When it’s time for a private company to go public, or the board of directors determines that fundraising is needed on a large scale, an IPO is not the only option. There’s also a less-well-known and, until recently, less-well-respected option: a reverse merger into a public shell. It is often called an Alternative Public Offering (APO).
This reverse takeover process, which can be faster and cheaper than a traditional Initial Public Offering, is growing in popularity.
Scott Jordan (no relation to InterimExecs’ CEO Robert Jordan), an investment banker and CFO who spent 30+ years working in biotech, engineered a reverse merger of a biopharma company in 2019. He says that while the coronavirus caused capital flow interruptions, investors in the private markets are still providing capital to companies with novel or scientifically validated biotechnology companies.
That means reverse mergers and PIPEs (Private Investment in a Public Entity) can still raise money needed to complete their deals. He estimates that about 20 biotech firms debuted in the public markets last year as a result of reverse mergers and the number is on track to repeat in 2020, despite the virus.
But let’s back up and begin at the beginning.
What is a Reverse Merger?
A reverse merger into a public shell occurs when a private company that holds shares not available to the public acquires the sluffed off shell of a public company as a way to begin trading on a public stock exchange. The public shell is a legal entity still licensed to trade on a public stock exchange, even while the former underlying operating business may be defunct or nonexistent.
The newly merged entity retains the ticker symbol with a new management team, board, staff, and operating business, without having navigated the expensive and uncertain waters of a traditional IPO.
A conventional IPO can take months or years and cost millions. Typically, a reverse merger can be done more quickly — and in most cases at far less expense.
What is a Public Shell?
The target company is, literally, a shell – it’s a public company that ran into trouble. In the case of the deal Jordan completed, the target was a biotech firm working on a drug to ease muscle cramps.
The company went public in 2015 with an $88 million IPO. But the drug didn’t pan out. Clinical trials ended in 2018 and the company began searching for a buyer or someone to take over the entity.
“Shell company” started out with a bad rap. It was the name given to companies that were nothing more than a tax dodge or a way to launder money.
Shells targeted for reverse mergers, however, are exactly what the name implies: a company that is a shell of its former self.
“These non-operating public companies are looking for innovation, so they can rescue any remaining value associated with the public shell,” Jordan says.
It’s a strategy that works particularly well in the biotech world because, he says, biotech is inherently risky. Only one in 10 drugs gets approved at the IND (Investigational New Drug) stage of development (right before entering Phase 1 clinical trials), leaving the other nine companies in need of rescue.
“They have a clinical failure and lose a lot of their value,” Jordan says. “The remaining shareholders want to monetize the shell.”
What Are the Benefits of a Reverse Merger?
There are several, Jordan says. Among them:
- Going public gives the acquiring private firm access to the vast liquidity of the public markets.
- It’s easier to raise capital given access to vast amounts of capital available in the public markets
- It’s an option for smaller companies. Typically an IPO would require a valuation of $200 million or more. A reverse merger can be done by companies with as little as $40 million valuation.
- The reverse merger process is less susceptible to market risk / economic cycles than a conventional IPO.
- Owners can more easily sell their shares, although the merger likely will have a lock up clause limiting the company’s stock sales for a period following the transaction.
How Does a Reverse Merger Work?
Jordan outlines the 9 steps he took:
Establish relationships with investment banks that specialize in this niche.
A private company gets introduced to the shells thanks to investment bankers. While it’s possible to do a reverse merger without going through a bidding process, vetting shells on your own can be difficult and significantly riskier.
Jordan points to Roth Capital Partners, H.C. Wainwright, Maxim, Ladenburg, Wedbush, and Oppenheimer as firms in the business of courting private companies and keeping track of publicly available shells.
Prove yourself worthy.
In many cases, an investment bank will be representing the public shell and will run an auction process.
The investment bank running the process will review proposals assessing strength of the scientific platforms, the operating company, and the management team as part of the due diligence process to see if your company is the best use of the public entity.
Win the bidding and negotiate the deal.
Now it’s time to negotiate an “exchange ratio.” That means spelling out who owns what and setting the terms of the deal.
“For example, if you think your company’s worth $36 million and the shell’s worth $12 million you have a $48 million post. That works out close to an 80:20 securities exchange ratio,” Jordan says.
While deals vary, that 80-20 split is fairly common, he says, with the shareholders of the shell company ending up with 20 percent ownership as passive investors. The board is comprised of people from the operating company who have the controlling interest and take over running the new merged entity.
Raise some cash.
The private company has to bring a certain amount of cash to the deal. Often that means the private company needs fresh, third party funding to complete the takeover.
In Jordan’s case, he closed a $6.4M Series A prior to the transaction vs. another valuable financing vehicle that ensures merged entities have the capital necessary to reach valued milestones, a PIPE – Private Investment in Public Entity.
