Honest Shell Games?

Despite the stigma of past trading abuses, small companies still go public by merging with existing shells.

Traditionally, next-step capital for such companies has come from small institutional investors in Europe or the United States. But the costly and complex valuations required in both places have all but wiped out this avenue of funding. In Europe, self-imposed requirements for pre-investment valuations went largely ignored for years, but European boards are no longer so cavalier about their potential liability if investors challenge a redemption price. In the United States, meanwhile, investment fund managers say regulatory audits and subsequent negotiations with the SEC have resulted in investment firms being required to mark-to-market such investments at least quarterly.

“If a small company needs less than $20 million, it’s in no-man’s land,” says Anthony Loumidis, CFO of privately held American Distributed Generation Inc. The Waltham, Massachusetts-based company provides electricity, heating, and cooling systems, and has $13 million in annual revenues. The company ran into this funding block several times in seeking $3 million to $10 million from institutional investors representing mutual funds and hedge funds. “Investors didn’t want to bother hiring an independent firm to value our company on a quarterly or monthly basis,” he says.

“I think you are going to see more and more companies going through a nontraditional process, because the IPO process is so expensive,” predicts Surgenor of Cyberkinetics. The company’s vice president of finance, Kimi Iguchi, who joined at the time of the merger, is now applying to switch the company’s stock to the American Stock Exchange from Nasdaq’s over-the-counter bulletin board. Going public through a reverse merger, says Feldman, can cost as little as $250,000 in expenses (not including the cost of acquiring the shell), and usually is accompanied by a PIPE that covers the costs. Most small companies taking that route end up on the OTC Bulletin Board, which has fewer exchange-driven regulations than the New York Stock Exchange, Nasdaq, or Amex.

Such companies also are so small that Sarbanes-Oxley regulatory burdens don’t pose the same disincentives that they pose for larger companies. “Assuredly, there are incremental costs,” says Anderson’s Rock, “but they are outweighed by the ability to get capital.” As for the stigma associated with shells, recent SEC regulation has reduced it significantly. In the past, “whenever anybody walked in talking about reverse mergers, I’d throw them out of my office,” says Rock. “Now it may be the best source of funding.”

Perhaps. But one SEC official, noting the limitations of the recent rule-making, cautions companies considering a reverse merger: “Be very careful who you deal with, because there is still a lot of fraud going on in this space.”

Tim Reason is a senior writer at CFO.

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