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other means. Feldman, a securities lawyer, is a frequent — W ALL S TREET J OURNAL —Charles Weinstein, CPA
public speaker, seminar leader, and counsel on issues Managing Partner, Eisner LLP

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related to the implementation of these transactions.

Reverse
“. . . [Investment banker Gregg Mockenhaupt] wrapped up a $50 million reverse
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Reverse Mergers
Taking a Company Public
Without an IPO

David N. Feldman

With contributions by Steven Dresner

Bloomberg Press
New York
© 2006 by David N. Feldman. All rights reserved. Protected under the Berne Convention. Printed in
the United States of America. No part of this book may be reproduced, stored in a retrieval system,
or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or
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planning decisions made by the reader.

First edition published 2006

1 3 5 7 9 10 8 6 4 2

Library of Congress Cataloging-in-Publication Data

Feldman, David N.
Reverse mergers : taking a company public without an IPO / David N. Feldman ; with con-
tributions by Steven Dresner. -- 1st ed.
p. cm.
Includes index.
ISBN 1-57660-231-1 (alk. paper)
1. Going public (Securities) 2. Going public (Securities)--Law and legislation--United States.
3. Corporations--United States--Finance. I. Dresner, Steven II. Title.

HG4028.S7F45 2006
658.1'64--dc22 2006014703

Edited by Janet Coleman

 To the loves of my life:

the inside-and-out beautiful Barbra,

the superbly talented Sammi,

and the always happy Andrew.

 CONTENTS

List of Illustrations .................................................................. xii

Introduction ................................................................. 1

1 Why Go Public? ............................................................ 7

Advantages of Being Public ......................................................... 7
Access to Capital .................................................................. 7
Liquidity ........................................................................... 8
Growth Through Acquisitions or Strategic Partnerships .................... 9
Stock Options for Executives ................................................. 10
Confidence in Management ................................................... 10
Disadvantages of Being Public ................................................... 11
Emphasis on Short-Term Results ............................................. 11
Public Disclosure ................................................................ 12
Fraud and Greed (Even After Sarbanes-Oxley) ............................. 13
It’s Expensive! .................................................................... 14
Public Companies Attract Lawsuits .......................................... 14
Weighing the Pros and Cons ..................................................... 15

PA RT O N E | THE BUSINESS OF REVERSE

MERGERS

2 IPOs Versus Reverse Mergers ....................................... 19

Advantages of a Reverse Merger Versus IPO .................................. 23
Lower Cost ....................................................................... 23
Speedier Process ................................................................. 24
No IPO “Window” Necessary ................................................ 25
No Risk of Underwriter’s Withdrawal ....................................... 26
Much Less Management Attention Required ............................... 27
Less Dilution .................................................................... 27
No Underwriter ................................................................. 28
Disadvantages of a Reverse Merger Versus IPO .............................. 29
Less Funding ..................................................................... 29
Market Support Is Harder to Obtain ........................................ 29
3 Shells and Deal Structures ........................................... 31
Public Shells ......................................................................... 31
Value of Shells ................................................................... 32
Reverse Merger Deal Structures ................................................. 36
The Reverse Triangular Merger ............................................... 37
Other Deal Structures .......................................................... 39
Reverse Stock Splits ............................................................. 39
Doing a Deal ........................................................................ 40

4 Introduction to Rule 419 ............................................ 43

Rule 419 .............................................................................. 43
Basics of Rule 419 .............................................................. 44
Life After Passage of Rule 419 ................................................ 45
The Internet Boom (and Bust) ............................................... 48
Today’s Reverse Merger Market .................................................. 49

5 Financing ................................................................... 51
How Not to Do It .................................................................. 52
How Financing Drives the Deal ................................................. 55
Time and Money ................................................................... 62

