VC Cliche of the Week
There are times in the venture business when you really want to get liquid on an investment but you can’t find any buyers at an acceptable price and the company is too small to make for an interesting public offering candidate.
That’s when people start talking about the "back door IPO".
A back door IPO, also known as a reverse merger, is when someone who controls a public company with little or no business in it but often some cash (known as a "public shell") agrees to merge with another company, thereby creating a new publicly traded business.
I can think of at least 5 times when its been proposed that one of our portfolio companies do a back door IPO as a way of getting public and getting us liquidity.
We’ve never done it and I don’t think we ever will.
There are a bunch of reasons for this.
- The people who control public shells are generally not the highest integrity people and they are not easy or desirable to do business with. I know that there are probably decent people who find themselves controlling a public shell, but the vast majority of the people that I have come in contact with in this business are not the kind of people I want to be in business with (see lie down with dogs, come up with fleas).
- The people who control the public shells demand a "premium" for their business because they have the public company asset. The premium they demand often gives them a significant percentage of the merged business and it is rarely a fair deal for the privately held company.
- There is no way to determine the valuation at which the merged entity will trade at once the merger is completed. In a traditional public offering shares are sold at the IPO and that sale price is a good indication of where the stock will initially trade. Because there is no way to determine the value at which the merged company will trade, there is no way to determine what the value of the deal is to the privately held business.
- Because there is no stock sold as part of the deal, there is no marketing effort associated with the back door IPO. One of the best things about the IPO process is the road show in which the company has the opportunity to tell its story to a large number of institutional investors, thereby insuring some interest in the stock. In a back door IPO, you could, and often do, end up with a public company that nobody knows or cares about.
- If cash is an issue for the privately held company, the back door IPO often doesn’t bring a lot of cash and once the company is public, its much harder to do a financing with private equity investors. The result is that a back door IPO may make it harder to raise money in the future, not easier.
- There is no guarantee of liquidity in the stock. There is no value in having a public company if there is no real market for the stock. The idea that because a company is public you can sell your stock is false, particularly if you have a large position in the public company.
- It costs a fortune to operate as a publicly traded company, particularly in the age of Sarbanes Oxley. I have heard that it costs at least $2mm per year to comply with all the rules and regulations associated with being a publicly traded company. Adding $2mm of annual expenses is not often easy to accept for a small privately held company.
These are the main reasons why I think back door IPOs are a bad deal for privately held companies.
There are probably other reasons against (or for) back door IPOs and if any of you have anything to add to this, please post it in the comments.