How to go public on the OTCBB, Reverse Merger or DPO self-filing

Going Public by
“Direct Filing” vs. Reverse Merger

To Become Public

If the objective of your company is to be public and you are not large enough to
attract a big-time Wall Street underwriter for a traditional IPO, you need
to consider the significant benefits of a direct filing with the SEC
as an
IPO alternative. Often referred to as a “self-filing” or a “direct public
offering”, when you file directly with the SEC (either on Form 10 or Form S-1)
your company becomes a fully-reporting public company. If you choose a Form S-1
filing, shares of the company and its shareholders can be registered for
resale. In contrast, a Form 10 filing subjects the company to the SEC’s public
information reporting requirements only, without any registration of shares. A
Form S-1 would have to be filed following a Form 10 if you want to register
shares for investors and others to enable a trading market beyond any
non-restricted shares held by shareholders at the time.

vs. Reverse Shell Mergers

Over the years, transactions using trading shell companies, which we will generally refer to as “reverse mergers”
have gained some validity through their use by investment bankers and some
major companies. Even the SEC has given credence to shell transactions by
conforming rules and regulations to address “shell companies”. (SEC has defined
them as companies “with no or nominal operations and either no or nominal
assets, assets consisting solely of cash and cash equivalents, or assets
consisting of any amount of cash and cash equivalents and nominal other
assets”). At the same time, however, the SEC has created several new issues
with regard to shells that have complicated things substantially. I have to say
that while there are limited situations where a reverse merger with a shell may
make sense, there are plenty of reasons not to go the shell route. Some
important ones include:

• Shells transactions may easily cost five times more than self-filings

• Misperceptions regarding shareholder base and value

• Actual time for a self filing is not that much more than a reverse merger

• A company that has ever been a shell must remain current forever

• Difficulties in removing stock certificate restrictive legends

• Private financing is substantially complicated

Let’s examine some of the key considerations:

1. Cost

Reverse Mergers.
When current OTC Bulletin Board shells are being offered at prices in the
$400,000-$600,000 range and up, the cost to complete a business combination
with a shell is a significant issue, especially because that is the base cost
of the shell only. You still have to add in audited statements, significant due
diligence costs, legal fees and a variety of other costs just to hit the ground

Perhaps you can lower your out of pocket cost by using shares of your company to cover
part of your acquisition costs. Now your transaction just got really expensive.
You have just given away a big piece of your company, for no cash, at a price
you might not ever consider accepting on a straight investor proposal. Since
you have had to negotiate a purchase using stock instead of the cash price
requested, the likelihood that you have to agree to other items increases (e.g.
paying off liabilities or granting registration rights). Given the relatively
low valuation you have just established in the transaction for your company and
the significant dilution resulting from the arrangement, you might find the
transaction is much more expensive in the long run.

Self-Filings - Conversely,legal fees for a self-filing will be less. I can’t speak for other firms but we
can file an S-1 and register shares for a client for well under $40,000. We can also provide introductions to experienced SEC-approved accounting firms that are accustomed to working with smaller companies and can provide some extremely competitive pricing. Being able to tell investors that they can
invest in your company today and you will use their funds wisely, including
promptly registering their shares with the SEC, makes for a compelling presentation.
A self-filing allows you to hold on to your cash to the extent possible and
should help you avoid the ongoing search for financing that is the fate and the
downfall of many smaller public companies.

2. Misperceptions regarding Shareholder Base

Reverse Mergers.
While the term “going public” has traditionally referred to an initial public
offering of shares to raise money, IPO alternatives like self-filings and shell
combinations make your company public but are not funding techniques. If your
company does not already have sufficient revenues to carry it through the
process and comfortably cover the extra costs of being public, a separate
financing transaction should occur before, or contemporaneous with, the
commencement of the IPO alternative.

