Emerging from a shell spells major success for more firms.

WHERE there's a will, small companies find a way. And at a time when the IPO market is not welcoming to unproven ideas, the reverse merger has become a popular back door path for getting access to public markets.

Rather than go through the expensive process of filing documents with the Securities and Exchange Commission, a small company can find a publicly traded shell company whose business consists only of the name and public registration.

The private company can strike a deal with owners of the defunct company and merge into the shell, becoming public through what is called a reverse merger. It's an easy, fast and cheap way for small companies to raise money.

"Years ago, the reverse merger field was largely a universe of small-time stock promotions, which were flaky at best," said Mike Donahue, attorney with Richardson & Patel LLP who advises emerging companies. "But some SEC rule changes over the past several years have really advanced the quality of the bulletin board."

Not quite New York Stock Exchange material, this sub-market called "over-the-counter" is made up of the bulletin board and the pink sheets. The OTC market does not require quarterly financial statements, outside audits or investment bankers. There are minimal filing requirements to remain listed. Stocks typically are thinly traded, which means selling can be difficult if things go bad.

Despite the rap, reverse mergers are sometimes a company's only option.

"A lot of the small investment banks are gone, so unless you have a significant track record of sales, you're not going to be able to do an IPO," said Charles Lesser, chief financial officer of True Religion Apparel Inc., an L.A.-based fashion-denim company that went public in a reverse merger in 2003, raising $1.2 million.

Private equity or additional rounds of venture capital money used to be the choice for companies that weren't ready for the rigors of going public. But since the tech bust, investors are a little gun-shy of any bright new idea without a track record.

"The market for very small IPOs has significantly dried up," said Christopher "Kit" Jennings, managing director with Roth Capital Markets.

In its stead, a reverse merger is an easy way to go public, said Cromwell Coulson, chief executive of Pink Sheets LLC, the private company that owns the pink sheets trading platform and quotation system. "Once you're public, you can have access to the PIPE financing," he said.

PIPEs, or private investment in public companies, have become a popular way for small companies to raise money. However, some traditional players look askance at PIPEs because they offer large investors equity at a discount to the public price.

Keeping control

Companies are also bypassing venture money, Lesser said, because they would like to retain total control of the business.

True Religion is a poster-child for the reverse merger. The premium jeans company now trades in the $14-a-share range, with a market capitalization of about $310 million, and it has an application pending to move to the Nasdaq Stock Market. Other premium denim companies have followed suit, most recently Commerce-based Blue Holdings Inc., which did a reverse merger in April and now trades at $9 per share.

But a copycat transaction will only take a company so far. "Like any public company, they have to fundamentally perform or they'll be fundamentally unhappy with how their stock does," Jennings said.

Lesser said the biggest challenge of the reverse merger is the lack of Wall Street support. "You have nobody making a market in your stock, and you've basically inherited a bunch of shareholders who have no idea what you do," he said.

In an IPO, it's the investment bank's job to generate interest in the stock. When there is no investment bank, the company has to drum up interest on its own by going out to talk to shareholders and institutions. Holders of the original shell company retain a small stake--usually about 5 percent--and they need to be sold on the stock as well.

Other companies choose the bulletin board for its forgiving nature. Robert Bernstein, chief executive of Los Angeles-based Material Technologies Inc., has spent most of his career in the over-the-counter market. The company has been in the "development stage" for nearly 30 years. It executed a reverse merger in 1997 and has spent the past decade working on technology that can detect metal fatigue in bridges. With three full-time employees, it reported a $25.5 million loss last year on revenues of $147,000.

"We've just reached the point where we're coming out of the lab," Bernstein said. The stock trades at $1.45 and has a market cap of $129 million.

Bernstein acknowledged that it would be better to be on a larger exchange.

"But that is all based upon the essence of the business," he said. "And in order to be on the Nasdaq there are certain requirements--like revenues--which we do not have."

Shell Games

MORE companies, such as fashion-denim maker True Religion, have chosen to go public through reverse mergers--assuming the public stock registration of a company that exists in name only. Most end up trading on the over-the-counter bulletin board or the pink sheets.

Pros

* Easier: Avoids stringent financial reporting requirements

* Funding: Being public, small companies get access to capital

* Faster: No need for lengthy approvals or application process

* Control: After reverse merger, executives still run company

Cons

* Baggage: New company needs to make sure it finds a "clean shell" with no liabilities, lingering legal issues

* Opaque: Fewer disclosure requirements can lead to murky financial statements

* Illiquid: OTC stocks tend to be thinly traded, and selling shares can become a problem

* Trust: Investors are less forgiving when a company fails to deliver on promises