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Regulation of Reverse Mergers & PIPEs

We recently interviewed several experts on Reverse Mergers in connection with our April 25, 2006, Alternative Exits Conference which will feature panel discussions on Reverse Mergers, SPACs, PIPEs and Chinese Reverse Mergers. Among the interesting findings from these interviews are the following:

• The average cost to execute a reverse merger on the bulletin board these days is anywhere from $600,000 to $1 million. The alternatives, you could do those for $200,000, $300,000, and with a little bit of time and effort, make it into a bulletin board.
• Bulletin boards transactions make up only about 9% of the overall marketplace of shells and the other 91% are the alternatives. The alternatives are pink sheets, other OTC or what people refer to as grays, non-trades that are non-reporting but have a shareholder base, and non-trades that are reporting that have a registration statement on file.
• One area of potential concern for companies conducting PIPE transactions is EITF-0019, that is from the Emerging Issues Task Force and it deals with Accounting for Derivative Financial Instruments index to and potentially settled in a company's own stock. Now, this has been around for about five years. However, for some reason, it got the attention of the SEC's accounting staff in late 2005 in connection with a PIPE transaction and what the accounting staff is focusing on are really two issues, one are registration rights agreements in connection with a PIPE transaction, which is a standard feature of a PIPE transaction, and in particular, the liquidated damage clauses in those registration rights agreements, that is, if your registration statement is ineffective by a particular period of time, then there are liquidated damages payable back to the investors in the PIPE for not having their shares registered or their securities registered and tradable. The staff has looked at this and concluded, they think that these liquidated damages clauses constitute a derivative and as a result that characterizes the PIPE issuances as a liability rather than equity capital on the issuers' balance sheet. The real significance here is that it could force a re-characterization of all the previously issued PIPEs as well on an issuers' balance sheet, and in today's post Sarbanes-Oxley world, having to go back and restate your financials is not something that issuers want to do. So, it is really wreaking havoc on PIPE deals at the moment until this issue gets sorted out. It is a accounting issue, it is something that the SEC has to work out with the accounting community and this FASB itself is going to be looking at this issue during the course of this year, but not before June. So, for PIPE transactions that are being conducted between now and probably through the third quarter of this year, this issue is going to be looming out there.
• The other aspect of a PIPE transaction that this particular accounting issue affects is convertible securities where there is a variable mechanism in the convert, and if the same issue arising whether it constitutes a liability or equity and you have to re-characterize all your previous convertible securities as liabilities on your balance sheet as well. So, it is certainly something to be aware of and stay tuned to as you are conducting your PIPE transactions.
• Section 16 provides that various classes of corporate insiders or beneficial owners owning more than 10% of a class of securities, they have to disgorge their profits earned from the short-swing transactions in those securities over a six-month period of time. Now, the key here is beneficial owners owning more than 10% of a class of securities. If you look at PIPE investors as a group, you may well easily exceed that 10% threshold, right, whereas if you look at them individually, the likelihood is no individual PIPE investor is going to exceed that 10% threshold. If they then are viewed as a group and exceed the 10% threshold, then they require to disgorge profits.

More on this topic and more will be discussed at IncreMental Advantage's Alternative Exits Conference, December 12, 2006 in New York City. For more information visit www.incrementaladvantage.com/conferences or contact Neomi at 609-919-1895 x100 or neomi@incrementaladvantage.com.

Reverse Mergers / SPACs Conference Highlights

The following points were among the insights elicited at our recent Reverse Mergers / Forward Momentum conference:

With regard to reverse mergers:

• The new 8-K rules will make full disclosure more onerous (since documents must be filed within 4 days of a transaction instead of the 70 days that was previously the rule) but will improve the quality of companies executing reverse mergers.
• Net operating losses are of very little value--as they can only be used when income is produced, they expire, and must be amortized over a long period of time--to companies that execute reverse mergers.
• Companies receiving PIPE financing from hedge funds must realize that these funds have very short-term time horizons.
• There is little merit into reverse merging into a pink sheet company other than cost savings.
• Shell providers should provide indemnifications when selling their shells. If they are not willing to provide the indemnifications, there are usually reasons relating to the lack of shell hygiene.
• High levels of free trading stock held by advisers such as PR firms and insiders is usually a sign of concern.

With regard to SPACs:

• Specified Purpose Acquisition Corporations are shell companies formed by management teams with industry experience and is organized with the purpose of effecting a combination with an existing business in the target sector.
• By law, 85% to 93% of the proceeds raised in the IPO for the SPAC are held in trust. The SPAC must sign a  letter of intent for a business combination within 18 months of the IPO or it will be forced to dissolve and return the assets in the trust to public stockholders. If a letter of intent has been signed within 18 months, the SPAC can close the transaction within 24 months. The target of the acquisition must have a fair market value that is equal to at least 80% of the SPACs assets at the time of acquisition. Shareholders must approve the combination.
• The management team of the SPAC typically receives 20% of the equity in the vehicle at the time of offering, exclusive of the value of the warrants. The equity is typically locked up for 2-3 years. Management typically agrees to repurchase about 10% of the outstanding warrants once they start trading after the IPO. In many cases, management agrees to pay for the expenses in excess of the amounts outside of the trusts if there is a liquidation of the SPAC because no target has been found.

