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Filling the GAP: doing "reverse mergers" into shell companies has become a major avenue for private companies seeking new capital, but established practices like PIPEs and mezzanine financing have their share of the action, too.

At first glance, a sailing concern and a biotechnology company would seem to have little in common. But--talk about an odd couple--just such a business combination was consummated last March when, in San Diego, a biotechnology company joined forces with Global Yacht Services.

After the merger, the yacht-chartering business, which had been a public company, disappeared. In its place, the life-sciences company sprang to life as a public company, took the name Halozyme Therapeutics Inc. and began selling stock to the public.

Welcome to the world of reverse mergers. It's a world where privately held companies go public by merging into the shell of dormant public companies. As the hurdles for an initial public offering (IPO) have grown steeper in the post-tech bubble world, the reverse merger has become an increasingly popular way for private companies to go public. And it's an especially suitable tool for companies that don't require the financing afforded by an IPO.


"The IPO market is tough now," says Byron Roth, chairman and CEO at Roth Capital Partners, a San Diego investment banking boutique. "The market has been fickle, and a lot of IPOs are getting pulled--which is why reverse mergers are picking up."

Halozyme could be a poster child for a successful reverse merger. Now listed on the American Stock Exchange (AMEX:HTI), the company has been able to tap into the capital markets to fund the therapies and drug processes it's developing for the treatment of cancer, infertility and eye diseases. Most recently, the company raised $13.9 million in October 2004, using a PIPE financing agented by S.G. Cowen and Co., a New York investment bank.

"I'm not exactly sure why," says David Ramsay, CFO at Halozyme, "but it has been easier for us to access the capital markets than venture capital. It's ironic," he adds, "because venture capitalists are supposed to be the ones taking risks."

Dr. Jonathan Lim, chief executive of Halozyme, who participated with Ramsay in a joint telephone interview, adds: "The universe of financiers available for public companies is much larger than that for private companies. You have a bigger ocean to fish in."

The reverse merger is just one of several creative financing strategies and structures that emerging growth companies like Halozyme are employing these days. These strategies, which include private investments in public entities (PIPEs) and mezzanine financing (see sidebar), are often quicker and cheaper to accomplish, as well as more confidential and flexible, than conventional financing methods. And, for companies that don't fit neatly into the criteria employed by most banks, venture capital firms or big Wall Street firms, these financing mechanisms are proving crucial to commercial success.

"This was the most convenient way for us to take our company to the next level," Halozyme's Lim says of the reverse merger.

PIPEs, which have myriad uses for emerging growth public companies, are fast becoming the financing vehicle of choice for companies using the back-door strategy of the reverse merger. When used together, the two financial mechanisms are, if not displacing the initial public offering, at least offering a viable alternative.

There are no exact figures on the number of reverse mergers taking place these days, but indications are that they are on the upswing--and for good reason. According to the online publication, reverse mergers are lighter on the wallet than an IPO: a reverse merger typically costs between $50,000 and $100,000, about one-quarter the expense of an IPO. At the same time, the average reverse merger can usually be completed in about one-third the time--no more than 60 days for the reverse merger, compared with 180 days for the IPO.

Still, reverse mergers and PIPEs both have their trade-offs, if not their downsides. When contemplating a reverse merger, for example, a company must be prepared to surrender as much as 20 percent ownership to the shell company. In the case of Halozyme, the yacht company's shareholders were rewarded for their trouble with a 10 percent ownership stake in Halozyme.

The chief worry attending a reverse merger, however, is that the shell company could be contaminated--that unseen troubles lurk below the surface that could prove destructive later on. "I think investors shy away from [a reverse merger] because they're concerned about potential liabilities," says Tracy Lefteroff, global managing partner for private equity and venture capital at PricewaterhouseCoopers.


Lefteroff says he once witnessed a case in which a company involved in a reverse merger "didn't do its homework, and they got bit by unrecorded liabilities." He adds: "Basically, there were unpaid bills that had never been recorded. People stepped forward and said they were owed money and went after the company's assets. And once the cash was gone, the merged company did not survive."

Such admonitions are well taken: executives at companies doing reverse mergers nowadays take pains to perform due diligence before hooking up with merger partners. That concern was uppermost on the mind of Garry Lowenthal, CFO at Viper Power Sports Co., a high-end motorcycle manufacturer in Minneapolis that executed a reverse merger in March.

