Chapter 10: Analysis and Valuation
of Privately Held Companies
Answers to End of Chapter Discussion Questions
10.1 What is the capitalization rate and how does it relate to the discount rate?
10.2 What are the common ways of estimating the capitalization rate?
10.3 What is the marketability discount and what are common ways of estimating this discount?
10.4 Give examples of private company costs that might be understated and explain why.
10.5 How can an analyst determine if the target firm’s costs and revenues are understated or overstated?
10.6 Why might shell corporations have value?
10.7 Why might succession planning be more challenging for family owned firms?
2
10.8 What are some of the reasons a family-owned or privately-owned business may want to go public? What are
some of the reasons that discourage such firms from going public?
10.9 Why are family owned firms often attractive to private equity investors?
10.10 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.
Practice Problems and Answers
10.11 It is usually appropriate to adjust the financials received from the target firm to reflect any changes that you
as the new owner would make in order to create an adjusted EBITDA. Using the Excel spreadsheet entitled
“Adjusting Target Firm’s Financials” on the CDROM accompanying this book, make at least two
adjustments to the target’s hypothetical financials to determine the impact on the adjusted EBITDA. (Note:
The adjustments should be made in the section on the spreadsheet entitled “Adjustments to Target Firm’s
Financials.”) Explain your rationale for each adjustment.
10.12 An analyst constructs a privately held firm’s cost of equity using the “build–up” method. The 10-year Treasury
bond rate is 4% and the historical equity risk premium for the S&P 500 stock index is 5.5%. The risk
premium associated with firms of this size is 3.8% and for firms within this industry is 2.4%. Based on due
diligence, the analyst estimates the risk premium specific to this firm to be 2.5%. What is the firm’s cost of
equity based on this information?
10.13 An investor is interested in making a minority equity investment in a small privately held firm. Because of the
nature of the business, she concludes that it would be difficult to sell her interest in the business quickly.
Therefore, she believes that the discount for the lack of marketability to be 25%. She also estimates that if
she were to acquire a controlling interest in the business, the control premium would be 15%. Based on this
information, what should be the discount rate for making a minority investment in this firm? What should
she pay for 20% of the business if she believes the value of the entire business to be $1 million. Answer:
Discount rate = 9.78% and Purchase price for a 20% interest = $180,440
10.14 Based on its growth prospects, a private investor values a local bakery at $750,000. She believes
that cost savings having a present value of $50,000 can be achieved by changing staffing levels and
store hours. Based on recent empirical studies, she believes the appropriate liquidity discount is 20
percent. A recent transaction in the same city required the buyer to pay a 5 percent premium to the
asking price to gain a controlling interest in a similar business. What is the most she should be
willing to pay for a 50.1 percent stake in the bakery?
10.15 You have been asked by an investor to value a restaurant. Last year, the restaurant earned pretax operating
income of $300,000. Income has grown 4% annually during the last five years, and it is expected to
continue growing at that rate into the foreseeable future. The annual change in working capital is $20,000,
and capital spending for maintenance exceeded depreciation in the prior year by $15,000. Both working
capital and the excess of capital spending over depreciation are projected to grow at the same rate as
operating income. By introducing modern management methods, you believe the pretax operating income
growth rate can be increased to 6% beyond the second year and sustained at that rate into the foreseeable
future.
The ten-year Treasury bond rate is 5%, the equity risk premium is 5.5%, and the marginal federal, state, and
local tax rate is 40%. The beta and debt–to-equity ratio for publicly traded firms in the restaurant industry
are 2 and 1.5, respectively. The business’s target debt–to–equity ratio is 1, and its pretax cost of borrowing,
based on its recent borrowing activities, is 7%. The business-specific risk premium for firms of this size is
estimated to be 6%. The liquidity risk premium is believed to be 15%, relatively low for firms of this type
due to the excellent reputation of the restaurant. Since the current chef and the staff are expected to remain
after the business is sold, the quality of the restaurant is expected to be maintained. The investor is willing to
pay a 10% premium to reflect the value of control.
Solutions to Chapter Case Study Questions
Shell Game: STK Steakhouse Chain Goes Public
Through a Reverse Merger
Discussion Questions
1. What are common reasons for a private firm to go public? What are the advantages and disadvantages or doing
so? Be specific.
