Reverse merger deal flow increased more than 25% in 2010 despite the market for such deals being plagued by attacks from short sellers, several fraud scandals, and the promise of heightened regulatory oversight.
There were 246 reverse mergers completed between reporting shell companies and private operating businesses last year, an increase of 25.5% from 2009. Those deals were valued at about $2.6 billion, an increase of nearly 53% compared to 2009's total value (values exclude deals involving non-trading shell companies).
The Chinese reverse merger market has been threatened many times before. Numerous circulars and regulatory decrees by the Chinese government, the market crash of 2008, and the short-seller attacks last year have from time to time created cause for concern since the structure gained popularity in 2005. In each case, it survived.
A reverse merger into a shell company (a back door IPO) is essentially the acquisition of a non-operating public company by a private company, with the public company surviving. The shareholders of the private company gain control of the public company by merging their company into the public shell and receiving shares in the public shell as their merger consideration. The public company is called a “shell” because there is nothing inside – it’s typically not an operating company at the time of the transaction. The private company shareholders obtain the majority of the shares and board control; the private company’s name is usually adopted. The process is often marketed as taking only a few weeks (much quicker than a traditional IPO) and avoiding a related lengthy and expensive SEC review – should the shell already be registered with the SEC.
To be fair, a reverse merger can be a cheaper and faster way to go public. You can often bundle it with a fund raising, lock up shareholders (so they don’t dump shares into the liquidity you might get) and cash out minority investors who need to sell. Theoretically, you can use the “public” shares as acquisition currency after you complete the transaction. And if the business performs well, you will have a higher price, liquidity and perhaps even an institutional following.
What you’ve seen more often is an increased burden for management from the demands of being public. Below a certain market cap institutions can’t or won’t buy company shares so investment banks aren’t motivated to make a market or initiate research coverage. As a result, shares trade thinly. Financing is tough – the participants in such transactions tend to litter their deals with warrants and dilutive and contingent terms (should the company not meet certain performance criteria). Since the initial “shell” company often failed, a stigma can linger. Unlike with an IPO, no large chunk of raised funds necessarily accompanies this route to becoming public (which can justify the increased scrutiny, cost and burden of being public).
According to NY Global Group, a leading China expert on Wall Street, "China-based companies with VIE (variable interest entity) structures are the single biggest “time bombs” in the U.S. Markets."
In a VIE structure, the public shareholders do not own the underlying assets in the operating entity – the actual business that generates revenues and earnings for common shareholders. Instead, all of the sales and incomes reported by the public company and filed with the SEC are booked through contractual agreements whereby a company’s management and founders agree to transfer their rights to sales and incomes from the operating business to the public company. The original founders retain the ownerships of the underlying tangible hard assets such as cash, factories, land use rights, machinery, customers etc. In theory and in reality, company management and founders can choose to walk away and leave the public shareholders with no legal claims to the assets of an operating entity. Doesn’t this sound crazy? It certainly does.
RINO was a good example of a VIE structure. RINO’s market capitalization was at one time approaching $1 billion. Shareholders that bought shares in RINO apparently did not realize the inherent risks involved since they perhaps did not bother to read the company’s SEC filings which disclosed risks associated with a VIE deal structure. In NY Global Group’s view, a public company in the U.S. with a VIE structure poses the single biggest risk to U.S. investors. Alarmingly, companies with the VIE structure represent more than 20% of the entire universe of China based, U.S. listed companies listed on U.S. stock exchanges, including almost all of the high flying internet stocks. The vast majority of them have become public companies in the U.S. through IPOs.
In contrast, China’s own domestic stock exchanges do not permit listing of any company whose revenues are organized under a VIE structure. The VIE structure was created by global law firms in the early 2000s to intentionally circumvent legal requirements in China that prohibit foreigners from owning shares in China based internet companies. That law is still applicable in China today. However, the “creative” VIE structure has become a main stream listing process for China based companies – with almost all of them listed through IPOs in the U.S. markets. What do shareholders own by buying shares of a company organized under a VIE structure? Legal professionals may argue that shareholders get sufficient protection through those management contracts. The reality is, in today’s China, a VIE structure is nothing but a piece of paper evidencing certain “right” that is next to impossible to enforce under Chinese laws. The New York Global Group avoids companies with VIE structures completely.
Is it the structure that we don’t like, or the reality that many companies who use it have few alternatives? Both. A lot of us are huge believers in taking money when they can…until doing so becomes too cumbersome, dilutive or difficult (for example, high debt burdens that are impossible to meet). But alternative methods are alternative for a reason; they’re often marketed with much hype but don’t deliver as promised. In the right situation a sophisticated and well counseled management team can benefit from such a transaction.
Many companies completing a reverse merger don’t succeed. In many cases it has nothing to do with being public. Companies pursuing these alternatives are typically smaller (on average with market caps of $50-$100 million initially) than IPO candidates, so they tend to fail at about the same rate as any group of similarly situated private companies. And others fail because they went public for the wrong reasons (such as only to obtain one round of financing).
When a Chinese company starts to trade on the OTC Bulletin Board more often than not faces thin trading initially. But good companies watch their market support build over time with proper IR help, etc. That’s why I am happy that firms such as RedChip, Rodman&Renshaw, HC International etc. do a great job to give exposure to these companies.
More and more companies are bypassing the Bulletin Board with a two step process of completing a reverse merger and PIPE, then doing a secondary public offering that brings the first trade right to Nasdaq or NYSE AMEX, where trading volume is typically much stronger.
Also, shells with a legacy can be problematic as issues from the past are inherited by the target when the new company merges in. More and more shells are turning to so-called Form 10 shells that are created from scratch as shells and never have any operating business at all. They become fully SEC reporting, but no trading is allowed until a reverse merger and subsequent SEC registration of shares takes place. Here there is no stigma from past operations. These Form 10s have been used successfully dozens of times in the two-step process outlined above.
Let's assume that any company looking at a reverse merger also has an IPO option available to it. Most of these companies do not meet the size criteria of the IPO investment banks, but yet know they can benefit from being public in order to make capital formation easier (millions of dollars in financing last year has gone to OTCBB companies), make acquisitions using stock as currency, creating a path to liquidity for themselves and their investors, and incentivizing management with valuable stock options.
And yes there are still some unscrupulous (Chinese) companies around, but if you work with legitimate, experienced, ethical management, a Reverse Merger can be a great way to bring a company to the next level according to David N. Feldman, a leading expert on reverse mergers and author of the book Reverse Mergers and Other Alternatives to Traditional IPOs, Second Edition (Bloomberg Press, 2009).
In my opinion the most important characteristics for a Reverse Merger to succeed are People (Management), Profit (Right business) and Promotion (Investor Relations).
My Top-5 of Chinese Reverse Mergers that will flourish in the coming years and meet my criteria of PPP but also meet my China Investor King's 3U model (Unloved, Undervalued and Underowned):
Weikang Bio-Technology (WKBT,OB)
American Lorain (ALN)
China Botanic Pharmaceutical (CBP)
New Energy Systems (NEWN)
SkyPeople Fruit Juice (SPU)
Disclosure: I am long WKBT.OB, ALN, SPU, CBP.