Lowenthal's company went public by merging into Echo Capital, an automotive leasing company whose "business model went away, and the company just sat there," he says. But before finalizing the deal, Lowenthal adds, "We went through the last 12 years to make sure there were no skeletons in the closet."

Occasionally, though, serendipitous benefits can arise from the reverse merger. That was the case with Meritage Homes Corp., a Scottsdale, Ariz.-based builder of single-family homes active mostly in the West and Southwest, and one of the best-known cases of a successful company that went public in a reverse merger. In December 1996, it conjoined what was then Monterrey Homes with Homeplex Mortgage, a publicly listed real estate investment trust (REIT), rather than go public conventionally.

"We talked to a couple of investment bankers [about an IPO] and they panned the idea," says Larry Seay, CFO at Meritage. "We were a smaller, one-state builder doing $100 million in revenue, and it would have been hard to do an IPO."

Dispensing with the wizards of Wall Street, Meritage sought out legal assistance and saved itself hundreds of thousands of dollars with a reverse merger. Meantime, the REIT that the homebuilder married not only brought $25 million in assets and equity, as well as zero debt, to the union but, says Seay, its dowry included $53 million in net loss carry-for-wards. "We were able to preserve those [carry-for-wards] because of the size of the companies and because there wasn't a change of control triggered by the reverse merger."

There were other consequences resulting from the reverse merger. On the plus side, the transaction flew beneath Wall Street's radar screen, with its surveillance network of bankers and research analysts. That made it possible for a company like Meritage to steer clear of the unfavorable publicity that so often attends an IPO that does not perform well--or fails outright.

Yet by avoiding attention, companies that do a reverse merger can find themselves wandering in the wilderness. "We've [invested in] a couple of these deals where companies get put in a shell," says Brian Ladin, managing director at Bonanza Capital, a Dallas investment firm. "You can buy in at a very good price, but the negative is that they don't trade all that well."

That, indeed, was the initial experience for Meritage. "We were shunned at first," Seay says. "When you don't have a Wall Street firm supporting the offering, it means that you don't have someone marketing your stock. And, typically, there's no analyst coverage provided, either."

But the situation was remedied, Seay says, after the company used Wall Street firm Dillon Read--which has since become part of banking giant UBS--to manage a high-yield debt financing in 2001. Meritage raised $165 million in 2001 with a 10-year bond carrying a coupon of 9.75 percent. And this past March, the company raised another $350 million in another 10-year debt financing at 6.25 percent, relying on Deutsche Bank, Smith Barney/Citigroup and several regional brokerage houses.

Now, Meritage is not only listed on the Big Board (NYSE:MTH) but it is trading at $92.95. Its profits rose by 140 percent to $59.2 million in the second quarter, compared with a year earlier, and earnings per share leaped to $2.05, outstripping the guesstimates of some dozen analysts polled by Thomson First Call, whose EPS consensus was for just $1.73 a share.


For emerging growth companies that are already public--especially micro-cap companies in the life sciences, high technology and energy sectors--an increasingly popular financing strategy is the use of a PIPE. The most common variety of this hybrid financial instrument is known as a "plain vanilla" PIPE, in which a public company issues new stock to institutional investors or qualified investors using an investment bank as an agent on the deal. As the issuer, it's up to the company to file a registration statement with the Securities and Exchange Commission (SEC) within 120 days. Once filed and approved by the SEC, the securities become fully tradable.

As noted earlier in the case of Halozyme, PIPEs are frequently being used in conjunction with reverse mergers to provide companies with not just an alternative way to go public, but with financing once they are listed on the OTC Bulletin Board or, better yet, one of the stock exchanges. Many companies availing themselves of this alternative strategy, asserts investment banker Roth, are eligible for a full-blown IPO but are opting for the reverse merger-cum-PIPE, both to avoid the costs and to keep a low profile.

And, Roth asserts, PIPEs are increasingly being used by companies with plenty of other options. "We are doing a $50 million PIPE now for one company that is using that simultaneously with a reverse merger" to go public, he says. "This is a company that could have done an IPO but instead chose this route."

