The U.S. securities markets offer companies the richest source of capital in the world as a result of their size, credibility, and pool of investors. However, going public in the U.S. is a major undertaking. In order to complete this process, companies must engage experienced legal counsel, financial advisors, and auditors to assist them.
There are generally two methods for a company to become public in the U.S.: (1) Initial Public Offering (“IPO”) of securities; and (2) the alternative to IPO- a reverse merger with a U.S. public shell corporation, often in conjunction with a private placement of securities in which capital is raised. We have experience with both alternatives and will cover in detail each approach in the following discussion.
Prior to the rise of reverse mergers, the more traditional method of going public in the U.S. was through an initial public offering, or IPO as it is most commonly called. An IPO typically refers to a registered offering of shares of a private company's capital stock where its equity securities are being offered to the public for the first time. The offering may be a primary or a secondary offering. In the context of certain U.S. Securities and Exchange Commission (“SEC”) and Financial Industry Regulatory Authority (“FINRA”) rules, the term IPO may refer to an offering of securities by a company that has not previously been required to file reports under Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934.
In order to conduct an IPO, an issuer must attract and retain an investment bank to serve as underwriter. An IPO is typically more expensive and time consuming than a reverse merger. Typically, only large and established companies go public through an IPO.
The company and the investment bank will first meet to negotiate the deal. Items discussed typically include the amount of money the company will raise, the type of securities to be issued, and all the details in the underwriting agreement. The deal can be structured in a variety of ways. For example, in a firm commitment, the underwriter guarantees that a certain amount will be raised by buying the entire offer and then reselling to the public. In a best efforts agreement, however, the underwriter sells securities for the company but does not guarantee the amount raised. Also, investment banks are often hesitant to shoulder all of the risk of an offering. Instead, they form a syndicate of underwriters. One underwriter leads the syndicate and the others sell a part of the issue.
The IPO issuer, with the assistance of its counsel, must ensure that all of its charter documents, material contracts, lock-up agreements, stock records and stock options plans are in a condition which permits the issuer to complete the IPO and ultimately function as a public company. The underwriters usually require the issuer's business to be conducted through a single corporation or a parent corporation with subsidiaries. The company can be required to implement corporate governance standards consistent with securities exchange listing standards and the requirements of the Sarbanes-Oxley Act of 2002. Affiliated party arrangements may need to be terminated or revised. These corporate changes, as well as many other potential corporate clean-up modifications, must be done before filing the registration statement.
After the company has engaged an underwriter and structured the transaction, the company’s legal counsel, in conjunction with the company and the underwriter, draft and file a registration statement with the SEC. The registration statement contains disclosures about the company and its financial condition and information about the terms of the offering. A well-drafted registration statement should enable investors to properly evaluate the merits of the offered securities by providing accurate and complete information, which complies with the disclosure requirements of the Securities Act of 1933.
Following a detailed review by the SEC, the company goes on a road show and is presented to brokers and investors. The underwriter seeks subscriptions to purchase the company’s shares. Once the underwriter has obtained a sufficient number of subscriptions, the company closes the IPO, becomes a public company, and receives the proceeds of the offering.
In conjunction with the closing of the IPO, the company typically seeks to list its stock on a U.S. securities exchange. Listing the company’s securities on a national exchange such as the NASDAQ Stock Market or the New York Stock Exchange (“NYSE”) is the primary method for achieving stockholder liquidity. This process is similar to the listing process following the completion of a reverse merger. Company counsel assists the company in preparing its listing application and obtaining the company's trading symbol. Each exchange has certain quantitative and corporate governance standards which must be met by a company seeking to have a listing approved on the exchange.
An IPO can take four to six months or longer. The amount of time required to complete the registration process depends on many factors, including the amount of preliminary work necessary to organize the company, the workload of the SEC, and the familiarity of company's counsel with the SEC rules and regulations. IPO issuers should expect to complete the steps necessary for filing the preliminary registration statement in two to three months. The working group needs time to draft the document and confirm the accuracy of the registration statement. The company should also expect a period of ten weeks or more from the date of filing for the registration statement to be declared effective.
