Exam 10: Analysis and Valuation

Intangible assets such as customer lists, intellectual property, licenses, distributorships agreements, leases, regulatory approvals, and employment contracts may offer significant sources of value.

There is widespread agreement over the magnitude of the liquidity discount.

Valuation of privately held businesses may involve substantial adjustment of the discount or capitalization rate.

Shell Game: Going Public through Reverse Mergers _____________________________________________________________________________________ Key Points Reverse mergers represent an alternative to an initial public offering (IPO) for a private company wanting to “go public.” The challenge with reverse mergers often is gaining access to accurate financial statements and quantifying current or potential liabilities. Performing adequate due diligence may be difficult, but it is the key to reducing risk. ______________________________________________________________________________ The highly liquid U.S. equity markets have proven to be an attractive way of gaining access to capital for both privately owned domestic and foreign firms. Common ways of doing so have involved IPOs and reverse mergers. While both methods allow the private firm’s shares to be publicly traded, only the IPO necessarily results in raising capital, which affects the length of time and complexity of the process of “going-public.” To undertake a reverse merger, a firm finds a shell corporation with relatively few shareholders who are interested in selling their stock. The shell corporation’s shareholders often are interested in either selling their shares for cash, owning even a relatively small portion of a financially viable company to recover their initial investments, or transferring the shell’s liabilities to new investors. Alternatively, the private firm may merge with an existing special-purpose acquisition company (SPAC) already registered for public stock trading. SPACs are shell, or “blank-check,” companies that have no operations but go public with the intention of merging with or acquiring a company with the proceeds of the SPAC’s IPO. In a merger, it is common for the surviving firm to be viewed as the acquirer, since its shareholders usually end up with a majority ownership stake in the merged firms; the other party to the merger is viewed as the target firm because its former shareholders often hold only a minority interest in the combined companies. In a reverse merger, the opposite happens. Even though the publicly traded shell company survives the merger, with the private firm becoming its wholly owned subsidiary, the former shareholders of the private firm end up with a majority ownership stake in the combined firms. While conventional IPOs can take months to complete, reverse mergers can take only a few weeks. Moreover, as the reverse merger is solely a mechanism to convert a private company into a public entity, the process is less dependent on financial market conditions because the company often is not proposing to raise capital. The speed with which a firm can “go public” as compared to an IPO often is attractive to foreign firms desirous of entering U.S. capital markets quickly. In recent years, private equity investors have found the comparative ease of the reverse merger process convenient, because it has enabled them to take public their investments in both domestic and foreign firms. In recent years the story of the rapid growth of Chinese firms has held considerable allure for investors, prompting a flurry of reverse mergers involving Chinese-based firms. With speed comes additional risk. Shell company shareholders may simply be looking for investors to take over their liabilities, such as pending litigation, safety hazards, environmental problems, and unpaid tax liabilities. To prevent the public shell’s shareholders from dumping their shares immediately following the merger, investors are required to hold their shares for a specific period of time. The recent entry of Chinese firms into the U.S. public equity markets illustrates the potential for fraud. Of the 159 Chinese-based firms that have been listed since 2006 via a reverse merger, 36 have been suspended or have halted trading in the United States after auditors found significant accounting issues. Eleven more firms have been delisted from major U.S. stock exchanges. Huiheng Medical (Huiheng) is one such firm that came under SEC scrutiny, having first listed its shares on the over-the-counter (OTC) market in early 2008. The firm claimed it was China’s leading provider of gamma-ray technology, a cancer-fighting technology, and boasted of having a strong order backlog and access to Western management expertise through a joint venture. What follows is a discussion of how the firm went public and the participants in that process. The firms involved in the reverse merger process included Mill Basin Technologies (Mill), a Nevada incorporated and publicly listed shell corporation, and Allied Moral Holdings (Allied), a privately owned Virgin Islands company with subsidiaries, including Huiheng Medical, primarily in China. Mill was the successor firm to Pinewood Imports (Pinewood), a Nevada-based corporation, formed in November 2002 to import pine molding. Ceasing operations in September 2006 to become a shell corporation, Pinewood changed its name to Mill Basin Technologies. The firm began to search for a merger partner and registered shares for public trading in 2006 in anticipation of raising funds. The reverse merger process employed by Allied, the privately owned operating company and owner of Huiheng, to merge with Mill, the public shell corporation, early in 2008 to become a publicly listed firm is described in the following steps. Allied is the target firm, and Mill is the acquiring firm. Step 1. Negotiate terms and conditions: Premerger, Mill and Allied had 10,150,000 and 13,000,000 common shares outstanding, respectively. Mill also had 266,666 preferred shares outstanding. Mill and Allied agreed to a merger in which each Allied shareholder would receive one share