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What can a small private company do when it wants to go public? Most small companies cannot take their businesses public through an initial public offering (IPO) these days. An IPO is the first sale of a company’s common shares to public investors. IPOs are governed primarily by the Securities Act of 1933, the regulations issued by the Securities and Exchange Commission (SEC) and the “Blue Sky Laws” of various states. Although small IPOs were rather common in the ’80s and ’90s, Wall Street will underwrite only sizable transactions these days. The average annual revenues of a private company currently participating in an IPO typically exceed $100 million. Thus, the only real alternative left for small companies is the reverse merger. A reverse merger permits a private company to become public through the acquisition of, or merger with, a public “shell” company. The shell is a public company that no longer conducts business and usually has very few, if any, remaining assets. The public company has usually been “delisted,” that is, it is not listed for sale on any formal exchange. The best public shells (those that are ready to participate in a reverse merger) are those that have already filed for bankruptcy. Although a private company can search for a bankrupt public shell, most often it is bankruptcy counsel for the public shell that locates, by contacting investment bankers or others, private companies that are interested in going public through a reverse merger. A reverse merger transaction can be completed outside of a bankruptcy. However, the completion of such a transaction outside of bankruptcy is often too risky for the private company. Even if it performs the best possible due diligence, it could still find itself saddled with hidden liabilities following a merger. On the other hand, a merger through the bankruptcy process offers the private company absolute certainty with respect to the public entity’s liabilities. Through the confirmation of a plan of reorganization, the public debtor can receive a discharge of all of its liabilities (known and unknown) in accordance with the provisions of � 1141 of the Bankruptcy Code. Advantages of reverse mergers in bankruptcy The completion of a reverse merger in bankruptcy also has three other main advantages. First, it is usually much less expensive than an IPO. While the average company going public can expect to incur between $10 million and $15 million in fees related to an IPO, a reverse merger in bankruptcy can be completed for substantially less than $1 million. Much of the savings is attributable to the fact that an IPO always requires the participation of underwriters and financial advisors, which the reverse merger does not, and to the fact that certain SEC regulations are streamlined in bankruptcy. Second, a reverse merger can be completed much more quickly than an IPO. The average IPO takes roughly six to 18 months to complete, during which time the private company’s management is usually required to dedicate substantial amounts of its time to performing tasks related to the IPO. By contrast, in bankruptcy, a reverse merger can usually be completed in less than six months. Third, a reverse merger in bankruptcy provides another type of certainty not available through an IPO. Unlike an IPO, a reverse merger does not depend on market conditions. Once a deal is struck, it should be able to proceed on schedule subject to the confirmation of a plan proposing such a merger notwithstanding a change in market conditions. A reverse-merger deal cannot be consummated without the right players. Both the private company and the public debtor shell will require the assistance of bankruptcy counsel. In addition, the debtor and the private company each will require the services of securities counsel and auditor/accountants. Further, a reorganization specialist and a financial advisor will often be employed by the debtor’s estate. Moreover, to obtain court confirmation of a plan of reorganization, the private company and the debtor will normally require the cooperation of the committees of unsecured creditors and equity holders (formed during the bankruptcy case) and their counsels. Finally, the SEC and bankruptcy court will have a say in the deal. Bankruptcy counsel helps each of the participants navigate through the bankruptcy process, including, but not limited to, the drafting of the merger agreements and the approval of a disclosure statement describing a plan proposal and confirmation of a plan of reorganization. Securities counsel assists the parties in complying with the SEC reporting requirements and complying with the regulations that will govern the merger. The auditor/accountants assist the debtor with staying current with its SEC reporting requirements and will also prepare financial statements and audits for the private as well as the public company. The reorganization specialist, who often receives the title chief responsible officer, manages the day-to-day due diligence tasks and other requirements of the merger process. A financial advisor may assist with due diligence and other matters in larger deals. The bankruptcy court oversees the proceedings, while the SEC monitors the compliance by all parties with the requirements of securities law. The reverse merger is proposed through the plan. The plan provides that the private company will merge with, and into, the public debtor so that the surviving company, the reorganized debtor, will now own the operations of the private company. The exact terms can vary greatly. The transaction may be structured as a stock-for-stock transaction or as a stock-for-assets transaction. However, it is typical for a debtor’s bankruptcy estate to receive 2% to 10% of the shares in the reorganized debtor (merged entity) in exchange for the owners of the private company keeping the balance of the stock interest in the merged entity. While the shares being given to the debtor’s estate usually go pro rata to unsecured creditors, if the unsecured creditors are being paid in full, the excess shares go to owners of the shares in the debtor premerger. Moreover, it is also typical for a liquidating trust to be created through the plan. Following plan confirmation, the assets (cash, causes of action, etc.) owned by the debtor’s estate and all of the estate’s liabilities would be transferred to the liquidating trust. This mechanism is for ease of plan implementation and further clarifies that the entity resulting from the merger is completely free of all liabilities of the debtor. In addition, the plan generally will provide that, following the merger, the reorganized debtor (surviving company) will issue the new common stock for the benefit of the debtor’s creditors to the trust. The stock, along with any other liquid assets, will be distributed to creditors by a liquidating trustee. Just as with all other plans of reorganization, the disclosure statement describing the plan will provide adequate information concerning the financial health and history of the private company, a description of the business in which the newly merged (surviving) company will be engaged, the identity of the reorganized debtor’s management and projections with respect to the reorganized debtor’s business. The completion of the reverse merger in bankruptcy also streamlines the SEC registration process for newly issued shares, ensuring that all shareholders will be able to freely trade their shares within a short period of time. Section 1145 of the Bankruptcy Code exempts stock that is issued by the debtor entity for the benefit of its creditors or equity holders from the SEC’s registration requirements. Thus, the shares issued to those parties through the plan need not be registered with the SEC. Also, although � 1145 does not exempt the stock issued to owners of the private company from registration, as a result of the reporting requirements that the debtor must comply with during the bankruptcy case, the registration of these shares will not be nearly as complicated or expensive as it would be in connection with an IPO, and can be accomplished quickly. Procedure offers small companies new currency Going public has many advantages. However, the main advantage is that it provides small companies (especially those that would like to acquire other businesses) with a new currency by which to finance growth. Instead of being limited to cash and notes, the newly public company can use stock to fund its acquisitions and it may fund its operations through the sale of shares to the public. Going public also provides the small companies with access to financing under terms that are much more favorable than those offered to private companies. A reverse merger in bankruptcy not only allows the small company to go public more quickly, less expensively and with a greater degree of certainty than outside of bankruptcy, but it also provides a method to give value to the creditors of the bankrupt public entity, which may substantially improve the distribution to creditors. Finally, being public gives the owners of the company the ability to sell small fractions of their ownership. This liquidity substantially increases the value of ownership of the company. A reverse merger in bankruptcy provides the small private company with a fail-safe way to gain access to the public market in a much safer, quicker and more efficient manner than an IPO. It is the method for going public the new-fashioned way. Craig M. Rankin is a partner, and Jacqueline L. Rodriguez is an associate, at Los Angeles-based Levene, Neale, Bender, Rankin & Brill, a bankruptcy boutique. The firm has represented many private companies seeking to go public, public shells seeking to gain value out of such a transaction and committees in reverse-merger transactions.

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