2. What are corporate shells, and how can they create value? Be specific.
3. What were the options available to One Group LLC to raise capital to finance their expansion plans? Discuss
the pros and cons of each. Be specific.
5
4. Discuss the pros and cons of a reverse merger versus an IPO.
5. Why is it likely that shares trade at a discount from their value when issued if investors attempted to sell such
shares within one year following closing of the reverse merger?
6. What is the purpose of ultimately listing of a major stock exchange such as NASDAQ?
Examination Questions and Answers
1. Both public and private firms always attempt to maximize earnings growth. True or False
2. Financial information for both public and private firms is equally reliable because their statements are
audited by outside accounting firms to ensure that are developed in a manner consistent with GAAP.
True or False
3. For privately held firms, firm specific risk may include lack of product, industry, and geographic
diversification; limited management depth, volatile stock markets, and unionized workforces.
True or False
4. Private firms are likely to understate revenue and understate costs in order to minimize their tax liabilities.
True or False
5. Revenue may be inflated by booking as revenue products shipped to resellers without adequately
adjusting for probable returns. True or False
6. If a buyer expects that the target firm’s revenue has been overstated, the buyer can reconstruct revenue by
examining usage levels of the key inputs required to produce the product or service. True or False
7. The purpose of adjusting the target’s income statement is to provide an accurate estimate of the
current year’s reported operating income or operating cash flow. True or False
8. Employee benefit levels in private firms are almost always mandated by state or federal law and
therefore cannot be changed. True or False
9. An increase in the target firm’s reserves for doubtful accounts increases taxable income, while a
decrease reduces the firm’s taxable income. True or False
10. It is easier to obtain the fair market value of private companies than for public companies because of the
absence of volatile stock markets. True or False
11. Methodologies employed to value private firms are substantially different from those employed to value
public firms. True or False
12. Asset valuation includes specific business risks but ignores any adjustment for liquidity risk. True or False
7
13. The risk associated with an illiquid market for a specific stock is referred to as the liquidity or marketability
risk. True or False
14. Shell corporations may have significant value to acquiring firms. True or False
15. Empirical evidence suggests that discounts have declined in recent years. True or False
16. Private businesses may need to be valued to settle shareholder disputes, court cases, divorce, or the
payment of gift or estate taxes. True or False
17. The availability and reliability of data for public companies tends to be much greater than for small
private firms. True or False
18. Managers and owners in public companies are likely to have the same emotional attachment to their
businesses as those in private firms. True or False
19. Because of data limitations, valuation of private firms often requires more subjective adjustments than for
public firms. True or False
20. Private firms must file quarterly earnings reports with the Securities and Exchange Commission.
True or False
21. Membership or subscription businesses, such as health clubs and magazine publishers, may inflate
revenue by booking the full value of muliyear contracts in the first year of the contract. True or False
22. 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. True or False
23. The primary purpose of the buyer adjusting the seller earnings is to provide an accurate estimate of the
current year’s operating income or cash flow in the base year. True or False
24. In adjusting base year income, an appraiser must be aware of the implications of various accounting
methods for value. During periods of inflation, businesses frequently use the last-in, first out method to
value inventories. This approach results a reduction in the cost of sales and an increase in gross profits
and taxable income. True or False
25. Before selling a business, an owner may increase advertising expenses in order to inflate profits.
True or False
26. Intangible assets such as customer lists, intellectual property, licenses, distributorships agreements, leases,
regulatory approvals, and employment contracts may offer significant sources of value. True or False
27. Fair value is by necessity more subjective than the concept of fair market value, because it represents the
dollar value of a business based upon an appraisal of the tangible and intangible assets of the business.
