Reverse Mergers: There's Always A Catch When It Looks Too Good, Right? Right.

by: Joseph Allen

You want to go public? There are basically three ways to do that. First option is to find an investment bank and do an Initial Public Offering or IPO. That's what Twitter just did, and wow, look what happened. Now it's not just Twitter, it's NYSE: TWTR and it's worth a cool $23 billion. But if you can't justify raising $50 million or more, it probably isn't going to happen.

Second option is to hire a lawyer and an auditor and file all the papers with the SEC to be public, and start reporting as a public company and eventually, after many steps, you'll be able to get a symbol on the Pink Sheets, which is the lowest level of national quotations for public companies.

Third option is to do a reverse merger, which means you buy most of the shares of a public company from someone who deals with "shells," and merge with it, change its name to yours and then you're public.

Reverse mergers have a mixed but basically respectable history; for years the reverse triangular merger was the only way to buy a smaller company and integrate it into your company. Then it was adapted to take private companies public, and many well-known companies went public through reverse mergers, including Occidental Petroleum (NYSE:OXY), Turner Broadcasting, Radio Shack (NYSE:RSH) and Texas Instruments (NYSE:TXN), to name just a few. The New York Stock Exchange (NYSE:NYX) itself, which was formerly a mutual company, had itself reverse-merged into Archipelago Holdings in order to become public. Muriel Siebert, the first woman to start her own broker-dealer, was a champion of the reverse merger as a vehicle for going public.

But then a couple of years ago the SEC put out a fraud warning on companies that had gone public through reverse mergers - most likely because of a lot of manipulation regarding a tidal wave of Chinese companies going public in the US through that device.

The market is broken when it comes to small companies, which are referred to, somewhat derisively, as microcap or nanocap companies now. Smallcap companies range in market capitalization from about $250 million to about $2 billion in market capitalization, maybe more. So if you want to raise $10 million, you are an ant in a roomful of elephants. Most small companies that want or need to be publicly traded, opt for Door Number 3: the reverse merger.

Vapor Corp (NASDAQ:VPCO) is an example of what can happen with a relatively successful reverse merged company. It makes various kinds of electronic cigarettes - that is, fake cigarettes that allow a smoker to inhale something that is said to taste like cigarette smoke and may have some nicotine in it, but is basically a type of vapor, with no smoke in it at all. No smoke, no second-hand smoke, and you can "smoke" these cigarettes in places where real cigarettes are banned. They reversed into a Nevada shell that was originally a cattle feeding business that went belly up. Then called Smoke Anywhere, they acquired the shell and eventually renamed themselves Vapor Corp. Today they are trading about 330,000 shares a day at about $0.92 and the shares have traded as high as $1.32 this year. Its market cap is about $57 million. If you look at a trading chart, it is entirely possible that many of the investors, if they have stayed around for a while, have made a good return on their money, at least as of today.

On the other hand, from the same industry - electronic cigarettes - you could look at Smokefree Innotec (OTCPK:SFIO), which merged into a Washington State shell about five years ago. It has very few documents on file with the SEC, and trades for about a penny, with spikes up to a few pennies. Looks like dead money.

The most spectacular of the electronic cigarettes from a stock point of view is Victory Electronic Cigarettes (ECIG), which reversed into a Nevada mining shell quite recently, and according to Yahoo!Finance, the stock has traded in a range of $0.56 to $60.00 (although the highest closing price that I can see is $42) in the past 52 weeks. It is currently trading at $8.10 with a market cap of about $373 million. Hard to tell if anyone has made money, because since a huge spike in mid-September, the stock has only traded down trendwise, so it's possible that the only people who have made money are the residual holders of the old mining company. The trading volume is so low that it might be impossible to sell a position, too. But it is a remarkable chart if you like roller-coasters.

Just to be clear, I am not trashing electronic cigarettes as an industry. I think the big tobacco companies are all over that, and there is at least one privately held "independent" that seems to have a huge advertising budget and a famous actor as a spokesperson.

The thing is, if you're a small company and you elect to do a reverse merger, usually accompanied by a private placement or PIPE that is to be filed on a registration statement shortly after the closing - it is a good thing to remember that 99.99% of the market will be unaware of your existence. If you sell for pennies (which means under about $3), brokers in most firms can't sell your stock to their clients due to compliance problems (the brokerage that employs them sets rules that attempt to keep them from being sued for bad practices).

In an old-fashioned IPO, the company going public meets a lot of potential investors on the road trip(s) during the deal, and is at least eligible for a fair amount of publicity, as well as research coverage by some or all of the investment banks that are involved with the IPO. You'll have none of that with a reverse merger, so on the first day of trading, there is frequently a stunning silence, because you can't have trading without buyers.

So you have to duplicate what goes on in an IPO, possibly with the help of a good investor relations firm. You have to meet institutional investors of all kinds - hedge funds, mutual funds, family offices, retirement trusts, philanthropic trusts, et al. You need to bring yourself to the attention of research analysts, even though they will not cover you unless and until your stock is trading upwards of $500,000 a day. You need to have a presence in the media, and in these days, no matter what field you're in, you need to take a position in social media. Think StockTwits, LinkedIn (LNKD), SeekingAlpha, and even Motley Fool. You need to hit all the financial conferences you can, especially the ones sponsored by investment banks, broker-dealers or research organizations like Sidoti.

If you are not able to get these things done, your trading may be disappointing, and your valuation may be unrealistically low. If either of those things happens, your ability to access the capital markets in a financing will be seriously impacted for the worse. You need to have a list of institutional investors who own the stock; you need to trade something like 100,000 shares a day at $5 to get the attention of an investment bank or an analyst. Your trading needs to be able to accommodate blocks without destroying the valuation.

I have been unable to find any statistics on how many reverse mergers succeed, or are still operating after five years, but I suspect the mortality rate is fairly high. But you gotta do what you gotta do, and there are ways to make your odds better. They take time and effort, and possibly their equivalent: money. Put in simple language, you need to increase the size of your audience every day, and most entrepreneurs need help getting that done. Nothing happens until somebody bids for your stock.

On the other hand for investors, looking at recent reverse mergers may be a great way to find deep value discounts, because typically the trading opens at the price of the shell, which may be a lot lower than the value of the shell plus the merged company. If you'd draw on 14 at a blackjack table, this might be a good market for you.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.