Sunday, January 16, 2011

Chinese RTO's explained

All investors in Chinese RTO's I would recommend to read the book:

Reverse Mergers: And Other Alternatives to Traditional IPOs (Bloomberg Financial) from David N. Feldman an authority and leading expert on reverse mergers, in which a private company becomes publicly traded through a merger with a publicly held "shell" company. His book on the subject, Reverse Mergers and Other Alternatives to Traditional IPOs, Second Edition (Bloomberg Press, 2009) was originally published in 2006.

A reverse merger into a shell company (a back door IPO) is essentially the acquisition of a non-operating public company by a private company, with the public company surviving. The shareholders of the private company gain control of the public company by merging their company into the public shell and receiving shares in the public shell as their merger consideration. The public company is called a “shell” because there is nothing inside – it’s typically not an operating company at the time of the transaction. The private company shareholders obtain the majority of the shares and board control; the private company’s name is usually adopted.

The process is often marketed as taking only a few weeks (much quicker than a traditional IPO) and avoiding a related lengthy and expensive SEC review – should the shell already be registered with the SEC.

To be fair, a reverse merger can be a cheaper and faster way to go public. You can often bundle it with a fund raising, lock up shareholders (so they don’t dump shares into the liquidity you might get) and cash out minority investors who need to sell. Theoretically, you can use the “public” shares as acquisition currency after you complete the transaction. And, if the business performs well you will have a higher price, liquidity and perhaps even an institutional following.

What you’ve seen more often is an increased burden for management from the demands of being public. Below a certain market cap institutions can’t or won’t buy company shares so investment banks aren’t motivated to make a market or initiate research coverage. As a result, shares trade thinly.

Financing is tough – the participants in such transactions tend to litter their deals with warrants and dilutive and contingent terms (should the company not meet certain performance criteria). Since the initial “shell” company often failed, a stigma can linger. Unlike with an IPO no large chunk of raised funds necessarily accompanies this route to becoming public (which can justify the increased scrutiny, cost and burden of being public).

Many companies completing a reverse merger don’t succeed. In many cases it has nothing to do with being public. Companies pursuing these alternatives are typically smaller (on average with market caps of $50-$100 million initially) than IPO candidates, so they tend to fail at about the same rate as any group of similarly situated private companies. And others fail because they went public for the wrong reasons (such as only to obtain one round of financing).

When a company starting to trade on the OTC Bulletin Board more often than not faces thin trading initially. But good companies watch their market support build over time with proper IR help, etc. And more and more companies are bypassing the Bulletin Board with a two step process of completing a reverse merger and PIPE, then doing a secondary public offering that brings the first trade right to Nasdaq or NYSE AMEX, where trading volume is typically much stronger.

Also shells with a legacy can be problematic as issues from the past are inherited by the target when it merges in.

More and more shells are turning to so-called Form 10 shells that are created from scratch as shells and never have any operating business in them. They become fully SEC reporting, but no trading is allowed until a reverse merger and subsequent SEC registration of shares takes place. Here there is no stigma from past operations. These Form 10s have been used successfully dozens of times in the two-step process outlined above.

Assume that any company looking at a reverse merger also has an IPO available to it. Most of these companies do not meet the size criteria of the IPO investment banks, but yet know they can benefit from being public in order to make capital formation easier (and yes billions of dollars in financing over the years have gone to OTCBB companies), make acquisitions using stock as currency, creating a path to liquidity for themselves and their investors, and incentivizing management with valuable stock options.

And yes there are still some unscrupulous Chinese companies around (show me an area of Wall Street where that isn’t true), but if management is legitimate, experienced and ethical a company can prosper and we investors also.

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