Small-Cap Reverse Mergers Poised for a Comeback
The good news about reaching bottom is that the only place to go from there is up. As I have blogged about recently, since 2009, the small cap and reverse merger market has diminished greatly. According to industry statistics, 2011 was the slowest year for reverse mergers since 2004.
To reiterate my previous blogs, I can identify at least seven main reasons for the downfall of the reverse merger market. Briefly, those reasons are: (1) the general state of the economy, plainly stated, it’s not good; (2) backlash from a series of fraud allegations, SEC enforcement actions, and trading suspensions of Chinese company’s following reverse mergers; (3) the 2008 Rule 144 amendments including the prohibition of use of the rule for shell company and former shell company shareholders; (4) problems clearing penny stock with broker dealers and FINRA enforcement of broker dealer due diligence on penny stocks; (5) DTC scrutiny and difficulty in obtaining clearance following a reverse merger or other corporate restructuring; (6) increasing costs of reporting requirements, including the new XBRL requirements; and (7) the new listing requirements imposed by NYSE, AMEX and NASDAQ and prohibition against immediate listing following a reverse merger.
However, despite these issues and the chill in the reverse merger market, the fact is that going public is and remains the best way to access capital markets. Public companies will always be able to attract a PIPE investor. For cash poor companies, the use of a trading valuable stock is the only alternative for short term growth and acquisitions. At least in the USA, the stock market, day traders, public market activity and the interest in capital markets will never go away; it will just evolve to meet ever changing demand and regulations.
That very evolution has created new opportunities, including the opportunity for a revived, better, reverse merger market. Certainly there are alternatives to a reverse merger, for instance a company can go public directly either through a private placement followed by S-1 registration statement; a direct public offering (DPO) or especially for those in the internet or tech business, trading on a private company market place (PCMP).
However, each of these alternatives can be difficult and time consuming. Many companies abandon DPO’s or private offerings prior to completion. Raising money for a trading public company is difficult, for a non-trading pre-public company, it can be impossible. Unscrupulous unregistered companies and individuals prey on these entities, taking their time and money and leaving a mess that can take years and more money to clean up.
A reverse merger remains the quickest and cleanest way for a company to go public. The increased difficulties in general and scrutiny by regulators may be just what the industry needed to weed out the unscrupulous players and invigorate this business model. Shell companies will necessarily require greater due diligence up front, if for no other reason than to ensure DTC eligibility and broker dealer tradability. Increased due diligence will result in fewer post merger issues.
The over the counter market should regain credibility and support higher stock prices, since exchanges are forcing companies to trade there for a longer period of time before becoming eligible to move up. Rule 419 SPAC’s may increase providing clean new entities to complete reverse mergers. Resale registration statements, and thus disclosure, may increase to combat the Rule 144 prohibitions. We have already seen greater disclosure by non-reporting entities trading on otcmarkets.com.
In summary, we believe that the issues and setbacks of the reverse merger market since 2008 have primed the pump and created the perfect conditions for a revitalized, better reverse merger market beginning in mid to late 2012.
Attorney Laura Anthony,
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions
Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public Companies as well as private Companies intending to go public on the Over the Counter Bulletin Board (OTCBB), now known as the OTCQB. For more than a decade Ms. Anthony has dedicated her securities law practice towards being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.
Ms. Anthony’s focus includes but is not limited to compliance with the reporting requirements of the Securities Exchange Act of 1934, as amended, (“Exchange Act”) including Forms 10-Q, 10-K and 8-K and the proxy requirements of Section 14. In addition, Ms. Anthony prepares private placement memorandums, registration statements under both the Exchange Act and Securities Act of 1933, as amended (“Securities Act”). Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of the Exchange Act, state law and FINRA for corporate changes such as name changes, reverse and forward splits and change of domicile.
Contact Legal & Compliance LLC for a free initial consultation or second opinion on an existing matter.
