Reverse Mergers

5 min readOct 21, 2019

When a private company may go public by being one with a public company that is usually a corporate shell or an inactive one, the term for this is a reverse merger. Shell company, on the other hand, is a company that went public in the past but no longer conducts business operations and has few, if any, physical assets and its assets consist mainly of cash and cash equivalents. While they can be an excellent opportunity for investors, there are cons in addition to the pros.

The public company, which was once private, has greatly enhanced liquidity for its equity. In addition, the process can be quicker and more reasonably priced than a traditional initial public offering. This means it’s not only shorter but it is also simpler in terms of the process than that of a conventional initial public offering where 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. The bank also helps to establish interest in the stock and provide advice on appropriate initial pricing.

Processing Reverse Mergers

As said earlier, a reverse merger is quick to process. It may take between two and three months to complete, whereas an IPO is more is a more involved process that takes more months. Reverse mergers, unlike IPOs, also do not require dilution which may involve investment bankers requiring the company to issue more shares than what it would prefer. This saves the company a lot of time and energy, ensuring that there is sufficient time devoted to running the company.

Furthermore, reverse mergers are less dependent on the state of the IPO market. When the market is weak, reverse mergers are unaffected as they can still be viable. Because of this, there is usually a steady flow of reverse mergers, which explains why it is common to see in the financial media corporate “shells” advertised for sale to private companies seeking this avenue to go public.

Since 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.

Unlike the traditional IPO, a reverse merger is also not a capital raising event. Here, the shares are exchanged but commonly not cash. However, with reverse mergers, the shares are usually very thinly traded after the deal. Because of this, insiders usually cannot use a reverse merger to cash out their ownership in the firm, whereas in an IPO this may be possible.

They are indeed an attractive strategy for corporate managers and investors alike. For instance, 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 and tools to complete these deals

Another benefit of doing a reverse merger is that it allows the company to have more liquid shares to use in order to purchase other target companies. This may be appealing to corporate managers or investors whose goal is to finance stock-for-stock acquisitions.

The reverse merger has often been associated with stock scams since market manipulators have often merged private companies with little business activity into public shells and tried to “hype” up the stock to make short-term fraudulent gains, but 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. Hence, it defeats the goal of converting the private company into a public entity. This strategy is often used by private companies, generally those with $100 million to several hundred million in revenue. Once they’ve decided on this, 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.

Reverse mergers increased from 2003 to 2010 but declined from 2011 to 2016. For many companies, going public through a reverse merger may seem attractive and interesting, but it actually lacks some of the important benefits of a traditional IPO. These benefits of the IPO actually make the financial and time costs of an IPO worthwhile.

One drawback is that due diligence is required. Managers must thoroughly vet the investors of the public shell company. They must know the motivations for the merger and if they have done their homework to make sure the shell is not tainted. Pending liabilities, like those from litigation and other “deal warts” that hound the, shall also be considered. Investors of the public shell should also conduct reasonable diligence on the private company.

After the private company executes the reverse merger, it should be important to know if the investors really obtain sufficient liquidity. Smaller companies might not be prepared to be a public company since there may be a lack of operational and financial scale. On the contrary, the traditional IPO allows the company going public to raise capital and usually provides an opportunity for the owners of the closely held company to liquidate their previously illiquid privately held shares.

Last but not least, when a private company goes public, mergers are usually inexperienced in the 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.