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Reverse Mergers for Foreign Companies
BY RONALD STONE
F E AT U R E S The United States is one of the best places in the world for foreign (non- U.S.) companies to raise capital and create a public market for their stock. Foreign companies have for years sought access to the U.S. capital markets. With the U.S. dollar at its weakest level in 30 years, there has not been a better time to do so. A weak dollar means that the dollar-denominated earnings of a foreign company appear much more attractive to U.S. investors. A weak dollar also means that transaction costs appear less expensive to foreign companies. Choosing to go public in the U.S. is not an easy process. Perhaps the biggest hurdle a foreign company must overcome is complying with U.S. GAAP standards. If the company follows International Accounting Standards and chooses not to restate to conform to U.S. GAAP standards, then that company must add a footnote to its financial statements showing how the financial statements differ from GAAP standards. In addition to U.S. GAAP considerations, companies should also consider the general benefits and drawbacks to becoming a U.S. reporting company. The chart below shows why it does and does not make sense to be a public company in the U.S. Foreign companies can enter the U.S. capital markets in basically two ways: through an initial public offering (“IPO”) or a reverse merger. An IPO is a preferable option for larger companies. It is generally not a good option for smaller companies because an IPO is complex, time-consuming and expensive. Also, smaller companies have difficulty finding willing investment bankers to do the deal. Investment bankers typically work with larger, more established companies in bigger deals. Further, certain foreign governments, notably China, restrict smaller companies from doing an IPO in the U.S. Because of these reasons, Benefits of Being a Public Company /Drawbacks of Being a Public Company Liquidity for investors /Less confidentiality Facilitates acquisitions — /Stock as currency Burdensome reporting requirements Higher valuations /Ownership dilution Greater access to capital markets / Greater liability
Enhanced prestige Higher costs many small and mid-sized foreign companies are better off with the alternative - a reverse merger. A reverse merger may be the most cost efficient way for small and mid-sized foreign companies to raise money and go public in the U.S. Doing a reverse merger, however, makes sense only if the company is profitable and has audited financial statements. Once a company decides to proceed with a reverse merger, it must identify the “shell” company into which it will merge. This company is referred to as a “shell” because it is a legal entity, less all assets and liabilities. It is critical that a thorough due diligence be conducted on the proposed shell to uncover any hidden liabilities and assure proper legal structure. Often a Private Investment in a Public Entity (“PIPE”) accompanies a reverse merger. PIPE is the vehicle through which investors add capital to the new entity. These investors generally have a short investment time span. The main investors in PIPEs are hedge funds. Demand for hedge funds by institutional investors is predicted to grow nine-fold between 2005 and 20151, with corporate and public pension plans expected to lead the way. That equates to a 10-year compound annual growth rate of 24 percent. The total worldwide market for hedge funds is expected grow from $281 billion to $2.5 trillion. 2 The growth in hedge funds means that there is no shortage of cash available to fund reverse mergers. To complete the reverse merger, the shell company issues additional shares of its stock to the PIPE investors and the foreign company. The shell company then changes its name to the foreign company’s name. The shell is the surviving company into which the foreign company has merged, but it has mostly new ownership and a new name (“Newco”). After the merger,Newco will file a registration statement with the Securities and Exchange Commission (“SEC”) to notify the SEC of the merger and to register the new shares for sale. SEC Rule 415 limits the initial registration of Newco shares to 30%-35% of the total outstanding shares. Once the stock is registered, Newco should hire an investment relations firm to help market the securities. Unlike an IPO, which involves significant investment coverage and marketing of the company and its stock, a reverse merger is done with less publicity. In effect, a company doing a reverse merger is responsible for marketing its own stock. An investment relations firm is crucial during the reverse merger process to help get the word out. Having proper marketing will help ensure an active and stable market for the company’s stock, one of the chief requirements of PIPE investors. PIPE investors look for stocks with a stable market to provide them a way to cash out without damaging Newco’s market value. A weak U.S. dollar is good news for foreign companies. There is not a better time for a foreign company to look to the U.S. to raise money and/or list shares in the U.S. stock markets. While there are different routes to doing this, many small and mid-sized foreign companies can realize significant advantages in doing a reverse merger. Under the right conditions, a reverse merger may be the easiest and cheapest way for a company to go public. Ron Stone is a principal of Profit Planners West, a consulting firm for the reverse merger industry. You can reach him at rstone@profitplanners. com.
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