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Reverse mergers may be gaining popularity in difficult IPO market

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The so-called initial public offering “window” is open once again, but subpar returns for those that have tried to go public and general market volatility has companies and investment bankers thinking twice: perhaps postponing the IPO or considering other options.

There are a number of exit alternatives -- merge, acquire, be acquired, self-file with regulators, go public on a foreign exchange, etc. -- but one choice that appears to have been gaining momentum and traction with larger companies over the years is the reverse merger.

“When the U.S. IPO market slows down, dries up, window closes -- whatever you want to call it -- and companies can’t go public, they look to other things,” said Craig Johnson, a veteran San Diego biotech executive who is now chief financial officer at NovaDel Pharmaceuticals. “Reverse mergers are certainly one of them.”

A reverse merger is when a private company goes public by merging into a public “shell,” a company that is technically active but has few assets or operations. A name change is usually involved. The process can be shorter and less costly than filing for an IPO, thus giving the company in question a little more certainty: Management has a better idea of market conditions for when shares go public.

An IPO can be “an expensive proposition,” said Bob Stephenson, a managing director in Roth Capital’s investment banking group. “You could spend a million (dollars) getting yourself ready to go public, and then you don’t get it done.”

Meghan Leerskov, assistant managing editor of Deal Flow Media’s “Reverse Merger Report,” said the number of U.S. reverse merger deals has remained relatively unchanged -- around 200 -- since Deal Flow Media started tracking reverse mergers in 2004.

However, the company quality has improved and average company size has grown, she said.

For Envison Solar (OTC: EVSI), one of the most recent San Diego companies to go public via a reverse merger, the benefits included access to capital and a higher profile, said CEO Bob Noble, who added that he was focused on getting the best value for shareholders rather than timing the market.

“I wouldn’t defend the reverse merger model, I wouldn’t criticize it. I can tell you that it appears to have been the right decision for us,” said Noble, whose company merged into Casita Enterprises in February. The solar energy company installed solar parking structure features at the University of California, San Diego and recently launched LifeVillage, which features pre-fab solar-equipped structures.

Leerskov said there has been a surge in solar companies doing reverse mergers as the sector has become increasingly popular.

Stephenson, who focuses primarily on companies in China, says reverse mergers are particularly popular there as a means for going public in the United States -- even preferable to an IPO. Leerskov noted that roughly a third of reverse mergers are Chinese companies.

That mentality hasn’t quite crossed over to the United States with the same ardor. IPOs are considered more conventional, and a U.S. company that favors a reverse merger during a robust IPO market might raise some eyebrows.

Reverse mergers aren’t without drawbacks of their own, after all. The public shell could come with some “baggage,” its name and reputation marred by product scandal or a CEO with dirty laundry.

The public company usually comes with a pool of investors, which some companies view as useful -- unless the investors are angry and frustrated that their precious mining venture is now a shoe company. Also, existing private company investors, such as venture capitalists, dislike the automatic dilution that comes when they’re joined by investors who haven’t put in the same time and money.

Detractors also warn of scams and other financial pitfalls: They warn investors of shady companies trying to “pump and dump” their stock. They caution company executives against investment bankers trying to line their pockets and financial structures that leave management empty-handed.

For public shells, the private companies targeting them could financially take advantage of their desperation.

Executives who have come through the reverse merger essentially unscathed say that it’s important to exercise the same due diligence and care required of any transaction. Employing a team of seasoned, trusted advisers is also essential.

A reverse merger can be a profitable decision, they agree: Warren Buffett’s Berkshire Hathaway (NYSE: BRK) is arguably among the most successful reverse mergers in history.

And particularly in volatile financial times like these, reverse mergers are gaining credence as more than a “penny stock promoter game,” as investment banker Byron Roth put it at a venture capital industry event earlier this year.

Torrey Pines Therapeutics is an example of a private San Diego company that chose to reverse merge because of market timing, although their reverse merger into Axonyx was in September 2006.

“We were at the point in our development that it made sense for us to become a public company,” said NovaDel’s Johnson, who was CFO of Torrey Pines Therapeutics at the time. “When it was our time, the markets were just closed like a drum, so we started looking for other ways.”

Torrey Pines Therapeutics’ situation is illustrative of why reverse mergers have become increasingly popular in the biotechnology space. A public biotech with a failed drug essentially becomes a shell -- but with unused cash.

In Torrey Pines’ case, Axonyx was a shell with $45 million in capital and was in the process of interviewing hundreds of companies as reverse merger prospects, Johnson said.

Winning the reverse merger would have worked out well for Torrey Pines if the company hadn’t suffered a clinical failure of its own, around the end of 2008. Torrey Pines had another prospective drug, but needed to raise cash.

Torrey Pines then decided to implement a reverse merger with Novato, Calif.-based Raptor Pharmaceuticals (Nasdaq: RPTPD), which merged into Torrey Pines in September 2009 and then changed its name back to Raptor Pharmaceuticals.

The way Johnson tells it, the transaction didn’t work out quite as well as hoped. Raptor was able to make the jump from the over-the-counter bulletin boards to the Nasdaq, and Torrey Pines executives were able to avoid liquidation. But Johnson describes some “bait and switch” by Raptor on certain verbal agreements, and Torrey Pines executives had no choice because their company was in distress.

For the most part, however, it still seems that U.S. companies choosing the reverse merger route are too small to file for an IPO because of the costs involved and the returns required to make the effort worthwhile.

Like Envision Solar’s Noble, executives agree that sometimes the reverse merger simply turns out to be the most strategic move among a variety of options -- and they keep the doors open to those alternatives while negotiating their reverse merger.

For example, San Diego-based Halozyme Therapeutics (Nasdaq: HALO) -- which Johnson described as one of the “most successful” local reverse mergers -- turned to the option in 2003 after searching for venture financing failed to turn up the desired valuations.

“It just made a lot of financial sense for the company to do that at the time,” said David Ramsay, who was CFO at the time and is now Halozyme’s vice president of corporate development.

Whatever the case, reverse mergers, when executed properly, appear to be simply another way to grow the company.

“In the last couple years, when the economy was down, CEOs and CFOs were looking at every avenue they could to carry their business forward,” said Greg Hanson, a senior vice president with Brinson Patrick Securities. “From that perspective, it (the reverse merger) became a solution that maybe wasn't the ideal solution, but it was a solution that allowed the company to move forward. And that's the most important thing: survival.”

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