Use of reverse mergers instead of venture capital for risk financing

The more you look at reverse mergers, the more you begin to understand that reverse mergers compare favorably with the classic VC model for venture financing.

Business financing is obviously key to the success of any new or growing business. The classic venture capital model seems to work like this: the entrepreneur and his team formulate a business plan and try to present it to a venture capital firm. If they are well connected, they can be successful, but most VC firms are overloaded with funding requests.

If the entrepreneur is not in a business that is all the rage among venture capitalists, they may not be able to find financing.

If the entrepreneur is very lucky, they will be invited to launch the VC. If the company survives this test, it will receive venture capital term sheets. After protracted and adversarial negotiations, an agreement is reached and the venture firm signs hundreds of pages of documents. In these documents, the businessman and his team give up most of the control of the company and, usually, most of the equity in the deal. Their shares are 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 on the deal. The company may need to reach certain set milestones in order to obtain funding. If the company falls behind schedule, it may lose equity interest.

As the company develops, venture capitalists may or may not add value, and they will most likely challenge the entrepreneur and his team. If the venture is successful, the venture capital firm will reap the lion’s share of the rewards. If the venture is unsuccessful, most of the capital will be lost forever. Some businesses end up in the land of the walking dead, not bad enough to finish, not good enough to succeed.

In the worst case, venture capitalists take control early on, become dissatisfied with management, and drive out the original management, who lose most of their position and 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 with the shell on terms he determines. It maintains control but has the burdens of a public company.

He determines how to run his company, including wages. You can offer stock options to attract talent. You can buy other companies for shares. He determines when he gets paid.

Instead of having to report to the venture fund, you need to report to shareholders.

Subject to the limitations of securities laws, you may sell part of your shares for cash.

You can search for money whenever you want; he is in control.

Problems: Can be attacked by short sellers. You can buy a shell with a hidden defect. You have to pay for the shell.

From the point of view of investors

Venture capital funds are typically funded by institutional investors seeking professional management. They don’t have time to run a bunch of small businesses and delegate this task to venture capital partners. Small investors are rarely allowed. Private equity funds allow institutional investors to diversify.

VC fund investors are locked up for a period of years. If they are returning 30% per year, they have done very well.

The venture capital model encourages the venture capital firm to negotiate hard for a low price and hard terms. A venture team seeking financing and knowing it has a great future cannot be bound by such terms. However, for a weak company that is only looking to collect salaries for a few years before retiring, in other words, a company that is a bad investment, it can accept any term, no matter how harsh. Therefore, the venture capital model is biased towards selecting the worst investments and rejecting the best ones.

Small investors can buy shares in reverse merger companies. They should take the time to investigate these companies, but may not have the resources to do so intensively. Most small investors lose money. If they win, they can win big. They can, if they wish, diversify their investments. They have no influence on management except to sell when they are not satisfied.

Summary

The reverse merger model compares very favorably with venture capital. While venture capital is always in short supply, reverse mergers are always available for any company that might interest investors. The company can usually raise money on better terms from the public than from venture capitalists.

In general, the great advantage of the reverse merger is that the company has full control over its destiny. The team can be sure to be well rewarded for success. The company sets the terms, it can sell shares when it sees fit on whatever terms it sees fit, the experts can sell too, and the venture team isn’t questioned by the amateurs in their field, and the venture team doesn’t have to fear losing equity or jobs.

Another advantage is the lower risk for the investor. The investor is in a publicly traded stock. If the investor does not like what is happening, he can sell. He can sell at a loss, but he can get out. The investor can also pick and choose companies themselves, instead of making a single investment decision: the decision to back the VC firm, which then takes control of the rest of the decisions.