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Understanding A Reverse Merger (Best Guide on Reverse Takeovers)

Looking to better understand a reverse merger?

Looking for the best guide on reverse takeovers?

How does reverse merger work and why do it?

In this article, we will break down the notion of reverse mergers so you know all there is to know about it. 

We will look at what it is, why companies use this strategy, what is the process, the advantage, disadvantages and even things like reverse triangular takeovers!

Are you ready?

Let’s get started…

What is a reverse merger?

A reverse merger, or a reverse takeover, is when a private company acquires or takes control of a publicly-traded company with the objective of itself becoming public.

Once the private company takes control of the public company, the final step is for the two companies to merge into one single publicly traded organization.

A reverse merger is like an initial public offering (IPO).

The difference is the company intending to go public does not go through all the administrative and regulatory filing processes of going public but simply acquires and merges with an already publicly-traded company that has gone through such processes.

Generally, following a reverse merger, the shareholders of the private company will acquire a significant portion of the shares in the public company.

Why do a reverse takeover?

There are many reasons why reverse mergers can be considered instead of an initial public offering process.

In certain cases, a once operating public company may see its operations decline to a point where it is only meeting the minimum share price requirements to remain publicly traded.

The public entity does not have any meaningful future growth possibilities and is on its way to getting delisted.

The fact it is listed in the stock exchange is the asset attracting private companies looking to go public.

In this scenario, an operating private company with a prosperous future looking to go public may be interested in taking advantage of the public status of the company to get listed in the exchange. 

As a result, the private company will acquire and take control of the defunct public entity to go public.

What’s interesting to note is that the private entity and the public entity do not need to be in the same industry or line of business.

Actually, quite often, they are not.

The real consideration from the private company’s point of view is to go public fast and for the public company to find a new life.

How does a reverse merger work?

The reverse merger transaction is pretty straightforward.

To start with, you need a private company and a public company.

The private company is an operating company aspiring to go public.

The public company is an entity listed in the stock exchange and is either a shell company, a dormant company or a non-operating company.

To complete the reverse takeover process, the private operating company merges into the public dormant company.

The shareholders of the private company are issued a majority of the shares in the public company.

The directors of the private company are appointed as directors of the public company.

The operations of the private company are moved into the public dormant company.

Quite often, the public company will change its name to reflect the name of the private operating company.

In exchange, the shareholders of the public dormant company lose control of their company in exchange for a minority stake in the private company operations having growth potential. 

At the end of the day, the public company post-merger will be controlled by the same shareholders of the private operating company and the same directors.

In other words, the private company may have given away a minority stake in its company shares to the shareholders of the dormant public company for the ability to take control of the public company’s shell.

Difference between a reverse merger and an IPO

An initial public offering or IPO is the traditional process for a private company to go public.

We have heard of many large and mediatized IPO listings such as Google’s IPO and Facebook.

In an IPO process, a private company will need to:

  1. File all the regulatory paperwork with the applicable securities commission (in the United States, it’s the Securities and Exchange Commission or SEC)
  2. Engage an investment banking firm to underwrite the issuance of the shares
  3. Work with the investment banking firm to determine the initial pricing of the stock
  4. Work with the investment banking firm to generate public interest in the shares

A successful IPO requires that you successfully handle the regulatory filing process and capital-raising process.

On the flip side, with a reverse merger IPO, separates the regulatory filing process from the capital-raising process.

Generally, a shell company is used to complete the regulatory requirements in a quick, simple and inexpensive way.

So the regulatory filing and registration part is done.

Then, the private company uses the reverse merger strategy to merge into the public shell.

Once the reverse merger process is completed and the private company becomes public, it can start using the public exchange as a means to raise capital.

Investment bankers will also provide the necessary support in the capital-raising process as well.

What are special purpose acquisition companies?

Special purpose acquisition companies or SPAC’s can be used in a reverse company merger.

A SPAC is a shell company that is taken public with the objective of acquiring a private operating company within eighteen to twenty-four months.

In practice, going public using a SPAC entity may not be as enticing for private operating companies as the process may be as involved as a traditional IPO process. 

Merger arbitrage 

Merger arbitrage is a strategic investment strategy intended to profit from a reverse merger transaction.

In merger arbitrage, an investor will buy and sell shares in the corporate entities involved in a reverse merger to profit from the company valuation fluctuations.

Generally, the shares of the buying entity will decrease in value while the shares of the selling company will increase in value.

This is a rule of thumb and may not be the case all the time.

Also, considering that most often a private operating company intends to go public, a public investor cannot perform merger arbitrage investments as the shares of the private company are not available for investment.

As a result, private equity firms or PE funds will consider merger arbitrage by investing in a private company with the intention of profiting from the merger arbitrage potential.

What is a reverse triangular merger?

A reverse triangular merger is a common reverse merger structure used for private companies to go public.

In a reverse triangular merger, the non-operating public entity will create a wholly-owned subsidiary that merges with the operating private entity.

The shares of the private entity are exchanged for the shares of the public subsidiary.

Once the transaction is consumed, the private entity becomes a wholly-owned public subsidiary of the parent public company.

