When it’s time for a private company to go public, or 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 oftentimes called an Alternative Public Offering (APO).
This process, which can be faster and cheaper than a traditional Initial Public Offering, is growing in popularity and might grow faster in our confusing coronavirus world.
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 virus has caused capital flow interruptions, investors in the private markets are still providing capital to companies with novel / 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 a step and begin at the beginning.
What is a reverse merger?
A reverse merger into a public shell occurs when a private company acquires the sluffed off shell of a public company, 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 uncertain waters of a traditional IPO. Typically, a reverse merger can be done more quickly than a traditional IPO — and in most cases at far less expense. An IPO, conversely, can take months or years and cost millions.
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.
- A reverse merger is less susceptible to market risk / economic cycles than a traditional IPO.
- Owners can more easily sell their shares, although the merger likely will have a lock up clause limiting stock sales for a period following the transaction.
How does a reverse merger work?
Jordan outlines the 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, identifying 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 and 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 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 private company who 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 ($8-10) to facilitate 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 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.
You’ll need to get used to paperwork, too. Once the shareholders approve the deal, it’s back to the NASDAQ (if NASDAQ is your exchange of choice) 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 the 3Q 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.”
Would he 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 downsides 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 times of 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.
InterimExecs RED Team is an elite group of CEOs, CFOs, COOs, and CIOs who help organizations through turnaround, growth (merger, acquisitions, ERP/CRM implementation, process improvement), or absence of leadership. Learn more about InterimExecs RED Team at www.interimexecs.org/red-team or call +1 (847) 849-2800.