« Change in NYSE and AMEX Listing Requirements For Companies Completing Reverse Mergers with Public Shell Companies Section 3(a)(10) Debt Conversions In a Shell Company Pre-Reverse Merger »
Form 10-Q – Quarterly Reports
All companies that are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) are required to file quarterly reports on Form 10-Q. As my clients are all smaller reporting companies (less than $75 million a year in revenues) and non-accelerated filers, this article will be limited to a discussion of those filers. Form 10-Q must be filed within 45 days of the end of each of the first 3 fiscal quarters of the Company.
A Form 10-K is filed following the end of the fourth fiscal quarter and will be the subject of an upcoming article.
Each filer has the right to file for an extension on Form 12b-25 which will not result in the filing being deemed delinquent. Extensions must be filed no later than the due date of the 10-Q and extends the filing time for up to 5 calendar days.
The cover page of the Form 10-Q contains basic company information, including the type and date of the report, the companies’ name and address, SEC filer name, federal tax id number and telephone number. In addition, on the cover page each company must state whether it is a shell company or not by checking a yes or no box. This small piece of information has big ramifications.
Companies that are, or ever were a shell company are severely restricted in the use of Rule 144, may not register the sale of securities accept in accordance with Rule 419 and must file a Super 8-K containing Form 10 type information within four days of a transaction resulting in them no longer being a shell. Attorney practitioners requested to perform services, or investors considering an investment (either through a PIPE or on the open market) should make it standard operating procedure to review historical 10-Q’s for shell company status.
Item 1 of Part I and the bulk of the Form 10-Q are the financial statements. Rule 8-03 regarding interim financial statements for smaller reporting companies provides that “Interim financial statements may be unaudited; however, before filing, interim financial statements included in quarterly reports on Form 10-Q must be reviewed by an independent public accountant using professional standards and procedures for conducting such reviews, as established by generally accepted auditing standards, as may be modified or supplemented by the Commission.”
Interim financial statements must include a balance sheet as of the end of the companies’ most recent fiscal quarter, a balance sheet as of the end of the preceding fiscal year, and income statements and statements of cash flows for the interim period up to the date of such balance sheet and the comparable period of the preceding fiscal year. In addition, the financial statements must include footnotes.
Item 2 of Part I of the Form 10-Q is the Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A). In addition to the financial statements, MD&A is arguably the most important part of a Company’s reporting requirement. Moreover, it is MD&A that requires the most effort and care by company management. In a separate blog, following this blog, I will discuss in-depth the requirements for MD&A. However, in short MD&A is a discussion, in layman’s terms, of a Company’s plans of operation, results of operations, liquidity and capital resources.
Item 3 of Part I of the Form 10-Q, Quantitative and Qualitative Disclosures About Market Risk, is not applicable to smaller reporting companies.
Item 4 (4T for smaller companies) of Part I of the Form 10-Q is an attestation of Controls and Procedures. This item requires the Companies’ principal executive and principal financial officers to attest to the Company’s disclosure controls and procedures and financial controls and procedures. This attestation is in addition to the certifications required at the end of both 10-Q’s and 10-K’s. Both this attestation and the certifications are the result of the enactment of the Sarbanes Oxley Act of 2002.
Item I of Part II of Form 10-Q, Legal Proceedings, requires a disclosure of either a new legal proceeding or one in which there has been material development during that particular quarter. Ongoing legal proceedings should be disclosed by reference to the 10-Q in which it was first reported. The disclosure should include the name of the court or agency in which the proceedings are pending, the date instituted, and the principal parties thereto, a description of the factual basis alleged to underlie the proceeding and the relief sought. Moreover, the Company must include similar information as to any such proceedings known to be contemplated by governmental authorities.
Item 1A of Part II of the Form 10-Q, Risk Factors, is not applicable to smaller reporting companies.
