What is a Reverse Merger?
A private company can go public faster if it adopts ‘Reverse Merger’.
When a company wants to go public, it’s usually a complicated, long and tedious process.
This process involves hiring an investment bank to underwrite and issue the shares.
There are various regulatory approvals, a long due diligence process, paperwork, and above that this process would take time depending on the market conditions.
Reverse Merger is a strategy that involves a smaller company acquiring a company that’s already publicly listed/traded.
The ‘survivors’ of the merger form the members of the public company and the owners of the private company become the shareholders.
After this process, the merged entity is reorganized according to the new vision, which means replacing the board of directors, taking necessary steps in altering assets and looking into the operations.
How does a Reverse Merger work?
Generally, while rolling out an (IPO) initial public offering the process goes on for months but sometimes it may take more than a year.
A reverse merger proves advantageous because it allows a private firm to go public at a relatable faster rate.
Apart from time, it saves the firm accounting and legal fees.
With a reverse merger, a private company merges with an existing, smaller company that’s already listed on an exchange.
Usually, more than 50% of the public company is bought.
Once the private company feels it has effectively gained control over the public company, the mergers of operations segment are taken care of.
The public company in this scenario is known as a “shell company”.
There is no technical reason behind referring to it as “shell”, it is a simple company, which can be stepped into and therefore access the public market.
The major difference here is that, unlike in an initial public offering (IPO), there is no capital being raised immediately during a reverse merger.
That is the main reason ‘why’ the process of going public is wrapped in a limited time period.
This also indicates that reverse mergers are only appropriate for private firms that do not need cash at their disposal right away.
Therefore, the traditional process of IPO is more favourable to the companies looking to raise cash as they go public.
Now that you have understood the ‘whats’ and ‘whys’ of Reverse Merger lets us understand its Advantages and Disadvantages in brief:
Advantages of Reverse Mergers
A Simple Strategic Move
Reverse mergers are allowing a private company to go public without raising capital, which considerably simple and convenient because we are not raising immediate capital at our disposal.
Considering conventional IPOs which take months or years to materialize, reverse mergers on the other hand is just a few weeks game.
This saves ample management time and energy, ensuring that there is sufficient time devoted to running the company.
Less Risk
Undergoing the traditional IPO process still does not guarantee that the company will ultimately go public.
Spend hundreds of hours planning for an IPO, in a traditional way, could go in vain if the stock market conditions aren’t favourable to the proposed offering.
Therefore, under such circumstances, there is a high chance that the deal may get cancelled.
Who would want to waste all those hours?
Therefore, going for a reverse merger minimizes this risk.
Market Conditions
Traditional IPO is at high risk because it includes both the go-public and capital-raising functions.
And hence it involves such risk.
On the other hand, a reverse merger a strategic move or a mechanism to convert a private company into a public entity.
This process is less likely to depend on market conditions because of not proposing to raise capital.
Therefore, market conditions have little bearing on the offering.
Benefits of a Public Company
Once a private company crosses revenue of $100 million to it usually attracts the prospects of going public.
The next step is initiated by trading the company’s securities exchange with greater liquidity.
The original investor/investors gain the ability to liquidate their holdings, providing there is a convenient exit alternative to the company buy back their shares.
This company has greater access to capital markets, as management is eligible 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 additional capital infusion into the company.
Which is good!
There is increased liquidity, which means that both the general public and large operational companies who have access to the company’s stock, can drive its price.
Here if the Management seeks strategic options to pursue growth, mergers and acquisitions are optimal ones.
As a member of the acquiring company, company stocks can be used in place of the currency with which the target company is acquired.
Management uses stock incentives wisely to attract and retain its employees, this is because public shares are more liquid.
Public companies often trade at higher multiples than private companies.
Disadvantages of a Reverse Merger
A reverse merger can be simpler, yet it cannot escape some of the long regulations and due diligence processes.
Due Diligence
There must thorough scrutiny on the investors of the public shell company.
Understanding some of the below-listed questions becomes crucial because of various reasons.
What are their motivations for opting for the merger decision?
Have they done their homework to make sure the shell is clean and not ruined?
Are there pending liabilities or any form of litigation or other “deal warts” hovering around 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, due diligence is necessary.
There should be a transparent disclosure between both parties.
Investors of the public shell should also conduct reasonable diligence on the private company, including its management, investors, operations, financials, and all possible pending liabilities.
Dump risky stock
If the public investors sell significant portions of their shares right after the merger, this can negatively affect the stock price.
To reduce this risk that the stock will be dumped, clauses can be incorporated into a merger agreement for a specific period.
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 public companies.
Attracting analyst assistance from Wall Street can be a challenge because of the limited financial scale.
The demand starts pouring after the reverse merger is consummated.
Reverse mergers do not replace or twerk fundamentals.
For a company’s shares to be attractive to prospective investors, the company itself should be attractive financially and operationally.
Compliance and Regulatory Stuff
Even though everything and everyone is prepared for the post effects of Reverse Merger, there is a potentially significant setback when a private company goes public.
This is because very often the management board overseeing the actual process is inexperienced regulatory and compliance section requirements of becoming a publicly traded company.
This ‘stuff’ matters, because there is time and money involved.
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 avoid this, collaborating with investors of the public shell who have experience in being officers and directors of a public company might prove helpful.
The CEO can additionally consult specialised with compliance matters.
In addition to this, a prior ‘tick’ mark in terms of administrative infrastructure, resources, road map, and cultural discipline would be helpful to meet these new requirements after a reverse merger.
What is it that we can expect from a ‘Reverse Merger’?
Reverse Merger is a straightforward process.
There is no fuss right from the start till the end.
A private company buys shares of the public company and becomes a shell.
A new, tradable entity is born.
The process does an end to end expense calculation right from raising new capital, with all of the fees charged by stock underwriters and the market risk surrounding new share offerings.
New Share
If you’re holding shares in a company that’s going to be acquired in a reverse merger, you’re going to have to sell at the price fixed by the buyer or exchange your shares for stock in the new company.
There may or may not be a profit in such investment, unless you hold voting right or convince a majority of the stockholders that it’s a bad idea, you won’t stand a chance.
A reverse merger generally benefits both businesses: the private company grows larger and wins new markets and products.
The public company gains some business support and financial safety by becoming part of a bigger entity.
Disclosure Duties
The Securities and Exchange Commission requires Form 8-K when a merger takes place.
This is a public document that is available through the SEC’s online, searchable EDGAR database.
The filing will reveal the new company name, the makeup of the new board of directors and the shares and capital that will be exchanged between the buyer and the shell.
Wading through these fine-print documents will give you a good handle on the merger and help you make the crucial decision: either sell your shares immediately or wait for the merger to go through.
Costs And Fees
There’s one final but important consideration with a reverse merger: whenever some major change takes place with stock investment, your broker may charge a fee for any accounting work that needs to be done.
When in doubt don’t hesitate to seek opinion/advice.