Reverse Takeover. Strategic motivation and financial performance based on a case study of the West African Mining Industry

TABLE OF CONTENT

Summary

List of figures

List of tables

List of abbreviations

1 Introduction
1.1 Background
1.2 Statement of the problem
1.3 Purpose of the thesis

2 Fundamentals of Reverse Takeover
2.1 Definition of Reverse Takeover
2.2 Transaction structure
2.2.1 Reverse Takeover by absorption
2.2.2 Reverse Triangular Takeover
2.3 The Reverse Takeover process
2.4 SWOT Analysis of Reverse Takeover
2.5 Three-period decision making model whether to choose aReverse Takeover or an IPO

3 Literature review
3.1 Introduction
3.2 Characteristics of companies using Reverse Takeovertransactions
3.3 Costs of Reverse Takeover transactions
3.4 Financial performance of Reverse Takeover

4 Case Study: The Reverse Takeover of Stellar Diamonds
4.1 Introduction
4.2 The diamond market - a brief outline
4.3 Company profile prior to the Reverse Takeover
4.3.1 Stellar Diamonds Ltd
4.3.2 West African Diamonds plc
4.4 The Reverse Takeover process of Stellar Diamonds
4.5 Business description of Stellar Diamonds
4.6 SWOT analysis of Stellar Diamonds
4.7 Three-period decision making model whether to choose aReverse Takeover or an IPO in practice
4.8 Financial Performance of Stellar Diamonds during post-takeover, 2010 - 2012

5 Conclusion
5.1 Background
5.2 Restatement of the aims
5.3 Findings
5.4 Significance of the findings
5.5 Limitation of the paper
5.6 Recommendations for further work

Appendix A

References

SUMMARY

The paper focuses on reverse takeover transactions which are an alternative way for a private corporation to obtain exchange listing (Floros & Shastri 2009, p.8). Besides the Initial Public Offering, a reverse takeover is classified as going public through the backdoor (Gleason, Rosenthal, Wiggins 2005, p.56). A public corporation legally acquires a private corporation but in reverse the private corporation is the acquirer for accounting purposes and takes over the majority of voting rights, the managerial control and changes the name of the newly created public entity (Gleason, Rosenthal and Wiggins 2005, p. 56; Fassnacht 2011 pp.18-20). The paper introduces the theory on reverse takeover with focus points on the SWOT analysis and the three-period decision making model by Arellano- Ostoa & Brusco (2002, pp.12-17). The literature review classifies the available descriptive and empirical researches with an emphasis on the evidently lower costs of reverse takeovers and the financial performance. The aim of the paper is to put the theory and the available literature on the term reverse takeover into context by analysis and application to a case study. The reverse takeover of Stellar Diamonds plc headquartered in London, United Kingdom, is a result of two companies both operating in the diamond mining industry in West Africa (STEL Annual Report 2010, p.4). Besides the theory and the applicable literature, the case study discusses the SWOT analysis with focus points on the operating industry, operating countries and strategic motivation as well as the three-period decision making model in practice and the financial performance during post- takeover. Finally, the paper summarizes the main findings, classifies its significance, the limitations and the recommendations for further work.

LIST OF FIGURES

Figure 1: Transaction structure of the Reverse Takeover by absorption

Figure 2: Transaction structure of the Reverse Triangular Takeover

Figure 3: Phases and steps during a Reverse Takeover

Figure 4: SWOT Analysis of a Reverse Takeover

Figure 5: 2011: Diamond value from production until sales

Figure 6: The history of Stellar Diamonds Ltd

Figure 7: The history of West African Diamonds plc

Figure 8: Transaction process of Stellar Diamonds

Figure 9: SWOT analysis of Stellar Diamonds

LIST OF TABLES

Table 1: Diamond mining projects of Stellar Diamonds in West Africa

Table 2: Operational loss of Stellar Diamonds, 2010 - 2012

Table 3: Capital increase of Stellar Diamonds, 2010 - 2012

Table 4: Valuation of the production: Bomboko mine

Table 5: Financial figures of Stellar Diamonds’ mining projects,2010 - 2012

Table 6: Valuation Measures of Stellar Diamonds, 2010 - 2012

Table 7: Profitability Measures of Stellar Diamonds, 2010 - 2012

Table 8: Liquidity Measures of Stellar Diamonds, 2010 - 2012

Table 9: Recommendations for Stellar Diamonds to increase liquidity and profitability

Table 10: Findings and discussion

LIST OF ABBREVIATIONS

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1 INTRODUCTION

1.1 BACKGROUND

Reverse takeover transactions date back to the 1970th and are an alternative way for a private corporation to obtain exchange listing (Floros & Shastri 2009, p.8). Besides the Initial Public Offering, a reverse takeover is classified as going public through the backdoor (Gleason, Rosenthal, Wiggins 2005, p.56). The public corporation acquires the private corporation but in reverse the private corporation takes over most of the voting rights, the managerial control and changes the name of the newly created public entity (Gleason et al. 2005, p. 56; Fassnacht 2011 pp.18-20). The paper looks at the theoretical background, analyzes the strengths, weaknesses, opportunities and threats of going public through the backdoor and classifies the existing empirical and descriptive literature. The theory is complemented by a case study of London Stock Exchange (AIM) listed Stellar Diamonds plc, which is the result of a reverse takeover transaction of two companies both operating in the diamond industry in West Africa. The paper analyzes the case study in greater details by applying a SWOT analysis, a theoretical decision making model introduced by Arellano-Ostoa & Brusco (2002, pp.12-17) and validates the financial performance during post-takeover.

1.2 STATEMENT OF THE PROBLEM

Since the 1970th, a number of reverse takeover transactions were conducted. However, these researches differ in an overall definition of reverse takeover, research methods and comparable results (Arellano-Ostoa & Brusco 2002, pp.22-27; Gleason et al. 2005, pp.64-75; Adjei, Cyree, Walker 2008, pp.178-188; Floros & Shastri 2009, pp.12-31; Carpentier, Cumming, Suret 2010, pp.18-32; Fassnacht 2011, pp.191-205; Faelten et al. 2013, pp.8-13). The U.S. capital market has been well studied on reverse takeovers and recently on Chinese Reverse Mergers¹. In contrast, empirical studies on European capital markets are available very little. Fassnacht (2011) and Faelten, Appach and Levis (2013) examine European and reverse takeover transactions in the United Kingdom(UK). Further, the empirical and descriptive discussion on the evidently lower costs of going public through the backdoor and the financial performance diverge and make an application to the case study challenging (Gleason et al. 2005:59/64/69; Adjei et al. 2008, pp.178-179; Sjostrom 2008, pp.748-749; Floros & Shastri 2009, p.25; Fassnacht 2011:235/191-192/228). The theoretical three- period decision making model (Arellano-Ostoa & Brusco 2002, pp.12-17) is applied to Stellar Diamonds and analyzed within its limitations. The political instability of the operations in West Africa affects Stellar Diamonds to a high degree and has its weight in the SWOT analysis (IMF Survey 2012). The findings of the financial performance and the recommendations for Stellar Diamonds are very specific and may not be directly comparable to other companies or industries.

1.3 PURPOSE OF THE THESIS

The purpose of the paper is to put the available empirical and descriptive literature on reverse takeover into context by applying the theory and analyzing a case study in greater detail. The conditions of a company operating in developing countries, which only recently restored peace, are of different nature and have to be taken into account while analyzing. So far, the paper broadens the view on the term reverse takeover especially in developing countries, Sierra Leone and Guinea, and the diamond industry and draws conclusion on the strategic motivation and financial performance.

The paper is structured in a theoretical part which describes the fundamentals of reverse takeover. Then, the different findings of the empirical and descriptive literature are discussed in depth. These findings and the theory of reverse takeover is further applied to the case study of Stellar Diamonds plc operating in the diamond industry in West Africa. Finally, the paper draws conclusions and summarizes the findings.

2 FUNDAMENTALS OF REVERSE TAKEOVER

2.1 DEFINITION OF REVERSE TAKEOVER

Among the scientific literature, there are different definitions and terms such as reverse takeover (Bournet 2004, p.32; Gleason, Rosenthal, Wiggins 2005, p.56; Semenenko 2011, p.1455), reverse merger (Arellano-Ostoa & Brusco 2002, p.7; Feldmann 2009, p.1; Ojha, Maheshwari, Jain 2013, p.1), and reverse acquisition (International Financial Reporting Standards [IFRS] 3² 2009, B19; Zwirner 2009, p.1) describing similar transactions between a private and a public corporation. Under IFRS3 (2009, B19):

“Reverse acquisition sometimes occurs when a private operating entity wants to become a public entity but does not want to register its equity shares. To accomplish that, the private entity will arrange for a public entity to acquire its equity interests in exchange for the equity interests of the public entity.”

