The reverse merger is a process whereby a privately owned small or midsize company purchases the trading rights of a public shell company and then uses the acquired stock for acquisitions. This go–public technique is by no means a new thing: Ted Turner applied it with Rice Communications some 20 years ago. But it has just recently started to get attention in the press. So there is a good chance that some investors have owned shares in a company that went through a reverse merger, but simply didn't know it.

Gaining Credit

Nearly half of the U.S. companies that went public over the past five years did so through reverse mergers, according to a study conducted by consulting firm Halter Financial Group. In 1995, the percentage of reverse mergers reached 54.3%. Last year, they made up 36% of all new listings. A few of the many companies that have made use of this this method include Alford Refrigerated Warehouses (ALFO), Microwave Transmission Systems (MWVT) and KMG Chemicals (KMGB).

The popularity of the trend has stretched farther to attract a growing number of European companies as well. In the United Kingdom, for instance, reverse takeovers accounted for a respectable 18% of all new listings on London's Alternative Investment Market this year. That translates into a total of 30 companies that exploited the method, about 76% more than last year.

Advantages

The reverse merger offers a company the benefits of being public, such as liquidity for investors, stock for acquisition, access to a source of capital, and an identifiable market cap. In addition, a public company can fetch a higher sales price than most private companies. 'A public company will sell for around 25 times its trailing earnings,' according to Timothy Halter from Halter Financial Group. 'But a private company generally sells for between four and six times its cash flow.'

Another big plus is that the reverse merger saves a company time and money, as there are neither road shows nor underwriting fees involved. The procedure generally costs between $100,000 and $400,000 to complete, whereas IPOs can run much higher.

Skeletons in the Closet

Most companies that prefer the traditional IPO against the reverse merger do so because the latter does not involve capital raising. The limited publicity, on the other hand, makes it very hard for companies to attract solid backing from major institutional investors – those who can actually move the price of a stock. If the buying audience is not there, many deals often get withdrawn.

Different types of public companies available for reverse mergers entail different types of risk. The financial background of some firms used to be an enigma, because they would not file a prospectus with the SEC. Today, however, new regulations increasingly impose it on companies to report their activities to the agency and, thus, protect investors from getting into a non–operating shell.

The reversed merger provides existing shareholders with a readily available method for selling their ownership in the company. While they are usually happy with this flexible ownership, it could cause troubles for the private company having committed to the merger. Consider KFx Inc. (KFX), for instance. The Denver energy firm stumbled when several long forgotten shareholders from the original shell company rushed to sell shares after the merger was completed. As a result, KFx's stock saw a temporary slump.

Success Stories

Dallas technology firm Piranha Inc. (BYTE) is certainly a typical creation of a smooth reversed merger. When in late 1999 CEO Ed Sample came up the idea of developing data compression technologies, he had to think of a way to implement it. So he established a private company, called Zideo.com Inc., but it still needed the right science.

Richard Berger, chairman of Classics International Entertainment (CIE), offered a solution. He proposed a reverse merger, which in turn could work out the financial difficulties of his own company. Backed by 2,500 shareholders as well as brokers, the dormant CIE acquired Zideo in December and changed its name to Piranha. Since then, the company has completed some strategic acquisitions and established a subsidiary. It has recently filed to list on the Nasdaq.

There have been positive returns even from reverse takeovers involving a change of business focus. Such is the case with U.K. menswear retailer Blakes Clothing Plc, which has acquired Web management company MCA Holdings Ltd and changed its name to E–Xentric Plc. Shares have gained more than 200% since Blakes suspended its stock at 6.38 pounds on Dec. 7. (c)

Copyright: 2000 123jump.com, Inc.

By Savina Petrova