Tuesday, February 12, 2008

Reverse Mergers - ownership percentages

The percentage of public stock ownership is probably the most poorly understood aspect of reverse mergers. Shareholders of private companies that are negotiating reverse mergers always want to maximize the value of their interest in the combined companies. Unfortunately, they frequently attempt to do so by minimizing the ownership interest of the existing shareholders. While many shell promoters are all too happy to accommodate, experience shows that squeezing those last few points out of a reverse merger usually does far more harm than good.

Reverse mergers that give the owners of the private company 90%, 95% or even 98% of the combined companies are not uncommon in today's market. But to modestly increase the percentage ownership of the private company's shareholders, the number of outstanding shares has to increase dramatically. As a simple example, if a shell has 1,000,000 shares outstanding before a reverse merger:

  • It takes 4,000,000 shares to give the private company shareholders an 80% interest;
  • It takes 9,000,000 shares to give them a 90% interest; 
  • It takes 19,000,000 shares to give them a 95% interest; and
  • It takes 49,000,000 shares to give them a 98% interest.

Many small public companies can and do support a reasonable trading price with 5 million or even 10 million outstanding shares. But as the number of shares passes the 10 million mark, the number of companies that can support a reasonable trading price drops off precipitously. So the stockholders of a private company that is negotiating a reverse merger will ultimately have to choose between getting a small number of reasonably priced shares or a large number of very cheap shares.

We have never seen a good result when the shareholders of a private company demand too large a stake in connection with a reverse merger. Stock market investors are not always rational, but they can all multiply and divide. If a small public company has a sustainable market value of $25 million, it will be priced in the $5 range if there are 5 million shares outstanding and it will be priced in the $0.25 range if there are 100 million shares outstanding.

Low stock prices make it very difficult for small public companies to obtain additional financing on reasonable terms because investor confidence in the sustainability of market prices bears an inverse relationship to market prices. While a relatively high market price does not guarantee a high level of investor confidence, a relatively low market price will almost never give rise to a high level of investor confidence. Moreover, as the relative market price per share declines, the profit margin or "spread" that market makers charge buyers and sellers can and usually does increase rapidly as a percentage of the share price.

We believe the principal value of a public company lies in its inherent ability to issue additional shares in connection with future financing, property acquisition and compensation transactions. Initial ownership is important from a control perspective, but placing undue importance on initial ownership percentages can seriously impair a small public company's future.

While it is not a perfect analogy, we frequently compare public shells to printing presses. When the press is delivered to the buyer there are a limited number of stock certificates that were printed while the press was being built. Those shares are the initial public float. In connection with the sale of the press to the buyer, an additional pile of stock certificates is printed for the reverse merger transaction. The number of stock certificates that need to be printed in connection with the reverse merger is wholly dependent on the percentage ownership that the shareholders of the private company demand. Once the press is turned over to the buyer, he owns it and can print as many or as few additional stock certificates as he chooses.

If the press is used judiciously, substantial value is received in the reverse merger and substantial value is received every time a new stock certificate is printed, the market value of all outstanding shares will increase over time. If too many stock certificates are printed for the reverse merger or the press is used indiscriminately to print new stock certificates for dubious value, the market value of all outstanding shares will decline over time.

In the final analysis, there is no way to repeal the laws of supply and demand.

We once heard a Vancouver promoter quip "As long as a tree stands in British Columbia we will never run out of stock." This is a great truth and a real and present danger. A public company that indiscriminately issues stock in a reverse merger will permanently impair its ability to obtain new value in the future by issuing additional shares. If management lacks the discipline to maximize value per share from the outset, then their venture into the public markets is in grave peril before it starts.


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