A reverse takeover (RT)³ describes an acquisition (takeover) whereby a public corporation acquires a private corporation, but in reverse the private corporation acquires most of the shares of the public corporation (voting rights), takes over the managerial control and finally obtains its exchange listing (Gleason et al. 2005, p. 56). IFRS 3 (2009, B19) complements the statement by explaining that the legal acquiree is the private entity but is in reverse the acquirer for accounting purposes. After the RT, the former private corporation is the surviving entity (Gleason et al. 2005, p. 56). The public corporation is either a shell company which was founded to serve as a vehicle for a private company to obtain exchange listing or a defunct corporation which preserves its corporate structure, but is not profitable anymore (Arellano-Ostoa & Brusco 2002, p.2).

2.2 TRANSACTION STRUCTURE

2.2.1 Reverse Takeover by absorption

Figure 1 illustrates the transaction structure of an RT by absorption before (a), during (b) and after (c) the takeover. A public corporation, either a shell or defunct, (entity A) is the legal acquirer of a non-listed operating corporation (entity B) (IFRS3 2009, B20). Entity B aims at obtaining exchange listing through an RT rather than an Initial Public Offering (IPO). Entity A mergers with entity B and forms a new legal corporation (entity AB) (Fassnacht 2011, p.14). During the process, entity A issues new shares in exchange for the shares of entity B. The share exchange ratio is relative to the equity value of both entities. Mostly, entity A issues 100 percent new shares because the equity value is very low or negative comparable to entity B. Entity B gains control over entity AB with a majority stake of voting rights, which is at least more than 50 percent (Fassnacht 2011, p.15). The shareholder’s voting rights of entity A are diluted relative to the exchange ratio. These shareholders lose their controlling stake in favour of the shareholders of entity B (Bournet 2004:33/138/231). Entity B is, on the one hand, the legal acquiree and, on the other hand, the accounting acquirer with a controlling stake of voting rights after the RT (IFRS3 2009, B19).

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Figure 1: Transaction structure of the Reverse Takeover by absorption

Before the RT (a) During the RT (b) After the RT (c)

Source: Own figure based on Fassnacht 2011, p.15.

2.2.2 Reverse Triangular Takeover

The reverse triangular takeover emerged through to U.S. legal and tax advantages. It is commonly used in the U.S. involving domestic and foreign companies (Bournet 2004, p.33; Feldmann 2009, p.44). Figure 2 explains the reverse triangular takeover before (a), during (b) and after (c) the transaction. It is characterised by a public corporation (entity A1) which forms a wholly-owned subsidiary (entity A2). Entity A2 is the legal acquirer of a non-listed operating corporation (entity B). Entity B wants to obtain exchange listing through an RT and is therefore, the legal acquiree, but the accounting acquirer (IFRS3 2009, B19). Entity A2 merges with entity B. The sole shareholder of entity A2 is entity A1 acting and approving the transaction through the board of directors. There is no approval of entity A1’s shareholder necessary in contrast to entity B’s shareholder vote for the takeover (Feldmann 2009, p.45). The reverse triangular takeover is possible for public corporations without their shareholder’s approval trading on the Over- The-Counter Bulletin Board (OTCBB)⁴. Major exchanges such as NASDAQ insist shareholder approval of any RT. Therefore, a public corporation might delist from NASDAQ to relist on the OTCBB (Feldmann 2009, p.46). After the takeover, entity A1 as the sole shareholder issues new shares in exchange for the shares of entity B (Bournet 2004, p.34; Feldmann 2009, p.45). As described in the previous section, the shares of both entities are exchanged via a ratio relative to each entity’s equity value. The shares of entity A1 are diluted relative to the exchange ratio (Fassnacht 2011, p.13). Entity B’s shareholder acquire a controlling majority of entity A1. As a result of the takeover, entity A2 does not survive and disappears. Entity B is the surviving entity and becomes a wholly-owned subsidiary of entity A1 (Feldmann 2009, pp.45-46). Entity A1 is still the sole shareholder of the wholly- owned subsidiary entity B (Bournet 2004, p.34). Tax-free, contractual advantages and for instance the isolation of pre-existing liabilities of entity B for A1 strengthen the choice of a reverse triangular takeover (Kohl & Storum 2002, p. 1-3). The thesis does not further deepen the limitations of a reverse triangular takeover especially in terms of different tax laws across various countries, for further information see Bournet 2004, pp.154-198.

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Figure 2: Transaction structure of the Reverse Triangular Takeover

Before the RT (a) During the RT (b) After the RT (c)

Source: Own figure based on Fassnacht 2011, pp. 14-15.

2.3 THE REVERSE TAKEOVER PROCESS

Under IFRS3 (2009, B19) an RT is part of an acquisition process. Bournet (2004, p.115) distinguishes an RT with the following three steps:

1. Preparation (pre-merger)
2. Examination (merger)
3. Integration (post-merger).

Figure 3 illustrates the process and the steps within theses phases which may differ across separate RT transactions.

Figure 3: Phases and steps during a Reverse Takeover

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During the pre-merger phase, the private corporation identifies a suitable public corporation for the RT (Gleason et al. 2005, p.58). After a successful contact and interest, a due diligence of both parties is very important to identify risks, such as possible hidden reserves (shell-company), and potentials, such as synergies or strategic motivation (Zwirner 2009, p.32; Fassnacht 2011, pp.16-17). If one of the transaction partners does not fully trust the due diligence, a fairness opinion might be a reliable complement (Bournet 2004, p.124; Feldmann 2009, p.82). Following the results of the due diligence, the transaction agreement is under negotiation. Part of the contract is the transaction structure, the exchange ratio of the shares, the rights and obligations of the transaction partners and the conditions under which the contract is executed (Fassnacht 2011, pp.17-18). Conditions might be the shareholder approval for a capital increase against contributions during the general meeting and the indemnity and termination agreement. At the same time, communication materials and the general meeting are prepared (Fassnacht 2011, p.18).

The next stage of the process is the merger phase. The transaction partners sign the transaction agreement and make a public announcement. They invite the shareholder to the general meeting, prepare the prospectus to be authorised by the stock exchange and actively plan the integration of the private and the public corporation (Fassnacht 2011, pp.18-19). Depending on the transaction structure, the shareholder must vote, for instance, for a capital increase against contributions during the general meeting. The takeover is executed when the capital increase entered into the Commercial Register and the new shares are up for trading on the stock exchange (Bournet 2004, pp.124-128).

When the transaction is completed, the post-merger phase starts. The change of control (ownership structure) is then necessary, when the shareholder rights have changed at least to one third of all shares. There are different legal obligations involved into the conditions of the change of control, for instance, the need of a mandatory offer among different countries (Fassnacht 2011, p.20). The post- merger phase focuses on the integration of the transaction partner. The management of the former private partner takes over the responsibilities of the newly created public entity, owning at least more than 50 percent of the shares. Managers of the former public corporation might not be laid off, but given the opportunity to be on the board of directors or to consult in various services. Mostly the public corporation changes its name in favour of the former private partner (Gleason et al. 2005: 56/59; Dasilas, Koulakiotis, Vutirakis 2009, p.13).

2.4 SWOT ANALYSIS OF REVERSE TAKEOVER

This section examines the RT from different angles by looking at the strengths, the weaknesses, the opportunities and the threats. Figure 4 brings the key facts of the SWOT analysis together.

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Figure 4: SWOT Analysis of a Reverse Takeover

Source: Own figure based on⁵

Strengths

One of the strength of an RT is the possibility for a private corporation, especially small and young firms, to obtain exchange listing (Arellano-Ostoa & Brusco 2002, p.2; Gleason et al. 2005:55/59; Floros & Shastri 2009, p.25; Fassnacht 2011, p.191). Highly discussed in the scientific literature are the lower costs of an RT transaction compared with an IPO (Gleason et al. 2005, p.59; Adjei et al. 2008, pp.178-179; Sjostrom 2008, pp.748-749; Fassnacht 2011, p.235). The rather controversial discussion is deepened in 3.3 Costs of Reverse Takeover Transactions. A further strength of an RT is the execution in shorter time. Fassnacht (2011, p.234) finds a mean duration of three month. However, some RT transactions may take up to two years due to actions for annulment. Even if an RT is on a case-to-case basis timely, on average they outperform other going public mechanism (Gleason et al. 2005, p.59; Bournet 2004, p.22).

