VC Cliche of the Week

There are times in the venture business when you really want to get liquid on an investment but you can't find any buyers at an acceptable price and the company is too small to make for an interesting public offering candidate.

That's when people start talking about the "back door IPO".

A back door IPO, also known as a reverse merger, is when someone who controls a public company with little or no business in it but often some cash (known as a "public shell") agrees to merge with another company, thereby creating a new publicly traded business.

I can think of at least 5 times when its been proposed that one of our portfolio companies do a back door IPO as a way of getting public and getting us liquidity.

We've never done it and I don't think we ever will.

There are a bunch of reasons for this.

• The people who control public shells are generally not the highest integrity people and they are not easy or desirable to do business with.  I know that there are probably decent people who find themselves controlling a public shell, but the vast majority of the people that I have come in contact with in this business are not the kind of people I want to be in business with (see lie down with dogs, come up with fleas).
• The people who control the public shells demand a "premium" for their business because they have the public company asset.  The premium they demand often gives them a significant percentage of the merged business and it is rarely a fair deal for the privately held company.
• There is no way to determine the valuation at which the merged entity will trade at once the merger is completed. In a traditional public offering shares are sold at the IPO and that sale price is a good indication of where the stock will initially trade. Because there is no way to determine the value at which the merged company will trade, there is no way to determine what the value of the deal is to the privately held business.
• Because there is no stock sold as part of the deal, there is no marketing effort associated with the back door IPO.  One of the best things about the IPO process is the road show in which the company has the opportunity to tell its story to a large number of institutional investors, thereby insuring some interest in the stock.  In a back door IPO, you could, and often do, end up with a public company that nobody knows or cares about.
• If cash is an issue for the privately held company, the back door IPO often doesn't bring a lot of cash and once the company is public, its much harder to do a financing with private equity investors.  The result is that a back door IPO may make it harder to raise money in the future, not easier.
• There is no guarantee of liquidity in the stock.  There is no value in having a public company if there is no real market for the stock.  The idea that because a company is public you can sell your stock is false, particularly if you have a large position in the public company.
• It costs a fortune to operate as a publicly traded company, particularly in the age of Sarbanes Oxley.  I have heard that it costs at least $2mm per year to comply with all the rules and regulations associated with being a publicly traded company.  Adding $2mm of annual expenses is not often easy to accept for a small privately held company.

These are the main reasons why I think back door IPOs are a bad deal for privately held companies.

There are probably other reasons against (or for) back door IPOs and if any of you have anything to add to this, please post it in the comments.

Comments

[Charlie Crystle]

A friend of mine recently was in merger talks with a Chicago firm that planned a reverse IPO. He's been in business for 18 years and needs a break, so for him it would be a cashout and a way to reduce the daily stress associated with running a company. A few weeks ago he learned that the buyers had been in business before--as scam artists who merged with companies and drained tehir bank accounts. They had already served time for earlier crimes and were under investigation by the FBI.

Those are some pretty big fleas.

[Dave]

It would seem that if a privately held company is looking for liquidity, and it is too small to go public itself, then it would only be out of desperation that it goes through a reverse ipo.

After all, if the company is at all solvent, wouldn't some investor like to make a private placement in the company?

[Josh Kerbel]

You are probably right on all accounts. However, something to take a look at (I stress take a look at, not do) is the capital pool program offered up in Canada. Yes, I know this it is Canada, not the US. Basically, shell companies raise some cash on the TSX venture exchange and then have to perform a qualifying transaction in a limited period of time.

The capital pool program and venture exchange have really cleaned up their image as of late and have a much better reputation than dealing with Pink Sheets and OTCBB listed companies that are often proposed for the reverse take over transactions

[Shivering Timbers]

For all the reasons you listed, most serious money managers view a reverse IPO as a nearly-unforgivable taint on a company. The assumption is that a company would only do a reverse IPO if it knew that a traditional IPO would fail, therefore, a reverse IPO is a sign of something seriously wrong with a company.

I've found that there is a certain group of managers who get caught up in the idea of financial engineering: they forget that financing and capitalization is secondary to running a business, and that any way to achieve a particular goal is just as good as any other.

As an example, I recently had someone pitch a hostile takeover of a private company (!) to me. He even had a way to make it work from a financial engineering perspective (there was an outstanding warrant in weak hands). He was not happy when I told him I wasn't interested without board support: even if the takeover was successful, existing management could make it impossible to actually run the business if they were unhappy.

[JayR]

Fred, I think you've covered the basics. There is one other fact to consider - the rate of success of these things is ridiculously poor. As of about 4 or 5 years ago, something like 95% of these reverse merged company stocks never traded above the pre-merger prices (which were usually in the pennies to start with). Now, maybe in some cases, a 5% chance of success through a reverse merger is the best available alternative, but investors need to consider not only the real risks of transactions like this but also the potential reputational risk.

[ellen]

Very interesting post- I have been watching a company. The company became a holding company for 3 retail entities. The stock was at $1.99 two years ago and is now $13.65. The company had not shown a profit at all and has been running at a negative for those 2 years, yet the stock continues to go up. Last week the holding company had an ipo of one of their previously held entities and that entity began at $18 and is now trading at $25. I cannot understand how this company's stock continues to rise with all this negativity.

[Josh Kerbel]

I thought it was ironic that a few of your Google Adsense ads were for http://www.pubcowhitepapers.com and http://www.gopublictoday.com.