Item 2 of Part II of Form 10-Q, Unregistered Sales of Equity Securities and Use of Proceeds, requires that the Company disclose all unregistered issuances of securities, the person(s) to whom issued, the value of the issuance (price paid, debt cancelled, value of services, etc..) and the exemption relied upon for the issuance. Together with registered issuances, an analyst should be able to balance the total reported outstanding securities for each quarter and year, by reviewing a Companies’ Exchange Act reports, including this section of Form 10-Q. The Use of Proceeds disclosure requirement under this Section refers to a disclosure of the Use of Proceeds of any securities sold pursuant to an effective registration statement, if applicable. Finally, a Company must also report any repurchases of its own securities in this section.
Item 3 of Part II of Form 10-Q, Defaults Upon Senior Securities, requires that Companies’ report if there has been any material default in the payment of principal, interest, a sinking or purchase fund installment, or any other material default not cured to any indebtedness exceeding 5% of its total assets.
Item 4 of Part II of Form 10–Q has been removed and is being reserved by the SEC for future use.
Item 5 of Part II of Form 10-Q, Other Information, requires that Companies disclose other material information not otherwise disclosed in this report or previously in a Form 8-K.
Item 6 of Part II of Form 10-Q is a list of exhibits to be included with the Form, including certifications.
A form 10-Q must be signed by the principal executive and principal financial officers. These same individuals are required to execute separate certifications which are attached as exhibits to each Form 10-Q and Form 10-K. By signing the Form 10-Q and certifications, the principal executive and financial officers are attesting personally to the contents of the Form and to the attestations in the certificates and are subject to personal liability therefore.
Attorney Laura Anthony,
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions
Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public Companies as well as private Companies intending to go public on the Over the Counter Bulletin Board (OTCBB), now known as the OTCQB. For more than a decade Ms. Anthony has dedicated her securities law practice towards being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.
Ms. Anthony’s focus includes but is not limited to compliance with the reporting requirements of the Securities Exchange Act of 1934, as amended, (“Exchange Act”) including Forms 10-Q, 10-K and 8-K and the proxy requirements of Section 14. In addition, Ms. Anthony prepares private placement memorandums, registration statements under both the Exchange Act and Securities Act of 1933, as amended (“Securities Act”). Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of the Exchange Act, state law and FINRA for corporate changes such as name changes, reverse and forward splits and change of domicile.
Contact Legal & Compliance LLC for a free initial consultation or second opinion on an existing matter.
« Mergers and Acquisitions – Deal Protection Measures Management’s Discussion and Analysis of Financial Condition and Results of Operation (MD&A) »
Performing Due Diligence on Subject Companies During Reverse Mergers
Due diligence is a critical component of structuring any business transaction. In a reverse merger scenario there are two sides to the due diligence equation. There is the due diligence performed by the private company merging with the public shell (“Public Shell”) and there is the performance by the shell company of due diligence on the private company (“Private Company”).
In order to successfully complete a reverse merger it is essential for the Public Shell to perform appropriate financial, legal, corporate, market, and management due diligence on the private company merging with the Public Shell. At the most basic level the Public Shell needs to satisfy itself that the Private Company has all information completed and ready to file its Super 8-K within 4 days of completing the merger, including having audited financial statements prepared by a PCAOB licensed auditor.
As far as due diligence is concerned, particularly from a functionality standpoint, understanding management’s reasons for going public, as well as knowing the extent of their knowledge regarding public company operations, is critical to success and timeliness. Investors typically do not invest in the horse, but rather the jockey.
Post merger, the once private company will need to file quarterly, annual and periodic reports pursuant to the Securities Exchange Act of 1934, as amended, and must have the internal controls in place to ensure compliance with these reporting requirements. Hence, determining beforehand the qualifications of management is invaluable to ensuring a successful post merger operation.
Essential questions to be answered during the personal interview phase are set forth in the reporting requirements enumerated in Items 401 through 404 of Regulation S-K. From a fundamental business perspective, these Items will help current and future shareholders determine:
1. Is management competent?
2. How many years of experience in the industry do they possess?
3. Has management been successful in running the operation to date?
4. Does management understand the difference between running a private company verses the rigorous legal, investor relations and accounting demands of a public company?
5. Are there any legal roadblocks to future offerings or extremely detrimental disclosure items (i.e. bad boy provisions)?
