Pros and Cons of Reverse Mergers: A Guide for Investors

What Are the Implications of a Reverse Merger?

A reverse merger occurs when a private company becomes public by acquiring control of an already public company, offering an alternative to the traditional initial public offering (IPO). This approach is often faster and less costly than an IPO, allowing the private company to access public markets more efficiently.

However, while reverse mergers can simplify the process and reduce some risks, they also come with challenges such as meeting regulatory requirements, ensuring proper due diligence, and managing potential risks like post-merger stock dumping. Understanding both the advantages and drawbacks is necessary in making informed investment and business decisions.

How Reverse Mergers Work

Reverse mergers typically occur through a simpler, shorter, and less expensive process than a conventional IPO. With an IPO, private companies hire an investment bank to 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 option for corporate managers and investors.

In a reverse merger, investors of the private company acquire a majority of the shares of a public shell company, which is then combined with the purchasing entity. Investment banks and financial institutions typically use dormant public companies—shell companies—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 Securities and Exchange Commission (SEC) on the front end (before the deal), making the 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.

Benefits of Opting for a Reverse Merger

Reverse mergers have advantages that make them attractive options for private companies, such as a simplified 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 company.

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 stock market conditions become unfavorable 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 is 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 liquidity. The original investors gain the ability to 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 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 multiples than private companies. Significantly increased liquidity means that both the general public and 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 mergers and acquisitions.

As stewards of the acquiring company, the management can use company stock as the currency with which to acquire target companies. Finally, because public shares are more liquid, management can use stock incentive plans to attract and retain employees.

Potential Drawbacks of Reverse Mergers

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

Essential Due Diligence for Reverse Mergers

Managers must thoroughly vet the investors of the public shell company. What are their motivations for the merger? Have they done their homework to make sure the shell is clean and not tainted? Are there pending liabilities (such as those stemming from litigation) or other "deal warts" hounding the public shell? If so, shareholders of the public shell may merely be looking for a new owner to take possession of these problems. Thus, appropriate due diligence should be conducted, and transparent disclosure should be expected (from both parties).

Investors of the public shell should also conduct reasonable diligence on the private company, including its management, investors, operations, financials, and possible pending liabilities (i.e., litigation, environmental problems, safety hazards, and labor issues).

Risks of Rapid Share Disposal Post-Merger

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 holding periods.

Challenges of Low Share Demand After a Reverse 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 Wall Street. After the reverse merger is consummated, the original investors may find little demand for their shares. Reverse mergers do not replace sound fundamentals. For a company's shares to be attractive to prospective investors, the company itself should be attractive operationally and financially.

Navigating Compliance Challenges in Reverse Mergers

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 and 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 reverse merger offers a faster and less market-dependent way for a private company to become public compared to a traditional IPO. This streamlined process can save time and costs, making it appealing to growing businesses.

However, companies must still conduct thorough due diligence and be prepared for the regulatory and operational responsibilities that come with being publicly traded. Without proper oversight and readiness, the advantages of a reverse merger can quickly turn into challenges.