Using reverse mergers instead of venture capital for venture financing
The more you look at reverse mergers, the more you begin to understand that reverse mergers compare favorably to the classic venture capital model for venture funding.
Business financing is obviously key to the success of any new or growing business. The classic venture capital model seems to work like this: the entrepreneur and his team formulate a business plan and try to pitch it to a venture capital firm. If they are well connected, they can be successful, but most venture capital firms are overloaded with funding requests.
If the entrepreneur isn’t in a business that’s all the rage among venture capitalists, they may not be able to find financing.
If the entrepreneur is very lucky, he will be invited to launch the VC. If the company survives this test, it will receive venture capital term sheets. After protracted and adversarial negotiations, an agreement is reached and hundreds of pages of documents are signed by the venture firm. In these documents, the entrepreneur and his team relinquish most of the control of the company and, usually, most of the equity in the deal. Their shares are locked up and if they want to sell to get some cash, they probably have to offer the buyer to the VC first. Time from start to finish: 90 days or more.
If the company needs more money, it must negotiate with the VC and the entrepreneurial team may lose ground on the deal. The business may need to reach certain set milestones in order to obtain funding. If the company falls behind schedule, it may lose equity interest.
As the company develops, the venture capitalists may or may not add value, and will most likely question the entrepreneur and his team. If the company is successful, the venture capital firm will reap the lion’s share of the rewards. If the company is not successful, most of the capital will be lost forever. Some businesses end up in the land of the undead, not bad enough to end, not good enough to succeed.
In the worst case scenario, the venture capitalists take over from the start, become dissatisfied with management, and kick out the original management, which loses most of its position and jobs.
The Reverse Fusion Model
The entrepreneur finds a public shell. He has to scrape together some cash to do this and pay the legal and accounting bills.
He buys control and merges with the shell on terms he determines. It maintains control but has the burdens of a public company.
He determines how to run his company, including salaries. You can offer stock options to attract talent. You can acquire other companies by shares. He determines when he gets paid.
Instead of having to report to the hedge fund, you should report to the shareholders.
Subject to the limitations of securities laws, you may sell part of your shares for cash.
You can search for money whenever you want; he is in control.
Problems: Can be attacked by short sellers. You can buy a shell with a hidden defect. You have to pay for the shell.
From the point of view of investors
Venture capital funds are typically funded by institutional investors looking for professional management. They don’t have time to manage a number of small businesses and delegate this task to venture capital partners. Small investors are rarely allowed. Venture capital funds allow institutional investors to diversify.
Venture capital fund investors are locked in for a period of years. If they get a return of 30% per year, they have done very well.
The venture capital model encourages the venture capital firm to bargain hard for a low price and tough terms. A venture team that is looking for funding and knows that it has a great future cannot submit to such terms. However, for a weak company that is only looking to collect salaries for a few years before retiring, in other words, a company that is a bad investment, you can agree to any term, no matter how harsh. Therefore, the venture capital model is biased toward selecting the worst investments and rejecting the best.
Small investors can buy shares in reverse merger companies. They must take the time to research these companies, but may lack the resources to do so intensively. Most small investors lose money. If they win, they can win big. They can, if they wish, diversify their investments. They have no influence on management except to sell when they are not satisfied.
Summary
The reverse merger model compares very favorably to venture capital. While venture capital is always in short supply, reverse mergers are always available for any venture that might interest investors. The company is usually better able to raise money from the public than from venture capitalists.
In general, the great advantage of the reverse merger is that the company has full control over its destiny. The team can be sure of being well rewarded for success. The company sets the terms, it can sell shares when it sees fit on whatever terms it deems appropriate, the experts can also sell, and the venture team is not questioned by fans in their field, and the venture team does not have to fear losing equity or jobs.
Another advantage is the lower risk for the investor. The investor is in a publicly traded stock. If the investor does not like what is happening, he can sell. He can sell at a loss, but he can get out. The investor can also pick and choose companies himself, instead of making a single investment decision: the decision to back the venture capital firm, which then takes control of the rest of the decisions.