True or False
28. Valuation of privately held businesses may involve substantial adjustment of the discount or capitalization
rate. True or False
29. The term capitalization refers to the conversion of a future income stream into a present value, and it is a
term often used by business appraisers when future income or cash flows are not expected to grow or to
grow at a constant rate. True or False
30. Restricted stock is often issued to employees of privately held firms as a significant portion of their total
compensation. Such stock is similar to other types of common stock except that its sale on the open market
is prohibited for a period of time. True or False
31. A private corporation is a firm whose securities are not registered with state or federal authorities. True or
False
32. Privately owned businesses are often referred to as “closely held” since they are usually characterized by a
small group of shareholders controlling operating and managerial policies of the firm. True or False
33. Very few closely held businesses are family owned. True or False
34. All family owned businesses are small. True or False
35. In many family owned firms, family influence is exercised by family members holding senior management
positions, seats on the board of directors, and through holding super-voting stock (i.e., stock with multiple
voting rights). True or False
36. The M&A market for employer firms tends to be concentrated among smaller firms, as firms in the United
States with 99 or fewer employees account for 98% of all firms with employees. True or False
37. Family owned businesses account for about 89% of all businesses in the U.S. True or False
38. Firms that are family owned but not managed by family members are often well managed, as family
shareholders with large equity stakes carefully monitor those charged with managing the business. True or
False
39. Succession issues tend to be easier for small family owned firms than for large publicly traded firms. True
or False
40. The market model of corporate governance is readily applicable to privately held, family owned firms.
True or False
41. In many countries, family owned firms have been successful because of their shared interests and because
investors place a higher value on short-term performance than on the long-term health of the business. True
or False
42. The control model of corporate governance may be more applicable where ownership tends to be highly
diverse and the right to control the business is separate from ownership. True or False
43. A family owned firm’s board faces the sometimes daunting challenge of achieving the proper balance
between monitoring and collaboration to minimize the emotionality and overlapping roles that often
characterize such firms. True or False
44. Because of the need to satisfy both the demands of stockholders and regulatory agencies, public companies
need to balance the desire to minimize taxes with the goal of achieving quarterly earnings levels consistent
with investor expectations. Failure to do so frequently results in an immediate loss in the firm’s market
value. True or False
45. Despite the lack of public exchanges for privately held firms, Wall Street analysts have ample incentive to
analyze such firms in search of emerging companies. True or False
46. Private companies are generally not subject to the same level of rigorous controls and reporting systems as
are public companies. True or False
47. Small firms may lack product, industry, and geographic diversification, which add to their specific business
risk. True or False
48. 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. True or False
49. It is rare that the owner or a family member is either an investor in or an owner of a vendor supplying
products or services to the family owned firm. True or False
50. A sudden improvement in operating profits in the year in which the business is being offered for sale may
suggest that both revenue and expenses had been overstated during the historical period.
True or False
51. EBITDA has become an increasingly popular measure of value for privately held firms in recent years.
True or False
52. The fair value concept is applied when no strong market exists for a business or it is not possible to identify
the value of substantially similar firms. True or False
53. If the cash flows of the firm are not expected to grow or are expected to grow at a constant rate indefinitely,
the discount rate used by practitioners often is referred to as the capitalization rate. True or False
54. If the discount rate is assumed to be 8% and the current cash flow is $1.5 million and is expected to remain
at that level in perpetuity, the implied valuation is $18.75 million. True or False
55. A control premium is the additional premium a buyer is willing to pay for the right to direct the activities of
a firm. True or False
56. An investor in a small company generally has little difficulty in selling their shares because of the high
demand for small businesses. True or False
57. It is generally easier to sell a minority interest than a majority interest in a business without loss of the
value of the original investment. True or False
58. Shell corporations rarely have any value. True or False
59. Private investment in public entities (PIPES) is a commonly used method of financing reverse mergers.
True or False
60. Shell corporations may be attractive for investors interested in capitalizing on the intangible value
associated with the existing corporate shell. This could include name recognition; licenses, patents, and
other forms of intellectual properties; and underutilized assets such as warehouse space and fully
depreciated equipment with some economic life remaining. True or False
61. Studies of restricted stock sales since 1990 indicate a median liquidity discount of about 20 percent with
several showing a decline to 13 percent after 1997 following the holding period change under Rule 144
from two years to one. True or False
62. There is widespread agreement over the magnitude of the liquidity discount. True or False
63. A minority discount is the reduction in the value of a minority investor’s investment because minority
owners have little influence in how the firm is managed. True or False
64. A pure control premium is the value the acquirer believes can be created by replacing the target firm’s
incompetent management, by changing the strategic direction of the target, by gaining a foothold in a
market not currently served, or by achieving unrelated diversification. True or False
65. Studies show that control premiums vary widely across countries reflecting the efficacy of shareholder
rights laws and how well such laws are enforced in each country. True or False
66. Increasing market liquidity will reduce the value of control; an increasing value of control will reduce
market liquidity and contribute to increasing liquidity discounts. True or False
1. Which of the following are often true about the challenges of valuing private firms?
a. There is a lack of analyses generated by sources outside of the company.
b. Financial reporting systems are often inadequate.
c. Management depth and experience is often limited.
d. Reported earnings are often understated to minimize taxes.
e. All of the above.
