BECOMING PUBLIC

I.  The Initial Public Offering (IPO)
If an immediate raise of at least several million dollars in the public markets is an essential part of the short-term needs of the privately owned company, an initial public offering (IPO) may be the best course of action.  This is especially true if the company does business in an industry where the first public raise needs the “sizzle” of a successful private company going public in conjunction with the raise.  However, unless there is a "firm commitment" from an underwriter early in the process, the IPO candidate can spend a great deal of money, invest many months of effort and have the underwriter decide (even at the last minute) that your offering will be done on a "best efforts" basis rather than as a "firm commitment." 

There can also be last minute disagreements between the company and the underwriter of the planned IPO regarding the offering price of the stock and other important issues that may result in the underwriter withdrawing from participation prior to going out to the public markets to raise money.  These uncertainties are a major problem when a company goes public through an IPO, because the failure of the underwriter to go public with an offering can leave the company in a privately owned status.   If these underwriting issues can be overcome and a substantial raise of money is accomplished, an IPO can be very beneficial for the newly public company.

If there is no immediate raise of money in the public markets planned, other methods are available with the two most practical being: 

• (a) a reverse merger with a shell company that has had a history of prior operations or
• (b) a reverse merger with a newly created spinoff by an existing publicly owned company.

An IPO has a significantly higher cost than other means of going public, because the offering process is expensive and time-consuming.  Though no money is raised as a part of the reverse merger with a shell corporation or going public through a registered spinoff, the post-merger company is almost always in a stronger position to raise money through private equity sources (such as Regulation S stock placements or other private placement) after a reverse merger than it was as a privately owned company.  In the economic climate that exists today, private equity sources are more likely to be the answer to capital needs for a small public company than an initial or secondary public offering.  When the public markets regain their interest in funding small public companies, one important hurdle will still be present for the company seeking to go public by an IPO—the seven figure underwriting fees and the large number of shares of seed stock that will be issued to underwriters and market makers.

II. Shell Mergers
References here to "shell corporations" mean publicly reporting and trading companies that have had past operations, but which are no longer an operating company.  The company may have simply liquidated its assets and ceased operations.   Some shells have cash on hand.

Even without current operations, a shell public company may continue to file financial reports with the United States Securities Exchange Commission (SEC) and may trade (although it is usually thinly traded).  Many companies go public through a reverse merger with a publicly owned shell company.  A shell merger is often much less expensive (and much more certain of success) than if the company had attempted to go public through an IPO.

The merger of a privately owned company with a shell corporation with a prior operating history as a means of going public is based upon assumptions that:

• (1) that acquisition of and merger with a trading shell is the fastest way to become a publicly traded company;
• (2) that the merger with a trading shell costs less than an IPO and preserves operating capital, and
• (3) that the merger with a trading shell postpones the date on which the privately owned company will need to provide audited financial statements and to undertake other expensive and time-consuming SEC compliance filings.

In some cases, these assumptions are incorrect.  A shell merger almost always takes less time than an IPO but is similar in the amount of time needed to going public through a merger with a registered spinoff.   Shell mergers are in come cases more expensive than other means of going public.  In most cases, a post-merger company is required to file the same business and financial information with the SEC (complete audited financial statements and pro forma financial statements with the information to be filed on Form 8-K within 15 days of the succession) as would be required if a company became a fully reporting company by filing a registration statement, by virtue of an IPO or through a merger with a registered spinoff.

Another disadvantage of a merger with a publicly traded shell corporation is that it is often not as "clean" as the owners and promoters claim.  Unknown or undisclosed liabilities can pose great risk.  Cleaning up a supposedly “clean” shell is also a time consuming and expensive challenge.  Conducting due diligence regarding a shell public corporation is sometimes as challenging as the evaluation of an opportunity to acquire an operating business.

Today, the primary business reasons for a privately owned company to merge with a trading and reporting shell would be

• (1) if applicable, the presence of much needed cash in the shell,
• (2) if applicable, useable net operating loss carry-forwards in the shell,
• (3) the acquisition of a large shareholder base suitable to qualify for listing and quotation on a stock exchange and
• (4) to incur fewer expenses than an IPO and to eliminate the uncertainties associated with an IPO.  These advantages should be pursued if the usual risks associated with a shell merger (possible undisclosed liabilities, etc.) can be successfully managed and if the management of the privately owned company has the training and experience to operate a public company.
  