The costs of an IPO are substantial. Costs include professional fees (underwriters, auditors, and legal counsel); professional service providers (registrar and transfer agent, financial printer, etc.); and filing fees (SEC, FINRA, and state securities commissions). The underwriters’ discount or commission is usually the biggest expense of an IPO. The commissions to be paid to the underwriters are negotiated between the issuer, selling stockholders (if any), and the lead manager on a deal-by-deal basis, and are often between 5% and 7% of the gross offering proceeds (but may be as low as 2% or as high as 10%). The issuer’s legal expenses may include fees paid to company counsel for conducting pre-offering corporate clean-up matters, preparing the registration statement, negotiating the underwriting agreement, and conducting due diligence. Also, the issuer may be required to pay certain fees to the underwriters' counsel—for example, fees for preparing a survey of applicable blue sky requirements, for filing any required state notices, and fees relating to FINRA’s review of the underwriting arrangements. The issuer must pay for the work done by the auditors to prepare the financial statements for the registration statement. The issuer must also pay any expenses for its financial and accounting due diligence, the preparation of the comfort letter delivered to the underwriters and the issuer, and any time spent in discussion with the SEC if pre-filing conferences or negotiation of accounting comments are needed. The considerable requirements of the Sarbanes-Oxley Act of 2002 may require an issuer to engage in extensive review and upgrading of its internal controls over financial reporting as part of its pre-offering preparation process. This would considerably increase the cost of the offering as well.
To better illustrate the IPO process and its timeline, we provide below this timeline and responsibility chart for an initial public offering. This chart assumes that the comments of the SEC are not extensive and that the company will need to file only two amendments to the registration statement before printing the preliminary prospectus. This chart also assumes that the IPO includes selling stockholders, which may not always be the case. This timeline and responsibility chart does not reflect the special accommodations available to emerging growth companies (“EGC”s) under the JOBS Act . This chart will need amendments throughout the registration process to reflect any timing issues that arise during the process.
A - Auditors
C - Company
CC - Company counsel
FWP - Free writing prospectus
SS - Selling stockholders
SC - Selling stockholders’ counsel
UW - Underwriter
UC - Underwriter’s counsel
Beginning a few years ago, as a result of some highly publicized accounting fraud issues involving Chinese companies which had engaged in reverse mergers, there was a downturn in the number of Chinese-based reverse mergers. However, we believe that the trend has shifted again for several reasons. First, investors in the U.S. securities markets have been aggressively seeking to invest in the Chinese economy. This has provided many Chinese companies with increased access to capital. Second, Chinese entrepreneurs are seeking to reduce their exposure to the Chinese markets as well as increase their global market share. They view operating through a U.S. public company as an important step in the process. Third, wealthy Chinese entrepreneurs are seeking to diversify their holdings by acquiring operating entities in the U.S., and they believe that using the stock of a U.S. public company will assist them in acquisitions. Lastly, Chinese entrepreneurs are seeking liquidity for their personal wealth.
There are various reasons to undertake a reverse merger instead of a traditional initial public offering. Many Chinese clients prefer this approach because it is often less expensive and can often be quicker. If combined with a private placement offering, the company is able to receive the proceeds of the securities offering more quickly. On the investor side of the equation, they will have liquidity shortly after the offering, assuming the reverse merger and offering are properly structured.
In a reverse merger, the private company shareholders merge their company with the U.S. shell company, and in exchange, obtain control of the public shell company. At the closing, the shell company issues a substantial majority of its shares (typically 80%-95%) to the shareholders of the private company. This share exchange and change of control completes the reverse merger and the private company is then public.
The transaction involves the private company and shell company exchanging information about each other, negotiating the merger terms, and signing a share exchange or merger agreement. In order to protect the company against unforeseen liabilities, it is important for the private Chinese company to have its legal counsel perform extensive due diligence on the shell company.
Within four business days after the closing of the reverse merger, the combined companies must file an extensive disclosure document with the U.S. Securities and Exchange Commission (“SEC”). This can be a daunting task for management of the private company who most likely are unfamiliar with the type and extensive level of disclosure required under SEC regulations. The company’s legal counsel typically starts drafting this document well in advance of the closing of the reverse merger.
Following the closing of the reverse merger, the company succeeds to the trading market of the public shell, which typically is the Over the Counter Bulletin Board (“OTCBB”). While this is a securities market, the OTCBB is not a securities exchange and does not provide the level of liquidity and prestige that companies are often seeking. Therefore, companies often seek a listing on NASDAQ or the New York Stock Exchange (“NYSE”). In order to obtain a securities exchange listing, the company’s legal counsel assists the company in meeting exchange listing criteria, completes the application process, and communicates with the exchange regarding the company’s application.
Oftentimes, a company completes a private placement of securities in conjunction with the reverse merger. In order to raise capital through a contemporaneous private placement, the issuer must provide the investors with disclosure about the company and comply with numerous SEC regulations.