2. In valuing private businesses, the U.S. tax courts have historically supported the use of which valuation
method for purposes of estate valuation?
a. Discounted cash flow
b. Comparable company method
c. Tangible book value method
d. A combination of a and c
e. All of the above
3. All of the following are true of reverse mergers except for.
a. May be used to take a private firm public
b. May represent an effective alternative to an IPO
c. Commonly use private equity placements for financing
d. Requires 2 years of audited financial statements to take a private firm public
e. A and B
4. Which of the following is not true of liquidity or marketability risk or discount?
a. It is measurable.
b. It is believed to have declined in recent years
c. The magnitude of the discount or risk is inversely related to the size of the investor’s equity
ownership in the business.
d. The magnitude of the discount or risk is directly related to the size of the investor’s equity
ownership in the business.
e. It is important to adjust the discount rate for liquidity risk.
5. Corporate shells have value because they enable the buyer to
a. Avoid the cost of going public
b. Exploit intangible value such as brand name
c. A and D only
d. Provide limited liability
e. A, B, and D only
6. Leveraged employee stock ownership plans are frequently used by owners of private businesses to
a. Hide assets
b. Motivate employees
c. Sell the firm to the employees
d. B and C
e. A, B, and C
7. All of the following are often true of privately held firms except for
a. Financial data is often inaccurate and out of date
b. Internal controls are ineffective
c. Have limited access to capital markets and product distribution channels
d. Are more easily valued than public companies
e. Have limited ability to influence customers, suppliers, unions, and regulators
8. Fair market value is
a. The cash or cash equivalent value that a willing buyer would pay or seller would accept for a
business
b. The cash or cash equivalent value that a willing buyer would pay or seller would accept for a
business, assuming each had access to all necessary information
c. The cash or cash equivalent value that a willing buyer would pay or seller would accept for a
business, assuming each had access to all necessary information and that neither party is under
duress.
d. The discounted value of free cash flow to the firm
e. The discounted value of free cash flow to equity investors.
9. The discount rate may be estimated using all but the one of the following:
a. The capital asset pricing model
b. The share exchange ratio
c. The cost of capital
d. Return on total assets
e. Price-to-earnings ratio
10. All of the following represent common sources of value in appraising private or publicly owned businesses
except for
a. Intellectual property
b. Customer lists
c. Licenses
d. Contingent liabilities
e. Employment contracts
11. Revenue Ruling 59-60 describes the general factors that the IRS and tax courts consider relevant in valuing
private businesses. Of the following valuation methods, which do the IRS and tax courts view as the most
important?
a. Discounted cash flow
b. Comparable company methods
c. Tangible book value
d. Replacement cost method
e. All of the above
12. The most important element(s) in selecting a business valuation professional include which of the
following: (Select only one)
a. Overall experience
b. Demonstrated ability in the industry in which the firm to valued competes
c. Degree of specialization
d. Number of professional degrees
e. A and B only
13
13. A business owner may overstate revenue by
a. Failing to deduct from revenue products returned by customers
b. Billing customers for products not ordered
c. Booking the entire value of a multiyear contract in the current year
d. Counting interest income as revenue
e. All of the above
14. A business owner may overstate revenue and understate actual expenses when
a. The business is about to be sold
b. They are being audited by the IRS
c. They are trying to minimize tax liabilities
d. All of the above
e. None of the above
15. A corporate shell may have value because
a. It may enable the owner to avoid the costs of going public
b. The name is widely recognized
c. It could own the rights to various forms of intellectual property
d. All of the above
e. None of the above
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,
14
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.1 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
1 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.
15
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.2
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