The market for medical technology IPOs has effectively been closed since late 2007, despite the fact that the NASDAQ has rebounded from a March 2009 low of 1,268 to nearly 2,300 in January. For a small to medium size company that wants additional liquidity without an acquisition, there are not many alternatives. The reverse merger seems to be one of the few alternatives that companies such as Cardiovascular Systems, Inc, St. Paul, MN, and Sanuwave, Inc, Alpharetta, GA, have used recently to become publicly traded.

Several years ago, the reverse merger had a negative connotation to it and it was not highly regarded by the Securities and Exchange Commission. However, today, the stigma seems to have lifted and companies are taking advantage of this alternate avenue to going public.

What is it?

The reverse merger takes a combination of two parties, a private operating company and a public shell with no operations, to consummate a reverse merger. Typically, the operating company brings the majority of the value to the transaction since it is generating the revenue and profits of the continuing organization. Additionally, the shell company typically brings cash and an entity that is already publicly traded. Since it is an expensive, laborious process to go public, there is value to a shell.

Mechanically, the shell company will issue a large amount of shares to the current shareholders of the operating company in exchange for 100% of the shares of the private company, which will then be retired. Since the majority of the value typically comes with the operating company, these shareholders will ultimately own 80 to 95% of the surviving entity and the original owners of the shell will own the remaining 5 to 20% depending on the level of cash originally held by the shell.

Advantages and disadvantages

The primary advantages of the reverse merger include a faster, less expensive path to the public markets. The process of going public through an IPO typically involves multiple SEC filings that are scrutinized by lawyers, accountants, and the SEC. Also, investment bankers typically earn a higher fee with a typical IPO process. Additionally, it is difficult to find a banker that will handle smaller IPOs.

The primary disadvantage to a reverse merger is the lack of hype that goes along with an IPO and the lack of the quick jump in share price shortly following the closing of an IPO. However, with the IPO window closed, these disadvantages don’t seem as relevant today.

What to avoid

The primary concern with shell companies is the potential existence of liabilities, contingent liabilities, or regulatory problems that carry over from the shell company’s past. We advise our clients to find what is often referred to as a “clean” shell company.

These issues are relatively easy to avoid by undertaking a thorough due diligence process before entering into an agreement with a shell company. Your due diligence exercise should focus on uncovering existing liabilities, potential contingent liabilities, such as lawsuits, and potential regulatory issues, such as an SEC action.

Becoming public

Before making the decision to pursue a reverse merger, the management team and board should ensure that they are ready to operate a public company and accept all of the regulatory and reporting requirements that go along with it. Many managers comment that they feel pressure to operate the company differently after going public due to the short-term performance pressures that are created by quarterly reporting requirements.

With that said, now appears to be a good time to use the reverse merger as a viable alternative to an IPO while gaining liquidity for your shareholders. And to avoid any mistakes and pitfalls before committing to a reverse merger, please be sure to consult with your CPA and attorney.

Best wishes for a successful 2010!