Even though reverse mergers and initial public offerings (“IPOs”) are both mechanisms by which a private company can go public, there are stark differences between the two. Rather than offering its shares directly to the public through an IPO, in a reverse merger, the private company negotiates an agreement to acquire a controlling interest in a public shell company. As a result of the reverse merger, the private company typically becomes a wholly-owned subsidiary of the public shell company. The shell company may be an already existing public company or a company newly formed by parties seeking to effect a merger. Because a full registration statement does not need to be filed and reviewed by the Securities and Exchange Commission (“SEC”) at the time of the reverse merger, the parties have more control over the timing.
As an alternative to an IPO, a reverse merger is often used to raise capital through a private placement offering which is exempt from the registration requirements of the Securities Act of 1933. By limiting the offering to accredited investors and no more than 35 non-accredited investors, companies generally can avoid the time-consuming registration process required for an IPO. But not all companies raise money at the time of their reverse merger. Some do so right before the reverse merger, while others do so a period of time after going public.
The principal benefits of a reverse merger over an IPO are:
· Cost. The cost of doing a reverse merger is substantially lower.
· Time. The process is much faster than a traditional IPO.
· Sensitivity to market. The IPO “window" is said to be open or closed and can change very unpredictably. In general, reverse mergers are not market sensitive.
· Pricing. Underwriters generally price an IPO based on the conditions of the market during the week the IPO is launched. This may result in a last-minute reduction in the sale price, or cancellation of the deal. This rarely happens in reverse mergers.
· Management’s involvement. In reverse mergers there is much less demand on the company management’s time.
· Dilution. The money raised in an IPO often is substantial and dilutes management’s and other investors’ ownership. At times, IPO underwriters entice companies to raise much more money than they realistically need in the short term, which increases the underwriters’ commission. This dilutes the ownership of management and existing investors further, and presumably is at a sale price that will be the lowest the company hopes to achieve. Successful reverse merger companies raise money in smaller chunks over time, but at ever-increasing prices, leading to less dilution. Of course this assumes a robust market for raising money, which is not always the case.
· Control. Reverse mergers allow owners of private companies to retain greater ownership and control over the new company, which is a huge benefit to owners looking to raise capital without giving their companies away
· No underwriting. Underwriters are not typically involved in reverse mergers. Although they serve an important purpose in public offerings, they also often put pressure on the company to change elements of its long-term business strategy to make financial information look better to investors.
There are two regularly cited disadvantages of a reverse merger as against a traditional IPO:
· Less capital raised. This is generally true, with some notable exceptions. Because the company raises a smaller amount of money initially, it may have to return to the market for capital sooner than it would if it completed an IPO.
· Difficulty in developing market support. Developing market support for a post-reverse merger stock can be a real challenge. Most companies completing a reverse merger list their stock on the OTC Bulletin Board, on which it is difficult to obtain analyst coverage or attention from Wall Street.
The principal disadvantage of an unregistered offering is that investors receive shares that initially are not publicly tradable. In general, shares of stock become tradable either through a registration process (where the company registers the stock for initial sale or where an investor owning stock registers the stock for resale) or where an exemption applies. Following a reverse merger, stockholders often rely on the exemption available under Rule 144 to exit the investment.
Generally, Rule 144 allows public resale by a stockholder whose shares were not registered. It focuses on the stockholder's status and the length of time he has held the shares in question. The general rule for a public company that was never a shell is that a non-affiliate holder (generally, someone who is not an officer, director, control person, or closely connected to such a person) may start publicly selling shares, with no volume limits, six months after acquisition. During the next six months, the only condition is that the company must be current in its regular periodic SEC filings for the 12 months before sale. Starting one year after acquisition, public sale can occur with no volume limits regardless of whether the company is current in its SEC filings. An affiliate has the same arrangement, except that the stockholder may sell only a limited amount during each 90-day period for the time the person (or entity) is an affiliate and for 90 days thereafter.
However, resales of shares of shell companies and former shell companies are treated differently. A resale of shares under Rule 144 generally is not permitted while the company is still a shell company. The six month holding period described above effectively begins six months after closing of a reverse merger and filing the so-called "super" Form 8-K.
Therefore, a non-affiliated PIPE investor buying stock at the time of the merger has a one-year holding period. An investor buying stock three months after the reverse merger has a nine-month holding period. Someone investing six months after the merger or anytime thereafter has the normal six-month holding period.
