As I write this, very few, if any, initial public offerings for venture companies are being done. The IPO market is at a virtual standstill for small companies looking to raise venture capital. Yes, you can do the big deals, but where does the smaller company get its money?

As the IPO market slowed, there has been a trend to more and more reverse mergers. As you may know, in a reverse merger, an operating company merges with a public shell or OTC shell to have publicly trading stock.

Generally, there are only two reasons to for going public, whether it is done with an IPO underwriter or through a reverse merger with a clean OTC shell. Naturally, these two reasons are (1) to get capital, and (2) to get liquidity for selling shareholders, whether these selling shareholders are the principals, employees with stock options, or companies that have been acquired by the public company.

For the company seeking venture capital, the reverse merger or pubic shell route seemed to be the only choice.

An SEC rule issued in 2005, SEC Release 33-8587, requires companies merging with a public shell company to file disclosure with the SEC tantamount to the disclosure required in a full-blown IPO. This disclosure is filed in a Form 8-K, called a Super 8-K. The Super 8-K must be filed within four days after the merger is closed.

With this rule, there are few if any time advantages or cost advantages to a reverse merger compared with registering stock for sale.

I believe that more and more we will find companies, especially companies seeking venture capital, choosing a self-filing or direct registration to go public. In a self-filing, the company does not buy a shell but rather simply files a registration statement with the SEC.

This registration statement is much the same as the super 8-K filing in information, time and expense.

The advantages of a self-filing are easy to understand. In a self-filing, you are saving as much as 20% of the stock in the operating company that would otherwise go to the shell company shareholders. You also save having to pay at the same time a large amount of cash, typically $50,000 to $750,000, to the shell promoters, in addition to your legal and accounting bill.

Shell promoters may point to the fact that the shell already has a trading market. As a former OTC market maker who traded shells, many IPOs, and many venture companies, I can tell you with authority that the trading market for most shells is weak in volume and market makers. The trading market for any decent operating or venture capital-backed company can easily surpass any shell’s trading market you care to name.

Shell promoters further point to the fact that the shell comes with many shareholders. They call this distribution. However, when you start to look deeper, ask questions, and do the math, you can discover that this also is illusory.

If the shell is 60% owned by the promoters and has another 200 shareholders, this means that the average shareholder pre-merger owns one-fifth of one percent of the stock. In the reverse merger, even if the shell shareholders receive 20% of the stock in the combined company, this means that the promoters now own 12% of the combined company and the average minority shareholder of the shell company now owns two-one hundredths of one percent (0.0002) of the combined company.

If the operating company was worth $25 million pre-merger, the shell promoters now have stock worth $3 million to throw on the market. This is a large amount of stock to take off the market before further buying will push the price up.

This will not make for a good trading market. Based on my experience, the shell promoters will do whatever it takes to get cash fast, causing the shell stock price to collapse. The minority shell shareholders may not even be aware that they have stock in a new company.

Even if the operating company does a large amount of investor relations to promote their stock, the market usually collapses. As the price collapses, all investor interest in the company usually goes with it.

Who wants to buy stock in a company at $0.0001 per share?

Consider the effect of a weak stock on the goals of doing the reverse merger. Does a weak stock price help to raise cash or venture capital? No. Does a weak stock price provide liquidity to key employees? No.

Does a weak stock price help management acquire other companies for stock? No. Thus, all of the original goals of the operating company are often crushed by a reverse merger done ineptly.

For a self-filing, the picture is much improved. Selling stock to friends, family, employees and associates of the company can create two hundred shareholders. These people are likely to make loyal shareholders. The block of stock in the hands of the shell promoters is gone so there is no overhang of stock depressing the market.

For these and other reasons, we believe that the more you look at a self-filing compared to a shell deal, the more you are likely to want to do a self-filing to achieve your goals.

Whether your chose a shell or a self-filing, be sure to get a good advisor on the transaction. Not only will you need someone versed in corporate law, securities law and investment banking, as the after-market is key to your being able to achieve your goals, having someone with market making and security analyst experience is key team member. I trust that you will discover the wisdom in having such a team behind you. There are many traps for the unwary in the financial markets and mistakes can be more than expensive, they may even stop your company’s development altogether.

The author, John Lux, has been an OTC market maker in new issues, shells and other companies, a security analyst, an investment banker, and attorney. He is a principal in several venture companies and private equity funds. You can learn more about reverse mergers, going public, raising money and developing a market for your stock from John Lux at mailto:lux.investor@gmail.com

New Technique for Going Public Instead of Doing a Reverse Merger with a Public Shell

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It is important to note the history of going public techniques. First, we had the initial public offering or IPO. A company, let’s call it a venture company, seeking to raise money finds an underwriter for their stock offering.

Then came the reverse merger or merger with an OTC shell. The company seeking money, the venture company, found a (hopefully) clean shell trading over the counter. The shell usually had no assets but had trading public stock. The venture company merged with the OTC shell, giving up 5-20% of its value to the public shell shareholders and paying $50-$750,000 to the principals of the public shell. The result was a publicly trading company – fast.

Several problems developed in this reverse merger approach. First, the stock of the new company was trading usually without full disclosure. Second, the people who controlled the shell often dumped their stock on the market without mercy, leading to a disastrous decline in the stock price of the new company and unjustified shareholder anger at the new management for letting the stock price slip when the new management were simply victims as well.

In fact, there were so many abuses in the reverse merger game, that the SEC in 2005 and passed a rule saying that the venture company had to file a Form 8-K within four days after the merger. This Form 8-K had to contain essentially all the information you would need to file in a public offering. Now there would be full disclosure to investors– essentially the same disclosure you would need to file if you were registering the stock for sale. So we now call it a Super 8-K.

However, if you are essentially filing the same information as when you register the stock for sale in an IPO, why not just register the stock for sale and forget about buying the OTC shell? The answer is that there are usually no good reasons to buy the shell. You might as well do what is sometimes called a self-filing or direct registration.

Moreover, when you do a reverse merger, there are many drawbacks to buying the shell over registering the stock in a self-registration. The cost of the cash payment to the principals of the shell and the percentage of your company you give up to the shareholders are very expensive. Shells can have undisclosed problems and liabilities. Instead of having to prepare a filing on one company, in effect you must prepare the documents for two companies that are now in the new company: your company and the shell. Also, a shell deal may carry some negative stigma with some in the financial community.

Having the shareholders in the public shell dumping stock in the market is not a good thing for your stock price. You want loyal shareholders. As a former market maker as well as an attorney and investment banker, I can tell you that a strong operating company can attract more and better market makers than those that usually trade OTC shells. The market makers who trade public shells themselves position blocks of the stock when it is a shell and dirt cheap, buying the stock for a few cents and dumping it in the market when it is a few dollars after the merger. (I know, I did this from time to time as a market maker.) The volume of trading in a shell company is usually thin. While some may think they are paying for a trading market by buying a shell, they are really buying a market that has nothing of much value.

Thus, the more you look at the alternatives, the more you can start to see the advantages of a self-registration. Now you want to contact a good advisor on these transactions. I believe that the more you look at it, the more it usually makes sense to do the self-filing.

The author, John Lux, has been an OTC market maker in new issues, shells and other companies, a security analyst, an investment banker, and attorney. He is a principal in several venture companies and private equity funds.

How can you learn more? Contact John Lux: mailto:lux.investor@gmail.com