Partner Nick Abrahams discusses the rise of backdoor listings, or reverse takeovers, on the Australian Securities Exchange in an opinion piece published by The Australian Financial Review.
This article was originally published by The Australian Financial Review and is reproduced with permission.
Record numbers queuing up for backdoor listings
Backdoor listings or reverse takeovers on the ASX look set to beat the record this year. It's a record, not surprisingly, set back at the peak of the dotcom boom in 2000 when 32 companies backdoor listed. For the first six months of this calendar year, there have been 16 backdoor listings – and there's fever in the market for taking tech stocks public this way. Based on current sentiment, 2014 will cut 2000's lunch well and truly. It is boomtime for tech companies going onto the ASX.
There are so many tech companies being backdoored into mining stocks, Kalgoorlie's raucous annual mining conference many well need to change its name to "Diggers, Dealers & Developers".
Australian tech entrepreneurs have long complained that we lack growth capital. Sure we have recently developed some good sources of early stage venture capital but it has always been hard to find the $2 million to $5 million cheques. With the decline in the resources sector, the public markets have stepped in to fill this funding gap.
Contrary to popular opinion, there is a significant amount of risk-chasing growth capital in Australia. It has just been reserved for the listed junior miners and explorers. Once commodity prices go below a certain number, these speculative ventures become unviable. The choice is simple – give the money back to shareholders or find a new business to put into the shell. After having received the money, no self-respecting entrepreneur is giving the cash back, so the latter option is the preferred choice.
My recent weeks have been littered with meetings with either the owners of listed shell(s) looking for cloud businesses to put into the shells, or with bewildered tech entrepreneurs who have been approached by promoters offering "backdoors", "guaranteed shareholder spreads" and a fast track to liquidity.
I am not going to pass judgment on whether it is better to get onto the exchange by the back or the front door, to say nothing of whether these tech businesses are right for the costs and scrutiny of listing. Vocus and Village Roadshow are two very successful results of backdoor listing, so you never know. I will look at why shell shareholders like backdoor listing and what are the main reasons tech companies might look to be part of such an event.
Why shells like backdoor listings
Generally the core business of these shells has become unviable but they are sitting with $1 million to $2 million in the bank and sometimes, not always, they have been suspended from trading. If the shell acquires a tech business, then, while the existing shareholders might be diluted, they have at least some upside in the share price and, importantly, they are not restrained from selling their stock. The owners of the tech business that has been vended into the shell will generally be restricted from selling their shares for one to two years.
For investors, it is worth noting that, according to research by UTS's Peter Lam, most money is made on trading in the shares between the date the backdoor listing is announced and the date that the transaction completes. Interestingly the shares are not required to be suspended from trading after the announcement, even though it is still possible that the transaction will not complete as it is subject to a vote by shareholders of the shell.
Backdoor benefits
- It is just an M&A deal: In this case, the shell and the target tech company are in the same or similar businesses, but the shell might be smaller than the target tech company such as in the case when listed minnow Mnemon "acquired" the much larger Grays Online. Both companies were in e-commerce, so the deal made sense for Grays to get access to the ASX.
- Idiosyncratic circumstances: In some cases, it may be that getting onto the ASX via the front door would take significant restructuring. For example when Asian social media flyer Mig33 backdoored into Latin Gold, CEO Steven Goh said that because the original business was a US/Singaporean hybrid, the business restructuring to get to an initial public offering would have caused significant delay and costs when compared to a backdoor listing
- De-risk the listing: The process to backdoor list is transparent and direct. The tech company negotiates with the controller of the shell, a deal is then struck for the tech company to be acquired in return for a certain amount of stock. The rest is process and the tech target has the benefit of knowing that because the shell is listed already, it generally has (or can get relatively simply) the required spread (or minimum number) of shareholders holding minimum parcels. There is no significant risk associated with movement in the equity markets during the backdoor listing process.
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By comparison, the IPO route has risk. The prospective company must engage advisers and seek to generate enough interest in the IPO to get to the required minimum number of shareholders. This may take several months and there are no guarantees. The arrangements could fall over at any stage up until listing, especially if there is adverse movement in the equity markets during the process.
- Size matters: Generally speaking underwriters like companies with a minimum of $10 million in revenue and annual growth rates of more than 30 per cent. The alternative for smaller companies is to backdoor list. In addition to getting on the boards, the target company often combines the listing with a small ($3 million to $5 million) capital raise. It is often easier to raise the money this way as investors are attracted to the idea that there will be liquidity in the stock as a result of the listing (though such liquidity may not occur if the stock is ultimately thinly traded). The target tech company also gets the benefit of whatever cash the shell has in the bank, a handy start to the capital raise.
Backdoor folklore
There is a general feeling the backdoor listing process is simpler, faster and cheaper than an IPO. This is generally not the case.
- Simpler than an IPO: There is a very similar process, whether the company is getting on the ASX by the front or the back door. For example a prospectus/information memorandum is required in both cases. The only exemption to this requirement is where the shell and the target tech company have similar businesses that are of a similar scale such as in the Pie Networks and NewZulu listing. In these cases, a prospectus-like document is not required, making the process faster.
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Adding to the complexity is that, in a backdoor listing, due diligence needs to be done on two companies (shell and target tech company) rather than just one in an IPO scenario. There will also be a sale agreement to be negotiated and likely a capital restructure.
- Faster than an IPO: Because the process is similar, it is not necessarily true that a backdoor listing can get a company onto the ASX faster than an IPO. Indeed because of the need to negotiate with the shell, it can take longer.
- Cheaper than an IPO: The ASX costs are roughly the same, whether backdoor or IPO. One of the major costs of a backdoor listing or IPO is the need for a prospectus/information memorandum. So unless the deal falls into the Pie/NewZulu category, a prospectus-like document and its attendant expenses will be required. The public markets are more eager to back tech companies than they have been since 2000 and, generally, the share prices of the companies coming to the market have performed well.
We need to hope that the market does not get flooded with the more speculative end of the tech world, as failure to achieve goals will be viewed harshly by shareholders and a rash of poor performance has the potential to adversely impact the market for all tech stocks.
The last time we saw such a rush on tech companies coming onto the ASX was during dotcom. The resulting carnage tarnished tech stocks for many investors. Our regulators are a wake-up to the potential for trouble and a few weeks ago ASIC issued a warning in relation to the surge of backdoor listings. True the fundamentals of tech businesses today are much better than they were back in dotcom, but there does seem to be a quote that is quite relevant for these times: "Those who fail to learn from history are doomed to repeat it".
Nick Abrahams is a partner at global law firm, Norton Rose Fulbright and leads its Technology Practice in APAC. In 2000, he was the COO of listed dotcom company, Spike Networks. @NickAbrahams
