Taking companies public is an oft misunderstood process. The steps, cost and timing vary widely, depending on the method, process and exchange on which the stock is traded. The higher the exchange, the larger the firm, the greater the cost. The cost, quality and speed trade-off also comes into play. The faster you want a deal done, the more it will cost and chances are the lower quality deal you will receive. Knowing how and when to fish or cut bait is helpful when doing deals. Understanding the pitfalls can also help business owners deciding whether or not public status is right for them. What follows should be a helpful crash course for unwary business owners who think going public is a walk in the park.
Concentration and Limitations on Public Float
When a company’s shares become tradable in the public markets, the number of trading shares is referred to as the “public float.” After a reverse merger occurs, most of the shares will be held by the owners of the once private company. Consequently, shares available to trade will only be limited to the shares owned by the previous shell.
Immediately after the merger, owners’ shares are often registered with the SEC and some will be locked and unable to sell for a time. While the rest are released to help build the public float, immediately after the merger, the number of shares immediately available to trade in the public float will be limited.
Public float is often most limited by the group or individual that either controlled the public shell prior to the merger or the shareholders of the private company that has been merged in. The very nature of reverse mergers typically doesn’t bode well for immediate sale of shares held by those closest to the transaction, including those just mentioned. One of the biggest reason for this is that even a limited sale of these shares could cause the stock price to fall. Thus, free trading shares are regulated both naturally and unnaturally immediately following a “going public” event.
Minimal Analyst Coverage
Market research is used heavily by institutional investors with deep pockets that typically invest in public companies. Limited research and data for recently reverse merged companies means limited investment from larger, institutional investors. Issuer sponsored research is also limited and–because it creates conflicts of interest–is typically considered less reliable.
In addition, most institutional folks avoid investing in “penny stocks” or stocks that typically trade for under a dollar. There is also limited trading on lower market exchanges like the OTCBB or OTC Markets.
Few Market Makers
Market makers that trade on lower exchanges are becoming more of a endangered species. Their disappearance is the result of both micro and macro factors, but their importance in mid and micro-cap “going public” promotion cannot be understated. Market makers need personal incentive to sell securities, particularly those that may not be well known or for which they have little confidence. It’s unfortunate in some instances, but well warranted in many others. Stocks that deserve attention often don’t get it while their nefarious “pump and dump” counterparts may get feigned praise.
Furthermore, regulatory changes like Sarbanes-Oxley have made it less justifiable for market makers to chase smaller opportunities, regardless of the legitimacy or clout they may hold. Part of that comes from the regulation itself making promotion a bit more difficult, part comes from fear on the part of the market-maker that they might step out of the regulators’ good graces. Whether either is legitimate, doesn’t matter as newly issued shares in legit private-to-public transactions have been and continue to be negatively impacted.
Pressure from Short Sellers
There are a number of reasons investors and traders may be incentivized to short sell a stock including sending a message of dissatisfaction or riding the presumption the stock is headed south. The problem with newly initiated reverse mergers with thinly-traded shares is the pressure of short selling exposes the stock to increased risk. Shorting stock that is thinly traded can cause the stock to plummet precipitously. The downward spiral caused by short sellers can cause the broader outside market to lose confidence, thus sending the value of the stock down further still.
The unfortunate aspect of such bets is that those who perpetrate the schemes are able to reap massive profits at the expense of legit businesses. Luckily practices like this are, if proven to be done with fraudulent intent, illegal.
Other pressures on small cap stocks tend to make them less desirable. For instance, thin trading in newly formed public companies also limits the amount that can be raised from the public markets. But regardless of what the naysayers will propagate, it still remains easier for microcap stocks to raise money from the capital markets without the costly burden of venture capital. When done properly, going public through the back door with reverse mergers can provide a huge benefit to the right company with the right plan in the right industry. There are always instances where the fit just isn’t right. Having the wisdom to know when to hold ‘em, know when to fold ‘em is helpful when doing niche deals like reverse mergers.