Downsides of Taking Your Startup Public with a Reverse Merger

Ask any educated, well-informed advisor and they’ll tell you that taking a startup public is risky business. The dotcom failures of the late nineties are prime examples of …

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Ask any educated, well-informed advisor and they’ll tell you that taking a startup public is risky business. The dotcom failures of the late nineties are prime examples of the complete failure of going public too soon, without any real revenue. And while the SEC loves to provide opinion, they’re ultimately not there to say whether a deal is good or bad. They just want to make sure the disclosure is sufficient to protect investors. The most successful public companies are those with a great product or service, a proven management team and the right funding to take their product or service to market. While the upside for capital growth remains in the startup field, the downsides of being public as a startup can be onerous. The right process for any particular startup is dependent on the company’s ability to become successful as a publicly-traded firm. While some companies are doomed for failure, being public can speed up the time it takes for a company to make it to the public shell graveyard. Hopefully some of the items outlined below can help prevent this untimely fate for your next APO deal.

1. Lack of Liquidity & Broad Support

Perhaps the biggest issue with small, public firms is the inability to have real public stock liquidity. Yes, the stock is technically public and trades on a public exchange, but in reality, the float is likely not that high and neither are the number of total shareholders. Without broad market support small, microcap companies lack the trading necessary to create a liquid market. This means shareholders that are looking for an “exit” may have a difficult time selling their shares in the open market. This becomes particularly biting if the seller is an insider with >5% of the company’s stock.

Broad support and overall liquidity is something that typically must be earned over years of brand-building and gut-wrenching work. Only a small aspect of the deal can be blamed on a quality market maker. The rest of the deal is often a byproduct of the quality of the company, as it should be. Long term market support is built over years of profitable business operations and good business building.

2. Initial & Ongoing Costs

Many private startups lack the funding to even create a public company, let alone provide the cost and support to manage one once it’s up and trading. The legal and compliance costs of being public are not too onerous, but they are for a lean startup that needs to husband resources for paying things like product development and salaries for key employees.

While the upfront and ongoing costs associated with audits and keeping up-to-date with the SEC filings are less than some might assume, they still represent a regular, annual cost of doing business if your company is public–a cost that is avoided by staying private.

3. Increased Scrutiny & Legal Exposure

Once you are public, the likelihood of being sued for anything from misrepresentation or large downward fluctuations in the share price, increases almost tenfold. Investors and their blood-thirsty attorneys will look for ways–legitimate and otherwise–to claim your firm failed to live up to the expectations of shareholders.

Part of the increased scrutiny natural occurs as a result of simply having a great deal of proprietary company information available on the EDGAR database. It’s more difficult to scrutinize a private company due to the fact that the company’s information, including financial statements and other disclosures, are not made publicly available.

4. Less Capital is Raised

Unlike an IPO, a Direct Public Offering (DPO) or reverse merger typically doesn’t raise nearly as much capital when the shares first begin trading. Because there is a general malaise and lack of overall market support, Alternative Public Offerings generally raise between $1 million and $20 million, with the lion’s share in the <$5 million range. This is typically great for a startup with no real story and revenues at the time of the capital raise–and is frankly the overall reason many startups do go public via reverse mergers in the first place–it doesn’t mean the company is prepared to deal with the headache of all the items previously discussed.

In fact, the problems outlined in items one, two and three above can typically be hurdled if enough capital is raised. This is where the catch 22 surfaces. Without revenues and a good story, there will be a lack in the amount of capital raised. Without the capital raised, items one, two and three become even greater issues. And on the cycle goes.

There are certainly upsides to being public, but the downsides outweigh the upsides in most instances. This is particularly true of the those seeking to go public that are still in a start-up phase of doing business. Risky ventures like oil exploration and other development projects with little to no proven track record typically don’t make good public companies–at least initially. Perhaps the best private-to-public company stories come from businesses with large, rapidly-growing revenues, positive EBITDA and a superb management team are all helpful in selling the story to potential investors and shareholders.

 

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