REVERSE MERGER: DEFINITION, Advantages, and Disadvantages

Reverse merger

A reverse merger is the process of an already-public corporation by a smaller, private company. Because it is less frequent for a private firm to take over a public company, this is characterized as a “reverse” merger.
Here’s a primer on reverse mergers and what they entail for investors. We’ll also go into details about a triangular reverse merger and the IPO process.

What is a Reverse Merger?

A reverse merger approach includes a smaller company acquiring an already publicly traded company—typically a relatively modest public corporation with limited activities.

While the public firm “survives” the merger, the proprietors of the private company become the controlling shareholders. They reform the merged organizations in accordance with their vision, which usually entails replacing the board of directors and changing assets and business activities.

Why Would a Business Pursue a Reverse Merger?

The conventional way for a private company to go public is through an initial public offering (IPO), which is generally a complicated and time-consuming operation. Hiring an investment bank to underwrite the financing and issue shares is typical of the IPO method, as is a significant due diligence process, a large amount of documentation, and regulatory approvals. Unfavorable market conditions may also have an impact on the timing of the IPO. The reverse merger, on the other hand, allows a firm to go public faster while avoiding many of the time-consuming and difficult stages of a regular IPO.

It is customary for the process to include the acquisition of a small-scale public firm with a low level of operations. Although the public firm stays intact following the acquisition, the owners of the (formerly) private company become the controlling shareholders. The reorganization of the company’s assets and operations usually follows, as well as the election of a new board of directors.

Reporting Requirements and Reverse Triangular Merger

The most typical type of reverse merger is a reverse triangular merger. The public shell business establishes a subsidiary firm, which then combines with the private company using this structure. Shareholders exchange their private company shares for public company shares, and the private company becomes a wholly-owned subsidiary.

Because the new subsidiary business has only one shareholder: the public share company, obtaining authorization from company shareholders is usually easier with a reverse triangular merger. By structuring a reverse merger in this manner, the public company is able to evade the Securities Exchange Act’s merger proxy requirements.

The SEC maintains certain reporting obligations for reverse mergers. The public firm must submit Form 10 within four days of the completion of the reverse merger transaction. The private corporation will not become a public company until this is accomplished.

Securities issued to private company shareholders must be registered under the Securities Act or qualify for an exemption.

The Reverse Merger Process

Many public corporations with shares traded on public stock exchanges—typically over-the-counter (OTC) markets—have little to no ongoing operations or assets. These are known as “shell corporations,” and they are frequently the subject of reverse mergers.

The first step in a reverse merger is for the public firm’s shareholders to purchase at least 51 percent of the shares of a shell company. Once they have a majority position, they exchange the private business’s shares for existing or new shares of the public shell company. After then, the private company becomes a completely owned subsidiary of the shell company.

In contrast to a traditional IPO, no additional money is raised during a reverse merger. Because there is no need to generate publicity for the transaction and attract the attention of institutional or retail investors, they can be executed more swiftly.

How To Spot a Reverse Merger

Stay watchful in order to successfully discover reverse mergers. It is feasible to uncover possibilities in future reverse mergers by paying attention to the financial media.

It is also prudent to invest in businesses that are attempting to raise at least $500,000 and are predicted to generate at least $20 million in sales within their first year as a public company.

Some potential signals to check for if you’re looking for reverse-merger candidates:

  • Check for proper capitalization. In general, reverse mergers are successful for companies that do not require financing immediately. A successful publicly-traded company will typically have at least $20 million in sales and $2 million in cash.
  • Companies that are looking to raise $500,000 or more in working capital are the greatest candidates for a reverse merger. Armand Hammer successfully merged into Occidental Petroleum, Ted Turner completed a reverse merger with Rice Broadcasting to form Turner Broadcasting, and Muriel Seibert took her brokerage firm public by merging with J. Michaels, a furniture company in Brooklyn, are all examples of successful reverse mergers.

Fraud and Reverse Mergers

The possibility of fraudulent or unethical reverse mergers is very serious, given the lower levels of regulatory monitoring and fewer investors involved in a deal.

“In reverse mergers, compliance and fraud risks of a shell business are major challenges, and a ton of scrutiny is required,” says Kyle Asman, managing partner of Backswing Ventures, an Orlando-based startup fund. “Moreover, most reverse mergers fail since most companies turn to them when they can’t obtain money in private markets and don’t generate enough demand for an IPO.”

The Securities and Exchange Commission (SEC) has raised concerns about the fraud risks offered by some reverse mergers, warning that public businesses formed as a result of a reverse merger may collapse or struggle to remain viable.

The Benefits of Reverse Mergers

Reverse mergers provide advantages that make them appealing solutions for private companies, such as a simplified and less risky route to going public.

#1. A Simplified Process

Reverse mergers enable a private firm to go public without obtaining cash, greatly simplifying the process. While traditional IPOs can take months (or even a year) to execute, reverse mergers can be completed in a matter of weeks (in some cases, in as little as 30 days). This saves management time and energy, ensuring that enough time is committed to running the business.

