What Are the Implications of a Reverse Merger?

A reverse merger is when a private company becomes a public company by purchasing control of the public company. Reverse mergers allow a private company to become publ꧒ic without raising capital, which considerably simplifies the process. While a reverse merger can be an excellent opportunity for investors, they also have certain disadvantages.

Reverse mergers are also referred to as reverse takeovers or reverse 澳洲幸运5官方开奖结果体彩网:initial public offerings (IPOs).

Understanding Reverse Mergers

Reverse mergers typically occur through a simpler, shorter, and less expensive process than a conventional IPO. With an IPO, private companies hire an 澳洲幸运5官方开奖结果体彩网:investment bank to 澳洲幸运5官方开奖结果体彩网:underwrite and issue shares of the new, soon-to-be public entity.

Aside from filing the regulatory paperwork and helping authorities review the deal, the investment bank also helps to establish interest in the stock and provides advice on appropriate initial pricing. A traditional IPO process combines the process of going public with the capital-raising function. A reverse merger separates these two functions, making it an attractive strategic o🦩ption for corporate managers and investors.

In a reverse merger, investors of the private company acquire a majority of the shares of a public 澳洲幸运5官方开奖结果体彩网:shell company, which is then combined with the purchasing entity. Investment banks and financial institutions typically use dormant public companies—shell c🍰ompanies—as vehicles to complete these deals. (These companies are called "shell companies" because they rarely have assets or net worth and do not♕ have active and ongoing operations.)

The shell company can be registered with the 澳洲幸运5官方开奖结果体彩网:Securities and Exchange Commission (SEC) on the front end (before the deal), making the 澳洲幸运5官方开奖结果体彩网:registration process relatively straightforward and less expensive. To consummate the deal, the private company trades shares with the public shell company in exchange for the shell's stock, transforming the acquirer into a public company.

Advantages of Reverse Mergers

Reverse mergers have advantages that make them attractive options for private companies, such as a 澳洲幸运5官方开奖结果体彩网:simplifi🌱ed way to go public and 🅠with less risk.

A Simplified Process

Reverse mergers allow a private company to become public without raising capital, which considerably simplifies the process. While conventional IPOs can take months (or over a year) to materialize, reverse mergers can take only a few weeks to complete (in some cases, in as little as 30 days). This saves management time and energy, ensuring that there is sufficient time devoted to running the ꦦcompany.

Less Risk

Undergoing the conventional IPO process does not guarantee that a company will ultimately go public. Managers can spend hundreds of hours planning for a traditional IPO. But, if the 澳洲幸运5官方开奖结果体彩网:stock market conditions become unfaཧvorable to the proposed offering, the deal may be canceled—and all of those hours will amount to a wasted effort. Pursuing a reverse merger minimizes this risk.

Less Dependence on Market Conditions

♒ As mentioned earlier, the traditional IPO combines both the process of going public and the capital-raising functions. Because the reverse merger is solely a mechanism to convert a private company into a public entity, the process i♔s less dependent on market conditions (because the company is not proposing to raise capital). Since a reverse merger functions solely as a conversion mechanism, market conditions have little bearing on the offering. Rather, the process is undertaken in an attempt to realize the benefits of being a public entity.

Benefits of a Public Company

Private companies—generally those with $100 million to several hundred million in revenue—are usually attracted to the prospect of going public. Once this happens, the company's securities are traded on an exchange, and their shares enjoy greater 澳洲幸运5官方开奖结果体彩网:liquidity. The original investors gain the ability to 澳洲幸运5官方开奖结果体彩网:liquidate their holdings, providing a convenient exit alternative (versus having the company buy back their shares). The company has greater access to capital markets because management now has the option of issuing additional stock through 澳洲幸运5官方开奖结果体彩网:secondary offerings. If stockholders possess warrants—the right to purchase additional stock at a pre-determined price—the exercise of these options provides an additional capital♚ infusion into the company.

Public companies often trade at higher 澳洲幸运5官方开奖结果体彩网:multiples than private companies. Significantly increased liquidity means that both the general public and 澳洲幸运5官方开奖结果体彩网:institutional investors (and large operational companies) have access to the company's stock, which can drive its price up. Management also has more strategic options to pursue growth, including 澳洲幸运5官方开奖结果体彩网:mergers and acquisitions.

As stewards of the acquiring company, the management can use company stock as the currency with which to acquire 澳洲幸运5官方开奖结果体彩网:target companies. Finally, because public shares are more liquid, management can use 澳洲幸运5官方开奖结果体彩网:stock incentive plans to attract and retain employees.

Disadvantages of a Reverse Merger

A reverse merger can be simpler, but it also requires adherence to regulations and due diligence to be successful.

Due Diligence Required

Managers must thoroughly vet the investors of the public shell company. What are their motivations for the merger? Have they done their homework to 澳洲幸运5官方开奖结果体彩网:make sure the shell is clean and not tainted? Are there pending 澳洲幸运5官方开奖结果体彩网:liabilities (such as those stemming from litigation) or other "deal warts" hounding the public shell? If so, 澳洲幸运5官方开奖结果体彩网:shareholders of the public shell may merely be looking for a new owner to take possession of these problems. Thus, appropriate 澳洲幸运5官方开奖结果体彩网:due diligence should be conducted, and transparent disclosur𒉰e should be expecte⛦d (from both parties).

Investors of the public shell should also conduct reasonable diligence on the private company, including its management, investors, operations, 澳洲幸运5官方开奖结果体彩网:financials, and possible pending liabilities (i.e., litigation𝓡, environmental problems, safety hazards, and labor issues).

Risky Stock Will Be Dumped

If the public shell's investors sell significant portions of their shares right after the merger, this can materially and negatively affect the stock price. To reduce or eliminate the risk that the stock will be dumped, clauses can be incorporated into a merger agreement, designating required 澳洲幸运5官方开奖结果体彩网:holding periods.

No Demand for Shares Post Merger

After a private company executes a reverse merger, will its investors really obtain sufficient liquidity? Smaller companies may not be ready to be a public company. There may be a lack of operational and financial scale. Thus, smaller companies may not attract analyst coverage from 澳洲幸运5官方开奖结果体彩网:Wall Street. After the reverse merger is consummated, the original investors may find little demand for their shares. Reverse mergers do not replace sound 澳洲幸运5官方开奖结果体彩网:fundamentals. For a company's shares to be attractive to prospective investors, the company itself should be attractive operationally and financially.

Regulatory and Compliance Burden

A potentially significant setback when a private company goes public is that managers are often inexperienced in the additional regulatory and compliance requirements of being a publicly-traded company. These burdens (and costs, in terms of time and꧑ money) can prove significant, and the initial effort to comply with additional regulations can result in a stagnant and underperforming company—especially if managers devote more time to administrative concerns than to running the business.

To alleviate this risk, managers of the private company can partner with investors of the public shell who have experience in being officers and directors of a public company. The CEO can additionally hire employees (and outside consultants) with relevant compliance experience. Managers should ensure that the company has the administrative infrastructure, resources, road map, and cultural discipline to meet these new requirements after a reverse merger.

The Bottom Line

A revers🥂e merger occurs when a private company becomes a public company by purchasing control of the public company. The shareholders of the private company usually receive large amounts of ownership in the public company and control of its board of directors. A reverse merger is a less time-consuming and less costly alternative to the conventional initial public offerings (IPOs).