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July 28, 2005

Why "reverse mergers" are often bad ideas

When their portfolio company is too small to launch a successful IPO, investors consider "reverse mergers" to obtain liquidity. (Reverse mergers or "reverse IPOs" - in which a publicly listed company with little or no business activity merges with a private company - are a pretty common occurance in the Indian market.)

Fred Wilson provides whole bunch of reasons why he dislikes such transactions:
# The people who control the public shells demand a "premium" for their business because they have the public company asset. The premium they demand often gives them a significant percentage of the merged business and it is rarely a fair deal for the privately held company.
# There is no way to determine the valuation at which the merged entity will trade at once the merger is completed. In a traditional public offering shares are sold at the IPO and that sale price is a good indication of where the stock will initially trade. Because there is no way to determine the value at which the merged company will trade, there is no way to determine what the value of the deal is to the privately held business.
# Because there is no stock sold as part of the deal, there is no marketing effort associated with the back door IPO. One of the best things about the IPO process is the road show in which the company has the opportunity to tell its story to a large number of institutional investors, thereby insuring some interest in the stock. In a back door IPO, you could, and often do, end up with a public company that nobody knows or cares about.
# If cash is an issue for the privately held company, the back door IPO often doesn't bring a lot of cash and once the company is public, its much harder to do a financing with private equity investors. The result is that a back door IPO may make it harder to raise money in the future, not easier.
# There is no guarantee of liquidity in the stock. There is no value in having a public company if there is no real market for the stock. The idea that because a company is public you can sell your stock is false, particularly if you have a large position in the public company.

Arun Natarajan is the Editor of TSJ Media, which tracks venture capital activity in India and Indian-founded companies worldwide. View sample issues of TSJ Media's Venture Intelligence India newsletters and reports.