6 Winning Market Support ............................................ 63

The Market Support Challenge ................................................. 64
Limited Float .................................................................... 64
Concentration of Control of the Float ...................................... 64
Weak Analyst Coverage of Penny Stocks .................................... 65
Minimal Support from Market Makers ..................................... 65
Short Selling Pressure .......................................................... 66
Thin Trading Reduces Ability to Raise Money Versus Active Trading .... 66
Does an IPO Guarantee Strong Market Support? ........................... 67
How to Build Post–Reverse Merger Support ................................. 68
Get a New Attitude ............................................................. 68
The Importance of Investor Relations ....................................... 69
Earn Your Support .............................................................. 70
Movin’ on Up .................................................................... 71
Ticker? What Ticker? .............................................................. 74
7 Shady Tactics ............................................................. 77
A Few “Bad Guy” Anecdotes ..................................................... 78
Telltale Signs: Not Disclosing Biographical Information or Trying
to Avoid Full Disclosure ..................................................... 79
One Company’s Search for a Clean Shell: A Case Study.................. 80
“Bad Guy” Tactics .................................................................. 83
Inappropriate Expenses and Compensation ................................ 83
Strange Money-Raising Activity .............................................. 84
Insider Trading .................................................................. 84
Press Releases and Hype ....................................................... 84
Time Pressure .................................................................... 85
Incomplete Disclosure.......................................................... 85
Incomplete Insider Filings ..................................................... 85
Refusal to Back Up Representations and Warranties ...................... 86
Messy Isn’t Dirty and “Not Nice” Doesn’t Mean “Bad” .................. 86
Bad Investment Banker Tactics .................................................. 86
Lack of Due Diligence ......................................................... 86
Nonregistration As Brokers .................................................... 87
Accredited Investors or Not? .................................................. 88
Looking for Mr. Good Guy ...................................................... 88

PA RT T W O | LEGAL ISSUES AND TRAPS FOR

THE UNWARY

8 Deal Mechanics .......................................................... 93

Structural and Implementation Issues Around Shareholder Approval .... 93
Structural Approaches to Avoiding Shareholder Approval ................ 95
Forward and Reverse Stock Splits ............................................... 96
Other Problems in Capitalization and Share Availability ................. 98
Name Change of the Shell .................................................... 100
Schedule 14F: Board Changes ............................................... 100
A Merger Isn’t an Offering. Or Is It? ........................................ 102
Other Legal Issues ................................................................. 106
Unique Legal Opinion Issues ................................................ 106
Are Reps and Warranties from a Shell Meaningless? ..................... 107
Issues Relating to Fairness Opinions ........................................ 109
Above All Else: Seek Competent and Experienced Advisers .............. 111
 9 Due Diligence ........................................................... 113
The Basics ........................................................................... 114
Clean, Dirty, and Messy Shells (and Footnote 32 Shells) ................. 115
Messy Shells ..................................................................... 115
Dirty Shells ..................................................................... 119
Due Diligence Review of the Private Company ........................... 125
Minimize Surprises ................................................................ 125

10 The Regulatory Regime .............................................. 127

Implementation of SOX .........................................................127
June 2005 SEC Rule Changes: Reverse Mergers Are Further
Legitimized (but Tougher to Consummate) ............................... 130
Genesis of the June 2005 Rule Changes .................................... 131
The Rule Is Adopted .......................................................... 132
Specifics of the Rule ........................................................... 133
One Nice By-Product: Information ......................................... 136
Who Is Exempt? ................................................................ 137
A Little More on Footnote 32 ............................................... 137
So, Is It Good or Bad? ............................................................ 138

PA RT T H R E E | A FEW OTHER SIMPLE WAYS

TO GO PUBLIC

11 Self-Filings ................................................................ 141

Introduction to Self-Filings ......................................................142
When Does Self-Filing Make Sense? ........................................142
There Is No “I” in Team .........................................................151

