A recent column painted reverse mergers with a broad, negative brush. Reverse mortgages offer a compelling way for young companies to come public. They are faster and more cost-effective than traditional, banker-backed IPOs.
This Sunday’s New York Times had an interesting article by Kurt Eichenwald on the topic of reverse mergers, but I have to take issue with his view.
A reverse merger is a way of taking a company public that skirts the Goldman Sachses (GS:NYSE) and Morgan Stanleys (MWD:NYSE) of the world. And, consistent with my articles on PIPEs, Dutch auctions, and SPACs, I am always in favor of any financial structuring that takes the power out of the larger banks and makes it more accessible to smaller companies and investors.
Eichenwald is the author of a best selling book about Enron that I highly recommend, but I can’t say the same about this article. Titled, “A Mini-Enron at Every Corner?” the column describes the case of two brothers who engineered a reverse merger that eventually went bankrupt. Along the way to bankruptcy, the brothers (it’s unclear if it was one or both ) engaged in various activities that may have skirted the law. The implication of this article, conflating the experience of this one event to all, is that all or most reverse mergers could quite possibly be cesspools of corruption and boiler-room activity.
Behind the Reverse Merger: A public company with no business operations acquires a private company with operations. The public company changes its name and management to that of the private company, and now the private company has become public. Many companies that have gone public through this route were, in fact, used by boiler rooms in pump-and-dump operations. But in my mind this is really no different than the blue-chip investment banks taking junk like Pets.com public and engaging in their own versions of the pump-and-dump scheme to drive up shares of the IPO. However, just like in the case of companies brought public by Goldman Sachs, there is the occasional quality company brought public through the reverse merger mechanism.
What are the advantages of a reverse merger as opposed to a traditional IPO? The company can avoid paying the exorbitant fees that the investment banks charge for an IPO, it’s faster (no roadshow, less SEC review of the filings), and it’s often easier for a smaller company to go public through a reverse merger than by attracting a larger investment bank. This was all particularly advantageous in 2001 when not only was the market cruising toward its eventual 2002 bottom, but investment banks were starting to come under scrutiny for questionable IPO practices. A reverse merger conveniently skips all of that. So why go public at all? The downside of a reverse merger is that if your business plan does not succeed and you fail to attract investor attention, it will be impossible to raise money again through the issuance of shares, and all your faults and failures will be on public display through SEC filings.
The upside is that it can provide potential liquidity to your early investors and you now have currency (your stock) with which to do acquisitions and potentially raise money through either secondaries or PIPE (private investment in public equity) offerings.
My own experience with the reverse merger process began in 1999 when I helped start a company, Vaultus, which provided wireless software to large enterprises. Typical for those times, we raised $30 million in a split second from the likes of CMGI (CMGI:Nasdaq), Investcorp, Henry Kravis and others. Then, early in 2001, we were exploring our options, and the option that seemed most likely to succeed was a reverse merger with a public shell.
In May 2001, we found ourselves a shell that had $10 million in cash in it but no operating assets. Previously, the shell had been the home of an Internet portal that itself had been a reverse merger several years earlier. The stock of the portal in 1999 had gone from $1 to $30 before reality set in, shares settled down between 20 and 40 cents, and management wound down the operations of the portal.
When debating the merits of whether or not to do a reverse merger, one of our board members posed the question, “But has a reverse merger ever worked before? Because I don’t want to base a decision on ‘this time things will be different.’ ”
With no solid answer to his question, we eventually passed on the opportunity only to watch the stock we were going to consummate our merger with do another deal and then proceed straight to over $5 a share on heavy volume, where it trades today.
We didn’t know the answer then, but now I do have the answer to the question of the Vaultus board member.
Armand Hammer brought his little company, Occidental Petroleum (OXY:NYSE), public in 1950 (after making millions selling pencils to postwar Russia) through a reverse merger.
Ted Turner took his billboard company public in 1970 when he merged into publicly traded, failed TV company Rice Broadcasting, changed the name of the new public entity to Turner Broadcasting, and took over the company.
Or Muriel Siebert, who took over the public furniture company, J. Michaels, in 1996, renamed it Siebert Financial (SIEB:Nasdaq), and the public company is now a financial services company. Other companies that have used the reverse merger vehicle to go public and then went on to fame and fortune include Waste Management (WMI:NYSE – commentary – research) and Blockbuster Video (BBI:NYSE), before it was acquired by Viacom (VIA.B:NYSE).
Arguably the most famous reverse merger is Berkshire Hathaway (BRK.A:NYSE), the old-school Maine textile manufacturer that was taken over by Warren Buffett when he bought the controlling interest in the company and then merged his insurance empire into it. The only thing he didn’t do was change the name.
To be fair, probably 90%-plus of reverse merged companies fail. But this is not because the process is bad but because, like with IPOs, or any area of life that touches the investing (read: gullible) public, there are those who abuse and take advantage of the system; I’ve written about some of these situations in prior columns in this space.
Like anything in investing — good, profitable, growing companies will eventually shine. The beauty of the reverse merger process is that diligent work can uncover these gems before the investing public is told about them by the larger banks.
Recent examples of successful reverse mergers include RAE Systems (RAE:Amex), which did a reverse merger in 2002 at approximately 20 cents a share and is now cruising between $2 and $3 after reaching a high of $9.50. And Intermix (MIX:Amex), which merged into Motorcyle Centers of America, a business with no operations, in 1999, went through several years of pain and below-$1 prices before emerging as a successful e-commerce player that currently trades at $5.70. Global Sources (GSOL:Nasdaq), a China-focused business-to-business play, reverse-merged with asset less shell Fairchild and now has a market cap of $250 million, $50 million in cash, no debt and $22 million in EBITDA.
Another recent example is CKX (CKXE:Nasdaq), formerly Sports Entertainment, which traded under the symbol of SPEA.ob. On Feb. 7, SPEA, a stock trading at the 5-10 cent level, announced a reverse merger with Elvis Presley Enterprises, which controlled all the rights to Elvis Presley’s estate. Since then they also announced a deal with the producers of American Idol. Now the stock is trading at $26.64 and has a $2 billion market cap.
The way to invest in reverse mergers is to find companies like the above that have been through the process but have not yet to be touched by the larger banks and hence receive no analyst coverage and very little media coverage. This allows the companies to grow and enhance their stature before the Street jumps on the stories. In other words, you can invest in legitimate, growing, perhaps even profitable companies that nobody knows about. But if they execute, the investment banks will come sniffing around when they smell the scent of M&A fees and secondary offerings. But for the moment, the untouched beauties may have room to rise.