W eaknesses and Opportunities

On the weaker side, capital is not directly raised through an RT (Gleason et al. 2005, p.56; Semenenko 2011, p.1456). Still, there is the opportunity to have easier access to capital in terms of Seasoned Equity Offerings (SEO)⁶ or Private Investment in Public Equity (PIPE)⁷. That might be shortly after the RT or at a later stage (Floros & Shastri 2009, p.10; Gleason et al. 2005, p.71). On the weaker side, RT transactions may not need to fulfil as much disclosure regulations as an IPO (Arellano-Ostoa & Brusco 2002, p.17; Adjei et al. 2008, p.185). Therefore, an RT is rather viewed as information asymmetric for outside investors (Isa 2002, p.100; Floros & Shastri 2009, p.32; Semenenko 2011, p.1456). The increase of transparency is therefore an opportunity during the post-takeover phase. Chu, Gotti and Schumann (2012, pp.22-23) and Carpentier, Cumming and Suret (2010, pp.31-32) show the importance of qualitative auditing among the big four auditors in terms of higher earnings quality and survival rate of an RT. An opportunity for the transaction partners could be to achieve strategic goals such as growth strategies (Floros & Shastri 2009, p.21), re-brand the company’s business (Makamson 2010, p.124) or to use synergy effects of the public and the private corporation (Isa 2002 p.100; Gleason et al. 2005, p.61; Fassnacht 2011, p.189).

Threats

On the contrary, country and exchange specific disclosure regulations could be a threat after the takeover (Brenner & Schroff 2004, p. 49; Aydogdu, Shekhar and Torbey 2007, p.1338). Darrough, Huang and Zhao (2012, pp.12-13) examine fraudulent behaviour of Chinese Reverse Mergers (CRM) among their sample listed on U.S. stock exchanges. Besides a number of reasons, auditors’ quality and regulation requirements were part of these fraudulent CRMs. Darrough et al. (2012, pp.27-28) conclude negative spillover effects on stock prices of non- fraudulent CRMs and Chinese IPOs. Weak corporate governance structure of the newly created public corporation might lead to an increase in information asymmetry and less qualitative disclosure regulations and can therefore be threatening for the company’s success (Aydogdu et al. 2007, pp.1337-1338; Floros & Shastri 2009, p.25; Lee, Li, Zhang 2013, p.2).

The SWOT analysis of an RT shows the main strength, the possibility for a private corporation to be listed on the stock exchange and therefore, get easier access to capital. On the weaker side, an RT might not fulfil the listing requirements and operates with higher information asymmetry, which could be reduced by auditing among the big four auditors and implementation of governance structures. However, an opportunity might be the strategic intentions like growth or re-branding strategies of the transaction partners. The SWOT analysis draws general conclusions of strengths, weaknesses, opportunities and threats of an RT but needs to be looked at a particular transaction to apply and prioritize internal and external drivers, which affect a particular RT.

2.5 THREE-PERIOD DECISION MAKING MODEL WHETHER TO CHOOSE A REVERSE TAKEOVER OR AN IPO

Arellano-Ostoa & Brusco (2002, pp.12-17) examine the conditions under which a company chooses to go public through an IPO or an RT. Their three-period decision making model involves a company facing uncertainty about an investment project and its financing needs. The three-periods, t0, t1, t2, involve two companies, risk neutral agents and investors. The interest rate is r=0. The uncertainty about the financing of the investment project at t2 requiresinvestment I. If the investment project is certain and financed immediately, the expected value is A1. If funds for the project have to be raised, the expected value A2 will be delayed which is costly (A1>A2). The net present value (NVP) of the project is positive: Ai-I>0, i=1,2. The probability of a profitable project is set with qL (low-type) and qH (high-type) at time t0; qL<qH. Whether a project is high or low-type is private information to the company. At t1, the company has to make a decision whether to go public to raise capital for the uncertain investment project in t2 through (a) an IPO, through (b) an RT or (c) do nothing. If the project is not available in t2, the raised capital will be kept as cash reserves. If a company chooses an IPO, the costs are CIPO which might be greater than the costs of the RT CRT, CIPO> CRT. In t2, the company knows, if the project is certain and can invest directly, if it went public through an IPO at t1. If it chose an RT in t1, it has to raise capital, for instance, through SEO or PIPE which is costly with CSEO in t2. Therefore, the company generates a value of A2 at costs of CRT and CSEO. If the project is not available, the capital raised through an IPO remains as cash and the CRT are lost. The NPV is CIPO>CRT+CSEO. Arellano-Ostoa & Brusco (2002, pp.16-17) conclude a separating equilibrium for high-type projects chosen by an IPO and low-type projects chosen by an RT. They interpret the signal of quality between the choice of an IPO over an RT. Arellano-Ostoa & Brusco (2002, p.24) conclude that the RT transactions just fulfil the continued listing requirements and are a choice for companies with lower quality. Across the scientific literature, empirical research resulted in RT of rather small and early-stage companies, underperforming the IPO control sample (Gleason et al. 2005, p.59; Adjei et al. 2008, p.183; Fassnacht 2011, p.191). Adjei et al. (2008, p.185) find only 1.4 percent of the RT which do not fulfil the listing requirements at all and would not go public except through an RT. Arellano-Ostoa & Brusco’s research has to be critically questioned in terms of sample size (52 RT), control group (is an IPO suitable or rather a penny stock IPO or a merger and acquisition transaction) and supported by further research. Their three-period decision making model is very simple, for instance, by assuming that the company already knows about the profitability outcome of the project. Therefore, the results should be taken into account with care.

3 LITERATURE REVIEW

3.1 INTRODUCTION

During the last decades a number of descriptive and empirical researches became available on the topic of RT. This chapter looks at different descriptive and empirical researches, distinguishes the characteristics of companies using an RT, the evidently lower costs of RT and the financial performance of the transaction partners before the takeover and the performance well after.

3.2 CHARACTERISTICS OF COMPANIES USING

REVERSE TAKEOVER TRANSACTIONS

Section 2.5 Three-period decision making model whether to choose a Reverse Takeover or an IPO introduced the research of Arellano-Ostoa & Brusco (2002, pp.12-17). They classify firms as high or low-type depending on the choice of an IPO or an RT. Their research of 59 RTs between 1990 and 2000 show that in total 32.6 percent of the RTs were delisted (Arellano-Ostoa & Brusco 2002, p.24).

Gleason et al. (2005, p.59) studied 121 RT transactions in the U.S. between 1987 and 2001. They conclude that small firms choose an RT with a mean value of total assets of 8.4 million USD. Gleason et al. (2005, p.72) further found out that 27.3 percent of the RTs were delisted, whereas 53.7 percent did not survive⁸ until two years after the takeover.

Adjei et al. (2008: 181/183) analyzed 286 RT transactions and 2,860 IPOs between 1990 and 2002 in the U.S. The descriptive statistics show that RT firms are smaller, one fifth of the size of the IPO control sample, and younger. IPO firms outperform the RT firms with a mean total assets of 674.9 USD compared to 136.3 USD. Further, Adjei et al. (2008, p.185) find that most of the RT firms meet at least one listing requirement similar to the IPO counterparts. Three years after the takeover, 42.7 percent were delisted compared with 27 percent of the

IPO control sample (p.188). These findings support Arellano-Ostoa & Brusco’s as well as Gleason, Rosenthal and Wiggin’s findings of RT firms being rather small, young and less likely to survive compared with IPOs.

Floros & Shastri (2009: 8/16) compared 408 RT transactions to 213 penny stock IPOs in the U.S between 1979 and 2006. They chose penny stock IPOs because of the smaller market capitalization of the private company, which is similar to the private corporation in an RT transaction. The analyzed RTs are characteristic for smaller and younger firms. Among the survival rate, Floros & Shastri (2009, p.13) find that 9.8 percent of the RT transactions do not survive three years after the takeover. This is in contrast to the higher non-survival rate of Arellano-Ostoa & Brusco (2002, p.24), Gleason et al. (2005, p.72) and Adjei et al. (2008, p.185). Floros & Shastri (2009, p.13) argue, that hand in hand with additional financing, such as PIPE financing, two qualitative criteria, the additional managerial control through private investors and the interpretation of potential of RT firms, are part of the high survival. 47.06 percent of their sample is financed through PIPE. The non-surviving RT transactions are rather financed through long-term loans and credit lines. Floros & Shastri (2009, p.21) conclude that firms use an RT as a stepping stone for further acquisitions with the ability to pay in stock.

