The more you look at reverse mergers the more you start to understand that reverse mergers compare favorably with the classic venture capital model for venture funding.
Venture funding is obviously key to the success of any new or growing venture. The classic venture capital model seems to work like this: The entrepreneur and his team formulate a business plan and try to get it in front of a venture capital firm. If they are well connected, they may succeed, but most venture capital firms are overloaded with funding requests.
If the entrepreneur is not in a business that is the latest fad among venture capitalists, he may not be able to find funding.
If the entrepreneur is very lucky, he will be invited to pitch the VC. If the venture survives this trial, it will receive a venture capital terms sheets. After prolonged and adversarial negotiations, a deal is struck and the venture company signs hundreds of pages of documents. In these documents, the entrepreneur and his team give up most of the control of the company and usually most of the equity in the deal. Their stock is locked up and if they want to sell to get some cash, they probably have to offer the buyer to the VC first. Time from start to finish – 90 days or more.
If the company needs more money, it must negotiate with the VC and the entrepreneurial team may lose ground in the deal. The company may have to reach certain set milestones to get funds. If the company falls behind of schedule, it may lose equity share.
As the venture develops, the venture capitalists may or may not add value, and most likely will second-guess the entrepreneur and his team. If the venture succeeds, the venture capital firm will reap most of the rewards. If the venture does not succeed, most of the capital will be lost forever. Some ventures wind up in the land of the living dead – not bad enough to end, not good enough to succeed.
Worst case scenario, the venture capitalists take control at the outset, become dissatisfied with management, and oust the original management which loses most of not all of their position and their jobs.
The Reverse Merger Model
The entrepreneur finds a public shell. He has to come up with some cash to do this and pay the legal and accounting bills.
He buys control and merges into the shell on terms he determines. He keeps control but he has the burdens of a public company.
He determines how to run his company, including salaries. He can offer stock options to attract talent. He can acquire others companies for stock. He determines when he cashes out.
Instead of having to report to the venture fund, he has to report to the shareholders.
Subject to the limitations of the securities laws, he can sell part of his stock for cash.
He can seek money whenever he wants; he is in control.
Problems: He may be attacked by short sellers. He may buy a shell with a hidden defect. He has to pay for the shell.
From the Investors’ Point of View
Venture capital funds are typically funding by institutional investors seeking professional management. They do not have the time to manage a number of small companies and delegate this task to the venture capital partners. Small investors are rarely permitted. Venture capital funds allow the institutional investors to diversify.
Venture capital fund investors are locked in over a period of years. If they make 30% per year returns, they have done very well.
The venture capital model encourages the venture capital firm to negotiate hard for a low price and harsh terms. A venture team seeking funding that knows it has a big future may not submit to such terms. However, for a weak company that is just looking to collect salaries for a few years before folding, in other words a company that is a bad investment, can accept any terms, no matter how harsh. Thus, the venture capital model is skewed toward selecting out the worst investments and repelling the best.
Small investors can buy stock in reverse merger companies. They must take the time to investigate these companies but may lack the resources to do so intensively. Most small investors lose money. If they win, they can win big. They can, if they choose do so, diversify their investments. They have no influence on management, except to sell when they are displeased.
The reverse merger model compares very favorably with venture capital. Whereas venture capital is perpetually in scarce supply, reverse mergers are always out there for any company that can interest investors. The company can usually raise money on better terms from the public than from venture capitalists.
Overall, the big advantage of the reverse merger is that the company has total control over its destiny. The team can be assured of being rewarded well for success. The company sets the terms, can sell stock whenever it sees fit on whatever terms it merits, the insiders can sell too, and the venture team is not second-guessed by amateurs in their field, and the venture team does not have to fear losing equity or jobs.
Another advantage is less risk to the investor. The investor is in a publicly trading stock. If the investor does not like what is happening, he can sell. He may sell at a loss, but he can get out. The investor can also pick and choose companies himself, instead of making only one investment decision – the decision to back the VC company which then takes control of the rest of the decisions.