The Series A capital allowed Jordan’s public companies to feel more confident of having enough cash to maintain operations and cover public company expenses. The last thing the public company wanted was to run out of capital after the merger was completed.
Get board approval.
This can be tricky because the deal likely requires a name change, dilution associated with giving up ownership to public shell entity, and a reverse stock split. While the latter can carry a stigma for a publicly traded company whose share price dropped below a $1, it is a necessary element of a reverse merger to have a share price at least in the high single digits ($8+).
“That facilitates orderly trading while limiting de-listing risk,” he says.
The biotech firm he sold in a reverse merger included a 25:1 reverse stock split.
File NASDAQ paperwork.
This can be voluminous – financial statements, risk factors, liabilities, and more. Don’t underestimate the time and expense involved in meeting all of these requirements.
Get shareholder approval.
You’re about to become a public company. That means asking for approval from shareholders. Get used to it. It’s your new reality.
File more paperwork.
Once the shareholders approve the deal, it’s back to the NASDAQ (if the listed company’s shares will trade on the NASDAQ) with additional filings required by the SEC associated with continued operations.
If you can’t meet SEC reporting requirements timelines (10Q, 10K etc.), it would be detrimental to maintaining an ongoing public listing and could result in delisting.
Raise more money.
After the deal closed, Jordan went back to the market to raise another $11 million to get the newly formed company through Q3 of 2021 via a S-1 offering sponsored by Ladenburg Thallman.
“The company now has enough capital to reach value inflection points (clinical read-outs),” he says. “You optimally want at least two years of runway.”
Wait. I Want a Full SPAC!
SPACs, or Special Purpose Acquisition Companies, are a special type of reverse merger in which the the acquiring company (the SPAC) has no commercial operations. In this IPO process, the SPAC is formed strictly for raising capital through an initial public offering to acquire or merge with an existing company.
SPACs have been around for decades. but their popularity has soared in recent years. In 2020, 247 SPACs were created with $80 billion invested, and in 2021, there were a record 613 SPAC IPOs. By comparison, only 59 SPACs came to market in 2019, according to Investopedia.
However, in the spring, the market for both SPAC IPOs and mergers and acquisition deals slowed over fears the US Securities and Exchange Commission would increase regulatory oversight.
Do you really want a SPAC?
No sweat! Just know that SPACs are a much bigger and more formal deal than a reverse merger into a public shell. Heck. They make a reverse merger look like a bake sale at your kid’s grade school versus a banquet for 100 of your best friends.
Why? Because the SPAC requires a third party to raise a bunch of money, typically around $200 million, according to the NASDAQ. That’s waaaay more than Jordan had to raise.
Plus, SPAC owners commit to millions of dollars in upfront legal costs before they even get to approach the capital markets to raise a penny.
Once they raise all that money, the hunt is on and the clock is ticking. If no deal presents itself within 24 months, typically it’s time to refund all of those investors – with interest. So if there’s no deal, the SPAC promoter is out legal fees, accounting fees, and interest – many millions of doh reh me.
Final hurdle: the shareholders must approve of the merger with the target investment. If they don’t – say the markets tank even if the target is wonderful – you still have to give back their investment plus interest.
Then there is the post-merger performance. Wall Street is less enamored with SPACs these days. As many as 70 percent of SPACs that had their IPO in 2021 were trading below their $10 offer stock price as of Sept. 15, 2021, according to a Renaissance Capital strategist.
Would Jordan do Another Reverse Merger Deal?
“It was a tough road, but it could be easier. It’s deal specific — meaning my experience could be completely different than yours,” he says.
“I do know that it is a really effective vehicle to getting to the NASDAQ public markets. If you feel like you’re a little early to attract institutional capital and/or complete a traditional IPO, it’s a way to reach the public markets and then finance yourself via various shelf offerings/at-the-market financing vehicles. You can increase access to capital, get liquidity, raise the profile of the firm and use stock as currency to buy other companies.”
What are the Disadvantages of a Reverse Merger?
“It can be very expensive to be a public company. I mean, a million and a half, two million a year annually just in public company expenses.”
Plus, he says, “you’re highly regulated. There’s a lot of bells and whistles, restrictions, blackout periods. There’s a lot of reporting requirements that are really arduous. Don’t take it lightly. You want to go into the public markets knowing the time commitment. But go into the markets with purposed intensity, meaning look to leverage the public company listing to ‘company build’ (e.g. finance additional assets, form collaborations etc.) providing consistent and ongoing news flow valued by existing and new investors. You don’t want to rely on small thinking because you’re taking a big step into the public markets.”
Even in a pandemic, the leading indicators for optimism include the public markets, with their massive pools of capital and liquidity and wide variety of funding mechanisms and structures.
Jordan’s story is not just one of access to markets, but of a CFO’s resilience, resourcefulness and smarts in taking a small company to greater heights.