of Mill stock for each Allied share they held. With Mill as the surviving entity, former Allied shareholders would own 96.65% of Mill’s shares, and Mill’s former shareholders would own the rest. Step 2. Recapitalize the acquiring firm: Prior to the share exchange, shareholders in Mill, the shell corporation, recapitalized the firm by contributing 9,700,000 of the shares they owned prior to the merger to Treasury stock, effectively reducing the number of Mill common shares outstanding to 450,000 (10,150,000 – 9,700,000). The objective of the recapitalization was to limit the total number of common shares outstanding postmerger in order to support the price of the new firm’s shares. Such recapitalizations often are undertaken to reduce the number of shares outstanding following closing in order to support the combined firms’ share price once it begins to trade on a public exchange. The firm’s earnings per share are increased for a given level of earnings by reducing the number of common shares outstanding. Step 3. Close the deal: The terms of the merger called for Mill (the acquirer) to purchase 100% of the outstanding Allied (the target) common and preferred shares, which required Mill to issue 13,000,000 new common shares and 266,666 new preferred shares. All premerger Allied shares were cancelled. Mill Basin Technologies was renamed Huiheng Medical, reflecting potential investor interest at that time in both Chinese firms and in the healthcare Without the reduction in Mill’s premerger shares outstanding, total shares outstanding postmerger would have been 23,150,000 [10,150,000 (Mill shares premerger) + 13,000,000 (Allied shares premerger)] rather than the 13,450,000 after the recapitalization. industry. See Exhibit 10.4 for an illustration of the premerger recapitalization of Mill, the postmerger equity structure of the combined firms, and the resulting ownership distribution. While Huiheng traded as high as $13 in late 2008, it plummeted to $1.60 in early 2012, reflecting the failure of the firm to achieve any significant revenue and income in the cancer market, an inability to get an auditing firm to approve their financial statements, and the absence of any significant order backlog. Having reported net income as high as $9 million in 2007, just prior to completing the reverse merger, the firm was losing money and burning through its remaining cash. The firm was left looking at alternative applications for its technology, such as preserving food with radiation. Huiheng’s SEC filings state that the firm designs, develops, and markets radiation therapy systems used to treat cancer and acknowledge that the firm had experienced delays selling its technology in China and had no international sales in 2009 or 2010. The filings also show the reverse merger was directed by Richard Propper, a venture capitalist and CEO of Chardan Capital, a San Diego merchant bank with expertise in helping Chinese firms enter the U.S. equity markets. Chardan Capital invested $10 million in Huiheng in exchange for more than 52,000 shares of the firm’s preferred stock. Chardan and Roth Capital Partners, a California investment bank, were co-underwriters for a planned 2008 Huiheng stock offering that was later withdrawn. Chardan had been fined $40,000 for three violations of short-selling rules from 2005 to 2009. Roth is a defendant in alleged securities’ fraud lawsuits involving other Chinese reverse merger firms. Exhibit 10.4 Mill Basin Technologies (Mill) Pre-Merger Equity Structure: Common 10,150,000 Series A Preferred 266,666 Recapitalized Equity Structure Common 450,000a Series A Preferred 266,666 New Mill Shares Issued to Acquire 100% of Allied shares Common 13,000,000 Series A Preferred 266,666 Post-Merger Equity Structure: Common 13,450,000b Series A Preferred 266,666 Post-Merger Ownership Distribution of Common Shares: Former Allied Shareholders: 96.65% c Former Mill Shareholders: 3.35% aMill shareholders contributed 9,700,000 shares of their pre-merger holdings to treasury stock cutting the number of Mill shares outstanding to 450,000 in order to reduce the total number of shares outstanding postmerger, which would equal Mill’s premerger shares outstanding plus the newly issued shares. This also could have been achieved by the Mill shareholders agreeing to a reverse stock split. The 10,150,000 pre-merger Mill shares outstanding could be reduced to 450,000 through a reverse split in which Mill shareholders receive 1 new Mill share for each 22.555 outstanding prior to the merger. bPost-Merger Mill Basin Technologies’ capital structure equals the 450,000 premerger Mill common shares resulting from the recapitalization plus the 13,000,000 newly issued common shares plus 266,666 Series A preferred shares. c(13,000,000/13,450,000) Huiheng ran into legal problems soon after its reverse merger. Harborview Master Fund, Diverse Trading Ltd., and Monarch Capital Fund, institutional investors having a controlling interest in Huiheng, approved the reverse merger and invested $1.25 million in exchange for stock. However, they sued Huiheng and Chardan Capital in 2009 as Huiheng’s promise of orders failed to materialize. The lawsuit charged that Huiheng bribed Chinese hospital officials to win purchasing deals. The firm’s initial investors forced the firm to buy back their shares as a result of a legal settlement of their lawsuit in which they argued that the firm had committed fraud when it “went public.” The lawsuit alleged that the firm’s public statements about the efficacy of its technology and order backlog were highly inflated. Huiheng and its codefendants settled out of court in 2010 with no admission of liability by buying back some of its stock. In 2011, the firm had difficulty in collecting receivables and generating cash. That same year, Huiheng’s operations in China were struggling and were on the verge of ceasing production. -Mill was recapitalized just prior to completing its merger with Allied. What was the purpose of the recapitalization? Did it affect the ability of the combined firm's to generate future earnings? Explain your answers.