One of the chief arguments for the cost
of a shell (dollars and dilution) is that there is a ready-made float of public
non-affiliated shareholders, sometimes numbering in the hundreds, and that this
is necessary for a healthy trading market. It is argued that institutional
investors may pass on an investment with your company prior to going public if,
afterwards, the shareholder float is neither large nor developed. Further, it
is argued that a reverse merger results in an active and meaningful trading
market commencing immediately following completion of the transaction and
regulatory approvals.


argument requires some careful analysis. While there are always exceptions, the
actual percentage of shares owned by public shareholders with no affiliation to
the company, or its principals and promoters, is typically very small – maybe
two or three percent, so perhaps one to two percent is actually being traded by
public. Everything else is controlled by the principals and the typical terms
might be delivery of up to 95% of the shares, give or take a percent or two. In
some cases, virtually all the float is controlled, directly or indirectly, by
insiders. In fact, a colleague recently advised me that someone was selling a
shell and was able to deliver 100% of the shares if requested. Hundreds of
thousands of dollars for a shell with a symbol only and no real trading market,
does that really make sense?


does the argument mentioned earlier - that a shell combination results in an
active and meaningful trading market – really end up being valid? It may
certainly be “active” since you have long-time shareholders who invested in a
different company and who have been hoping for a way to cash out, especially
when they see a bit of movement in the price of the stock resulting from
optimistic merger press releases. True, some may stay in to see how the new
company works out but many of these hopefuls will also be tempted to dump their
shares the moment the new company’s plans fail to materialize as fast as these
shareholders expect (often unreasonably).

The question regarding whether the trading market is “meaningful” depends on who
you ask. The fact that there is a trading market is a positive in general terms
however there is often a good bit of insider trading going on initially. If you
ask an institutional investor whether two percent is meaningful and
demonstrates a trading market with depth, I am fairly certain the answer is no,
unless the investor is not a long-term institutional investor and, instead, is
an investor whose goal is to flip blocks of shares up to the limits allowed
once they are registered – actions highly likely to depress the per share price
with a thinly-traded stock.


Self-Filings - As an
executive of your company, the question you may wish to ask yourself is whether
such a thinly-traded and essentially illusory market is worth a half million
dollars to you, give or take some. Everyone around you will be looking to make
money on the stock market with the company’s shares when everything is
underway. Due diligence with a shell is a major undertaking and it is often
extremely difficult to tell who all of your shareholders are because of ownership
in street name, untraceable ownership entities and so forth. It is not uncommon
for shell combination companies to watch their stock rise and fall drastically
from unknown parties taking short positions and generally affecting the price
of a company’s stock much more than the company’s activities or when there has
been no change at all.

is truly in the interest of your company is the growing of your business. A
self-filing means that you know who your shareholders are because your company
grows organically.

In fact, 30-40 shareholders are all you
really need to begin trading and you build from there. Sometimes we’ll do a
Regulation D offering or similar private placement immediately before the
self-filing to secure some funds and increase the number of shareholders if
needed. You may find that it is not that difficult to reach the requisite
number of shareholders needed for a public float. You may also find that
“meaningful” trading is more likely to come from a base of shareholders who
have invested because of the business plan and management of the company rather
than a base of shareholders who invested in the past in business of a different
company that failed or who have invested recently solely as speculators
(nothing wrong with any of that of course but the focus here is on the
stability of your public shareholder base).


can introduce our self-filing clients to market makers, investor relations and
PR companies, and transfer agents that can assist our clients in their efforts
to build their shareholder base in an organized and professional manner. (You
would of course discuss your company directly with these firms so that you can
mutually decide whether you have a good fit.)  


Little Difference in Timing

One of the benefits conventionally attributed to reverse mergers is speed when
compared to IPO’s. Indeed, IPO’s take much longer to complete than reverse
mergers, or self-filings for that matter (an often-used rule of thumb for IPO
transactions is 9-12 months, although that varies of course). Not only are you
dealing with a more complex filing but you are dealing with other parties, like
syndicates of underwriters and their counsel, which involve wholly separate
negotiations, due diligence and various agreements and expenses, even before you
can commence the filing process for the IPO with the SEC.


factors are not present when filing directly with the SEC. A proper
comparison of the timing differences between a self-filing and a reverse merger
can only be accomplished by looking at each transaction in its entirety. A
reverse merger can easily take you, as an executive of your company, several
months or more. From the point you make the decision, you have to go about the
task of finding candidates for a merger. You will likely talk to several
sources including investment bankers and brokers. Many of them are
professionals with a track record of successful reverse merger transactions and
they can provide good advice and experience with their services. Assume that at
some point in the process you have located two shell companies and you begin to
analyze whether one of these is the right company, with the right principals,
to merge with your company. The principals with both shells have represented
that their shell is “clean” and the transaction is very straightforward. You
will begin to negotiate the price to be paid in cash, the equity of your
company to be transferred to shell insiders, the proposed capitalization,
including any required stock splits, and similar issues. At this point, your
attorneys will have to commence serious and detailed due diligence with respect
to the shells. Did they have a bona fide, fully-operating business when they
first went public or would the SEC view them as “Footnote 32” companies? How
did the shell become reporting? What were the past circumstances with all past
share issuances?