III. Registered Spinoffs - an increasingly common method of going public
More and more U.S. companies go public through a merger with a spinoff of a publicly held company (“Parent”) in which the private company provides a negotiated number of shares of common stock (“Dividend Shares”) to the Parent for distribution by the Parent to its shareholders.  Such Dividend Shares would be registered with the Securities and Exchange Commission (SEC).  In return, the Parent would allow the distribution of a Prospectus to its shareholders.  The Prospectus would describe the private company and its operations.  This transaction provides the private company with an essential asset: a shareholder base large enough to qualify for quotation and trading on the OTCBB or any other exchange for which the company qualifies.

Spinoffs, unlike shell companies, do not have a potentially troublesome operating history.  The registered spinoff is different from a spinoff of an operating subsidiary of a public company, which transactions are frequently the subject of articles in the financial section of newspapers and magazines. Registered spinoffs are created to create a new publicly owned and reporting company that has no history of operations.  Therefore, there are no liabilities hiding from view.

Some of the advantages of registered spinoffs compared to public shells with a prior history of operations are:

1. There is no potential problem of delinquent local, state and federal  taxes.
2. There is no potential issue of delinquent reports to the Securities and Exchange Commission.
3. There is no potential problem of unknown creditors, no potential suits by shareholders against the company’s officers and directors over past events, and no risk of court claims (such as environmental contamination litigation) being asserted against the company.
4. Any desirable corporate and equity structure can be created for the new registered spinoff, including the ideal number of authorized and issued shares.  There is flexibility in creating options, warrants, convertible securities, etc., because there are no pre-existing owners and equity interests to consider.
5. If a company’s underwriter terminates its efforts to take a company public through an IPO, the company may have spent over a million dollars during the process only to find that no offering will take place and that it is still privately owned.  If the company goes public through a merger with an SEC registered spinoff before attempting an IPO, the company will be publicly owned, publicly traded and fully reporting regardless of any future problems with an underwriter.  The new public company will have the opportunity to approach investment bankers and private equity sources for a private raise of money with advantages in this process that result from being publicly owned, reporting and trading.
6. As part of a shell merger, it is almost always necessary for the company to rollback the shares owned by the stockholders of the shell.  Assume the following:
   • The privately owned company’s shareholders will own 90% of the outstanding stock in the post-merger company;
   • There are 10,000,000 shares of stock issued and outstanding before the merger;
   • There will be 10,000,000 outstanding shares (and an additional 10,000,000 authorized, but un-issued shares of the post-merger company.
     

In order for the shareholders of the formerly private company to own 9,000,000 shares of the 10,000,000 to be issued, the shareholders of the shell will experience a 10:1 rollback of their shares and will own one (1) share for every 10 shares that were owned prior to the merger. It is often very difficult to create interest in purchasing additional stock among these shareholders in the face of their disappointment about the prior rollback.

On the other hand, when a company has gone public through a merger with a registered spinoff, there is an entirely different climate because each spinoff is structured according to the requirements of the private operating company. Creating interest in purchasing the post-merger company’s stock among existing shareholders is less of a challenge. The shareholders of the parent company will have received an unexpected and welcomed share dividend. The parent company’s shareholders are often eager to obtain more information about the operations and prospects of the post-merger company.

IV. Going Public by Filing a Registration Statement
A privately owned company that decides to become a public company by filing a registration statement with the U.S. Securities Exchange Commission can offer its securities for sale after a registration statement is filed, approved by the SEC staff and the SEC staff declares the registration statement "effective."
Before a privately owned company can trade on a stock exchange, it must complete an audit (prior to the filing of the registration statement), retain a stock transfer agent, submit the necessary application and documents for Standard & Poor’s financial listing (manual exemption for secondary trading in approximately 42 states), obtain a trading symbol and take all steps that are required to obtain qualify for listing on an exchange.
Registration statements have two principal parts:

• Part I is the prospectus, the legal offering or "selling" document. The company - the "issuer" of the securities - must describe in the prospectus the important facts about its business operations, financial condition, and management. Everyone who buys the new issue, as well as anyone who is made an offer to purchase the securities, must have access to the prospectus.
• Part II contains additional information that the company does not have to deliver to investors. Anyone can see this information by requesting it from one of the SEC's public reference rooms or by looking it up on the SEC Web site, www.sec.gov.