Carpentier et al. (2010:18-19/37) observed 684 IPOs and 771 RTs between 1993 and 2003 in Canada. They report that the RTs are chosen by smaller low-quality firms, which may be linked to an industry. The mining sector, however, has a long tradition of RT transactions (p.24).

Fassnacht (2011, pp. 185-191) examined 194 European RTs between 1986 and 2005. More than 70 percent of the private and the public corporations are from the UK. RT firms are rather small and young. Fassnacht (2011, pp.192-193) finds that half of the sample issue new shares shortly after the takeover, but only among UK takeover with one exception in Finland. Two years after the takeover, only 2.06 percent of the European RT transactions were delisted. In total, 15.46 percent did not survive⁹ (pp.197-198). These findings are similar to

Floros & Shastri’s (2009, p.13) survival rate of 9.8 percent, but in contrast to the higher delisting rate of Arelllano-Ostoa (2002, p.24), Gleason et al. (2005, p.72) and Adjei et al. (2008, p.185). Fassnacht’s research is one of the first researches among European RT transactions. More in-depth research in Europe has to be done to draw fundamental conclusions.

Faelten, Appach and Levis (2013, p.9) examined 273 RT and 1,643 IPOs in the UK from 1995 until 2012. Among the public corporation, they find three different types: Special Acquisition Purpose Company (SPAC)¹⁰, Mature Shell Company¹¹, and the Synergy RT¹². 30.1 percent of the RTs are delisted between 1995 and 2009¹³ (p.16). In contrast to Fassnacht’s delisting rate of 2.06 percent among European RT transactions (mostly UK RTs), this is rather high. The difference of the timing of the sample size might be an explanation. Fassnacht looked at the years between 1986 and 2005, whereas Faelten et al. examined the RT transactions from 1995 until 2009. Most of the delisting in the research of Faelten et al. took place in the third year after the transaction. It is unclear in which year exactly most of the delisting took place. Therefore, a direct comparison is difficult.

Darrough, Huang and Zhao (2012: 20/44) focused on RT transactions between 2000 and 2011 on the U.S. stock exchanges. They examined 125 Chinese IPOs, 378 CRMs, 129 RTs with other international firms on the U.S. stock exchange and 1,180 U.S. RT transactions. They study the spillover effect of 33 CRMs involved into fraud on other CRMs and Chinese IPOs before and after the U.S. Security and Exchange Commission (SEC) released a public warning about RTs including foreign firms, especially from China (SEC Investor Bulletin: Reverse Mergers 2011, pp.2-4). The research shows that the spillover effect before the investor bulletin warning was released was minor but became more prominent shortly after. Furthermore, the research implies that even CRMs outperform other

RT either with international firms or among U.S. firms (24/30). Lee, Li and Zhang (2013, p.21) support these findings when comparing CRMs to U.S. RTs. More aspects, such as long-term studies about CRMs going private and a possible exchange listing on Chinese exchanges, has to be observed over time. At the moment, fraudulent behaviour of CRMs is more current than before and has an influence on investors on U.S. exchanges (Darrough et al. 2012: 24/30).

3.3 COSTS OF REVERSE TAKEOVER TRANSACTIONS

Highly discussed in the scientific literature is the lower costs of an RT transaction compared with an IPO (Gleason et al. 2005, p.59; Adjei et al. 2008, pp.178-179; Fassnacht 2011, p.235). Gleason et al. (2005, p.59) show that the fees of an RT is 2.72 percent of the transaction value. Arellano-Ostoa & Brusco (2002, p.25) criticize the direct comparison of an RT and an IPO. They argue that only an RT which raises capital could be directly compared to an IPO. Their results claim no difference in terms of costs between these two going public mechanisms (Arellano-Ostoa & Brusco 2002, p.25). Sjostrom (2008, pp.748-749) supports the fact that only RTs coupled with financing can be compared to IPOs. Even if additional financing goes hand in hand with an RT, the amount of capital increase might be smaller compared with an IPO. Furthermore, Sjostrom (2008, p.748) raises the concern that an underwriter supports the IPO process from pre- until post-listing but is not involved in an RT. An underwriter is well costly and due to its absence in RT transactions not directly comparable. However, there are self-underwritten IPOs but no research in terms of costs was conducted yet. Fassnacht (2011: 192/196-197) underlines costs of six percent on average for RT transactions with additional financing. This is still lower than the findings of Kaserer & Schiereck (2011, p.31). Their research of IPOs with a volume up to 100 million EUR costs 8.29 percent of going public on the AIM. The comparison of Fassnacht’s findings and those of Kaserer & Schiereck is difficult because the sample size of 95 RT transactions with capital increase (Fassnacht) and the research and methodology of Kaserer & Schiereck differ. The findings of evidently lower costs involved in an RT among different capital markets, the U.S. and the UK, and control factors (RT with and without capital increase) are controversial. If only a fraction of the RT sample uses additional financing, it makes the comparison among relatively small sample sizes questioning. Further research with different control groups needs to be conducted world-wide. Lower costs of an RT may still differ on a case-to-case basis.

3.4 FINANCIAL PERFORMANCE OF REVERSE TAKEOVER

Public corporations prior to the takeover

Gleason et al. (2005, pp.62-63) find that the median return on assets (ROA), return on equity (ROE) and the net profit margin (NPM) is negative for the pool of public firms. Cash to total assets average is at 22 percent and the average of debt to total assets ratio is 20 percent. These results underline the rather low profitability of already listed public firms. Fassnacht (2011, p.225) determines that public corporations are quite small with a median balance sheet total of 10.93 million USD. The public corporations show negative EBITDA margins, cash flow margins and NPM supporting Gleason’s findings of low profitability public corporations (Fassnacht, 2011, p.224).

Private corporations prior to the takeover

Fassnacht (2011, p.226) looks at the financial performance of the private corporation prior to the takeover. The median growth in sales is 21.86 percent, which indicates the development stage of a growing company with a slightly negative cash flow ratio. This could be a reason for small growing private corporations to achieve expansion through an RT. Floros & Shastri (2009: 16/41- 42) support the fact that private corporations are rather small with negative cash flow ratios and strategic growth intensions. They find that private companies use to have more short-term than long-term debt, negative NPM and EBITDA but positive working capital.

Financial Performance after the takeover

Fassnacht (2011, pp.191-192) underlines the small average transaction value of an RT with 73.93 million USD. This is in line with an average value of 97 million USD found by Gleason et al. (2005, p.64). One year after the takeover, the profitability of the firms showed a very low but positive EBITDA and negative cash flow ratio and NPM. The EBITDA and NPM slightly improved at the end of year two; whereas the cash flow ratio was still negative (Fassnacht 2005, p.228). In terms of financial performance, the profitability of the companies after the takeover is slightly improving but still with an unstable liquidity, which might be due to the development stage of the growing company. However, the ROE is positive two years after the takeover and therefore strengthening (Fassnacht 2005, p.228). Gleason et al. (2005, pp.69) find that during two years after the RT, the corporations are growing both in terms of total assets and market value of equity but cash ratios decline, whereas debt ratios increase. Floros & Shastri (2009, p.25) support the strategic intention of growth by RT firms which make at least one acquisition within three years after going public.

Stock performance

The event study of Gleason et al. (2005, pp.66-67) show that RTs outperform IPOs in terms of short-term stock prices at the announcement date. Fassnacht (2011, pp.199-205) finds that the abnormal return of the stock prices is already positive shortly before the announcement up until one day after. The following days, the abnormal return becomes negative. This implication might be due to speculative information available before an official announcement. Carpentier et al. (2010, pp.28-29) indicate that the price earnings ratio is twice as high for IPOs as for RTs. They conclude that the choice of an IPO does increase the valuation of stock in the long-term. At the same time, they find over pricing among small issuers, which contradicts the hypotheses of large firms benefiting from lower cost of equity by increasing valuation (Carpentier et al. 2010, p.29).

In sum, RT transaction may be chosen by private companies which are small and in the development stage, and by public corporations which do not perform very well, but are still listed on the stock exchange. The financial stock performance on the announcement date indicates positive abnormal returns but is not consistent in the long-term. Firm financial performance does increase slightly, whereas liquidity is still unstable two years after the takeover. RTs might therefore be a possibility for small, growing firms to obtain exchange listing and expand further. The empirical findings are mixed and need further examination across borders, control samples and time-horizon.