Roth Capital was the top agent in brokering PIPE transactions in 2004, acting as agent on 42 PIPE placements. It led in dollar volume as well, according to, a leading tracking service for the PIPE industry, with $584.1 million; that amounts to $13.91 million per deal. "Our kind of PIPE is for companies with market caps of $35 million to $250 million," Roth says.

To provide some perspective, there has been a resurgence in the PIPE market over the past couple of years. Last year, PIPE financings expanded rapidly, growing to some 1,700 deals that raised $21.7 billion, up 13.6 percent over 2003 totals, according to PrivateRaise. That was the most robust year since the vertigo-inducing heights achieved in 2000, when $24.8 billion of PIPEs were issued for companies.

Many of those PIPEs, however, were granted to desperate dot-coms during the high-tech bubble that had no business having access to capital. Market participants say that the abuses of such "toxic PIPEs" are largely absent from the market.

One factor driving the PIPE market today is the fact that many companies are going public earlier in their life cycle, prompting the need for a capital infusion. Indeed, says Roth, "a big piece of the PIPE market now is PIPEs that are really part of IPOs," says Roth.

PIPEs Part of IPOs

A case in point is Interchange Corp., a Laguna Hills, Calif.-based company that provides online search services for the advertising industry. The company first went public, raising $25.3 million in an $8-a-share offering underwritten by Roth Securities in October 2004. Hard on the heels of the IPO, Interchange raised another $15 million in a PIPE financing last December priced at $18.25 a share.

Doug Norman, the CFO at Interchange, says that the company used the additional capital to purchase a Swedish Internet company, Inspire Infrastructure, which both expanded Interchange's market reach into Europe and added valuable new technology. "We raised the money for working capital," says Norman, "but once we had the money, we used it for the merger. It gave us the resources."

An important advantage of PIPEs is that they can be done more quickly, cheaply and confidentially than a secondary public offering, which requires registration up front and a more elaborate investor road show. "One of the things that makes this deal different," says Richard Gormley, managing director at S.G. Cowen & Co., "is that you never issue a press release until the public deal is done.

"There's a huge stigma if the public deal doesn't get done," Gormley adds. "So this protects companies from the risk of a public failure."

In addition, say financial experts, the confidentiality inherent in a PIPE keeps a small-cap or micro-cap company from being hammered by short sellers who reportedly lie in wait for companies announcing secondary public offerings. "Not only is the process [of a secondary public offering] time-consuming," says Luke Iovine, a law partner at Paul Hastings Janofsky & Walker in New York, "but if the market is aware that a large block of stock is forthcoming, that could be viewed adversely because it has a dilutive effect."

To be fair to the secondary-offering market, however, the companies that are most likely to avail them-selves to a PIPE--most of which are in the $5 million-$20 million range--are doing smaller financings, and a follow-on offering isn't really suitable. That's a big reason why boutique and regional investment banks predominate among the transactions. "For companies above $250 million," says Roth, "I would recommend either a shelf registration--if the company is eligible and doesn't have an immediate need--or a follow-on offering."

So, even if PIPEs carry the stigma that they are financings of last resort, that is just fine with company executives like Christopher Wood, the 58-year-old surgeon who is chairman and CEO of Bioenvision Inc., a New York-based biopharmaceutical company. Wood says that the company might not even be in business today--much less already in the market-place with its anti-cancer drugs--were it not for two PIPE financings totaling $35 million.

"PIPE financing has been absolutely vital" to both the company and to its drug development, he says. "It's been our lifeline."

It is also a big reason why the company has grown to a market capitalization of $250 million and has migrated from the OTC Bulletin Board to the American Stock Exchange to the Nasdaq. "They were best in show," says Jeff Davis, president of SCO Financial Group, a New York boutique investment bank that specializes in life-sciences companies and agented Bioenvision's PIPE financings.

The biggest trade-off involved in a PIPE financing is that institutional investors demand a 10-20 percent premium on the stock price for ponying up their money. In addition, warns Jocelyn Arel, a partner at the Goodwin Procter law firm in Boston, the wide-spread entrance of hedge funds into the PIPE marketplace has increased the danger of short sellers trading on inside information in anticipation that the announcement of a PIPE's completion will drive down the stock price.

"Placement agents are getting the investors in PIPEs to sign confidentiality agreements saying they won't trade in the stock," she says.