12 Form SB-2 ................................................................. 153

How Do Shares of Stock Become Tradable? ................................. 153
Registration of Shares ......................................................... 154
Exemptions from Registration: Rule 144 .................................. 155
Self-Filing Through Form SB-2 Resale Registration ....................... 157
Private Offerings During Registration ...................................... 158
Mechanics of Form SB-2 Self-Filing ........................................... 160
Engaging Professionals ........................................................ 160
 Identifying Shareholders ...................................................... 160
Preparing and Filing the Document ........................................ 162
SEC (and NASD) Comments and Revisions .............................. 163
Establishing a Trading Market ............................................... 165
Wrap-Up on SB-2 ................................................................. 165

13 Form 10-SB .............................................................. 167

Self-Filing Through Form 10-SB Registration .............................. 167
Form 10-SB Versus Form SB-2 (Exchange Act Versus
Securities Act) ................................................................ 168
Filing Form 10-SB and Automatic Effectiveness .......................... 170
Developing a Market After Filing a Form 10-SB ......................... 170
Brief Overview of Other Methods to Become Public ...................... 171
Regulation A .................................................................... 171
Intrastate Exemption .......................................................... 172
Rule 504 ......................................................................... 172
Regulation S .................................................................... 174
Which Way to Go? ................................................................ 176

PA RT F O U R | MANUFACTURING SHELLS AND

CURRENT TRENDS

14 SPACs ....................................................................... 179

Introduction to SPACs: The GKN Experience .............................. 180
The SPAC Resurgence ............................................................ 182
Anatomy of a SPAC ............................................................... 185
Advantages of SPACs ............................................................. 187
Advantages to a Company Merging into a SPAC ......................... 188
Disadvantages of SPACs.......................................................... 190
Disadvantages to a Company Merging into a SPAC ..................... 191
Are Junior SPACs Next? .......................................................... 193
Wrap-Up on SPACs ............................................................... 195
15 Form 10-SB Shells ..................................................... 197
Mechanics of Creating a Form 10-SB Shell .................................. 198
Getting Started: Forming and Capitalizing the Entity ................... 198
Preparing and Filing the Form 10-SB....................................... 200
Post-Effective Responsibilities Prior to a Merger .......................... 202
Merging with a Form 10-SB Shell ........................................... 204
Post-Merger Registration ..................................................... 205
Legal Issues Regarding Form 10-SB Shells ................................... 208
Can Entities Own Shares? Auditors Disagree .............................. 208
The Worm/Wulff Letters ..................................................... 209
Proper Capitalization .......................................................... 212
Challenges in Post-Merger Registration .................................... 213
Advantages and Disadvantages of Form 10-SB Shells ..................... 213
Advantages of Form 10-SB Shells ........................................... 213
Disadvantages of Form 10-SB Shells ........................................ 216
Endnote on SPACs and Form 10-SB Shells .................................. 217

16 The Experts Speak: A Look Ahead .............................. 219

Recent Developments ............................................................. 220
The New Small-Cap IPO ..................................................... 220
The Opening of China ........................................................ 221
SPACs Are Back ................................................................ 224
Shell Market Mayhem = Nontrading Shells and Self-Filings ............ 225
New, More Positive Regulatory Environment ............................. 226
A Broader Point of View ...................................................... 227
And So It Goes ..................................................................... 227

Acknowledgments ................................................................... 229

Appendix: The Worm/Wulff Letters .......................................... 231
Glossary................................................................................. 239
Index .................................................................................... 257
ILLUSTRATIONS

Figures

I.1 Closed Reverse Mergers by Year .......................................... 2

3.1 Flowchart of a Reverse Triangular Merger ............................ 38

6.1 Recent IPO Deal Activity ................................................ 68

6.2 American Stock Exchange Listing Standards ........................ 72

6.3 Nasdaq Listing Standards ................................................ 73

10.1 Burden of SOX on Smaller Public Companies ..................... 129

14.1 Trading SPACs (as of January 1, 2006) .............................. 183

14.2 SPACs in SEC Registration (as of January 1, 2006) .............. 183

xii
Reverse Mergers
 This page is intentionally blank.

