Small growing companies that are private and need to raise money merge with an OTC shell in a reverse merger. They hope the share price will be high on the public market and then they can sell shares privately, perhaps in a classic PIPE deal. The price in the private offer is usually a discount on the public price.
Unfortunately, whether or not the company does a PIPE deal, the new public company’s stock performance after a reverse merger with a public front is often dismal. The usual chart of reverse meltdown stocks looks like an outline of a waterfall as stocks begin to trade with high expectations, only to sink to near-zero bid after a while.
There are several possible reasons for this poor performance. First, it is almost certain that the front promoters will sell their shares. This action will be a substantial part of the company. Even making an agreement to lock their shares may not help much if they have given shares to others or held shares in other accounts that are not part of the lock agreement.
Second, substantial blocks of shares may be held by market makers. When I was making markets in over 300 stocks, inevitably one of them would sink almost to nothing. When the shares went to a very small offer, he would hoard the shares in case the company would later be used in a reverse merger. Since the price was extremely low, it took me little time to accumulate a large number of shares. When the reverse merger was announced, I’d be eager to sell my job. After selling the position, he would stop trading the stock. So the company that anticipated having me as a market maker lost on both counts: I was a seller and I left the market.
There were also other market makers who specialized in low-priced stocks. Unlike our firm, they had limited funds to take stock positions. These traders provided little to no liquidity in the market. When stocks went up, they would also sell and possibly stop making a market.
Therefore, many reverse merger companies that thought they were buying a front with market makers were not actually getting a real market.
The only reason a market maker trades a stock is because they believe they will see trading volume that will allow them to profit from the spread. He knows that unless the company engages in aggressive investor relations, there will be no volume in a small company’s stock and the price will go down. No new purchases = price declines.
This brings us to the next reason why reverse merger companies have bad secondary markets: They have been told by their lawyers, their financial advisors, and the people who sold them the shell that once they go public, the company will have unlimited access to the money.
In fact, all the company gets is an exit strategy that can be used to attract investors. You still have to grab an investor, take him down and mine his wallet. Since the lawyers, financial consultants, and reverse merger company all make money when the phantom deal closes, they somehow forget to explain what happens after the closing. That’s not your problem; it’s yours.
The last reason why reverse merger companies don’t do well in the secondary market is the baddest. They can be victims of short sellers.
Wall Street, as everyone should know, is not a place where mercy reigns. It is a place inhabited by sharks. Sharks prey on the weak and the unwary.
Short sellers know that small businesses need to have a continuous flow of money to grow. Growth requires constant new money, even profitable growth.
To get this money, reverse merger companies, indeed all companies, need to keep their share price high. When shorts storm the stock, they know that pushing the price down can destroy the company. A low stock price is a poor reflection of a company. He says that this company is weak and likely to go bankrupt. He says that this company cannot raise money at a good price. Customers, employees, and investors will exit and avoid a company with a low stock price. If you don’t know how to survive the ravages of short sellers, your business is in grave danger.
In short, doing a reverse merger without a comprehensive secondary market plan is a trap for the unwary. A reverse merger company that is sold a list of assets that a reverse merger is the total solution is likely to find its stock price headed down. You must have an investor relations and fundraising plan that includes attracting investors and market makers and combating attacks by short sellers.