for fiscal year 2002. Still, the company's share price has hovered between $3 and $4 -- a number that Baker is determined to boost.
Now Baker is on a quest to use Decorize's public status to raise capital to accelerate growth. Since July he's talked with some 35 investment groups across the country, heightening the investment community's awareness of Decorize. To date the company has raised $1.3 million through a private placement. It's considering a secondary offering and other equity-financing options. "Our job is to make Decorize an attractive-enough investment so if one of the original investors wants to get out in a year, there's a market there that wants to buy that stock at a reasonable price," says Baker.
The bottom line: it's not how a company goes public but how it performs before and after it does so that ultimately determines whether it will succeed in the marketplace. Baker, who ran three private companies before launching Decorize, knows that only too well. "You've got to have a unique company," he says. "You've got to have a track record of growth, and in this economy the bottom line comes into play. If our company performs, then in the end the route we've taken will have been good."
Thea Singer is an associate editor at Inc.
Shell I or Shan't I?
Reverse mergers may work for you if your company has --
- A unique business model, product, or service
- Revenues of at least $3 million
- A track record of dynamic revenue growth (say, 50% a year) and positive cash flow -- or the possibility of positive cash flow within six months
- Plans to increase revenues to at least $50 million
- An experienced management team
- Buzz in the industry
- A strong chief financial officer and audited financial statements
- The money to be public (fulfilling regulatory requirements can cost some $200,000 a year)
- Access to an experienced, ethical reverse-merger deal maker. That deal maker should rigorously perform due diligence on shells to guarantee that they're clean and should stick with the company after the merger is complete to provide support in the public marketplace.
The Whole New Business Catalog
IncQuery: Where Are the Customers?
Redesign: I Read It in the Funny Papers
Hands On: Roadside Assistance
Cost Cutting: The Money Pit
Hands On: Limited Power
Best of the Net: In the Lap of Luxury
Capital: Shell Game
Please E-mail your comments to firstname.lastname@example.org.