Reverse Mergers — Knowledgable Comment

Comments don’t get any better than this one, a detailed assessment of the hazards of reverse mergers. It was added as a comment to an earlier blog post of mine. I’m grateful for the contribution, and humbled by the writer’s knowledge and clear writing style.  Highly recommended.

 

A Reverse Merger (“RM”) is routinely pitched as a cheaper and quicker method of going public than a traditional IPO in China. This may be technically true but the comparison is VERY MISLEADING. 

As you mentioned a few times in your blog, an RM is not a capital raising transaction. No shares are sold for cash in the transaction. It will receive little attention from analysts ! The RM is often coupled with a PIPE financing. However, the amount of PIPE financing that can be raised is very limited. Additionally, PIPE financing is typically expensive relative to other financing options and may contain onerous terms. 

Generally, completing a $50 million IPO will roughly run a company 18% of the offering proceeds, including underwriter discounts, under pricing, and legal, accounting, filing, listing, printing, and registrar fees, or $9 million. 

Conversely, an RM was advocated as “costs only between $100,000 and $400,000 to complete”. This is the most tricky and misleading part, because this cost range does not include the value of the equity stake retained by the shell promoter and its affiliates. And most Chinese company does not understand this. 

Generally when the RM closes, the Chinese Operating Company is issued Shell Company shares only equal to 80% to 90% of Shell Co’s post-merger outstanding shares. The the remaining 10% to 20% of shares are retained by the owner of the Shell Company, the promoter and its affiliates.

Hence, in addition to the $100,000 to $400,000 in cash paid by Chinese Operating Co to complete the RM, the Chinese Operating Co has also “paid” a 10% to 20% stake in its company. If the market capitalization is $50 million post-RM, this stake is worth $5 to $10 million. 

So RM is not cheaper at all ! It is Usually an option for second and third tier companies to obtain financing via a PIPE, and Some PIPE investors may not be long-term investors. An active trading market for stock may not be developed through a RM. Company will probably not qualify to trade on the Nasdaq and will likely end up trading in the pink sheets or the bulletin board.