Reverse Mergers: Advantages and Disadvantages

A reverse merger is a way for private companies to go public and while they can be an excellent opportunity for investors, there are cons in addition to the pros.

Reverse mergers are typically through a simpler, shorter, and less expensive process than that of a conventional initial public offering (IPO), in which private companies hire an investment bank to underwrite and issue shares of the new soon-to-be public entity. They are also commonly referred to as reverse takeovers or reverse IPOs.

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

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 shell companies as vehicles to complete these deals. These simple shell companies can be registered with the Securities and Exchange Commission (SEC) on the front end (prior to the deal), making the registration process relatively straightforward and less expensive. To consummate the deal, the private company trades shares with the public shell in exchange for the shell's stock, transforming the acquirer into a public company.

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 (even over a calendar 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 a lot of time and energy, ensuring that there is sufficient time devoted to running the company.

Minimizes Risk

Undergoing the conventional IPO process does not guarantee that the company will ultimately go public. Managers can spend hundreds of hours planning for a traditional IPO. But if stock market conditions become unfavorable to the proposed offering, the deal may be canceled, and all of those hours will have become a wasted effort. Pursuing a reverse merger minimizes this risk.

Less Dependent on Market Conditions

As mentioned earlier, the traditional IPO combines both the go-public and capital-raising functions. As 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 order to 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 thus enjoy greater liquidity. The original investors gain the ability to liquidate their holdings, providing a convenient exit alternative to having the company buy back their shares. The company has greater access to capital markets, as management now has the option of issuing additional stock through secondary offerings. If stockholders possess warrants—giving them the right to purchase additional stock at a pre-determined price—the exercise of these options provides 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. Management also has more strategic options to pursue growth, including mergers and acquisitions.

As stewards of the acquiring company, they 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 in order to attract and retain employees.

[Important: As in all merger deals, the risk goes both ways. Both managers of of the company and investors need to conduct due diligence.]

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 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).

Risk 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 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, they may not attract analyst coverage from Wall Street. After the reverse merger is consummated, the original investors may find out that there is no 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.

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 and money) can prove significant, and the initial effort to comply with additional regulations can result in a stagnant and underperforming company if managers devote much 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.

• A reverse merger is an attractive strategic option for managers of private companies to gain public company status.
• It is a less time-consuming and less costly alternative to the conventional IPO.
• As a public company, management can enjoy greater flexibility in terms of financing alternatives, and the company's investors can also enjoy greater liquidity.
• Managers should be cognizant of the additional compliance burdens faced by public companies, and ensure that sufficient time and energy continues to be devoted to running and growing the business.
• It requires being a strong company with robust prospects to attract sufficient analyst coverage, as well as prospective investor interest. Pulling in these elements can increase the value of the stock and its liquidity for shareholders.