Reverse mergers give and they take away

Investors in Conatus, and especially those in Newlink, should question how valuations of the groups' reversing acquirers have been calculated.

For private companies that struggle to raise cash or to float the traditional way reverse mergers provide an alternative. The recent experience of Lumos Pharma and Histogen, respectively reversing into Newlink and Conatus, shows that listed cash shells can still be found for such a purpose.

An obvious attraction of reverse mergers is their low cost relative to an IPO, but there are drawbacks too, such as the fact that cash shells rarely have a clean history, and can carry nasty liabilities. There is also the business of valuing the private entity, and in this regard Lumos and Histogen could raise eyebrows.

Histogen, for instance, is being valued at $100m under the deal to reverse into Conatus announced yesterday. This is despite the fact that it has so far raised just $38m of equity, from entities including Lordship Ventures and Secure Medical, and founders.

There are likely two keys to this. Firstly the deal is an all-stock transaction, so the valuation is purely nominal, and its most important effect is to determine the ownership of the merged entity – in this case Conatus will end up being 74% owned by current Histogen holders.

Secondly Conatus had been laid low by a Nash failure last year, and with what little remained of its $23m third-quarter cash balance its negotiating position was extremely weak. Its investors had likely written off whatever they had put in, so any opportunity to recoup their losses would have been welcomed.

Highly questionable

A similar argument could be made of Newlink, which is trading 96% below its 2015 peak, though the case of this group falling to Lumos is highly questionable.

Newlink is also defunct, but unlike Conatus it boasts a healthy cash balance – $99m at the end of last September. The all-stock reversal of Lumos will see the private group’s investors get their hands on this cash pile, as current Newlink holders are proposing to give away a 50% equity interest.

Yet it could be argued that Lumos is also a distressed entity; the group has burned through most of its $48m of VC cash (the last raise having been in 2016), and its lead asset, LUM-201, was picked up for just $3.5m from Ammonett Pharma, which itself now seems to be inactive.

Little wonder that there has been opposition to the Newlink deal: Evercel and an affiliate, Corona Park Investment Partners, have countered with an all-cash offer of $1.75 per Newlink share. However, Newlink has rejected this.

A likely reason is that the counter offer also undervalues Newlink, since it amounts to $64m in cash. Not only would this buy Evercel Newlink’s cash balance, it might also net it a share of a Merck & Co priority review voucher, though Newlink’s precise economic interest in this is unclear.

For an entity like Lumos the attractions of a reversal include the avoidance of costly listing fees; as the chart below shows, reverse mergers remain popular despite a healthy IPO market. Risks include legacy liabilities, and the fact that reversals attract relatively little regulatory oversight, so the resulting entities are often criticised for having been insufficiently scrutinised.

But for Newlink the problem is more fundamental: if its investors really want to place a bet on LUM-201 they can just buy Lumos outright using Newlink’s cash on hand. Rather than throwing in the towel it behoves Newlink at least to consider Evercel’s offer as a starting point in negotiations.

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