Tip of the Week: Due Diligence is Critical!
By David Feldman at 6 October, 2009, 5:52 am
Whether you are a private company seeking to merge with a shell, or a shell company looking to find a private company, proper review of the other party’s legal, financial and business background is critically important. It can be done efficiently, but never cut corners when it comes to due diligence review. Here’s just a few stories:
- A client private business was operating as a public company following a merger about a year earlier. He came to me unhappy with the former shell owners, who were making life difficult for him post-merger. I took a fast look and determined that they actually never consummated the merger! Both sides went forward anyway, but I was able to let him know that he in fact was still a private company. There were other complications of course, including the fact that the public had been told the merger had been completed.
- A client one year after his reverse merger with a shell was presented with an individual who claimed to own 1,000,000 warrants to buy stock at a very cheap price. No one knew about this guy, including the shell promoters who sold my client the shell. The people these promoters had bought the shell from knew it. My client had to buy out the warrantholder for $1 million.
- A client took over a “messy” shell whose records were in extreme disarray. He signed the deal with a President of the shell who, it turned out, had been removed as President several years earlier and had no authority to sell the shell. My client had not insisted on Board consent for the transaction.
- A shell had completed a reverse split several years before its merger, but the split was never reported to Nasdaq and the Depository Trust Company, so no holder of shares in electronic form had their share ownership adjusted. After completing the reverse merger, suddenly hundreds of thousands of shares of stock that we all thought didn’t exist were being sold. It took months and the contribution of tens of thousands of shares of stock to resolve.
- In a famous case involving a non-US company, after it went public and traded on Nasdaq, it was determined that its vaunted Chairman was actually a totally fictitious person.
- In reviewing a list of shareholders of a shell, we determined that 12% of the stock was owned by an individual with significant SEC problems in his past. Yet this individual never reported his ownership on Form 3 and Schedule 13D as required. My client walked away from the shell.
Of course where a shell owner provides a personal guaranty, indemnity or hold back of shares the risk of the buyer of the shell is reduced. But not all are willing to do that, and one still has to go after the individual to be reinbursed the costs of dealing with the hassle. Keep vigilant when it comes to due diligence.
Due diligence seems universally obvious. The system needs to constantly preen and adjust to eliminate the knuckleheads and bottom feeders yet not be too restrictive as to hinder a successful raise, RM or etc..
What resources can one use to avoid those unsavory characters that seem to come around when a deal is being put together? Through experience we can construct our own ‘butchers bill’ of genuine managers and financial craftsmen, those that would be considered a positive ingredient to any undertaking. How can we learn from each others experiences without creating a slander?
Jay - it is indeed very tough. When a client comes to me proposing to work with someone who I know has a questionable reputation, what should I do? In general I let the facts speak for themselves. We do thorough background checks and look for the appearance of “things bad guys do” even if maybe not technically illegal. But I agree that it is inappropriate to simply pass on rumors or whisperings about someone where there is no evidence to back it up. So the resources that work best include a team of experienced RM professionals who can help sniff out issues of concern.
David