4 CASE STUDY: THE REVERSE TAKEOVER OF STELLAR DIAMONDS

4.1 INTRODUCTION

This section looks at the RT of Stellar Diamonds plc (STEL)¹⁴. Its objective is to apply and compare the theory, the empirical and descriptive findings practically at the case study of STEL. Focus points are the SWOT analysis with an emphasis on the operating industry, the operating countries, strategic motivations, the three-period decision making model by Arellano-Ostoa & Brusco (2002, pp.12- 17) and the financial performance post-takeover from 2010 until 2012. Thereby, empirical results of the financial performance examined by Gleason et al. (2005, pp.66-67), Floros & Shastri (2009, p.25), Fassnacht (2011:191-192/199-205/228) and Faelten et al. (2013, p.10) are discussed.

4.2 THE DIAMOND MARKET - A BRIEF OUTLINE

Key market participants

One of the influential factors on the opaque implementation of the Kimberley Process Certificate Scheme (KPCS)¹⁵ might be the control of the value chain by the De Beers Group (Bergenstock 2004, pp.34-37). De Beers was founded in 1888 in South Africa and is the leading and controlling diamond company in exploration, mining and marketing (Bergenstock 2004, pp.34-37; Bieri 2010, p.3; Frost 2012, pp.127-142; De Beers Group About us 2013). The market is shared among De Beers with 40 percent, the Russian state-owned company ALROSA with 20 percent, Australian BHP Billiton, UK-based Rio Tinto and Canadian Aber Resources each with a stake of 10 percent. The rest is split among small companies (Bieri 2010, p.3).

Market share

In 2011, 124 million carats of rough diamonds were mined valued at 15 billion USD. That is 24 billion USD in polished diamonds and 71 billion USD in jewels (Bain & Company & Antwerp World Diamond Centre 2011, p.2). Most of the value of the diamond is added when it comes to the retail sector (Bieri 2010, p.3). Figure 5 illustrates the added value from production until the retail sales. In 2008 and 2009, the diamond market declined but picked up in 2010 and 2011 with the highest growth potential in China and India (Bain et al. 2012, pp.2-3).

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Figure 5: 2011: Diamond value from production until retail sales

Source: Own figure based on Bain et al. 2012, p.2.

Supply and demand for rough diamonds

The expected demand of rough diamonds between 2010 and 2020 is estimated at 6.6 percent, whereas the supply is forecasted with only three percent. That would lead to an increase in prices for the rough diamonds industry (Bain et al. 2012, p.72).

4.3 COMPANY PROFILE PRIOR TO THE REVERSE TAKEOVER

4.3.1 Stellar Diamonds Ltd

Since its foundation in 2006, Stellar Diamonds is based in London, UK. It focuses on the diamond exploration in West Africa. Stellar Diamonds is a subsidiary of African Aura Mining Inc (STEL Press Release 2009). The history of the parent company dates back to its foundation in 1996. Carpentier et al. (2010, p.24) underline the tradition of an RT, especially in the mining industry. African Aura Mining undertook an RT in 1998 and 2009. Figure 6 illustrates the history of African Aura Mining until the subsidiary Stellar Diamonds was founded and the takeover between Stellar Diamonds and West African Diamonds took place.

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Figure 6: The history of Stellar Diamonds Ltd

Source: Own figure based on African Aura Mining Management’s Discussion and Analysis 2009, pp.1-28.

4.3.2 West African Diamonds plc

The public company, West African Diamonds (WAD), is listed on the AIM since 2007. It is a wholly-owned subsidiary of African Diamonds plc and located in Dublin, Ireland (WAD Annual Report 2009, p.4). 159 employees are part of WAD (WAD Annual Report 2009, p.33). The company operates in the diamond mining industry in West Africa (WAD Annual Report 2009, p.4). WAD’s operational loss is steady at 0.2 million GBP in 2008 and 2009 (WAD Annual Report 2009, p.12). The RT with Stella Diamonds was announced in 2009 and executed in February 2010 (WAD Annual Report 2009, p.3). Figure 7 illustrates the origin of WAD as a subsidiary of African Diamonds.

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Figure 7: The history of West African Diamonds plc

Source: Own figure based on WAD Annual Report 2009, pp.3-4.

4.4 THE REVERSE TAKEOVER PROCESS OF STELLAR DIAMONDS As described in section 2.1 Definition of Reverse Takeover Stellar Diamonds Ltd, the private corporation, is officially acquired by WAD, the public listed corporation. In reverse, Stellar Diamonds is the accounting acquirer and WAD the accounting acquiree but the legal acquirer (STEL Annual Report 2010, p.31). The RT of these two companies dates back to the announcement in October 2009 (STEL Press Release 2009) followed by the execution in February 2010 (STEL Annual Report 2010, p.4). Prior to the takeover, Stellar Diamonds unsuccessfully tried to list on the stock exchange by an IPO but was rejected due to adverse market conditions (STEL Annual Report 2010, p.4). This might underline that rather low-type firms choose an RT over an IPO but it is further deepened in 4.7 Three-period decision making model whether to choose a Reverse Takeover or an IPO in practice and 4.8 Financial Performance of Stellar Diamonds during post-takeover, 2010 - 2012. WAD agreed to acquire the complete issued share capital of Stellar Diamonds. 53,248,164 consideration shares of Stellar Diamonds Ltd on the basis of 1,005 new ordinary shares in STEL were issued. The fair value of these consideration shares is 16.6 million USD valued at a market price of 0.20 USD per share converted to 0.31 USD per share (STEL Annual Report 2010, p.22). The exchange ratio of the shares was agreed on a 75:25 valuation. Stellar Diamond’s shareholders received 75 percent consideration shares and WAD’s shareholders received 25 percent ordinary shares in STEL (STEL Annual Report 2010, p.4). The RT was completed when Stellar Diamonds Ltd had issued shares in exchange for WAD’s net assets. The key steps of the transaction process are illustrated in figure 8.

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Figure 8: Transaction process of Stellar Diamonds

Source: Own figure based on STEL Annual Report 2010: 4/22.

The general meeting approved the transaction and appointed a new Board of Directors. James Campbell, former Executive Deputy Chairman, was appointed as a Non-Executive Director on the new board. The other board member were either hired or already employed by Stellar Diamonds (STEL Annual Report 2010, p.23). Shortly after the takeover, 7.4 million USD were raised (STEL Annual Report 2010, p.31). This supports Fassnacht’s (2011, p.18) findings about capital increase while takeover among UK RT transactions. After the takeover, the former private partner, Stellar Diamonds Ltd, was now successfully listed on the AIM as Stellar Diamonds plc.

4.5 BUSINESS DESCRIPTION OF STELLAR DIAMONDS

STEL is located in London, UK. Worldwide 191 employees work for STEL (STEL Annual Report 2012, p.45). STEL maintains diamond mining projects in West Africa, Guinea and Sierra Leone. The portfolio consists of production to bulk sampling of kimberlite¹⁶ and of alluvial¹⁷ mining projects (STEL Annual Report 2010, pp.2-3). Table 1 gives an insight into STEL’s diamond mining projects in West Africa.

Table 1: Diamond mining projects of Stellar Diamonds in West Africa

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In 2011, STEL decided to close the Bomboko mine due to its unprofitability (STEL Annual Report 2011, p.17). Currently, STEL focuses on production of the Mandala mine and bulk sampling of the Droujba and Tongo mine (STEL Annual Report 2012, pp.2-4). In the following, the project development of the Droujba mine is briefly explained. The Droujba mine in Southeast Guinea was developed by the Soviet Aid Mission in 1960. Until 2007, research showed a subcorp area of about 0.85ha below five to ten metres (WAD Annual Report 2009, p.8). Further research comprised an area of 3ha and a value of 2.5 million carats in diamonds to a depth of 360 metres (STEL Annual Report 2012, p.13). Bulk sampling of the Droujba pipe found diamond reserves of industrial quality (STEL Interim Report 2012, p.3). STEL’s business goal of the Droujba mine is to complete the conceptual research studies and make a decision about further project activities by fiscal year 2013 (STEL Interim Report 2012, p.1). STEL’s Board of Directors consists of a Non-Executive Chairman, a Chief Executive Officer (CEO), a Financial Director and four Non-Executive Directors (STEL Annual Report 2010, pp.20-21). STEL’s corporate social responsibility activities are strengthening the local communities close to the diamond mines (STEL Annual Report 2012, pp.11-12).

