The 3-Headed Unicorn: SPAC v Reverse Merger v IPO
By Avraham Shisgal
Venture Partner @ www.NYVC.com
December 2020
Ownership of a private business, a business that does not have its shares traded on a public stock exchange, comes with advantages and disadvantages. Advantages include far fewer burdensome regulations to comply with and the ability to conduct and grow your business with no public disclosure. The biggest disadvantage, on the other hand, is lack of liquidity. Owners of a public business, a business whose shares are traded on a public stock exchange, do have to comply with regulations and disclosures but also enjoy the benefit of liquidity.
The term “liquidity” describes the ability of shareholders, or fractional-owners, of a business to easily and quickly buy and sell shares of ownership of the company, from a fraction of a single share to a controlling equity stake in the company. Liquidity attracts investors, small and large, and enables a company to use existing shares or newly issued shares to finance acquisitions and as collateral for debt financing. Liquidity also allows founders and early investors the ability to sell part or all the equity they owned before the company became a publicly traded entity.
There are three routes for a private business to become a publicly traded company: an IPO, a Reverse Takeover (RTO) also called a Reverse Merger (RM), and a SPAC. (A spin-off, where a publicly traded company spins off a portion of its operations into a separate publicly traded company, does not involve a private business.)
INITIAL PUBLIC OFFERING
An IPO, an Initial Public Offering, is a process in which the owners of a private company file a Registration Statement with (in the USA) the SEC, the Securities and Exchange Commission. The Registration Statement describes every aspect of the business, discloses risks, financial conditions, the business itself, and the ownership structure of the company. The SEC conducts a multi-step review of the Registration Statement, and once approved, the company becomes an SEC-Reporting Company and starts working with a stock exchange (eg. OTCBB, NYSE, or NASDAQ) to become listed on the exchange and obtain a stock “ticker” symbol enabling investor to buy and sell shares of the company through their brokerage accounts.
This IPO process could last many months during which time global or regional market conditions and the competitive landscape can drastically change before the “opening day” on which shares of the newly public company can begin trading on the exchange.
REVERSE MERGER
Another route is the Reverse Takeover (RTO), aka a Reverse Merger (RM), a process designed to skip the IPO process. A pure two-party Reverse Merger (RM) is a process in which the owners of a private business acquire from the shareholders of an unrelated public company, which has been listed and traded on a stock exchange for some time, substantially all the shares of the public company. The selling shareholders are typically paid a few hundred thousand dollars for their shares and are allowed to maintain private ownership of any physical assets or business operations the public company previously owned. At this point the owners of the private company, who own their original private business and the publicly traded company they have taken over, merge their private business into the publicly traded company, and their previously private business becomes a publicly traded one.
There are also three-party reverse merger transactions in which a well-financed third party acquires both a publicly traded shell and a private company, then merges them, i.e. folds the private business into the publicly traded entity, and positions the publicly traded business for growth.
Berkshire Hathaway is often presented as an example of a Reverse Merger, but it is not precisely so. Warren Buffet acquired Berkshire, a publicly traded failing textile company, but rather than merging a company he’d previously owned into Berkshire, he used Berkshire, years after he’d acquired it, as a vehicle for acquiring National Indemnity Company, an unrelated third-party insurance company.
Another example cited as a Reverse Merger is Rare Medium. But this transaction was also not a pure Reverse Merger. In the case of Rare Medium, a group of investors (Platinum Partners) acquired an air conditioning manufacturer trading on the OTCBB under the symbol ICC, allowed the selling shareholders to keep their air conditioning assets and business, and remained a publicly traded shell company (without a business). At this point, ICC, controlled by its new shareholders who were flush with capital, acquired a website development studio by the name of Rare Medium, changed the stock symbol to RRRR, and moved the company from the OTCBB exchange to the NASDAQ, driving the stock up from a penny-stock to nearly $100 a share.