A control premium is the additional premium a buyer is willing to pay for the right to direct the activities of a firm.

Rank from the highest to the lowest the liquidity discount you would apply if you as a business appraiser had been asked to value the following businesses: a) a local, profitable hardware store, b) a money losing laundry, c) a large privately owned but marginally profitable firm with significant excess cash balances and other liquid short-term investments, and d) a pool cleaning service whose primary tangible assets consist of a 2-year old truck and miscellaneous equipment. Explain your ranking.

In valuing private businesses, the U.S. tax courts have historically supported the use of which valuation method for purposes of estate valuation?

Asset valuation includes specific business risks but ignores any adjustment for liquidity risk.

Shell corporations rarely have any value.

A private corporation is a firm whose securities are not registered with state or federal authorities.

Cantel Medical Acquires Crosstex International On August 3, 2005, Cantel Medical Corporation (Cantel), as part of its strategic plan to expand its infection prevention and control business, announced that it had completed the acquisition of Crosstex International Incorporated (Crosstex). Cantel is a leading provider of infection prevention and control products. Crosstex is a privately owned manufacturer and reseller of single-use infection control products used primarily in the dental market. As a consequence of the transaction, Crosstex became a wholly owned subsidiary of Cantel, a publicly traded firm. For the fiscal year ended April 30, 2005, Crosstex reported revenues of approximately $47.4 million and pretax income of $6.3 million. The purchase price, which is subject to adjustment for the net asset value at July 31, 2005, was $74.2 million, comprising $67.4 million in cash and 384,821 shares of Cantel stock (valued at $6.8 million). Furthermore, Crosstex shareholders could earn another $12 million payable over three years based on future operating income. Each of the three principal executives of Crosstex entered into a three-year employment agreement. James P. Reilly, president and CEO of Cantel, stated, "We continue to pursue our strategy of acquiring branded niche leaders and expanding in the burgeoning area of infection prevention and control. Crosstex has a reputation for quality branded products and seasoned management." Richard Allen Orofino, Crosstex's president, noted, "We have built Crosstex over the past 50 years as a family business and we continue growing with our proven formula for success. However, with so many opportunities in our sights, we believe Cantel is the perfect partner to aid us in accelerating our growth plans." -What do you believe could have been the primary factors causing Crosstex to accept Cantel's offer?

How can an analyst determine if the target firm's costs and revenues are understated or overstated?

Which of the following is not true of liquidity or marketability risk or discount?

A business owner may overstate revenue and understate actual expenses when

Very few closely held businesses are family owned.

GHS Helps Itself by Avoiding an IPO In 1999, GHS, Inc., a little known supplier of medical devices, engineered a reverse merger to avoid the time-consuming, disclosure-intensive, and costly process of an initial public offering to launch its new internet-based self-help website. GHS spun off its medical operations as a separate company to its shareholders. The remaining shell is being used to launch a ‘‘self-help’’ Website, with self-help guru Anthony Robbins as its CEO. The shell corporation will be financed by $3 million it had on hand as GHS and will receive another $15 million from a private placement. With the inclusion of Anthony Robbins as the first among many brand names in the self-help industry that it hopes to feature on its site, its stock soared from $.75 per share to more than $12 between May and August 1999. Robbins, who did not invest anything in the venture, has stock in the new company valued at $276 million. His contribution to the company is the exclusive online rights to his name, which it will use to develop Internet self-help seminars, chat rooms, and e-commerce sites. -What are the advantages of employing a reverse merger strategy in this instance?

If the buyer believes that the seller has overstated revenue in a specific accounting period, the buyer can reconstruct revenue by examining usage levels, in the same accounting period, of the key inputs required to produce the product or service.

Corporate shells have value because they enable the buyer to

The market model of corporate governance is readily applicable to privately held, family owned firms.

Owners of private businesses attempting to minimize taxes may overstate their contribution to the firm by giving themselves or family members unusually low salaries, bonuses, and benefits.