4.6 SWOT ANALYSIS OF STELLAR DIAMONDS

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Figure 9 summarizes the internal and external factors which are of helpful and harmful influence to STEL after the RT in 2010 until 2012.

Figure 9: SWOT analysis of Stellar Diamonds

Source: Own figure based on WAD Annual Report 2009:12;STEL Annual Report 2010:1/3/6/20-21/26/31/36; STEL Annual Report 2011:4/7/17/37; Frost 2012:68-74/127-132; IMF Survey 2012; STEL Annual Report 2012:4/6/9; STEL Interim Report 2012:2-3/10.

Strengths

STEL produced 111,000 carats after the takeover in fiscal year 2010. Two years later, the production increased to 3.1 million carats. The synergy effects of both companies are funnelled towards an increase in production coupled with a know- how transfer (STEL Annual Report 2010, p.1; STEL Annual Report 2012, p. 6). The appointed Board of Directors has a strong experience in the West African Mining industry, for instance, Karl Smithson (CEO) gained experience with De Beers, SothernEra Diamonds and African Aura/Stellar Diamonds (STEL Annual Report 2010, pp.20-21). The increase in capital is another strength, which comprises 7.4 million USD shortly after the takeover (STEL Annual Report 2010, p.31).

Weaknesses and threats

WAD’s operational loss prior to the takeover was 0.2 million GBP (WAD Annual Report 2009, p.12). Table 2 shows the operational loss after the takeover until present.

Table 2: Operational loss of Stellar Diamonds, 2010 - 2013

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Source: Own table based on STEL Annual Report 2010, p.26; STEL Annual Report 2011, p.37; STEL Annual Report 2012, p.6; STEL Interim Report 2012, p.10.

After a peak of the operational loss in 2011, it further decreased but needs clarification in the audited annual report 2013¹⁸. If the operational loss does not further decline, STEL’s weakness is the liquidity risk and the going concern. Parts of the causes are the closing of the Bomboko mine, the reduced production at the Mandala mine due to adverse weather conditions and the further explained threats. In 2012, Sierra Leone’s government did not extent the licence agreement of the Kono mine respectively from 2009 (STEL Annual Report 2012:4/9). STEL is under ongoing relation but the mine is under maintenance and care until the licence is officially renewed (STEL Interim Report 2012, p.4). Sierra Leone’s history in the use of illicit diamond trade, conflict diamonds which support civil war and the rather unstable political situation raise the issue of a possible threat for STEL (Frost 2012, pp.68-74). Since 2011, Guinea appointed a democratic government for the first time after 1958. However, political instability, poor economic governance and infrastructure in Guinea may be threatening for STEL (STEL Annual Report 2011, p.7; IMF Survey 2012). An uncertainty over developmental and operational risks which resulted in the closing of the Bomboko mine could affect STEL further (STEL Annual Report 2011, p.17). The dominance of De Beers and its control over the diamond trade in demand and supply might be another threat (Frost 2012, pp.127-132).

Opportunities

The takeover raises the opportunity to access capital easier. Table 3 shows the capital increase during post-takeover.

Table 3: Capital increase of Stellar Diamonds, 2010 - 2013

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Source: Own table based on STEL Annual Report 2010, p.31; STEL Annual Report 2011, p.29; STEL Annual Report 2012, p.33; STEL Interim Report 2012, p.34.

The capital increases finance the interests in growth strategies. After the takeover, STEL invested into the joint venture with Petra Diamonds plc to access a majority of the licence agreement of the Kono mine in Sierra Leone (STEL Annual Report 2010, p.3). Along with the capital increase comes the financing of further projects of bulk sampling and trial mining (STEL Annual Report 2010, p.6; STEL Annual Report 2011, p.4; STEL Annual Report 2012, p.6). Another opportunity might be the reduction of financial risks due to the aligned projects of WAD and Stellar Diamonds in Sierra Leone and Guinea (STEL Annual Report 2010, p.36). At the moment, STEL invests into economic studies of the potential profit of the Droujba (Guinea) and Tongo (Sierra Leone) mine to avoid operational and developmental risks (STEL Interim Report 2012, p.3).

The SWOT analysis shows that STEL with its operations in West Africa may face a few threats due to the political, economical and environmental instability of Sierra Leone and Guinea. Additionally, the strong influence of De Beers on the diamond trade may affect STEL negatively. On the opposite, STEL’s opportunities are its growth strategies and therefore, the stronger position in a politically unstable environment. This is complemented by the strengths of increased production, know-how and experience of the Board of Directors. STEL’s ongoing operational loss is, however, decreasing, but might weaken the company’s liquidity and its going concern. This is a very strong weakness, which affects the company as a whole and must be weighted as priority. Due to the capital increase, STEL gets the opportunity to invest further into bulk sampling and trial mining of the Kono and Tongo mine to establish profitable productions sites and to reduce the operational loss (STEL Interim Report 2012, p.2).

4.7 THREE-PERIOD DECISION MAKING MODEL WHETHER TO CHOOSE A REVERSE TAKEOVER OR AN IPO IN PRACTICE

Arellano-Ostoa & Brusco (2002, pp.12-17) developed a three-period decision making model, which analyzes the characteristics of firms choosing an IPO over an RT (see 2.5 Three-period decision making model whether to choose a Reverse Takeover or an IPO). They conclude that low-type firms choose an RT and high-type firms an IPO. This theoretical model is so far the only simple model comparing IPO’s and RT’s decision making process. This section applies the theoretical model to STEL.

Prior to the takeover Stellar diamonds decision to go public via IPO was rejected (STEL Annual Report 2010, p.3). Therefore, the company decided to go public through an RT in to. In February 2010 at t1, Stellar diamonds Ltd went public through an RT with WAD (STEL Annual Report 2010, p.3). The three-period (to, t1, t2) decision making model assumes that the project in t2 must be financed. If a company chooses an RT, it needs to raise capital which is, on the one hand, costly, and, on the other hand, takes time. During an IPO, capital is raised directly. STEL raised 7.4 million USD shortly after the takeover in t2 (STEL Annual Report 2010, p.31). Arelllano-Ostoa & Brusco (2002, p.17) assume that the capital increase might be much later than hand in hand with the RT, which is in contrast to STEL. The costs involved in going public through an RT and the raise of funds were CRT + CSEO=380,023 USD (STEL Annual Report 2010, p.60). STEL’s aim after the takeover was to further grow and expand(STEL Annual Report 2010, p.4). One of the projects after the takeover was the Bomboko mine in Guinea. In t2, Bomboko was at trial mining stage and needed further financing. It had produced 5,100 carats of diamonds at an average value of 116 USD per carat until September 2010 (STEL Annual Report 2010, p.2). Table 4 shows the production output since the purchase of the licence in 2009. In quarter three in 2010, the price of the diamonds had increased from 111.15 USD to 114.82 USD (STEL Annual Report 2010, p.11). Therefore, STEL assumed a high potential of the Bomboko mine.

Table 4: Valuation of the production: Bomboko mine

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Source: STEL Annual Report 2010, p.11

Early in 2011, STEL completed the trial mining of the project with disappointing results and high segment costs which are classified with I=4,711,580 USD (STEL Annual Report 2011:3/40). The project was closed and specified as qL (low-type). Arellano-Ostoa & Brusco (2002, pp.12-13) assume that the private company already knows in t0, if the investment of the project is low or high-type. Their separating equilibrium states that firms with a high probability of an investment of a project choose an IPO (high-type) and firms with a low probability to raise funds (low-type) an RT (Arellano-Ostoa & Brusco 2002, p.17). The application of the model into practice does not draw as many conclusions. STEL seems rather low- type because going public through an IPO was rejected and the RT seemed a doable alternative. STEL was still able to raise funds shortly after the takeover in February and later in October 2010, which is in contrast to the findings of Arellano-Ostoa & Brusco (2002, p.17). The Bomboko mine was declared unprofitable, which might conclude that STEL’s investment was of low-type.

Another difficulty to apply the theoretical model into practice is the control sample. To fully justify if STEL is of low-type and to differentiate the costs CIPO > CRT + CSEO, it needs a comparable company which used an IPO to go public in the same industry and a comparable project. In practice, there are also other factors, for instance, governmental influence which might not be obvious from STEL’s annual report that have affected the decision to close the Bomboko mine. The three-period decision making model, however, gives a direction to consider low and high-type investments into projects with different results for an IPO and an RT. In practice, the model has its limitations to fully consider STEL of low-type.

