Reversal of fortune

When executives of a portfolio company approached Andy Funk with the idea of a reverse merger last year, his gut response was negative.

“I have to admit I was very skeptical of it,” says Funk, managing director of Santa Monica, Calif.-based venture firm Funk Ventures. “I don’t think most VCs would be eager to liquidate this way.”

And they’d have sound reasons to be hesitant. Reverse mergers—in which a private company acquires a public company to bypass the burdensome process of doing an IPO—have lots of drawbacks. Companies that go public in that fashion can expect, among other things, to have low trading volume, very little liquidity, nonexistent research coverage, and no market makers to support their stock.

Nonetheless, in the case of food retailer Organic To Go, Funk eventually reversed his position about reverse mergers. The company’s founder had been seeking follow-on funding for more than a year and Funk, Organic’s largest venture investor, decided a public listing was a sensible alternative for the fast-growing takeout chain.

In February, Organic carried out a reverse merger. Initial response looked too good to be true—and it was. After closing as high as $7.25, Organic’s shares have settled around $2. Funk is hopeful that he will see a pop by the time his lockup expires.

Viable option?

While reverse mergers are admittedly risky, venture capitalists are giving them more consideration as traditional IPOs have gotten harder and more expensive to carry out. So far, that hasn’t led to a surge in deal-making. As of late June, 90 companies completed reverse mergers on U.S. exchanges, compared to 222 and 212 in all of 2005 and 2006, respectively, according to DealFlow Media, a research firm based in Petaluma, Calif.

However, the growing practice of combining a private investment in public equity (PIPE) transaction with a reverse merger has pushed up average deal size. In the first quarter of this year, the average reverse merger had a market cap of $68 million. That’s an increase of 38% from Q4, according to DealFlow.

“This is the new small-cap IPO,” says David Feldman, a securities attorney at Feldman Weinstein & Smith and author of Reverse Mergers: Taking a Company Public Without an IPO. A regular booster of reverse merger-related benefits, Feldman is quick to point to brand name companies that took that route: Berkshire Hathaway, Blockbuster Entertainment, Turner Broadcasting and, more recently, the Jamba Juice chain.

I have to admit I was very skeptical of it. I don’t think most VCs would be eager to liquidate this way.

Andy Funk, Managing Director, Funk Ventures

But moving from reverse merger to high-flying market cap remains rare. The appropriate way to view the transaction, Feldman says, is as a financing event on the path to liquidity rather than a full-blown exit.

Still, some companies are raising sizeable sums through PIPE deals arranged simultaneously with reverse mergers. SVI, the company that merged with Jamba Juice, for example, sold 27.4 million shares at $7.50 each in a private placement before completing the combination in March, 2006. Jamba currently has a market cap of $500 million.

A juicy profit

As liquidity events go, the Jamba reverse merger was a “satisfactory” exit, said one venture backer. Prior to the reverse merger, the company raised about $50 million from funds including Benchmark Capital, Oak Investment Partners, Rosewood Capital, Technology Venture Investors and Trinity Ventures. Benchmark, the only venture firm listed as a beneficial owner in a Jamba proxy statement, owned about 7% of the shares, a stake worth $32 million.

The bigger deals like Jamba commonly involve specified purpose acquisition companies, or SPACs. These are publicly traded shell companies, like SVI in the Jamba deal, that raise money and then look for a candidate with which to consummate a merger.

Los Angeles-based clothing maker American Apparel followed much the same route earlier this year when it merged with a SPAC called Endeavor Acquisition Corp. in a deal valued at $383 million, including $110 million of debt assumption. Previously, American Apparel had raised $7.5 million in expansion funding from private equity fund C3 Capital.

Venture-backed companies have figured in a few other recent deals, too. Etrials Worldwide, a provider of software and services for collection and analysis of clinical trial data, went public in February, 2006, through a reverse merger with CEA Acquisition Corp. The company had previously raised $7 million from private equity investors including Newlight Associates and Nazem & Co. At current trading prices, Newlight’s stake is worth about $7 million, and Nazem’s is valued around $3.9 million.

Gobblin’ green

Kreido Biofuels

, a venture-backed developer of biodiesel plants and processing technology, raised $25 million in January through a private stock placement carried out in tandem with a reverse merger. The company, which currently trades as an over-the-counter stock, had previously raised $10 million from private investors including Hunt Ventures, Smart Technology Ventures and Unilever Ventures. Smart, the largest venture backer, owns 28% of outstanding shares, a stake valued at around $13 million.

Venture capitalists are the last holdouts in terms of accepting the benefits of this.”

David Feldman, Author, Reverse Mergers: Taking a Company Public Without an IPO

The amount raised in a PIPE is typically much smaller than what a company would bring in through a regular IPO. But it’s also faster and cheaper to arrange, And given that the IPO market is relatively closed to companies with valuations under $100 million, Feldman notes, small startups have limited options.

“You would never do it if you could do a traditional IPO,” agrees Dan Burstein, managing partner at Millennium Technology Value Partners, a New York firm that arranges private equity transactions. “But you might not be able to find the bankers to take a real institutional interest.”

Moreover, the reverse merger industry has done a reasonable job rehabilitating its image. Dodgy companies that went public through reverse mergers showed up with frequency in SEC enforcement actions several years ago. Regulators’ action against Houston-based Mountain Energy in 2001 was typical of the trend. Executives and directors of the energy company, which went public through a reverse merger in 1998, were charged with issuing a string of six fraudulent press releases, causing the company’s share price to leap from 5 cents to $1.75. Other enforcement actions early in the decade involved similar shenanigans following reverse mergers of companies in the biotechnology and Internet sectors.

Slimmer shadiness

Regulations have gotten tighter since then. The SEC took measures to clean up the reverse merger business in June 2005, adopting rules designed to protect investors from fraud involving the use of shell companies, while allowing their use for legitimate corporate purposes. Regulators also significantly increased the disclosure requirements associated with such transactions in the public markets.

Feldman says the new rules have had a measurable impact in bolstering investors’ confidence in the credibility of companies that go public through reverse mergers. One indicator: PIPE deals carried out alongside reverse mergers are attracting highly regarded institutional and private equity investors. A June reverse merger completed by VC-backed therapeutics developer Athersys, for example, drew concurrent PIPE investments from Hambrecht & Quist Capital Management, Accipiter Capital Management and OrbiMed Advisors, among others.

Nonetheless, Feldman says much work likes ahead in convincing venture capitalists of the virtues of reverse mergers, whom he considers “the last holdouts in terms of accepting the benefits of this.”

Now that a few VCs have tested the reverse merger waters with non-horrible results, is it the start of a trend? “Only when we’ve seen a few dozen actually work out,” says Funk. “Until that point, it’s really just a crap shoot.”