Subject: Stocks - Reverse Mergers

Last-Revised: 14 July 2002
Contributed-By: The SmallCap Digest (www.smallcapdigest.net)

A reverse merger is a simplified, fast-track method by which a private company can become a public company. A reverse merger occurs when a public company that has no business and usually limited assets acquires a private company with a viable business. The private company "reverse merges" into the already public company, which now becomes an entirely new operating entity and generally changes name to reflect the newly merged company's business. Reverse mergers are also commonly referred to as reverse takeovers, or RTO's.

Going public (in any way) is attractive to companies because after going public, the company can use its stock as currency to finance acquisitions and attract quality management; capital is easier to raise as investors now have a clearly defined exit strategy; and insiders can create significant wealth if they perform.

The reverse merger is an alternative to the traditional IPO (initial public offering) as a method for going public. Many people don't realize there are numerous other ways for private company to become publicly traded outside of the IPO. One widely used method is the "Reverse Merger".

The reverse-merger method for going public is more prevalent than many investors realize. One study estimates that 53% of all companies obtaining public listings in 1996 did so through the "Reverse

Merger". The same study concluded about 30% of newly publicly listed companies got there through Reverse Mergers in 1999. Percentages have recently dropped because Wall Street Investment Banking firms have had a huge appetite for IPOs in the late 90s. This led to many marginal companies receiving enormous financial windfalls.

In a reverse merger, the original public company, commonly known as a "shell company," has value because of its publicly traded status. The shell company is generally recapitalized and issues shares to acquire the private company, giving shareholders and management of the private company majority control of the newly formed public company.

The RTO (reverse take over) method for going public has numerous benefits for the private company when compared to the traditional IPO:

  • Initial costs are much lower and excessive investment banking fees are avoided.
  • The time frame for becoming public is considerably shorter.

There are also several disadvantages of going public through the RTO as compared to an IPO:

  • There is no capital raised in conjunction with going public.
  • There is limited sponsorship for the stock.
  • There is no high powered Wall Street Investment Banking relationship.
  • The stock generally trades on a low exposure exchange.

Many highly successful companies have become public through the RTO process. However, there some important negatives investors should be aware of.

There is a much higher failure rate amongst RTO companies versus the traditional IPO. Much smaller and less successful companies are able to become public through the RTO, and many are badly undercapitalized. Often these stocks trade very inefficiently in the absence of any sponsorship or following.

There is a cottage industry of merchant bankers and entrepreneurs who specialize in orchestrating reverse mergers. Unfortunately, there are no barriers to entry in this field. Therefore, scams are common place.

Through various methods, scam artists manage to accumulate large positions in the free trading shares of the shell company. An RTO is consummated with a marginal private company, and the scam artists put together a massive publicity campaign designed to create activity in the stock. Unrealistic promises and absurd claims of corporate performance find their way to the public. The enhanced trading volume allows the scam artist to dump his shares on the unsuspecting public, most of whom eventually lose their money once the newly formed public company fails. This scam is commonly known as a "Pump and Dump".

Alternatively there a hundreds of examples of highly successful companies which have yielded millions in profits for investors that have gone public through the RTO. Many of these companies deserve exposure to investors. Initial valuations can be reasonable, providing excellent opportunities for individual investors to accumulate positions ahead of Wall Street institutional money.

Here are some high-profile and successful RTOs:

  • Armand Hammer, world renowned oil magnate and industrialist, is generally credited with having invented the "Reverse Merger". In the 1950s, Hammer invested in a shell company into which he merged multi decade winner Occidental Petroleum.
  • In 1970 Ted Turner completed a reverse merger with Rice Broadcasting, which went on to become Turner Broadcasting.
  • In 1996, Muriel Siebert, renown as the first woman member of the New York Stock Exchange, took her brokerage firm public by reverse merging with J. Michaels, a defunct Brooklyn Furniture company.
  • One of the Dot Com fallen Angels, Rare Medium (RRRR), merged with a lackluster refrigeration company and changed the entire business. This was a $2 stock in 1998 which found its way over $90 in 2000.
  • Acclaim Entertainment (AKLM) merged into non operating Tele-Communications Inc in 1994.

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http://www.smallcapnetwork.net

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