4.8 FINANCIAL PERFORMANCE OF STELLAR DIAMONDS DURING POST-TAKEOVER, 2010 - 2012

Assumptions about the financial performance from 2010 - 2012

STEL steadily used the opportunity to increase its capital to invest into its mining projects. However, the operational loss reached a peak in 2011 with 14.9 million USD due to the closing of the fully commercialized Bomboko mine, the reduced production of the Mandala mine caused by adverse weather conditions and the relocation of production equipment from the Bomboko to the Droujba mine (STEL Annual Report 2011, p.9). In 2012, the operational loss reduced but the closing of the Bomboko mine, the licence dispute of the Kono mine and the weak recovery of production at the Mandala mine after the rainy season needs more time for STEL to recover (STEL Annual Report 2012, pp.4-5). Table 5 shows the revenue per mining project, the segment results and the resulting loss after tax from 2010 until 2012.

Table 5: Financial figures of Stellar Diamonds’ mining projects, 2010 - 2012

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Source: Own table based STEL Annual Report 2012, p.43.

STEL has a small market capitalization with 8.9 million USD in 2012 which declines due to an increase in common shares outstanding and a low share price (Thomson One Stock Performance Stellar Diamonds plc 2013). Price to Sales and Enterprise Value to Sales Ratio show a similar progress with a peak in 2012 based on decreasing sales and increasing outstanding common shares. These ratios indicate that STEL’s shares are rather expensive for investors compared to its value (Thomson One Stock Performance Stellar Diamonds plc 2013). Table 6 summarizes the valuation measures and discusses the results briefly.

Table 6: Valuation Measures of Stellar Diamonds, 2010 - 2012

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STEL’s financial performance after the takeover and two years later is critical at going concern, underlined by the unqualified auditor’s report by Deloitte & Touche (STEL Annual Report 2012, p.30). The EBITDA is negative with a peak in 2011 caused by the high operational loss. ROA and ROE are well negative with

27 percent indicating the unprofitability of STEL (Thomson One Financial Reports Stellar Diamonds plc 2013). Table 7 discusses the profitability measures from 2010 until 2012.

Table 7: Profitability Measures of Stellar Diamonds, 2010 - 2012^{21 22}

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The liquidity of STEL is unstable with a negative operational cash flow ratio which is, however, becoming less negative over the years (Thomson One Financial Reports Stellar Diamonds plc 2013). The quick and the current ratio’s peak in 2011 are due to the capital increase of 12.2 million USD (Thomson One Financial Reports Stellar Diamonds plc 2013; STEL Annual Report 2011, p.27). STEL is able to cover its short-term obligations with a positive quick and current ratio but only because current liabilities and receivables are quite low (STEL Annual Report 2012, p.32). Table 8 discusses these liquidity measures.

Table 8: Liquidity Measures of Stellar Diamonds, 2010 - 2012^{23 24 25}

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Financial Performance in relation to Reverse Takeover transactions

The transaction value of the takeover is 16.94 million USD. This is well under Fassnacht’s (2011, pp.191-192) average transaction value of 73.93 million USD which is already small. The total costs of the takeover and the capital increase are 380,023 USD. This is 2.2 percent of the transaction value and therefore well under Fassnacht’s (2011, p.196) average costs of six percent.

Fassnacht (2011, p.228) concludes that one year after the takeover, the EBITDA is very low but positive and cash flow ratio as well as NPM are negative. In contrast, STEL’s EBITDA is negative at 8.3 million USD in 2011 (Thomson One Financial Reports Stellar Diamonds plc 2013). The cash flow ratio at -10.7 percent and the net margin at -983.79 percent indicate a strong concern about the company’s profitability (Thomson One Financial Reports Stellar Diamonds plc 2013). Fassnacht (2011, p.228) finds that the ROE is significantly positive two years after the takeover. STEL’s ROE, however, was negative at 27.07 percent in 2012 (Thomson One Financial Reports Stellar Diamonds plc 2013). Floros & Shastri (2009, p.25) underline that RT firms make acquisitions at least once within three years after the takeover. STEL acquired licence agreements of Petra Diamonds and an interest in Friendship Diamonds Guinee SA in 2010, which supports the findings of Floros & Shastri (STEL annual Report 2010, p.40). Gleason et al. (2005, pp.66-67) and Fassnacht (2011, pp.199-205) find positive abnormal returns on the announcement date and one day before. STEL’s stock price did not change from 0.6 USD at the announcement date and one day later (Thomson One Financial Reports Stellar Diamonds plc 2013). Faelten et al. (2013, p.10) found out that among the RT firms in the UK most of them are synergy RTs. The RT of Stellar Diamonds and WAD definitely uses these synergy effects of diamond exploration in West Africa.

Recommendations for action

STEL’s financial performance is critical at going concern. The company meets its short-term liquidity but needs to consider further changes to fully use its potential. Table 9 discusses possibilities to increase liquidity and profitability. Focus points are to enhance production at the Mandala mine, further resource drilling at Droujba, the licence approval of the Kono mine, to put the Tongo mine under care and maintenance and access additional capital either through financial institutions or shareholder loans. Detailed financial figures are summarized in appendix A1 - A4.

Table 9: Recommendations for Stellar Diamonds to increase liquidity and profitability

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5 CONCLUSION

5.1 BACKGROUND

Besides the Initial Public Offering, a reverse takeover is an alternative way for a private corporation to obtain exchange listing. As part of the merger and acquisition process, a public corporation legally acquires a private corporation but in reverse the private corporation takes over the majority of voting rights, the managerial control and decides about the name of the newly created public entity (Gleason et al. 2005, p. 56; Fassnacht 2011 pp.18-20). The paper classifies the theory with focus points on the SWOT analysis and the three-period decision making model by Arellano-Ostoa & Brusco (2002, pp.12-17). The literature review introduces descriptive and empirical findings, whereas the evidently lower costs of going public through the backdoor and the financial performance are of key importance. The case study of Stellar Diamonds applies the theory as well as the discussed literature. Stellar Diamonds is a result of a reverse takeover transaction of two companies operating in the diamond industry in West Africa (STEL Annual Report 2010, p.4). The case study introduces the diamond market briefly, classifies Stellar Diamonds within the SWOT analysis, applies the three- period decision making model with its limitations and examines the financial performance during post-takeover.

5.2 RESTATEMENT OF THE AIMS

The paper aims at analyzing the theory, the descriptive and empirical literature on the term reverse takeover to apply the findings to the case study of Stellar Diamonds. Therefore, the circumstances of the operating environment of the diamond industry in West Africa, the strategic motivation and the financial performance are of key importance.

5.3 FINDINGS

The main findings are summarized in table 10 but deeper explained in the following.

Table 10: Findings and discussion

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The main strength of a reverse takeover is the possibility for a private corporation to obtain exchange listing. This is supported by the findings of the literature that rather small, young and growing firms choose a reverse takeover (Arellano- Ostoa & Brusco 2002, p.2; Gleason et al. 2005:55/59; Floros & Shastri 2009, p.25; Fassnacht 2011, p.191). On the weaker side, reverse takeover firms may not fulfil the listing requirements and operate with higher information asymmetry (Arellano-Ostoa & Brusco 2002, p.17; Adjei et al. 2008, p.185). This is supported by the attempt of Stellar Diamonds to get listed through an IPO, which was rejected prior to the takeover (STEL Annual Report 2010, p.4). The evidently lower costs of reverse takeover transactions are controversially discussed in the literature (Gleason et al. 2005, p.59; Adjei et al. 2008, pp.178-179; Sjostrom 2008, pp.748-749; Fassnacht 2011, p.235). Stellar Diamonds increased its capital while takeover with total costs of 380,023 USD. This is 2.2 percent of the transaction value and therefore well under Fassnacht’s (2011, p.196) average costs of six percent (STEL Annual Report 2010, p.60). A reverse takeover raises the opportunity to access capital easier and further expand (Floros & Shastri 2009:10/25; Gleason et al. 2005, p.71). In practice Stellar Diamonds used capital increase at least annually to invest into projects and finance the ongoing operations (STEL Annual Report 2010, p.31; STEL Annual Report 2011, p.29; STEL Annual Report 2012, p.33; STEL Interim Report 2012, p.34.). In the long- term, stock performance of IPOs outperform reverse takeovers (Carpentier et al. 2010, pp.28-29). This can be supported by Stellar Diamonds with a decreasing stock performance especially in fiscal year 2013 (Thomson One Stock Performance Stellar Diamonds plc 2013). Empirical results show that reverse takeover financial performance increases slightly two years after the takeover, whereas liquidity is still unstable (Fassnacht 2005, p.228). These findings can be partially supported as Stellar Diamonds liquidity is unstable but the profitability is well negative (STEL Annual Report 2012, p.43). The application of the three- period decision making model classifies Stellar Diamonds as a low-type company. A missing IPO control company in a comparable industry with a comparable project makes the assumption of Stellar Diamonds being low-type difficult. Together with the financial figures, the company’s ongoing operational loss, the treats of the operating countries, Sierra Leone and Guinea, its negotiation about licence agreements, reduced production due to adverse weather conditions are weakening the company’s performance (STEL Annual Report 2011, p.9; STEL Annual Report 2012:4/9). Even though Stellar Diamonds is unprofitable, the company has its potential with diamond projects in West Africa. The circumstances of politically and economically underdeveloped countries are limitations for Stellar Diamonds. If the company focuses on the recommend measures, it might increase revenue, decrease operational loss and establish a stable liquidity and profitability (see 4.8 Financial Performance of Stellar Diamonds during post-takeover, 2010 - 2012).