There are no firm figures on the returns to PIPE investors, but market participants generally seem happy going long in the affected stock. At Bonanza Capital, which invested in Halozyme--meaning that it put money into both a PIPE transaction and a company that had done a reverse merger--the deals are certainly within their criteria. "We don't invest in PIPEs to make a 5 to 10 percent return," says Ladin. "Our hurdle is to double our money in 24 months."

Paul Sweeney is a freelance writer in Austin, Texas, and a frequent contributor to Financial Executive. He can be reached at 512.499.8749.

RELATED ARTICLE: Mezzanine Financing Boosts Furniture Maker

For Bentec Inc., a Compton, Calif.-based manufacturer of lightweight office furniture, it was a case of "be careful what you wish for," says Charles Jumet, the company's CFO.

After limping along for several years in the economic downturn that began in 2001 and enveloped Southern California--"Everybody retrenched, and orders got canceled," Jumet says--the company finally caught a break. Not only did its orders pick up earlier this year amidst a reviving economy, but Bentec snared an important new client.

Winnebago, the biggest name in recreational vehicles, hired Bentec to turn out lightweight cabinets, doors, paneling and other wooden interiors for its RVs. Suddenly, the company had a tiger by the tail. "We needed money to retool, to buy inventory--new materials like plywood and veneer--and to staff up," says Jumet. "But we were already highly leveraged. And the banks told the company 'no.' So what do we do?"

That's where Snowbird Capital comes in. An investment firm based in Reston, Va., Snowbird was founded last year by a team of former entrepreneurs who now specialize in arranging mezzanine financings of $500,000 to $3 million for up-and-coming companies. "After running my own information technology company for 12 years," says Nelson Carbonell, president and chairman of Snowbird, "I found that I knew more about finance than technology."

Snowbird's target audience consists of private companies, mostly in the technology and services industries ("public companies can use the public markets," Carbonell notes), with less than $10 million in sales. He is partial to companies that are demonstrably profitable and on a growth track. Such companies, Carbonell asserts, can have a hard time finding bank financing because their growth lies ahead of them, while bankers are generally focused on past performance.

Venture capitalists are not always the best solution for such companies, either. At Cysive, the IT company that Carbonell started (with $10,000 in credit card debt) and headed for a dozen years, Carbonell always resisted surrendering the hefty chunk of equity that venture capitalists typically demand in return for funding. In addition, Carbonell says, equity financing typically means "new people sitting on your board and bossing you around."

So far, Carbonell says, Snowbird has raised a war chest of $50 million from wealthy individuals and the partners' own resources. "The plan," he says, "is to raise an additional fund next year from institutional investors like university endowments and hedge funds. But you have to have a track record."

The $500,000 in mezzanine financing that Snowbird arranged for Bentec did not come cheaply. Terms include a two-year, 12.75 percent loan that includes warrants for 5 percent of the company's shares. But the financing was done quickly--it took only 30 days from start to finish, Jumet says--and payments were suspended for six months. And while the transaction involved liens on certain company assets and life insurance policies on the principals at Bentec, "there was no cross-collateralization with personal real estate," among the covenants that a bank might impose, Jumet says.

Paying back the money shouldn't be a problem: this year, sales are on track to total $2.5 million to $3 million, Jumet says, which would more than double the $1.2 million that Bentec recorded in its latest fiscal year, which ended May 31. And the company's market is expanding as well: not only are other RV firms knocking on the door for its patented, lightweight interiors, but Bentec sees openings for making curved overhead bins, among other products, for luxury jets and yachts.

Indeed, business is so robust that Bentec plans to build an additional factory somewhere in the Midwest, probably Iowa. And that will certainly entail more financing. "We've got several options," says Jumet, "but frankly, we'll go back to Snowbird. They've been a perfect fit."

--Paul Sweeney


* Reverse mergers have grown in popularity in recent months as the initial public offering market has become more selective.

* Reverse mergers are generally faster and cheaper than IPOs and allow companies to avoid the critical scrutiny put on public offerings.

* PIPE financings, often discredited a few years ago, have been surging among small-cap public companies hungry for capital.

* Mezzanine financings may include warrants, but they can be done quickly and without some of the more onerous covenants that banks often require.
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Author:Sweeney, Paul
Publication:Financial Executive
Article Type:Cover Story
Geographic Code:1USA
Date:Sep 1, 2005
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