Does a complete shareholder transfer
register exist? What about non-disclosed liabilities? These and other important
due diligence items may not seem crucial with respect to the actual closing of
a reverse merger and becoming public. The real problems might arise if you have
promised investors that you will register their shares promptly following the
merger because the registration of shares for sale to the public prompts the
SEC to take a closer look at items such as the validity of registrations or
exemptions relied on by the company with respect to shares already issued by
the company as reflected in the registration statement under review.


thorough due diligence on shells is not an easy task. Your attorneys will spend
significant time performing a proper due diligence review and, if you are
lucky, one of the shells will pass muster.  


the same time, you will have to work with your attorneys so that they can draft
the company’s “Super 8-K” filing (so-called because of the substantial amount
of information now required in a filing for a reverse merger), draft merger
documents, make filings with the state, and so forth. You will also be working
with your accountants so your company will have audited financial statements.
In fact, getting final audited statements can often take longer than virtually
everything else.


Self-Filings - So - the
reverse merger process from beginning to end can easily take several months, if
not more. On the other hand, it may only take only one to two month’s longer,
if that, to complete a self-filing. (Our firm will generally quote four to five
months but we have been successful in obtaining SEC approval for many of our
self-filing clients in less time.) During this period, you would have more
direct control over the process and the timeline and will not be relying on
third parties to the extent generally necessary for a successful shell merger.
Instead of qualifying merger candidates and negotiating different terms with
different parties, a self-filer can spend that time concentrating on funding
and running the business. As an aside, our firm works with several different
SEC accountants who are accustomed to dealing with small public companies on a
fast-track basis and at a very competitive cost. If they wish, our self-filing
clients can speak directly to these firms to discuss their needs.


Companies Formed from Reverse Mergers Need to Remain Current Forever

One of the most significant problems faced by any reverse merger company, or any
company that has ever been a shell
, has resulted from the SEC’s recent
rulemaking with respect to Rule 144.


2000, no resale’s of shares issued in connection with a reverse merger with a
shell were permitted without registration of the shares (as opposed to registration
of the

Company) with the SEC. This was
applicable to all holders of restricted and non-restricted shares of
trading shells and non-trading shells, regardless of whether they were
reporting or non-reporting (I’ll refer to all of these categories of holders,
including those of operating companies that have ever been shells, as “Shell
Stockholders”). With a release issued by the SEC in December 2007, the SEC
reversed its “registration or hold” policy with respect to shell transactions
and opened a window slightly for Shell Stockholders. Upon the February 15, 2008
effective date of the release, a Shell Stockholder became able to resell
securities in reliance on Rule 144 if the issuer of the securities has ceased
to be a shell and at least one year has elapsed from the time the issuer filed
current Form 10 type information with the SEC reflecting its non-shell status.
The issuer must also have filed all reports and material required to be filed
under Section 13 or 15(d) of the Securities Exchange Act, as applicable, during
the preceding 12 months.


the SEC has offered some limited liquidity to Shell Stockholders – and that was
good news in view of the prior no-sale rule – the SEC mandated at the same time
that the company must remain current in its reporting requirements,
essentially forever, if its shareholders ever desire to sell their shares after
the initial 12 months of reporting. If for any reason the issuer falls behind
in its reporting filings, its shareholders would be unable to avail themselves
of Rule 144 regardless of how long they have held their shares. It is far from
clear what is required for a non-current reverse merged company before reliance
on Rule 144 is once again possible but a strict reading of the release could
require another 12 months of uninterrupted current filings before unregistered
shares might once again be sold in reliance on the rule.

while there are efforts among private practitioners to get the SEC to relent
from this treatment (e.g. perhaps if it has been a number of years since the
termination of the company’s status as a shell or some other arbitrary factor)
there is still no further revision or interpretation to rely on and no way to
tell when or if such a change will be forthcoming. Despite the consternation in
the reverse merger industry in 2000 with the SEC’s prohibition of all sales
without registration, it took eight years for the SEC to loosen the grip


Self-Filings - This is not
an issue with a company that has self-filed with the SEC because it was never a
shell company and does not have the associated limitations placed on it. Not
only can holders of unregistered shares sell their shares without concerns
regarding any potential lags in reporting filings, their holding period is only
six months after completion of the filing with the SEC.


