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Going Around Banks

Small companies are finding more alternate routes to fresh capital. But all of them could prove to be dead ends.
Constance Gustke, CFO Magazine
October 15, 2005

Growing up is hard to do. Quintessence Photonics had no trouble attracting venture capital when it started in the "optoelectronics" business, which combines laser and semiconductor technology to cut and join metal. But finding funds for its next stage of growth wasn't as easy. "The terms on follow-on venture capital rounds were too restrictive and much more onerous than funding from other sources," says co-founder George Lintz. And an initial public offering for a research-intensive outfit that has yet to make a profit isn't an option these days.

So Lintz instead is contemplating a reverse merger, in which a private company in need of capital sells itself to a publicly traded "shell" — a company with few if any assets besides its Securities and Exchange Commission registration statement. If successful, Lintz expects his firm to gather more capital than it could through an IPO, and he hopes for "the potential of higher valuations sooner." The fact that Quintessence won't have to pay an underwriting fee to a banker doesn't hurt.

The company considered another detour around bankers: the so-called pink sheets (see "Weighing Transparency," below). That means paying a broker-dealer to sell stock in the company through other market markers alone — that is, without the help of the public price quotation a stock exchange listing provides. This approach is more viable today, thanks to the development of the Electronic Quotation Service, which handles bid and ask prices via the Internet. Still, Lintz is pursing a reverse merger because exchanges provide more liquidity.

Gaining Traction
Quintessence isn't alone. More companies in its position are seeking alternatives to traditional routes to capital. Increasingly abandoned by venture capital firms more interested in taking public companies private, and ignored by banks that won't lower IPO underwriting fees, more small private firms are casting their lot with shell companies. Through mid-September, 103 reverse mergers were completed, compared with 114 for all of 2004, according to Reverse Merger Report. "There's no question that reverse mergers have blossomed," says David Feldman, a managing partner at New York law firm Feldman Weinstein LLP.

And higher-profile deals, including the acquisition of Archipelago Holdings by the New York Stock Exchange, increasingly use the technique, so that their size, once typically no greater than $10 million, now sometimes approaches $100 million. Bigger deals, however, usually require the help of investment banks to serve as brokers, which raises the cost. Yet they still typically amount to less than half as much as the standard 7 percent levy for underwriting an IPO.

Gregg Mockenhaupt, a managing director of Los Angeles investment bank Sanders Morris Harris Group, says he sees more inquiries into reverse mergers "every day that goes by." In June, he wrapped up a $50 million reverse merger for Ronco Corp., whose founder, Ron Popeil, sells kitschy trademark inventions like the Veg-O-Matic via infomercials. Ronco merged with a shell set up in 1990 with no earnings or products. The process took six months, but the payoff was "easy entrée into the public markets," says Ronco CFO Evan Warshawsky.

Reverse mergers aren't without problems. For one thing, finding a "clean" shell can be daunting. Lintz assigned a team of lawyers to investigate one candidate. "If we end up merging with an unsuitable partner, that can make or break our company," he says. "There's a lot of due diligence." Even so, reverse mergers remain cheaper and faster than IPOs. A $30 million reverse merger can cost $75,000, compared with at least $200,000 for a similarly sized IPO. And a reverse merger can be done in a few days versus a minimum of several weeks for an IPO.

The SEC also has cracked down on fraud in this arena. Previously, all the SEC required a shell to do was file a registration statement. That lack of disclosure made such deals susceptible to "pump and dump" schemes in which promoters talked up shell stock values by touting a merger with a private firm and then dumped their own shares before the merged firm's low value became obvious (see "Honest Shell Games?", CFO, April). And even if a partner is legitimate, a private firm that goes this route could still find itself with unwanted liabilities. "You want to make sure there are no skeletons in the shell," says Randy Rock, a partner at Andersen Partners in New York.

Under a new rule, shell companies must file information on their operating business with the SEC within days of merging. "Now, companies must be as prepared as if they were going public," observes Charles Weinstein, a managing partner at accounting firm Eisner LLP in New York, so "reverse mergers have less stigma" than they once did.

Confidence Counter
Yet another alternative may be preferable to both the pink sheets and reverse mergers: heading directly to electronic over-the-counter (OTC) markets, known as bulletin boards, which require full SEC reporting. "There's more transparency there," says Rick Schweiger, a partner at investment banker Keating Investments LLC in Denver. However, companies raising capital in OTC markets must already have at least 40 shareholders, so this approach is best suited to small but established companies.


Bob MacDonald, CEO of Ovation Products Corp., which makes water-purification technology, set his sights on the OTC bulletin board after his company raised $10 million in private financing, but failed to get follow-on VC funding (despite 11 patents). He says an OTC listing "reflects a higher level" of investor confidence than the pink sheets do and would cost his company about $200,000 less than the $400,000 (not including legal fees) for a shell. However, with fewer than the minimum number of shareholders required, the Nashua, New Hampshire–based firm will have to go the pink sheet route until more shareholders come aboard, he says.

Even less-expensive reverse mergers with good partners aren't problem-free. There's no analyst coverage, road show, or hoopla to sustain a company's stock price and help it raise more capital from the public down the road. "It's a very quiet way of going public," says Weinstein. That's why it's often just a first step to a private offering for additional capital, typically through a so-called PIPE (private investment in public enterprise) transaction. Quintessence's Lintz notes that a PIPE would likely close simultaneously with his company's reverse merger. Yet PIPE transactions aren't without woes, either (see "The Pipes Are Flowing," CFO, November 2004).

The bottom line: the alternatives to VC firms and investment bankers are growing more viable, but none are yet free of serious drawbacks.

Constance Gustke is a freelance writer based in New York.


Weighing Transparency

Going public via pink sheets remains a controversial option. The lack of Securities and Exchange Commission reporting requirements means little regulatory burden for companies, but it also makes investors wary of abuse. As a consequence, companies in need of capital tend to shy away. Yet not everyone considers pink sheets a less attractive option for raising capital compared with reverse mergers. Anthony Loumidis, CFO of American Distributed Generation Inc., a privately held firm that provides electricity, heating, and cooling systems, sees pink sheets as more viable than they used to be. That's why he hopes to raise as much as $10 million through them within a year. He believes that the "games people used to play with prices," which created huge spreads, are disappearing without SEC intervention, simply because bid and ask prices are more widely available thanks to the Internet. — C.G.




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