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Exits, M&A, IPO, Reverse Merger

Exits

Many people start companies because they are passionate about their idea, product, or vision.  Investors love to see that passion in a founder, but they are obviously wanting a return on their investment.  This is where exit strategies come into play, sometimes referred to as a liquidity event.  You could lump things like a dividend distribution or repayment on a note in as a form of exit for the investor to recoup their investment and gain their return; however, most early investors in startups are willing to take the very high risk of failure for that investment in return for a potentially large return on their investment and dividends are not usually as sexy of a return.

Mergers & Acquisitions

Common forms of exit are to merge with another company or be acquired (i.e. bought) by another company.  Of course, a startup could also seek out acquisition targets to obtain their intellectual property or their management team and be the one doing the buying, but we will look at M&A from an exit strategy point of view for the selling company.

Acquisitions typically come in one of two forms, a stock purchase or an asset purchase.  They are pretty self explanatory, in one the acquiring company buys all the outstanding stock to acquire control of the seller, the other the buyer simply purchase all of the selling company’s assets and the selling company simply dissolves.  There are a number of factors involved in making the decision of whether to utilize an asset sale or stock sale as the preferred method for the transaction, such as taxes, accounting, anti-trust, securities laws, liabilities, contract rights, and practical or logistical considerations.

Since these types of transactions usually require some form of majority vote of the shareholders, there are considerations such as dissenting shareholders’ rights or accounting rights if the shareholder refuses to vote for the M&A transaction.

All of the above considerations also go into whether to choose a merger instead of stock or asset sale.  A forward merger is treated similar to an asset sale and reverse merger treated similar to a stock sale.  A merger, stock sale, or asset sale can result in a liquidity event for investors, but not all the time.  The major factor for an investor is obviously the valuation of either the stock or assets of the company to see what their return will be.

IPO or “Going Public”

Many people don’t understand exactly what it means to “IPO.”  An initial public offering (IPO) is when a company registers their stock with the SEC and also sells some or all of the stock they are registering to the public to create a public marketplace for the purchase and sale of their stock.  Various federal and state securities laws place significant restrictions on transfer of private stock, but allow stock to be publicly traded between individuals once the stock is registered with the SEC.  The registered stock is then listed for sale on some form of exchange, such as NASDAQ or NYSE, or electronic marketplace, such as what are referred to as “Pink Sheets” or “Over the Counter Bulletin Board” marketplaces.  This provides a marketplace for average people to buy and sell that company’s stock.  In the IPO typically an investment bank comes in to sort of pre-market the company’s stock before it is actually publicly traded to get a sense for what the right price is and how much stock would be bought once it hits the market.  So not only does the IPO process register the company’s stock, it creates a public marketplace for resale, and raises money for the company.  Prior investors typically have registration rights before the IPO so that their stock is registered in the process and able to be sold, thus recognizing an exit.

Until the shares are registered, it is difficult for someone owning shares in a startup to be able to easily sell their stock due to restrictions on transfer and the fact that there is no public market to sell the stock in.  They have to try to do private sales and comply with securities laws or exemptions to allow the sale.  In many cases under Rule 144, they have to own their stock for a period of years before they can sell it.

So why doesn’t every company simply pursue an IPO right away?  The IPO process involves filing a registration statement, typically an S-1, with the SEC.  This document gives all kinds of explanations about the company, its financial performance, management team, and business plans for the future.  It also provided financial statements and other required disclosures.  In order to produce an S-1, auditors and lawyers need to be hired to audit financial statements, provide legal opinions, and assist with drafting the S-1 (See my discussion and links to Facebook’s S-1 as an example).  The SEC then will often have comments or request further information regarding the S-1 requiring the company to amend their S-1.  Often after several months, the SEC then declares the registration effective and the stock is registered.  The expense and time involved in this process can be tremendous, often costing from several hundred thousand dollars to several million dollars.

The other factor involved is the actual sale of the stock.  Many investment banks will enter into fee agreements that are a percentage based on money they raise, so it may not cost the company anything up front.  However, any major investment bank is not going to simply take on the IPO process for a no-name company because they want to know that there will be buyers out there willing to pay their asking price.  The market, investment bankers, and company want to be sure there will be enough liquidity (purchase and sales) in the marketplace to create a regular market.  Many stocks have gone public only to see the market for their stock drop to where there is so little volume (no buyers) that the stock price drops into the pennies per share.  These so-called “penny stocks” end up on the OTCBB or Pink Sheets with very little trading volume, so no current shareholders can even sell their stock on that public market.

Reverse Merger

There was a time when the new method to avoid the costs of going public was to do a reverse merger where the company merges into an already publicly traded company and takes over that company.  The private company exchanges its stock for the public company’s stock and like that, it is a publicly traded company without the need for the traditional IPO.  The shareholders go from shares in a private company to shares in a public company in a very short time.  This process sometimes involved cash changing hands, but was usually simply a transaction used to go public, not necessarily raise money.  The SEC cracked down over the last several years on the practice of using so-called “shell companies” that would go public by registering shares with the SEC and then simply not conducting any business and sell their “shell” to a reverse merger candidate who wants to quickly go public.  The reverse merger process is still something that can be used to create liquidity, but the limitations placed by the SEC place some obstacles to using this as a legitimate form of going public.  Essentially, the public company should not just be a shell formed for the purpose of avoiding the initial share registration process.  If it was actually an operating company that simply failed, but was still publicly listed, it still could be used for a legitimate reverse merger.

So a reverse merger can be included as a “going public” type of transaction to get liquidity or an exit for existing investors, but the more traditional forms of exits are IPO, traditional mergers, and acquisitions.  There are other creative ways to provide an investor an exit that can be examined such as new investment rounds purchasing some of the prior investors shares, company repurchases of shares, and others.  The bottom line is that every founder should analyze and be ready to discuss a proposed exit with investors; however, investors want to hear your passion for your idea and execution on it, not that you can’t wait to go public or be acquired and get rich.

A word of caution however, reverse mergers can be very complex transactions and you must complete full due diligence on any company involved.  They can be used properly, but are big targets for fraudulent shell company or pump and dump schemes.  See an example of the SEC going after these through:  SEC Suspends Trading on 379 Dormant Shell Companies

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Legal Disclaimer: All answers and discussions in this article are meant to be general and educational in nature only and should not be relied upon as legal, business, or tax advice for your specific situation.  Most discussions refer to laws and regulations as applied to a California corporation and these can vary by location, as can other factors in certain situations within California, so it is always best to consult with a licensed local attorney with experience in these matters.  Use of, or any discussion as a result of these articles does not create an attorney-client relationship and is not governed by rules on confidentiality.