This Reverse Merger process could, hypothetically, be achieved quickly, shortening the length of time required to take a private company public and avoiding long term market volatility and changes in the competitive landscape. Reverse Mergers have considerable shortcomings, though. It is difficult and expensive to find public companies traded on the NYSE or the NASDAQ willing to sell their public company and take their own business private. This relegates Reverse Merger prospects to the “Penny Stock” market, the OTCBB, a stock exchange not suited for growth companies with established institutional investors. A company traded on the OTCBB can be “cleaned up” and moved to the NYSE or the NASDAQ, but that involves another step and is subject to requirements imposed by the larger stock exchanges. For example, after a reverse merger, the NYSE and the NASDAQ exchange will only accept an issuer if 1.) the company traded for at least one full year on another regulated exchange, 2.) maintained on an absolute and on an average basis a stock price of at least $4 per share for a sustained period, and 3.) has timely filed with the SEC all required reports and filings.
Another risk involved with conducting a Reverse Merger is that, in terms of hidden liabilities, the existing publicly traded company is a cat-in-the-sack. For example, six months after a successful Reverse Merge, the company can be hit with a billion-dollar class action suit for something the public entity did six months before the Reverse Merger, and the previously unrelated business and shareholders could be on the hook for untold damages.
SPECIAL PURPOSE ACQUISITION COMPANY
A SPAC (Special Purpose Acquisition Company) is an IPO. Except that, rather than an ongoing private business enterprise becoming a publicly traded business, in a SPAC, a newly formed company with no business history files a Registration Statement with the SEC to become an SEC-Reporting publicly traded company intended to acquire an operating business after its stock has started publicly trading. SPACs typically raise capital or commitments from investment funds and institutional investors prior to completing the IPO. A SPAC that has raised capital for the purpose of this intended acquisition is required to hold the funds in an escrow account and has a limited amount of time to consummate the acquisition.
The IPO process of a SPAC, having no prior business history and rudimentary financial disclosure requirements, is faster and simpler than the IPO process of an ongoing business with years of operating history and complex audited financials.
Revers Mergers with SPACs do not have the same risks and limitations that plague Revers Mergers with operating companies. SPACS have no operating history and, for the most part, cannot be sued or held liable for prior business activities. SPACs are also formed with capital and broker-dealer support, which allows them to immediately become eligible for being listed on major stock exchanges.
In the past, SPACS were used as a vehicle to acquire companies in a manner similar to a Private Equity Buyout acquisition where one entity acquires an ongoing business from its former owners.
Recently, Private Equity and Venture Capital funds, the “Sponsors” of these SPACs, have been increasingly forming SPACs and positioning them as “Blank-Check” shell-companies at their ready. Having these clean SPACs publicly traded on the NYSE or NASDAQ positions them as optimal vehicles for a subsequent Reverse Merger with private companies that choose to become publicly traded and need to expedite the process. Such fund-backed SPAC + Reverse Merger transactions often take the form of an investment in the private business made by the Sponsor of the SPAC, an investment that offers capital in addition to the shares and control of the SPAC, in exchange for a negotiated number of preferred shares in the publicly traded merged entity.
In short, SPACs are prepackaged IPO-in-a-bottle instruments that enable fast growing companies to rapidly transition from a private company status to that of a publicly traded entity. A SPAC could be ideal for a company with specific needs, but a Reverse Merger with a SPAC comes with stricter regulations than a Reverse Merger with a public operating company that did not go public for the purpose of creating a shell-company. A public entity formed through a Reverse Merger with a non-SPAC entity is not considered a shell-company and can rely on various Safe Harbors stipulated in US security laws and on Rule 144 for resale of restricted or control shares. On the other hand, a public entity formed through a Reverse Merger with a Shell-Company SPAC is considered an “ineligible issuer” for three years and cannot rely on certain Safe Harbors. Additionally, its shareholders will have to wait a year before being able to rely on Rule 144 for resale of restricted or control shares.
Since 2017 the SEC allows all issuers, i.e. private companies planning to go public, to submit confidential Registration Statement drafts in advance of an IPO. With a little foresight, private companies can begin the IPO process early and complete it when needed and when conditions are ripe. Doing this will render the Reverse Merger option, whether with a SPAC shell-company or with a non-shell existing entity, entirely unnecessary. Accordingly, late-stage venture capital firms should encourage their Series C+ portfolio companies to begin the IPO process, even if the company is not quite ready to go public.