Furthermore, the shell company’s due diligence should gain insight as to the ability of the private company, through management and/or hired professionals, to address and remain compliant with: Sarbanes Oxley, GAAP, Exchange Act reporting requirements, including yearly 10-K’s, quarterly 10-Q’s and periodic 8-K’s, Investor Relations, internal controls, Annual Report filings and annual meeting, as well as other basics concerning the general daily operational factors of a public company.
At the corporate level of the due diligence process the public shell needs to review basic corporate records to determine that the Private Company is in legal corporate good standing and has maintained adequate books and records.
Legal due diligence encompasses such things as ensuring loans by insiders have been documented, extensions on outstanding obligations have been memorialized and documented, title to ownership of assets (including intellectual property and real estate) is in the corporate name and if not, proper linking documents (such as a lease agreement or assignment) have been prepared and executed. Does the Private Company rely on a distribution network? Make sure it’s in writing. In short, legal due diligence involves crossing the T’s and dotting the I’s and is part and parcel with the auditor’s job.
In addition to the personal matters there also exist the typical concerns of pending or anticipated litigation issues. These issues include, but are not limited to, product liability; hazardous waste; real estate liens; employment discrimination suits; other environmental concerns and other legal issues that could have a “material” negative impact in the future.
As stated, where relevant to the particular private company, environmental issues are an extremely important legal due diligence point. Environmental laws and the gaining power of the Environmental Protection Agency make this a critical factor. Failure to ensure that appropriate Phase I and Phase II environmental reports are in order could lead to expensive future cleanup and litigation costs. Furthermore, it is suggested that any potential future liability be signed off on by the appropriate agency or authority.
Now to the most important due diligence matter: financial due diligence. If the target entity does not have or cannot obtain completed audited financial statements, prepared by a PCAOB qualified auditor in accordance with GAAP, there exists no rationale to move forward with the merger.
Financial due diligence is the key element in the due diligence process. The Public Shell Company should be meticulous in reviewing the financials, margins, inventory and equipment lists of the private company going public. In addition there may be patents, intellectual property and employee compensation agreements that need to be reviewed. The Public Shell should be comfortable with the footnotes as well as the line item financial statements.
It must be understood that there are always going to be some sort of issues. However, the Public Shell Company’s objective is to address significant material issues via the due diligence process. By doing so the Shell Company enhances the probability of a successful reverse merger.
In summary, the due diligence process is designed to uncover material facts that may adversely impact the transaction. The process is not designed to destroy the deal but moreso to address key issues in order to strengthen the transaction and protect shareholders. Inversely, properly completed due diligence on the Public Shell Company to be acquired ensures that the merging Private Company reaps the benefits of a viable public entity by which to grow and enhance shareholder value.
Comprehensive, detailed and meticulous due diligence creates a foundation of integrity, authenticity and transparency on which a strong, operating public company can be built. The due diligence process can be time consuming, but it is most easily completed when all parties involved operate reasonably and professional cooperation is maintained throughout the due diligence process.
Attorney Laura Anthony
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions
Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public Companies as well as private Companies intending to go public on the Over the Counter Bulletin Board (OTCBB), now known as the OTCQB. For more than a decade Ms. Anthony has dedicated her securities law practice towards being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.
Ms. Anthony’s focus includes but is not limited to compliance with the reporting requirements of the Securities Exchange Act of 1934, as amended, (“Exchange Act”) including Forms 10-Q, 10-K and 8-K and the proxy requirements of Section 14. In addition, Ms. Anthony prepares private placement memorandums, registration statements under both the Exchange Act and Securities Act of 1933, as amended (“Securities Act”). Moreover, Ms. Anthony represents both target and acquiring companies in reverse and forward mergers, including preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of the Exchange Act, state law and FINRA for corporate changes such as name changes, reverse and forward splits and change of domicile.
Contact Legal & Compliance, LLC for a free initial consultation or second opinion on an existing matter.
« Potential Liabilities In The IPO Process– Part III OTCQB and OTCQX Compared and Contrasted »