#2. Lower Risk

Going through the traditional IPO reverse merger process does not guarantee that the company will eventually go public. A traditional IPO can require managers to devote hundreds of hours to planning. However, if stock market conditions become unfavorable to the anticipated offering, the transaction may be terminated, and all of those hours will have been in vain. Using a reverse merger reduces this danger.

#3. Less reliant on market conditions

As previously stated, the classic IPO combines the functions of going public and raising cash. Because the reverse merger is only a tool for converting a private corporation into a public entity, the process is less reliant on market conditions (because the company is not proposing to raise capital). Because a reverse merger only serves as a conversion mechanism, market conditions have no impact on the offering. Rather, the process is carried out in order to reap the benefits of becoming a public body.

#4. Advantages of a Public Company

Private companies with $100 million to several hundred million in revenue are typically drawn to the potential of going public. When this occurs, the company’s securities are traded on an exchange and have increased liquidity. The original investors acquire the ability to liquidate their holdings, which provides a more expedient exit option than having the corporation buy back its shares. Because management now has the option of issuing additional stock through secondary offerings, the company now has broader access to capital markets. If stockholders have warrants (the right to buy more stock at a certain price), the exercise of these options offers additional financial infusion into the company.

Frequently, public corporations trade at larger multiples than private companies. Significantly enhanced liquidity means that both the general public and institutional investors (as well as major operating companies) can access the company’s shares, which can influence its price. Management also has more strategic expansion alternatives, such as mergers and acquisitions.

They can utilize company stock as currency to buy target companies as stewards of the purchasing company. Finally, because publicly traded stocks are more liquid, management can use stock incentive plans to recruit and retain staff.

The Drawbacks of a Reverse Merger

A reverse merger may be simpler, but it nevertheless demands regulatory compliance and due diligence to be effective.

#1. Due Diligence Is Necessary

Managers must rigorously vet the public shell company’s investors. What are their reasons for joining forces? Have they done their due diligence to ensure that the shell is clean and uncontaminated? Are there any pending obligations (such as those resulting from litigation) or other “deal warts” that are hounding the public shell? If this is the case, the public shell’s shareholders may simply be looking for a new owner to take over these concerns. As a result, there should be proper due diligence, and transparent disclosure (from both parties).

Investors in the public shell should also do their homework on the private firm, including its management, investors, operations, financials, and any pending obligations (i.e., litigation, environmental problems, safety hazards, and labor issues).

#2. A risky stock will be disposed of.

If the public shell’s investors sell a large amount of their shares immediately after the merger, the stock price will suffer. To lessen or eliminate the danger of shares dumped, stipulations requiring mandatory holding periods might be added to a merger agreement.

#3. There will be no demand for shares following the merger.

Will a private company’s stockholders receive adequate liquidity following a reverse merger? Smaller businesses may not be ready to go public. A lack of operational and financial scale may exist. As a result, smaller companies may not receive Wall Street analyst coverage. After the reverse merger is completed, the original investors’ shares may have minimal demand. Sound principles are not replaced by reverse mergers. In order for a company’s shares to be appealing to prospective investors, the company itself must be appealing both operationally and financially.

#5. The burden of Regulatory and Compliance

When a private firm goes public, management is frequently untrained in the additional regulatory and compliance responsibilities of becoming a publicly-traded company. These responsibilities (and associated time and financial expenses) can be enormous, and the initial effort to comply with additional rules might result in a stagnant and failing company if managers dedicate far more time to administrative problems than to running the business.

To mitigate this risk, private firm managers might collaborate with public shell investors who have expertise serving as officers and directors of a public company. Additionally, the CEO can hire personnel (as well as outside consultants) with relevant compliance experience. Managers must ensure that the company has the administrative infrastructure, resources, road map, and cultural discipline necessary to meet these new criteria following a reverse merger.

Insurance Requirements for a Reverse Merger

Following a reverse merger, the new firm and its owners should be ready for continued regulatory compliance, which often involves analysis and potential upgrade of their insurance coverage. Depending on the nature of the firm, this may include property insurance, tax liability insurance, cyber liability insurance, and other coverage.

Reverse Merger FAQs

What is the difference between a merger and a reverse merger?

The target merges into the acquirer’s company in a forward merger, and the selling shareholders receive the acquirer’s equity. The acquirer merges into the target firm and receives the target company’s stock in a reverse merger.

How long does a reverse merger take?

The IPO registration and listing process can take months or even years. A reverse takeover shortens the process of going public from several months to a few weeks.

Do stocks go up after a merger?

When one firm buys another, the acquiring company’s stock price drops briefly, while the target company’s stock price rises. Because the purchasing business frequently pays a premium for the target company or incurs debt to finance the acquisition, the share price of the acquiring company falls.

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