The reverse merger process offers a quick, cost-effective route for a private company to go public. Instead of launching an initial public offering (IPO), which can be costly and time-consuming,  the private company simply merges with a listed company or publicly traded “shell company,” injects its resources into it, and then uses it to go public.

If your firm or its investors are considering a reverse merger transaction, here’s what you need to know before you initiate the deal.


How PEs Acquire a Company in a Reverse Merger

A private company looking to access the stock market through a reverse merger begins the process by hunting for a suitable public shell company to merge with.  

The US Securities and Exchange Commission defines a shell company, as a public reporting company with:

  • no or nominal operations, and;


  • no or no nominal assets
  • assets that comprise solely of cash or cash equivalents or;
  • assets that consist of any amount of cash or cash equivalents and nominal other assets.


During a reverse merger, the shareholders of the private company exchange their shares for a larger majority of the public company’s or listed company’s shares. 

This exchange grants the private company’s shareholders a controlling interest in the voting power as well as the outstanding stock of the shell company. They also take over the board of directors as well as the management of the public company.

The deal also includes a name change of the public shell company. The merged entity or reverse merger company then starts trading on the stock market under its new identity.

NB: A reverse merger process is different from a reverse triangular merger. In a reverse triangular merger, an acquiring company first forms a subsidiary, which then absorbs a target firm. 


The Benefits of Reverse Mergers


1. Provides a Faster Way of Going Public

An initial public offering (IPOs) is typically the primary way through which most private companies go public. 

Unfortunately, the IPO process can be long and complex. From selecting and hiring underwriters and advisors, to preparing relevant registration and financial documents, to waiting for regulatory reviews…the process can take many months, sometimes even years.

A reverse merger, on the other hand, can be completed in a matter of weeks, making it a much speedier way of taking a company public.


2. More Cost-Effective

Because it takes a shorter time to complete and there are no underwriters involved, the legal and accounting fees of reverse mergers are significantly lower than those of an IPO.


3. No Risk of Underwriter’s Withdrawal

In IPOs, one major risk is that the underwriter can decide to significantly change the offering share price at the last minute or, in the worst-case scenario, terminate the deal due to adverse security market conditions at the time. There’s no risk of that happening with reverse mergers.


4. Requires Less Attention From Management

Given the relative simplicity of the transaction, reverse mergers, in general, require less management attention than IPOs. 

The CFO, working with a couple of auditors and counsel, can handle the majority of the workload while the rest of the management focuses on executing the company’s business plan.


5. Not Dependent on the IPO Market for Success

Reverse mergers tend to thrive in all markets. This is different from IPOs, which are market-sensitive, meaning that their success depends on whether there’s high demand and attention for them in the market.

When the IPO market is weak, reverse mergers can act as a viable alternative for companies looking to go public. And when the IPO market is strong, private companies can still choose to go public via a reverse merger because of its many benefits, including speed and cost-effectiveness. 


Risks and Challenges of Reverse Mergers

While reverse mergers have their advantages, there are risks and challenges that you need to be aware of. Here are a few notable ones for a company considering a reverse merger.


1. Less Buzz and Publicity

Reverse mergers don’t have the robust market buzz or publicity that IPOs typically enjoy. This can translate to lower demand for the shares of reverse merge companies and thus fewer returns for current investors.


2. Lack of Interest After the Merge

Not all companies that go public via a reverse merger might be ready for it. A firm could go public only to realize later that it doesn’t have the operational capabilities or the resources required to maintain investor interest.

Indeed, the SEC warns that “many companies either fail or struggle to remain viable following a reverse merger.”


3. Requires More Due Diligence

The lack of a comprehensive regulatory environment means that heightened due diligence is necessary when it comes to reverse mergers.

The private company that is seeking to go public, for example, must conduct comprehensive due diligence to make sure there are no major liabilities or legal issues in the public shell company it’s acquiring or merging with that could negatively impact its future prospects or operations.

