Wednesday, February 08, 2006

VC: Reverse mergers..

VC: Reverse mergers

In previous posts, I've mentioned the most common ways in which venture funds 'exit' their investments: acquisition, and going public (IPO). There is a third way, which is mostly seen in down markets: the reverse merger. It's considered rather dodgy, for reasons I'll describe, so it doesn't feature in the usual VC script. Since the venture wire has brought news of two reverse mergers in the last week, Dwango North America and RoomLinX, I thought it might be a good time to describe this particular maneuver.

Reverse merger is a way for a private company to get public without those nasty details of an SEC S-1 filing and an underwriting by investment bankers. To start the exercise, the private company's management or investors locate an already public 'shell company.' A shell company is one that is nominally public, usually listed in the NASD OTC bulletin board or 'pink sheets', but that is pretty much dormant. It will likely have no remaining employees and maybe no management, and it will have ceased any business activities. A 'clean' shell company will also have little or no outstanding debt, will have kept its regulatory filings up to date, the stock will be listed at pennies per share, and majority control will be in the hands of relatively few shareholders.

This is a company that has passed into a coma, rather than dying a violent death.
The object of the exercise is for this moribund, but public, shell company to acquire the assets of the private company, which is a going concern. This will done by a stock swap. First, the owners of the private company must get the controlling shareholders of the shell to agree to the transaction. Often, the shell has already been groomed for such a transaction by a broker and the agreement is in hand.

Next, the investors of the private company buys an overwhelming majority of the shell shares for a nominal amount and/or the shell shareholders vote to authorize the issuance of a new large and highly dilutive block of shares. (For an entertaining dramatization of this process, find a copy of the old Frederick Forsyth thriller "The Dogs of War".)

Finally, the large block of shell company shares that is now controlled by the private company investors are swapped for the shares of the private company, thereby acquiring it. The shell company now owns the assets and ongoing business of the private company, including its name, which it usually assumes. The investors in the private company are now the controllers of the shell, and they have the ability to market their shares on the exchange where it is listed, often free of nasty items like lockup and standoff agreements.



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