Difficulties in Removing Stock Certificate Restrictive Legends

While Shell Stockholders may now have the right to have restrictive legends
removed after their company has become an operating company and has been
reporting for at least 12 months, actually accomplishing the legend removal has
become more problematic (and, in some cases, impossible). Since the reporting
filings of a company must be perpetually current, attorneys (who must render
opinions of counsel that a restrictive legend may be removed) and transfer
agents (who must cancel the share certificates on behalf of the company and
reissue non-legend free trading shares) are simply unable to do what is
normally done for companies that have never been shell companies.

Traditionally, a shareholder may request
that a legend be removed after the expiration of the applicable waiting period
and a process involving the company, its counsel and the shareholder’s broker
begins and finally culminates with the request made to the transfer agent. Once
the restrictive legend on the share certificate is removed, the shares become
freely tradable from that point forward. In the case of shares of a Shell
Stockholder’s shares, an opinion of counsel cannot be issued to remove the
legend indefinitely because, while the company may be current in its reporting
on the date of the opinion, there can be no assurance that the former shell
company will be current in its reporting at the time the shareholder desires to
sell the shares, as is required by the SEC.


are ways to draft Rule 144 opinions artfully to deal these new hurdles but if
not done correctly, you may face problems at the transfer agent stage. Many
transfer agents hesitate to lift the restrictive legend in close cases because,
even if the company is current in its reporting on the date the legend removal
is requested, if the transfer agent removes the legend it is possible that the
former shell company will not be current in its reporting at the time the
shareholder actually decides to sell the shares in the future. In such case,
the transfer agent does not want the liability of having removed a legend from
a certificate which would enable the shareholder to sell the stock without compliance
with Rule 144.


Self-Filings - Once again, a
company that files directly with the SEC has none of the foregoing issues with
respect to removal of restrictive legend because it became public through the
front door with a direct filing. When a shareholder desires to sell his
unregistered shares after the six month holding period, he or she uses the
traditional legend removal process and the transfer agent cancels the old
certificate and issues a new, free-trading certificate to the shareholder for deposit
with a brokerage firm.


Private Financing Substantially Complicated

Obtaining new financing for a company that has ever been a shell has also been
substantially complicated. Financing obtained through a PIPE (private
investment in public equity) and similar private funding will include
“registration rights.” The company is typically required to complete and file a
registration statement registering the investor’s shares so that they become
free-trading as soon as possible after the investment. The company is also
typically required by the investment documents to keep the registration of the
investor’s shares effective until the earlier of (i) the sale of all
shares that were registered by the company for the investor, or (ii) such time
as the holder of the shares can sell in reliance on Rule 144. In the case of a
former shell company, the holder will face the new, more encumbered regime of
restrictive legend removal and will likely rely strongly on the Company’s
pledge to keep the registration effective (possibly for years). The former
shell company in need of financing may find itself in an untenable position. It
must either agree to maintain the effectiveness of the registration
indefinitely (at significant financial, administrative and operational costs
and at the risk of facing stiff penalties under the registration rights
provisions) or negotiate terms from a weaker position and give up more to
escape the onerous requirements of maintaining an effective registration for


Self-Filings - These
difficult issues do not exist if your company self-files. While you will agree
to register the investor’s common stock to the extent permitted by SEC
guidelines, six months is the limit of your liability to maintain the
effectiveness of the registration statement.

After six months, investor shares will
not require registration because the investor can secure an appropriate opinion
of counsel and have the restrictive legends on their shares removed through
cancellation of the legend certificates and reissuance of clean certificates by
the transfer agent.



are indeed compelling reasons to consider self-filing as an IPO alternative but
remember that this outline only addresses this complicated area in very general
terms. If your company is currently considering your options or long-term
strategies in this regard, we’d be pleased to discuss them with you.  

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