Reverse mergers proliferate in dismal IPO market

For venture and private equity investors intent on earning 10X and bragging rights on a big exit, a reverse merger is probably a distasteful option to consider.

This backdoor approach to an IPO—in which a private company merges with a publicly traded shell—commonly produces a thinly traded stock that sells on a second-tier exchange for a couple of dollars a share. Research coverage and fast liquidity are seldom part of the deal.

Drawbacks aside, however, reverse mergers are gaining appeal among investors weary of waiting for a recovery in the moribund IPO market. In the past three months, a half-dozen venture- and angel-funded companies have announced or completed reverse mergers, with most incorporating a concurrent stock sale to institutional investors.

Now more investment capital is entering the field. Paragon Capital, a New York-based hedge fund, plans to raise a $50 million domestic fund targeting reverse mergers and PIPEs. The firm also plans to raise a $100 million offshore fund focused on secured debt and reverse mergers. Partners say they plan to focus on private businesses that face difficulty raising capital on public markets.

“The IPO market is dead. No one’s lending. So where do these good private companies go to raise funding? There is a market that’s open, which is this so-called alternative public offering,” says Alan Donenfeld, a general partner at Paragon.

Donenfeld says that the firm’s ideal target is a venture capital portfolio company or a middle market private equity portfolio company with a solid business and about $50 million in revenue. While those sorts of companies routinely pursued IPOs in the 1990s, today’s market conditions aren’t favorable.

A big part of the problem, according to Donenfeld, is a lack of underwriters for small deals. Since the late 1990s, major players in the IPO space, such as Hambrecht & Quist, Alex. Brown, Robertson Stephens and Montgomery Securities, have been merged or consolidated into larger banks that focus on bigger deals. The disappearance of these underwriters has displaced small companies from the IPO market.

Even when IPO investors were more receptive to small companies, some opted to take the reverse mergers route. Prominent past examples of reverse merger offerings include Berkshire Hathaway, Blockbuster Entertainment and Turner Broadcasting. More recently, the Jamba Juice chain and London-based hedge fund GLG Partners also went public through reverse mergers.

Today, special-purpose acquisition companies (Spacs), the shell corporations used to consummate reverse mergers, are factoring into much larger transactions. In 2007, Spacs raised $12 billion in proceeds from 66 offerings on U.S. markets, according to Spac Analytics, a research firm. So far this year, 11 Spacs have raised $3.4 billion, with average deal size surging to $307 million, from $183 million in 2007.

Venture-, angel- and PE-backed companies are factoring into a number of planned and recently consummated transactions, including:

• MiMedx, a medical device company that had acquired PE-backed spinal implant developer SpineMedia, announced in February that it merged into Alynx, a publicly traded shell company listed on the over the counter bulletin board. Alynx currently has a market cap around $100 million. SpineMedia had previously raised $10.6 million from Clayton Associates and Trelys Funds.

• CelLynx, maker of a device to boost cellular signal strength in buildings, agreed in January to carry out a reverse merger with public shell company NorPac Technologies. CelLynx also announced that it would raise financing of at least $1.8 million from private investors.

• Inflazyme Pharmaceuticals and Z-Tech, a privately-held medical device company, said they expect to complete a reverse merger in early April.

• Venture-backed Raven Biotechnologies is in the process of completing a reverse merger with VaxGen, which sells on the sparsely traded Pink Sheets.

• College Tonight, a social networking site, has completed a reverse merger with Simex Technologies, which trades on the Pink Sheets.