Shell Games

Reverse mergers are making a comeback, but so are the scam artists that peddle them.

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Remember the reverse merger? This technique for going public quickly–used by Ted Turner to launch the Turner Broadcasting System–had its wings clipped by the Securities and Exchange Commission in the mid-1990s. But now, Internet companies and roll-up firms, hell-bent on cashing in on Wall Street’s interest, are embracing the technique and making it fly once again.

In the past year, Internet firms such as Stamps.com Inc., Nettaxi Inc., and PhotoLoft.com Group Inc., and roll-ups Gerald Stevens Inc. and Precept Business Services Inc. have announced or completed reverse mergers–in which they purchase struggling or defunct companies that are still listed on an exchange and merge into them, thereby becoming public entities themselves. In the first two months of 1999, 61 reverse mergers were announced, compared with 49 for the same period last year, according to Securities Data Corp.

“The idea is to strike while the iron is hot,” says Eric Stevenson, president of Axiom Capital Corp., a corporate development firm based in Tempe, Arizona. “Reverse mergers allow companies to tap into the action quickly.” Not only do they get the benefits of being public without all the expense of an initial public offering, he says, but reverse mergers also give companies greater access to needed capital.

Cashing in on the Cybercraze

Reverse mergers flourished in the early 1980s, when “you could just about take the kitchen sink public,” says Stevenson, and again in the mid-1990s, reaching a peak of 1,010 deals in 1996. The SEC, however, objected to the practice of creating public companies for the purpose of selling them for reverse mergers, and made it more difficult to set up shells. “They have come under the scrutiny of the SEC through the years,” says Tom Byrne, president of Periscope Analytics Inc., a small-cap equity research firm based in Shrewsbury, New Jersey. So far, the agency has taken a wait-and-see approach with this group of mergers.

The technique is perfectly suitable for Internet mania. Companies that may not have adequate operating results to do an IPO can tap into the buzz that Internet companies have created on Wall Street. By completing reverse mergers, Internet companies gain a listing on a public exchange that brings them instant credibility among potential customers and business partners. In addition, they gain access to stock for attracting employees and acquiring other companies.

For Jesse Cohen, CEO of iChargeit Inc., an E-commerce company and creator of Internet malls, the reverse merger route made perfect sense. At many Internet companies, he says, “money is not pouring in at the beginning. You have to keep a low burn rate [on cash].” To raise capital through a traditional IPO, he says, would cost $3 million to $5 million in underwriting fees and take more than a year. In Internet time, that is eons. “The whole environment could change by then,” says Cohen.

Instead, he opted to complete a reverse merger with Para-Link Inc., a publicly traded Dallas-based firm that had been a marketer and distributor of dietary products. As a result, iChargeit will spend only about $300,000 for the shell company, or 10 to 15 percent of the resulting company. “And we can issue a little stock,” says Cohen, who plans to do a Reg D 504 issue and use it to purchase consulting and investor-relations services to cut down on the use of cash.

Floral Arrangement

Having stock to pay for acquisitions is key for roll-up companies, which otherwise could face being swallowed by competitors. For example, $100 million Gerald Stevens, a Fort Lauderdale, Florida-based consolidator of floral stores, is nearing completion of a reverse merger with Florafax International Inc. that will not only take the private company public, but will also give it strategic assets.

The public entity it is merging into is not a shell, but another floral company with a flower-by-wire service that generates more than $10 million in annual revenues. “The merger is a good fit from a business perspective,” says CFO Albert Detz.

The former CFO of Blockbuster Entertainment Inc., Detz claims that going public was not the only impetus for merging with Florafax. However, it’s hard to believe that going public wasn’t an important part of the deal.

Gerald Stevens will get 75 percent of the combined company and will change the name to its own. It will also get a listing on Nasdaq’s National Market System and replace all but one of the Florafax directors. “We will become a public company, without the time and cost normally associated with doing that,” says Detz.

Because the company Gerald Stevens merged into was in the same industry, there were a lot of benefits not usually available in a reverse merger. For one, the IRS is expected to rule it a tax-free transaction. For another, Florafax had some operating loss carry-forwards that Gerald Stevens will use to lower its taxes. “It makes a lot more sense when the business synergy is there,” says Detz. “It’s not enough to do the reverse merger just to get the public status.”

Lurking Liabilities

The process is not without its drawbacks, however. iChargeit’s Cohen says it will take six to eight months to “clean the shell,” an arduous process that includes bringing reporting status up to date, and settling any existing claims against the shell company. “You need to remember that you are buying someone else’s failure,” says Stevenson. In many cases, the defunct public company may have hidden liabilities, such as pending litigation or badly damaged balance sheets. As a result, “there is more due diligence required than in a regular merger,” he says.

Precept Business Services found out about the dangers of lurking liabilities the hard way. The Dallas-based distributor of printed business products was considering an IPO when an investment banker pointed out the reverse-merger alternative. It was halfway through completing the deal with U.S. Transportation Systems Inc., when it uncovered potential liabilities. “There were a lot more problems associated with the company that were not obvious,” says Precept CFO William Solomon. Some of USTS’s businesses were involved in litigation with former suppliers and owners that had never been settled. “We were ready to just walk away,” says Solomon.

Instead, the two companies negotiated what Solomon calls a “triangular- C reorganization.” They spun out the troubled units of USTS, and merged with four units that it considered clean–two bus shuttle operations, a trucking business, which it later sold, and a limousine service. (Precept already owned courier and limousine services in Dallas.) The process gave Precept a listing on Nasdaq. Former USTS shareholders got about 20 percent of the stock in the new company.

Pump and Dump

Hidden liabilities aren’t the only problem with reverse mergers. “There are so many holes in many of these deals you could drive a truck through sideways,” says Stevenson. For one, reverse mergers can backfire easily if the shareholders of the shell company dump the securities post merger and tank the stock price. Another problem is that promoters often buy up shares of the defunct company for almost nothing and hold them in street name, which masks the owner’s identity. They can end up with anywhere from 10 to 20 percent of the merged company. Then they promote the stock using telemarketers or posting messages on the Internet. Once the deal is done and the price increases, they sell their shares and the stock price falls to pennies per share. “There are a lot of shady characters peddling these deals,” says Stevenson.

There are also plenty of companies that complete reverse mergers that are not on the up and up. For example, the SEC filed suit against International Heritage Inc. last year, alleging it was an enormous pyramid scheme. The Raleigh, North Carolina, company claimed it operated a network marketing company that sold various products through an army of sales representatives. The SEC alleges the company illegally raised $150 million from more than 155,000 investors, and misrepresented its financial condition. International Heritage, which completed a reverse merger last year, later filed for bankruptcy. The suit is still pending.

Periscope’s Byrne says that some companies use reverse mergers to go public “without being subjected to the scrutiny of registration with the SEC.”

Stevenson advises companies that are looking to do reverse mergers to first audit the shareholder list of the potential acquisition. Shareholder-locator firms, such as Shareholder Locator Service, in San Francisco, can validate the authenticity of the list to ensure that the shareholders exist and that shares are not concentrated in the hands of a few people. He also encourages acquirers to sign agreements with the seller that restrict them from selling any stock for 12 to 18 months.

As the trend toward Internet firms and consolidators going public presses on, expect to see more reverse mergers by the smallest of them that think they need to be public to compete. But many will not live up to the rigors of being public. Says Byrne: “Sometimes you have to wonder if a company that has to resort to this method belongs in the public market.”

Joseph McCafferty is an associate editor at CFO.

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