Restoring the Image of the Tainted Reverse Merger

Posted On December 15, 2014 | by AllenCaron

By guest author Nate Nead, Managing Director of www.reversemergers.com

Display of Stock market quotesA recent conversation with a partner at a tier one law firm that regularly works on fully-underwritten IPOs went something like this.

Me: “Tell me about your experience, if any, in reverse mergers or direct public offerings.”

Attorney: “We don’t do them and we will never do them.”

Me: “Why not?”

Attorney: “They too easily manipulated and the players in that market are mostly schemers attempting to defraud investors. You should seriously reconsider even working in that market unless you want to go to jail.”

It’s unfortunate that reverse mergers have never had a good image. This Alternative Public Offering (APO) method has always been the rebellious and impetuous red-headed stepchild of the capital markets. Perhaps it’s impossible to completely burnish an image that never existed in the first place, but we can attempt to lift the tainted industry out of the realm of financial schemery.

Scraping Bottom

The truth is that most reverse takeover (RTO) deals are not high quality, the businesses aren’t as tested and the company management on the less sophisticated side. In many cases, the market for RTOs could be compared to the payday lending industry. While payday lenders receive a bad rap for usury on the poor, they fill a  gap in the chain of personal finance where traditional banks cannot or will not go.

Similarly, the RTO market fills a gap in providing an alternative to initial public offerings at a cheaper price, often to lower-tier businesses. It is true that, on occasion, a good business with a solid team and great potential will emerge on the OTC and become something that sellside analysts can actually talk about, but many reverse merger deals live and die as penny stocks.

There are simply casualties that occur in OTC companies without the revenue and management to maintain staying power. It is part of the nature of the over-the-counter market to be a home for these small, fragile companies. The need is to ensure that bottom scraping isn’t the goal of RTO facilitators, broker-dealers and attorneys. Danger signs usually involve at least one of the following:

Disregard for deal size, intellectual property or business sustainability

  • No background checks for deal operators
  • Focus on the fee and the deal, not on the  fundamentals
  • Non-USA deal focus with little accurate disclosure of fundamentals
  • Pink sheet and gray sheet public shell companies and overall lack of transparency .

By simply avoiding a few very specific and easily identifiable features of a sour deal, RTO operators will likely show much better track records.

Big Boys Moving Down Market

It’s also interesting to note that when times get tough and the IPO window closes, many of the most prominent investment banks have turned to PIPEs and alternative offerings to help fill the revenue and lack-of-activity gap. They too are not opposed to doing some bottom feeding when things get lean at the top.

Criticism from the bulge-bracket i-banks and securities attorneys is as falsely pious as Americans blaming South American farmers for slash-and-burn jungle clearance to create farmland.  When options are slim and liquidity is lean, the bigger boys feel untainted by moving down market. During such times, it’s much easier to tout the relative legitimacy of reverse mergers, because everyone’s doing it.

Overcoming a Stigma

My guess is that the stigma will remain regardless of the quality increases in dealflow and the policing by the SEC. One of the best ways to increase the market’s legitimacy is to ensure more deals become poster children for reverse mergers. Big companies like Turner Broadcasting and Occidental Petroleum have been touted as examples in this market for years, but more recently several interesting small caps have emerged, like Ronkonkoma NY-based Lakeland Industries (LAKE), a manufacturer of safety garments for industrial workers, or the tiny but fascinating Kirkland WA-based GeoTraq (GTRQ), which makes personal tracking and Cell ID devices.

The stigma is also likely to ebb away if principled advisors focus on the post-deal success of the companies they represent, not just on the deals themselves. This post-deal assistance includes efforts toward enhanced market liquidity, follow-on capital raising, accounting and reporting assistance and an adherence to long-term business sustainability. In doing so, a whole new generation of successful deals is likely to populate the RTO space, helping increase industry respect and rapport.

The main reason reverse mergers exist is because there is a need to play the public company game without the exorbitantly high costs of a traditional underwritten IPO. Cost effective methods for going public really don’t exist outside of reverse mergers and direct public offerings. But less expensive alternatives to the IPO will remain necessary for companies that need access to stock liquidity for investors. The hope of many legitimate operators is that the market for reverse mergers will grow larger and remain vibrant.

Nate Nead and his team have helped to take more than 100 companies public on both the OTC and Nasdaq.

The opinions expressed are Mr. Nead’s, and publication of this article does not imply endorsement of the content by About Small Cap Stocks, or by Allen & Caron, publisher of this blog.

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