Middle Market Deals and how to buy, sell and raise capital from $5 to $500 million

There are two groups of people reading this post; I apologize to both of you because I'll try to take the time to write this post so as to be relevant to both groups.  One group knows what a reverse merger is and wonders why I suggest that you run away from it.  The other group wants to know what a reverse merger is and why I suggest that you run away from it.

For group two, a reverse merger is a merger between a private company, typically with a small but promising business, and a public company that has discontinued its operations, leaving only a "shell" with publicly traded shares.  The transaction is usually structured with the public company acquiring the private one and subsequently changing the name of the public company to the name of the private company.  Because the public company had no operations, it likely had no officers.  The private company officers become the officers and directors of the public company.  Voila, the private company is public without a public offering.  Oftentimes, a third party or parties, will contribute equity capital to the newly combined company to provide needed capital.

It sounds easy enough, so you ask, what's wrong with that?

There are a variety of reasons that I have some concern about these transactions.  Fundamentally, financing a very small public company (one with a market capitalization under $75 million) is typically more expensive than financing a private one.  Some small public companies find that they cannot access additional capital at all. 

The promoters of these transactions usually make the opposite argument.  They can, of course, point to some tremendous successes.  My firm has a client with a market cap of nearly a billion dollars that became a public company by being spun out of another public company that had done a reverse merger.

The factors that allowed this company to succeed despite being public prematurely were:

1)  Relatively low capital requirements

2)  Positive cash flow from operation

3)  Rapid growth

4)  A large control shareholder with the wherewithal to provide additional growth capital when needed

If these elements had not all come together, the firm would likely have either been forced to complete an expensive round of financing that could have wiped out the now super-wealthy founder or  it might not have succeeded at all.  To simplify this observation, let me say only that our client succeeded not because it was public but in spite of being public.  The company would be a great candidate for an IPO today, were it not already public.

Bear in mind that the costs of simply being public can be enormous.  Things are only getting worse in the shadow of Sarbanes-Oxley. Imagine a private, $10 million revenue company with a net profit of $500,000 per year.  As a public company, subject to the corporate governance requirements of the SEC and perhaps an exchange, the company might easily spend its entire annual earnings just to comply with reporting standards.  All else equal, one thing is for sure, the company is worth less as a public company with no earnings than as a private one with $500,000 of annual net.  Without net income, it will struggle even to borrow the working capital it needs to operate.

So, if you are presented with an opportunity to get public early, either by a reverse merger or by any of a number of small business public offerings that allow you to raise a very small amount of money (up to $1 million), I recommend that pass politely on the offer and then run away!