There are many types of forms used to register securities offerings. The forms of registration statements are similar to a brochure, providing readable information. Each company must describe each of the following in the prospectus:

• its business;
• its properties;
• its competition;
• the identity of its officers and directors and their compensation;
• material transactions between the company and its officers and directors;
• material legal proceedings involving the company or its officers and directors;
• the plan for distributing the securities; and the intended use of the proceeds of the offering.
  

Registration statements also must include financial statements audited by an independent certified public accountant.

In addition to the information expressly required by the form, the company must also provide any other information that is necessary to make its disclosure complete and not misleading. The company must clearly describe any risks prominently in the prospectus, usually at the beginning. Examples of these risk factors are:

• lack of business operating history;
• adverse economic conditions in a particular industry;
• lack of a market for the securities offered; and
• dependence upon key personnel.

Registration Forms for Small Business Issuers

If a company qualifies as a "small business issuer," it can choose to file its registration statement using one of the simplified small business forms. A small business issuer is a United States or Canadian issuer:

• that had less than $25 million in revenues in its last fiscal year, and
• whose outstanding publicly-held stock is worth no more than $25 million.

Form SB-2 - To Raise Capital in Any Amount
If a company is a "small business issuer," it may register an unlimited dollar amount of securities using Form SB-2, and may use this form again and again so long as it satisfies the "small business issuer" definition.

One advantage of Form SB-2 is that all its disclosure requirements are in Regulation S-B, a set of rules written in simple, non-legalistic terminology. Form SB-2 also permits the company to:

• Provide audited financial statements, prepared according to generally accepted accounting principles, for two fiscal years. In contrast, Form S-1 requires the issuer to provide audited financial statements, prepared according to more detailed SEC regulations, for three fiscal years; and
  
• Include less extensive narrative disclosure than Form S-1 requires, particularly in the description of your business, and executive compensation.

Staff Review of Registration Statements
SEC staff examines registration statements for compliance with disclosure requirements. If a filing appears incomplete or inaccurate, the staff usually informs the company by letter. The company may file correcting or clarifying amendments. Once the company has satisfied the disclosure requirements, the staff declares the registration statement effective. The company may then begin to sell its securities. The SEC can refuse or suspend the effectiveness of any registration statement if it concludes that the document is misleading, inaccurate, or incomplete.

Comparative Cost a Shell, an IPO, a Spinoff and Filing a Registration Statement

IPO - The cost of an IPO is often $500,000 to $1,000,000 or more.  The process typically takes nine to 15 months.

Acquisition of and Merger with a Publicly Owned Shell - Persons controlling public shells that are fully reporting and publicly trading often request between $175,000 and $450,000, as consideration for issuing 75-95% of the public company’s stock in exchange for the assets of the privately held company.  It is also important to understand what filings were done by the shell at the time that it became public to determine if the shell is of a type that will suit the needs of the privately owned company that is seeking to go public.  A 504 shell is worth far less in the marketplace than a shell that started its life with a Form 10 or a Form 10SB filing.  If there are assets (including cash) or useable net operating loss carry-forwards in the shell, the cost of the shell (the cash paid for the shares of the shell and the percentage of shares that will be retained by the shell’s shareholders) will be higher in direct correlation to the value of the assets or tax advantages.   It will, depending upon issues raised by SEC staff in their comments regarding the merger documents and any registration statement, require 90 to 150 days for the post-merger company to become reporting and trading.  The post-merger company may also be required to pay $60,000 to $100,000 in SEC compliance costs within 90 after the merger.  Further, the costs of (1) purchasing shares placed for sale by the shell’s pre-merger shareholders, and (2) attempting to legally maintain orderly pricing of the company’s shares when post-merger trading takes place could easily cost the company in excess of $500,000, which is lost operating capital.

The SEC Registered Spinoff - The cost of acquiring a spinoff is usually about $125,000, including most out-of-pocket expenses paid to third parties.  If the Parent company requires the privately owned company to advance or reimburse its expenses, another $35,000 to $40,000 may be required.  It often takes between four months and six months to become a fully reporting and trading company on the stock exchange for which the new company qualifies.   An appropriate lockup agreement among the major shareholders of the spinoff and the major recipients of the stock dividend paid by the parent company should be negotiated to avoid the operating capital drain to maintain orderly pricing of the company’s shares suffered by some companies that merge into shells.

Filing a Registration Statement - The cost of going public by filing a registration statement includes (1) between $25,000 and $40,000 in attorneys fees, (2) audit fees that depend on the number of years for which the audits are conducted and possible special circumstances that vary from company to company and (3) $35,000 or more in other expenses.