With regard to China's demand for reverse mergers:

• There are 10 million mid-sized private companies in China. There are at least 10,000 to 20,000 companies in China with roughly $30 million in revenue and $10 million in net income. Out of these companies, at least 1,000 to 2,000 will want to have publicly-traded stock in the U.S. American investment banks are far too understaffed to take advantage of this demand by Chinese companies to go public through the traditional IPO route.
• It is extremely difficult to conduct due diligence on Chinese companies. Beyond language and cultural barriers, many Chinese companies solely use cash to transact their business which makes auditing nearly impossible. It is also often unclear how thoroughly the Chinese government privatizes its companies - there is often residual government ownership and influence.
• Reverse mergers with Chinese companies is difficult because it is still complicated to get money out of China. Also, government approval is required to execute direct share exchanges with Chinese companies and it is unclear how to receive such governmental approval. 

Conference materials can be obtained by contacting Neomi at 609-919-1895 x100 or neomi@incrementaladvantage.com. More this topic and more will be discussed at IncreMental Advantage's Alternative Exits Conference, December 12, 2006 in New York City. For more information visit www.incrementaladvantage.com/conferences or contact Neomi at 609-919-1895 x100 or neomi@incrementaladvantage.com.

Reverse Mergers and SPACs

Reverse Mergers became more legitimate when the New York Stock Exchange announced its intention to reverse merge into Archipelago. Special Purpose Acquisition Corporations (SPACs) have gained even more popularity over the past year or so. The following are a few of the kernels of wisdom included in Gateway Research’s Special Report on Reverse Mergers and SPACs:

• SPACs typically raise much more money than reverse mergers at the time of their IPOs. The average SPAC raised $30 million as the result of its IPO as compared to an estimated $5.24 million raised by companies going through reverse mergers in the months immediately preceding and following the completion of their IPOs.

• Richard Tullo, senior analyst at Gateway Research, calculated that the average SPAC market capitalization is $72.4 million as compared to a capitalization of $40.5 million for Gateway’s sampling of reverse merged IPOs.

According to Adam Gottbetter of Gottbetter & Partners:

• Companies that go through reverse mergers are often able to choose the investors in their private placements. (Conversely, in an IPO, you don’t get to choose your investors.) In reverse mergers, the investors receive stock that has to be registered. Thus, investors in reverse mergers tend to be committed to the company on a longer-term basis.

• Hedge funds are replacing the mid-sized and small investment banks in terms of providing capital to companies that are executing reverse mergers. Hedge funds are willing to take some of the risk that reverse merger transactions inherently have.

According to Ralph DeMartino of Cozen O'Connor:

• Today there are over $2 billion worth of SPACs in registration, well over $0.5 billion has been funded and there is a lot more than that combined amount on the shelf ready to file….I suspect that the number of warrants included in the unit will decrease overtime. I suspect that the management teams will become of a higher grade and much more targeted in terms of their target acquisition company. And I think that the open issue on SPACs is going to be to what extent the existing SPACs that are out there have success in acquiring companies at a decent valuation.

According to Spencer Feldman of Greenberg Traurig:

• We like shells that have an existing business going on and that do not disclose in their SEC filings that their only purpose is to find another company to merge into it. We like companies that are registered under 15D, so they don't have to immediately comply with the proxy rules. We also like shells that have capital structures that are conducive to these transactions.

According to Sarah Hewitt of Brown Raysman Millstein Felder & Steiner LLP:

• A SPAC has the benefit of offering a clean, pristine shell with no lingering liabilities. It offers a slug of cash that is available both for the acquisition and hopefully also for working capital for the company. And it offers a management team with a great deal of both capital markets and M&A experience, and possibly also industry experience in the sector in which it's targeted. In a reverse merger transaction, you are working with a pre-existing vehicle.

• A SPAC is similar to a blind pool trust in that you are unsure of the target that's going to be acquired. However, in a SPAC transaction, the investor gets a second bite at the apple in that the SPAC undertakes to get shareholder approval of the transaction before it's undertaken. And so, the investor has a choice whether to stay with the transaction or not by voting for the transaction or electing to sell their SPAC shares if the transaction is not something that they are interested in participating in.

• A SPAC has a limited life. If it does not enter into a transaction in a specified period of time, typically 18 to 24 months, it would be required to give the proceeds back to the original investors.

More this topic and more will be discussed at IncreMental Advantage's Alternative Exits Conference, December 12, 2006 in New York City. For more information visit www.incrementaladvantage.com/conferences or contact Neomi at 609-919-1895 x100 or neomi@incrementaladvantage.com.