Also, depending on the jurisdiction or state where the company is headquartered, there may be specific regulations and filings that need to be completed to ensure compliance with securities laws and stock exchange listing requirements.


4. Might Be Used As a Vehicle for Fraud

The regulatory lapse in reverse mergers, unfortunately means that these transactions can be used as vehicles for fraud.

That’s exactly what happened in the US in the late 2000s and early 2010s. After hundreds of Chinese companies used reverse mergers to enter the US stock market, most of these turned out to be fraudulent.

An SEC investigation revealed rampant abuse of dormant shell companies and a myriad of fraudulent practices by reverse merger companies, including the overstatement of activities and misrepresentation of income, assets, and cash balances.

A wave of short-selling after these revelations, combined with an SEC crackdown that saw hundreds of US-listed Chinese companies suspended, resulted in investors’ losses of over $500 billion between 2009 and 2012.


5. Regulatory Compliance Issues Post-Merge

As mentioned, the private company’s management will typically take over the board of directors and management of the new entity after its formation. Unfortunately, these managers may not have the necessary experience with the regulatory compliance requirements of publicly traded entities.

If any laws, rules, or regulations are breached, it could lead to fines or regulatory actions that adversely affect the operations and the financial condition of the business.

Alternatively, inexperienced management may focus most of their time and resources on regulatory compliance and neglect other important areas of the business.


6. Dilution of Ownership 

Reverse mergers can lead to a dilution of ownership for existing shareholders of the private company. When the private company merges with a publicly traded shell company, it typically issues new shares to the existing shareholders of the private company. This issuance of new shares can result in a reduction of ownership percentage for the existing shareholders.


7. Stock Price Volatility 

Reverse mergers can sometimes result in increased stock price volatility for the newly formed public company. The market reaction to reverse mergers can vary, and the stock price may experience significant fluctuations in the immediate aftermath of the merger. This volatility can impact shareholder value and may require effective communication and investor relations strategies to manage market perception.


The Efficiency of Reverse Mergers

There are several success stories of reverse mergers in history. Here are a few examples of companies that have gone public via reverse mergers and that are still thriving:


Despite these successful examples of reverse mergers, these deals might not be right for every company. The appropriateness of reverse mergers depends on your firm’s unique goals and circumstances.

For example, if you’re looking for fast market access to take advantage of favorable market conditions, a reverse merger can be an attractive option. But if your company needs to raise a substantial amount of capital first, an IPO might be more appropriate.

The suitability of a reverse may also depend on the industry in which the private company operates. For example, the tech industry might be more conducive to reverse mergers. 

Tech companies often operate in highly innovative and rapidly evolving markets where speed and agility are critical to staying competitive. Reverse mergers provide a quicker path to accessing public markets, enabling tech companies to capitalize on market opportunities without the delays associated with traditional IPO processes.

On the other hand, if you operate in an industry where investor confidence and market perception play a significant role, you might benefit more from the transparency and regulatory oversight usually associated with IPOs.


Final Thoughts

Reverse mergers provide an alternative way for companies to start trading publicly without going through an IPO. Key benefits of these deals include lower costs, a simplified, faster process, and low dependence on market conditions.

However, there are risks and challenges to be aware of, including the potential for lower returns due to less buzz and publicity, a possible lack of interest in the company after the merger, the possibility of reverse mergers being used as vehicles for fraud, and regulatory compliance issues after a merger.

Weigh these pros and cons, and consider your firm’s circumstances and goals to decide if a reverse merger is the right move.

If you decide to move forward with a reverse merger, Caplinked offers a reliable virtual data room (VDR) to help facilitate the due diligence phase of the transaction. 

With enterprise-grade security and other premium features, like digital rights management, detailed activity monitoring and reporting, and watermarking, CapLinked’s VDR can help you securely store, share and manage sensitive documents for a faster, smooth deal-making process.


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Sean LaPointe is an expert freelance writer with experience in personal and business finance. He has written for several well-known brands and publications, including The Motley Fool and Angi/HomeAdvisor.