[Link] b 7/12/06 [Link] PM

 Introduction

R
ecently, Wall Street has discovered that there are more ways to go
public than through the traditional initial public offering (IPO),
making it easier for more companies to reap the benefits of public
status. Public companies find it easier to attract investors than private ones
do because investments in public companies are more liquid. Because of
this liquidity, public companies can also use their stock more effectively
to fund acquisitions and reward executives. Having various options to go
public is good news to the vast majority of smaller companies, most of
which do not fit the typical profile investment banks use when deciding
which companies can successfully accomplish an IPO.
The two most popular alternatives to IPOs are reverse mergers
(including mergers with specified purpose acquisition companies, or
SPACs) and self-filings. The following well-known companies have gone
public through reverse mergers:
❑ Texas Instruments Inc.
❑ Berkshire Hathaway, Inc.
❑ Tandy Corporation (Radio Shack Corporation)
❑ Occidental Petroleum Corporation
❑ Muriel Siebert & Co., Inc.
❑ Blockbuster Entertainment
❑ The New York Stock Exchange

Less well-known deals are no less interesting:

❑ In February 2005, an investor group led by billionaire Robert

1
2 Reverse Mergers

F. X. Sillerman, former owner of well-known concert promoter SFX En-

tertainment, raised $46.5 million contemporaneous with the acquisition
of a public shell company called Sports Entertainment Enterprises, Inc.
and the acquisition of an 85 percent interest in Elvis Presley’s name, image
and likeness, and the operations of his home at Graceland. Since then the
company, now known as CKX, Inc., has completed several more acquisi-
tions including the proprietary rights to the American Idol television show
and, in April 2006, it paid $50 million for an 80 percent interest in boxer
Muhammad Ali’s name, likeness, and image.
❑ In 2002, RAE Systems went public in a reverse merger at $0.20 a
share. As of this writing in early 2006, the stock was trading around $4.
❑ Global Sources reverse merged into Fairchild. As of this writing, it
has a market capitalization of approximately $430 million.

Alternatives to IPOs have grown in popularity over the last six years.
The number of closed reverse mergers has increased fourfold since 2000.
(See FIGURE I.1, Closed Reverse Mergers by Year.) All signs indicate that
this fast-paced growth will continue for the foreseeable future.
There are several reasons for this. First, the IPO market effectively
closed in late 2000 following the dot-com bust. Those seeking to go pub-
lic were forced to find other ways to accomplish their goals. Second, the
alternatives to IPOs offer benefits that traditional IPOs do not, especially
to companies interested in raising capital in the $3 million to $20 million