There is another important SEC restriction on resales from shell companies. If the company was ever a shell company at any time in the past, a stockholder cannot publicly resell under Rule 144 unless the company has been current in its periodic SEC filings for the 12 months before the sale (the industry has dubbed this "the evergreen requirement"). This applies even if the company was a shell many years ago.
There are several legal issues that are unique to reverse merger transactions. The most common include challenges relating to the shell capitalization.
In the U.S., every state requires a new corporation (in its initial certificate of incorporation, also known as a charter) to authorize a certain number of shares of issuable stock. If it wishes to issue more shares than authorized, the charter must be amended, which typically requires stockholder approval. If the company is fully reporting with the SEC, this also requires SEC approval of a proxy or information statement.
One factor in determining the number of shares issued is the desired trading range of a company’s stock. If a company is valued at $50 million and 500 million shares are issued, the stock likely will trade around ten cents. Many traders prefer a stock to trade above $1 and sometimes above $5. This in part is determined by the minimum share price rules of certain stock exchanges and in part because some brokerage firms do not permit their brokers to sell stock to customers below a certain price. Private companies merging with shells must ensure that the resulting number of shares outstanding makes sense from a trading perspective and also works within the company's authorized number of shares of stock. Problems can arise when there are insufficient shares authorized.
For example, assume a company worth $50 million wants to merge with a shell that has 50 million shares authorized. This might work if the stock price should be around $1. But if the shell already has 30 million shares outstanding, those shares will remain outstanding after the reverse merger. However, the business deal between the parties says the current owners of the shell will retain only 5% of the total company after the merger. This is where the problems begin.
If the 30 million currently outstanding shares in the shell were to represent 5% after the merger, then 570 million shares would have to be issued to the private company’s stockholders, resulting in 600 million outstanding shares. Not only is this not permitted because only 50 million shares are authorized, but it would also be disastrous for the company’s stock price.There are usually two main options to avoid this situation:
1. Reverse stock split. In a reverse stock split the stockholders of the shell agree (their approval is required in most states) to take each share of the 30 million outstanding and reduce it, for example, to 1/100 of a share, leaving 300,000 shares for the shell owners. After the reverse stock split, each existing stockholder holds fewer shares but each share has a higher value. Each stockholder's percentage of ownership stays the same because the reverse split affects all holders, but it frees up many more shares to be reissued to the private company holders.
2. Amend shell charter. Another approach is to seek stockholder approval to amend the charter to increase the number of authorized shares. In this example, that approach would not make much sense because having 600 million shares outstanding would result in a stock price that is much too low.
Using a second example, say there are 2.5 million shares outstanding in the shell with 50 million shares authorized. This actually works perfectly as 5% of 50 million is exactly 2.5 million. In other words, the remaining 47.5 million shares can be issued to the private company stockholders and no reverse split or charter amendment is necessary. However, there are several problems with this example. Again, the price will be roughly $1, but the company may want it to be higher. In addition, this leaves no additional shares for future issuance to investors, employees, joint venture partners, or acquisition targets. Any additional share issuance would require a charter amendment approved by the stockholders. In this situation there are also two options:
1. Merge first. If timing is an issue, the reverse merger can close issuing the 47.5 million shares. Then after the merger a stockholder vote can take place to complete a reverse split.
2. Reverse stock split first. The other choice is to effect the reverse split before the transaction.
However, in either scenario, the parties should be wary of conditioning the merger on the completion of a reverse stock split. The shell needs to file a proxy statement with the SEC in connection with a reverse stock split, but the disclosure involved is not overly burdensome. If, however, the reverse stock split is a condition to the merger, the SEC will want the same level of disclosure as if the entire merger were being approved. Because this disclosure is quite substantial, if possible, one should structure the transaction so as to avoid a reverse stock split being an express condition to the merger.
In most cases the parties want to change the name of the shell company in connection with the reverse merger. In many cases the shell names have nothing to do with the business of the private company merging in. Changing it normally requires a charter amendment and delays getting disclosure through the SEC.
However, a little known section of the Delaware General Corporation Law (DGCL) allows a Delaware corporation to change its name by creating a wholly owned subsidiary with the name desired (see 8 Del. C. § 253(b)). The subsidiary is then merged upstream into the Delaware company, with the subsidiary disappearing and the original Delaware company taking the name of the subsidiary. This can be helpful post-reverse merger.
When assisting a Chinese company to go public in the U.S., we provide our client a team of experienced lawyers located in the U.S. and Asia that includes lawyers who speak English and Chinese. We believe that this is critical to the success of these transactions.