The End of Reverse Mergers

The End of Reverse Mergers
By
William Cate

Reverse Mergers are the most expensive way possible to take your private company public in the United States. While the front costs are usually under US$75,000, the Reverse Merger's stock support costs run into the millions of dollars. The shell buyers must pay the cost to buy all the Reverse Merger shell owners' shares. Since these past-owner shares will become part of the Reverse Merger's float, the shell buyers must then pay, every quarter, the cost of finding new buyers for the Reverse Merger's float. The investor relations costs ensure that the Reverse Merger Company is almost certain to fail within 2-5 years of the shell sale.

On July 19, 2005, the U.S. Securities and Exchange Commission (SEC) finalized two new rules. These Rules are 33-8587 and 34-52038. You can download these rules at the SEC's EDGAR website. Commencing in mid-August 2005, any reverse merger with a shell company is subject to these two rules. A shell company is defined as a company with no or nominal operations and no or nominal assets other than cash. A shell company that pays more than 50% of its issued shares to buy a private company is a reverse merger. The new rules require that a shell buyer MUST file a full registration disclosure statement with the SEC. The shell buyers must file either a SB-2 or a Form 10 with the SEC. These registration filings, which must be done within four days of the shell sale, must include a current audit of the private company being acquired. In addition, shares issued by shell companies cannot be resold without a SEC registration. Rule 144 won't apply until after the shell buyers register the acquisition shares with the SEC. Shell buyers may no longer use Form S-8 to register the shell company's issued shares.

It's highly probable that any shell buyer would register both the private company as a public company and the issued shares in the same SEC registration statement. Also, the shell company buyers would be wise to register shares for an IPO, if they can find an underwriter. It's unlikely that the shell buyers would use a Form 10 registration statement. If they used the Form 10 registration their shell company would no longer trade on the Over-the-Counter Bulletin Board (OTCBB) or on Nasdaq or on any U.S. Stock Exchange. Thus, all SEC registration filings will probably use Form SB2.

These two registration rules means there is no advantage whatsoever in going public in the States using a reverse merger strategy. The low front-end costs, certainty of trading and speed of the transfer are lost with the requirement to file a SB2 registration. Buying the shell, which has always made more sense than doing a reverse merger hits the same two SEC rules when the buyers attempt to transfer their private company into the trading shell.

The shell problem is that both the Form 10 and SB2 registration statements are subject to SEC comments. They won't become "Effective" until the shell company's attorney and accountant have adequately answered all questions. This can take more than a year. I expect that the NASD (National Association of Securities Dealers) will suspend trading of the shell company's shares until the SEC gives the Shell Company an "Effective Letter." The shell buyers are then in exactly the same position they would be without the shell. If they skip the reverse merger or shell purchase, they save money and they won't have a Tidal Wave of past insider shares to hit the market once they start trading. It's the sale of past insider shares that have ALWAYS made reverse mergers a terrible strategy.

The average cost of filing a SB2 registration statement for an initial public offering (IPO) with the SEC is between US$1,500,000 and US$2,223,000. The odds of getting an "Effective Letter" are about even. I suspect the costs of filing an SB2 for a reverse merger may be higher. The reason is that the previous owners shell company operations will be subject to SEC comments. The more issues the SEC can raise the longer it takes to get an "Effective Letter." The more SEC comments, the greater the costs of doing the registration statement, since the attorneys and accountants replying to the questions are charging by the hour.

For years, I've argued that reverse mergers are too costly and, until your company has unlimited money, going public via a reverse merger is a mistake. After August 2005, anyone going public via a reverse merger is a fool! There is no advantage and far greater public company costs.

Can SEC Rules 33-8587 and 34-52038 be legally circumvented? I suspect this question has been of primary concern to firms involved in the arrangement of reverse mergers and shell sales. I suspect the answer is "yes." I can see at least one cumbersome way around the SEC that avoids the filing. I suspect there may be others. It will be interesting to see what advice these firms offer to their reverse merger clients after next month.

There is still a low cost alternative to an SB2 filing. It works best for companies incorporated outside the United States. Like shells, it's a backdoor to becoming a public company in the States. As long as real company's seeking to protect their public shareholders uses the strategy, it's unlikely the SEC will outlaw it. If you are interested in exploring SB2 alternatives for your private company, visit: [http://home.earthlink.net/~beowulfinvestments/]

About the Author: William Cate is Managing Director of Beowulf Investments. He's had nearly a quarter of a century of experience in the stock market. You can email him at: Beowulfinvestments@Earthlink.net

He has been the Managing Director of Beowulf Investments [http://home.earthlink.net/~beowulfinvestments/] since 1981 and is the Executive Director of the Global Village Investment Club [http://home.earthlink.net/~beowulfinvestments/globalvillageinvestmentclubwelcome/]