FIGURE I.1 Closed Reverse Mergers by Year

200
180
160 179
168
Source: DealFlow Media/The Reverse Merger Report

140
120
100
80
60
71
40 54
46 46
20

0
2000 2001 2002 2003 2004 2005
 Introduction 3

range. Third, new SEC regulations and enforcement policies have turned
reverse mergers and self-filings into completely aboveboard, legitimate
methods of accessing the capital markets. (There is a history here, which
we will cover in Chapter 2. Some of the early practitioners of alternatives
to IPOs in the 1970s and 1980s were shady characters.) Fourth, in the past
several years the number of investors ready and willing to make private
investments in public equity (PIPEs) in connection with alternatives to
IPOs has increased dramatically. PIPEs are defined as follows: A private
placement of equity or equity-linked securities effected for a public com-
pany, typically with immediate required registration of the equity sold to
the investor. These days PIPE investors are constantly on the lookout for
soon-to-be public companies to invest in.
The idea behind the reverse merger is simple, yet powerful. To achieve
the goal of publicly traded shares, a private company merges into a public
one. (The public company has minimal, if any, day-to-day business opera-
tions. For this reason, it is called a “shell.”) The public company may be
the remnant of a bankrupt or sold organization or specially formed for the
purpose of investing in a private company. Either way, the basic maneuver
is the same: the private company purchases control of a public one, merges
into it, and when the merger is complete becomes a publicly traded com-
pany in its own right.
Self-filings take advantage of the SEC regulation that allows private com-
panies to become public by voluntarily following the same rules (and filing
the same documents) that public companies follow. After agreeing to man-
datory compliance with the SEC reporting regime, a company earns public
status and can then offer securities to the public market or complete a PIPE.
This book is written for seasoned pros and beginners alike. It is—as
of this writing—the first and only book to explain the business and legal
issues specific to reverse mergers and self-filings. My goal was to create
a text that would be useful to both company CEOs and CFOs and the
professionals who advise them—lawyers, accountants, consultants, and
investment bankers. Please note: I wrote this not just for lawyers; it covers
legal issues in plain English.
This book is my best effort to codify what I have learned about alterna-
tives to IPOs over the thirteen years since Feldman Weinstein & Smith,
the twenty-three-attorney law firm I lead, and a predecessor firm, began
this part of our practice. During that time we have worked with hundreds
of clients contemplating reverse mergers and self-filings. Steven Dresner,
my friend and contributor to this book, has enriched the text with the wis-
Source: TKTK

dom he has gleaned in his capacities as editor of PIPEs: A Guide to Private

Investments in Public Equity (Bloomberg Press, 2005), and as the organizer
of numerous business conferences on PIPEs and reverse mergers.
4 Reverse Mergers

The Structure of This Book

The book is divided into four parts. Part One covers the business of
reverse mergers. Chapter 1 discusses the pros and cons of going public.
Chapter 2 compares the benefits of a reverse merger to the benefits of an
IPO. Chapter 3 presents an overview of the market for shells, how they
are formed, and basic reverse merger deal structures. The shell market
is changing rapidly, in no small part due to recent rule changes by the
SEC. Chapter 4 reviews the history behind the famous SEC Rule 419
which in the early 1990s all but stopped the market for creating shells
from scratch and taking them public for awhile. Chapter 5 covers the
financings that typically accompany a reverse merger, especially those
done as PIPE investments. It includes examples of a few specific transac-
tions which are analyzed in depth from the fields of biotechnology, en-
tertainment, technology, and sports. Issues of disclosure and valuation
are discussed. An acknowledged challenge following a reverse merger is
building and obtaining support for the company’s newly trading stock.
Chapter 6 covers this issue in depth with the goal of changing attitudes
toward the issue. Rather than seeking an immediate “pop” in a stock
as sometimes happens after an IPO, reverse merged companies require
patience for support to build over time. Chapter 7, the last chapter of
Part One, provides a road map for those (hopefully all) seeking to steer
clear of unsavory and illegitimate activity in this field. Covered here
are bad shell owner tactics and bad investment banker tactics. A list of
signs that are consistent with behavior of a credible, legitimate player
is included. As in all things Wall Street, it is difficult to go anywhere
without finding some bad guys. Indeed, the venerable IPO suffered a
black eye when state and federal regulators fined IPO underwriters over
$2 billion for illegal excesses in the IPOs of the late 1990s. But reverse
mergers also have a checkered past, something many of us are working
hard to reverse both in terms of perception and reality.
Part Two covers legal issues and traps. Chapter 8 describes deal struc-
tures and issues in completing merger agreements. The famous “reverse
triangular merger” is examined. Issues in a shell’s capital structure and
availability of shares are also discussed. How parties back up their state-
ments and promises is another issue, as is changing the name of the
shell after a deal. Chapter 9 covers a critically important issue in reverse
mergers: due diligence. This involves “scrubbing” a shell which may have
a history of prior operations, as well as working to avoid or minimize
Source: TKTK

