Reverse mergers - Good, bad and ugly - Introduction

Over the last 20 years, there have been phenomenal changes in the IPO market. My first transaction as lead issuer's counsel was in 1987 and involved an underwritten $3 million IPO for a small technology company that immediately listed on Nasdaq. In 2007, the average IPO size was over $200 million and the only place you'll see a $3 million number in today's IPO market is in Item 13 of Form S-1 which relates to the estimated costs of registration, issuance and distribution.

What was once the goal of an IPO has now become the minimum price for admission to the game.

There are a number of reasons for the changes in IPO market dynamics. But the hard cold reality is that many small companies that would have been reasonable IPO candidates 20 or even 10 years ago are completely frozen out of today's IPO market. The net result is that entrepreneurs who can't qualify for a $200 million IPO, but need $20 to $50 million in financing and want to be publicly held, are forced to seriously consider alternative ways to access the public capital markets.

That search for an IPO alternative almost always leads to a consideration of a reverse merger with a public shell.

One of the most important differences between the IPO market and the shell market is frequently overlooked, or at best not fully understood. The IPO market is populated by broker/dealers that want to earn fees by raising money. 

The shell market, on the other hand, is populated by promoters that expect to profit from a variety of sources including (a) the fees they charge for raising money, (b) the fees they charge for arranging a shell merger, (c) the profit they earn from the eventual sale of their shell shares, and (d) the fees they charge for post-closing services. While the costs in the IPO market are usually transparent and predictable, the costs in the shell market are usually far more opaque and unpredictable; meaning that a company considering an IPO alternative needs to be more vigilant in its dealings with shell promoters and more diligent in its efforts to understand the true nature and extent of all current and future transaction costs.

SEC regulations generally define the term "shell company" to include any company that has registered its stock under the Exchange Act and:

• Has no substantial operations; and 
  
• Has no substantial assets; or
  
• Has substantial assets that are principally held in cash and cash equivalents.
  

Implicit in the definition is the existence of shares that can be lawfully resold by current stockholders without further registration under the Securities Act. In general, the SEC's definition of "shell company" is broad enough to include:

• SPACs that conduct IPOs for the purpose of raising capital that can be used to purchase assets or companies; 
  
• Unsuccessful public companies have no substantial remaining assets; 
  
• Companies that voluntarily register under the Exchange Act for the purpose of serving as shells; 
  
• Blank check companies that conduct registered stock offerings under Rule 419; and
  
• Reporting companies that have specific business plans but otherwise fall within the definition.
  

In addition, other acquisition-oriented companies that are not registered with the SEC are often referred to as shell companies. Over the next few weeks, I will try to explain the principal differences between the various types of shells that promoters are offering to companies that are seeking IPO alternatives.