Understanding Reverse Mergers with a Public Shell: Reverse Merger Due Diligence

Due diligence is a key element in any reverse merger transaction. If there are problems with the shell in the reverse merger, you shouldn’t do the deal. However, the basic difficulty in reverse mergers is that you can never really know what happened in the shell’s past. There may be skeletons hidden so deep in the closet and so far off the record that you can never find them—no matter how long and hard you look.

To get the most complete story of a shell company in a reverse merger, you often have to use unorthodox methods before beginning traditional corporation finance due diligence.

In the first phase of due diligence for a reverse merger, I focus primarily on intangible factors unrelated to the shell itself. I’m examining the players involved on the shell side of transaction and their past reverse merger track record. My theory is that if I am satisfied with the background of the people involved with the reverse merger, it is much less likely that there will be any unpleasant surprises further down the road. I only move forward with my due diligence of the shell company itself, if I am satisfied with the players.

 

 

If you have been in the reverse merger business for some time, you will know or have heard of most of the reputable attorneys and accountants in the business. It’s generally a positive sign if professionals I know and trust from past experience are on the other side of the shell transaction. I’ll call them and get the real scoop on this particular shell and the promoters and principals involved.

 

Of course, there are transactions where I don’t know the shell’s professionals. In this case, I call attorneys and accountants that I do know to get a lead. If no one knows anyone on the other side of the transaction, that’s not a positive sign, but I continue on by running their names through Google and EDGAR to see if anything shows up one way or another.

 

 

If I am still concerned, or my client requests, I spend the money and have an independent search firm do a background, litigation and liability check on the shell promoters and principals and their reverse merger history. I also have the search firm simultaneously run a litigation and liability check on the shell itself.  

 

When you are paying hundreds of thousands of dollars for a shell, the cost of a formal search firm investigation is minor compared to the potential benefit of information that might be discovered.

 

 

In this step, I put together a list of deals that a shell’s promoters and principals have been involved in over the past several years to look for any questionable signs. The first thing I review is trading history surrounding the reverse mergers. A spike in trading activity just before a merger announcement is a negative sign, as is lots of trading activity and downward pressure after a deal is closed.

 

I also pay attention to any press releases distributed near to the time of a reverse merger—who distributed them and how accurate were they? I also identify the principals of the private companies that merged with these prior shells. I’ll call and ask them what they thought of the transactions and the shell promoters and principals after the reverse mergers had closed and all the dust had settled.

 

 

I always want to know how the person that brought me the deal found this shell. Are there any intermediaries or finders involved in any way? If so, are they getting any form of compensation if we acquire or do a reverse merger with the shell? The Securities and Exchange Commission’s position on this issue is quite clear. Any intermediaries or finders who are getting any form of compensation in a shell reverse merger transaction are violating federal securities laws if they are not registered broker/dealers. (See SEC Releases 34-43708 43713, Dec. 12, 2000.) 

 

 

Financial statements are an important source of information on a reporting shell company. The lack of audited financial statements can kill a deal, and not just because they’re not worth the paper they’re printed on. If the shell is non-reporting or trading only on the Pink Sheets, the inability to secure an audit will doom any attempt to move the post-merger company up to the OTC Bulletin Board and beyond. If I want to move forward with this type of shell and eventually trade on the OTC Bulletin Board, I consult with a Public Company Accounting Oversight Board (PCAOB) member accounting firm and confirm that they can deliver the required audits to get the company reporting after the deal closes.

 

Then, after all these steps, you can go on to typical due diligence which you do in a non-reverse merger transaction as well.