risks from dirty or messy shells (these are two different things). So-called
Footnote 32 shells, which have been targeted by the SEC in its recent
rulemaking as being of questionable validity, are discussed. These are
 Introduction 5

particularly thorny shells to examine, because they appear to be real busi-

nesses that went public, when in fact they are either fake start-ups or
very small real businesses that will be stripped out or shut down upon a
merger. Chapter 10 discusses the regulatory regime in greater depth. In
particular, the chapter explores the sweeping and dramatic legislation,
known as the Sarbanes-Oxley Act, that was passed in 2002 following the
Enron and WorldCom debacles. This law requires many changes—most
of them for the good—in how public companies act. But, among other
things, it has led to increases in the cost of being public. This chap-
ter also reviews the new SEC rulemaking of June 2005 which imposed
significant new disclosure requirements immediately following a reverse
merger. By means of these rules, the SEC sought to eliminate more bad
players at the same time as it affirmed that these techniques are perfectly
legitimate means of structuring companies.
Part Three covers self-filings in depth and a few other methods
of going public without an IPO or reverse merger in overview. There
are two ways to go about a self-filing: either by means of a resale reg-
istration to allow existing shares to start trading, or through filing a
Form 10-SB, which simply puts the company on the mandatory SEC
reporting list. Once it is fully reporting, if shareholders have the abil-
ity to sell without having their shares individually registered with the
SEC, trading can commence. Part Four covers the most contemporary
techniques of going public without an IPO. Chapter 14, which looks
at SPACs, may be the first primer on a technique that has taken off
recently. A SPAC, or specified purpose acquisition company, is a public
shell, created specifically to enable a company to go public. It raises
large amounts of money that can then be given to the private company
it merges with. A SPAC’s shares are permitted to trade (most other
manufactured shells do not trade), and investors in the SPAC get to
review and approve the proposed merger. Each SPAC generally has an
industry or geographic focus, and has a management team experienced
in that sector to review potential merger candidates. As of this writing
in early 2006, over eighty SPACs have been formed just since 2004
and thirty-eight of them have successfully completed IPOs. These
shell vehicles are generally raising anywhere from $20 million to over
$100 million each. The next intense area of current activity, covered
in Chapter 15, is manufacturing Form 10-SB shells. The SEC appears
to favor these over some other types of shells (such as those created
under Rule 419). Nearly one hundred of these shells are being formed
Source: TKTK

by clients of my law firm alone! The last chapter of the book, Chapter
16, reviews a variety of other current issues: The intense desire of PIPE
investors and investment banks to benefit from the “public venture
6 Reverse Mergers

capital” returns that are possible when one invests in reverse merg-
ers. The “yuan rush” to complete deals involving Chinese companies.
And future prospects for SPACs, Form 10-SB shells, and the like. This
chapter includes extensive quotes and thoughts from over a half dozen
leading industry players, from accountants to investment bankers to
venture investors and others.

Source: TKTK
 CHAPTER 1

Why Go Public?

B
efore deciding how to go public, a company must decide whether
to go public. Or, as Tim Halter of Halter Financial Group asks his
clients: “If everything else in your company was the same, but you had
a publicly trading stock, would that be better?”

Advantages of Being Public

In general, there are five major advantages to being public: easier access to
capital, greater liquidity, ability to grow through acquisitions or strategic
partnerships, ability to use stock options to attract and retain senior execu-
tives, and increased shareholder confidence in management.

Access to Capital
It is easier for public companies to raise money than private companies.
This has little to do with a reasoned assessment of the merits of any specif-
ic private company. Public companies have five characteristics that make
them more attractive than private companies to investors.
First, public companies are required to disclose their financial results,
good or bad, and other material developments to the U.S. Securities and
Exchange Commission and the public regularly and in great detail. Dis-
closure requirements build investor confidence because it is harder for a
public company to hide problems than it is for a private one.
The second major benefit to an investor, which increases a public com-
pany’s access to capital, is an easier opportunity to create liquidity for the

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