5.4 SIGNIFICANCE OF THE FINDINGS

The paper adds to the literature by discussing the recent empirical and descriptive findings and applying the theory about reverse takeover transactions to the case study. The analysis of Stellar Diamonds adds to a better understanding of reverse takeover transactions in the mining industry which is a preferred field for going public through the backdoor (Carpentier et al. 2010, p.24). The in-depth SWOT analysis of reverse takeover in theory and the application to the case study make the backdoor listing more transparent and draw conclusions.

5.5 LIMITATION OF THE PAPER

The paper examines the reverse takeover of Stellar Diamonds operating in a much specified industry, the diamond mining industry. Therefore, the findings cannot be directly compared to other reverse takeovers. The classification of Stellar Diamonds being of low-type is dependent on more factors than only the investment project and costs (Arellano-Ostoa & Brusco 2002, pp.12-17). The working environment in Sierra Leone and Guinea has to be taken into account. Therefore, an exact classification within the three-period decision making model is rather difficult. Further, a control IPO operating in the same industry with a comparable project would have drawn more conclusions. Due to differing empirical findings of reverse takeover financial performance and evidently lower costs of these takeovers, the application to the case study could not be applied following a clear guidance (Gleason et al. 2005:59/64/69; Adjei et al. 2008, pp.178-179; Sjostrom 2008, pp.748-749; Floros & Shastri 2009, p.25;Fassnacht 2011:235/191-192/228). Most of the reverse takeovers do not survive three years after the transaction (Faelten et al. 2013, p.16). Stellar Diamonds audited financial statements for fiscal year 2013 will be available in October 2013²⁶ and must be examined in terms of Stellar Diamonds going concern and its survival rate.

5.6 RECOMMENDATIONS FOR FURTHER WORK

The three-period decision making model by Arellano-Ostoa & Brusco (2002, pp.12-17) could be further examined to analyze the influential success factors of either choosing an IPO or an RT. A linkage to behavioural finance and the decision making process would add to the three-period decision making model. Further research among European reverse takeover transaction, long-term stock performance, costs of the takeover and an overall definition would deepen the understanding and the transparency of opaque reverse takeover transactions. Research and observation of Chinese Reverse Mergers among capital markets world-wide and their strategic implications would further add to the recent literature.

APPENDIX A

A1) Financial Figures of Stellar Diamonds, 2010 - 2012^{27 28 29 30 31 32 33 34 35 36 37}

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A2) Market Capitalization, Enterprise Value, Ratio and Price to Sales Ratio of Stellar Diamonds, 2010 - 2012

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A3) Sales, EBITDA and Debt of Stellar Diamonds, 2010 - 2012

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A4) Quick, Current and Operational Cash Flow Ratio of Stellar Diamonds, 2010 - 2012

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¹ Chinese Reverse Mergers (CRM) are private Chinese firms involved in Reverse takeover 1

² International Financial Reporting Standards (IFRS) number three focuses on business combinations.

³ In the following, the abbreviation of RT is used for reverse takeover.

⁴ OTCBB is a regulated quotation service for over the counter (OTC) equity securities in the U.S. (OTCBB, 2013).

⁵ Isa 2002, p.100; Arellano-Ostoa & Brusco 2002:2/17; Bournet 2004:22/Gleason et al. 2005:55/56/59/71; Aydogdu, Shekhar, Torbey 2007, pp.1337-1338; Adjei et al. 2008:178-179/185; Sjostrom 2008:748-749/; Floros & Shastri 2009: 10/21/25/32; Carpentier, Cumming and Suret 2010, pp.31-32; Makamson 2010, p.124; Fassnacht 2011:189/191/234/235; Semenenko 2011:1458/1466; Chu, Gotti, Schumann 2012, pp.22-23; Darrough, Huang and Zhao 2012:12- 13/27-28; Ojha, Maheshwari and Jain 2013, pp. 24-25.

⁶ After a listing on the stock exchange, a company issues again shares which is called a Seasoned Equity Offering (SEO) (Gregoriou 2009, p.238).

⁷ Private Investment in Public Equity (PIPE) is a form of financing, privately negotiated between a limited number of inventors and a public corporation (Dresner, Kim 2006, p.2).

⁸ That includes delisting, acquisition, another RT, insolvency and sale of the private corporation’s core business (Gleason et al. 2005, p.72).

⁹ That includes delisting, acquisition, another RT, insolvency and sale of the private corporation’s core business (Fassnacht 2011, pp.197-198).

¹⁰ A Special Acquisition Purpose Company (SPAC) is created to be listed on the stock exchange and serve as a shell for a private company to become publicity traded through an RT (Faelten et al. 2013, p.9).

¹¹ A Mature Shell company is listed on the exchange for more than year but non-operating (Faelten et al. 2013, p.9).

¹² A Synergy RT is a public company which fully operates for more than one year. The public company is in the same industry as the private company (Faelten et al... 2013, p.9).

¹³ To study the survival rate, Faelten et al. (2013, p.16) selected the years 1995 until 2009.

¹⁴ Stellar Diamonds plc is abbreviated STEL in the following.

¹⁵ The Kimberley Process (KP) started in 2000 when sub-Saharan diamond producing states decided to avoid supporting conflict diamonds and strengthen a meaningful supply chain control (Hütz-Adams, Jung, Küppers, and Hausmann 2008, p.15). In 2003, the Kimberley Process Certificate Scheme (KPCS) for rough diamonds was set up. It consists of a certification which verifies the origin of the gemstone (Hütz-Adams et al. 2008, pp.14-15; Frost 2012, p.174).

¹⁶ Diamonds are formed from compressed carbon deep in the earth at extreme temperatures. They exist in pipes called kimberlites (Frost 2012, p.3).

¹⁷ By time, the kimberlite pipes were weathered and eroded; diamonds were washed away and scattered over large surfaces. These alluvial diamonds can be found in river gravels or on the surface (Frost 2012, p.3).

¹⁸ The fiscal year of STEL ends on 30 June.

¹⁹ Market Capitalization = Market Price-Year End * Common Shares Outstanding

²⁰ Enterprise Value = Market Capitalization at fiscal yearend date + Preferred Stock + Minority Interest + Total Debt minus Cash

²¹ ROA = Net Income / Total Assets

²² ROE = Net Income / Shareholder’s Equity

²³ Operational Cash Flow Ratio = Net Cash Flow to Current Liabilities Ratio

²⁴ Quick Ratio = (Cash & Equivalents + Receivables (Net)) / Current Liabilities

²⁵ Current Ratio = Current Assets / Current Liabilities

²⁶ The fiscal year ends on 30 June.

²⁷ Market Capitalization = Market Price-Year End * Common Shares Outstanding

²⁸ Enterprise Value = Market Capitalization at fiscal yearend date + Preferred Stock + Minority Interest + Total Debt minus Cash

²⁹ Debt to Total Assets Ratio = Short term + long term debt / total assets

³⁰ Quick Ratio = (Cash & Equivalents + Receivables (Net)) / Current Liabilities

³¹ Current Ratio = Current Assets / Current Liabilities

³² Operational Cash Flow Ratio = Net Cash Flow to Current Liabilities Ratio

³³ Gross Margin = Gross Income / Net Sales or Revenues * 100

³⁴ Net Margin = Net Income before Preferred Dividends / Net Sales or Revenues * 100

³⁵ ROA = Net Income / Total Assets

³⁶ ROE = Net Income / Shareholder’s Equity

³⁷ Sales Ratio = Net Sales / Revenues - 1 year Annual Growth