The advantage of a reverse triangular merger is that the newly created subsidiary will only have one or few shareholders to approve the transaction so the shareholder approval process is easier.

The regulatory compliance process is lighter as the private company may be exempt from producing a prospectus and other costly documents.

Advantages of reverse mergers

There are important advantages when considering a reverse takeover.

Fast-track public listing

Typically, it may take a company many months, or even more than a year, to complete an IPO listing.

On the flip side, a private company can adopt a fast-track method of becoming public through a reverse takeover or RTO in a matter of a few months.

A reverse merger is suitable for companies who are not looking to raise important sums of capital by going public.

Less costly process

The reverse takeover can cost significantly less than an IPO for a company to go public.

The traditional initial public offering process requires that a company go through a heavy administrative process with the regulatory authorities to go public. 

Generally, a company must produce a prospectus for the issuance of its shares on the market and so on, work with investment bankers to raise the needed capital and so on.

With a reverse merger IPO, a private company saves many steps in its administrative process leading to cost savings.

In addition to saving fees with regards to the actual regulatory filing for an IPO, a company can save a lot of money by the lack of an investment bank’s involvement in the process.

Investment banks charge significant fees and underwrite shares at a significant discount.

Increase in a company’s valuation 

By going public, a private company can see its valuation increase.

This can be a great opportunity for company shareholders and those having an interest in the organization.

Being public will bring the company additional exposure and potentially attract investors.

The more investors invest in the organization, the more the value of the stock goes up.

Market conditions 

Another advantage of a reverse merger is that it removes the company’s dependence on market conditions.

This is the case as the reverse merger process does not require a company to raise capital.

Reverse mergers are used as a conversion mechanism to convert a private company into a public company without the need to raise capital in the process.

When going public the traditional way, company managers are highly stressed about the market conditions.

In a typical IPO, the private company must work diligently with the investment bankers to adequately price its stock based on what they believe the market is prepared to pay for it.

This process can take a lot of effort and cost a lot of money.

If the market conditions change by the time the company is ready to go public, the IPO may not go through and the deal may even get cancelled.

Private investment in public equity (PIPE)

A private investment in public equity or PIPE, a listed company issues shares directly to investors in a private transaction.

In many cases, a reverse takeover is used in conjunction with a PIPE to provide private companies with flexible financing alternatives to companies.

The PIPE used with a reverse takeover mirrors a traditional IPO where you achieve a public registration and raise capital at the same time.

Disadvantages of a reverse merger transaction

Reverse acquisitions can be interesting for companies looking to expand their operations by going public.

It does come with some risk, however.

Risk of lawsuits

An important disadvantage with reverse mergers is that the board of directors of the private company and its stakeholders may not have kept good records of their business and by going public, their internal mismanagement becomes apparent.

The company’s poor record-keeping can lead to potential lawsuits and significant liability to the company.

Lack of management experience

In addition to that, a private company is not managed the same way as a private company.

As a result, the president or CEO of the resulting public company may not have the experience and knowledge to run a publicly-traded business.

Exposure to compliance risk

Failure to respect the securities laws and properly manage investors and various stakeholders can be costly to a company.

When going public, a company must devote time, energy and resources to ensure it complies with applicable laws, regulations and listing requirements.

For a publicly-traded company, compliance can represent an important risk factor that must be mitigated.

Due diligence required 

When considering a reverse merger transaction, both the private entity and public entity must perform their due diligence.

For the private entity, they must consider who are the investors in the public shell and why are they interested in this reverser IPO deal?

Does the public entity have a clear record and is free from any liability or risk of a lawsuit? 

The private company should thoroughly evaluate the public entity to ensure that it is clean and the reverse merger will not result in legal challenges and other unwanted problems.

Similarly, the shareholders and investors in the public entity should also perform due diligence on the private entity to ensure that it is operating a sound business, it is well organized and the management has the experience to operate a publicly-traded business.

The public entity should also ensure the private company does not come with the potential risk of lawsuit and liability as well.

Inability to raise capital 

Assuming that everything goes well, a private company finds a nice public shell to merge into, goes through the reverse merger transaction and starts trading its shares on the stock exchange.

And then, crickets!

There is a lack of demand for the company’s stock.

The company is unable to raise the needed capital or attract new investors.

Just because a company was able to go public does not guarantee that it will raise capital and have investors running to buy its shares.

At the end of the day, the business must be attractive enough and produce solid financial figures for investors to consider buying its stocks.

Risk of fraud 

Investors, be careful!

According to the SEC’s Investor Bulletin on Reverse Mergers in the United States, inventors are cautioned to be careful about fraudulent activities.

In fact, during the 2008 financial crisis, many Chinese companies using the reserve takeover scheme got listed in the U.S. markets taking control of non-profitable businesses.

Due to various fraudulent schemes and misrepresentation, they were able to attract investors who were buying shares into sometimes worthless companies.

Ultimately, American investors lost billions of dollars by investing in seemingly good companies with interesting prospects while in reality, it was a bad investment to start with.

Reverse merger examples

There are some interesting examples of successful companies leveraging the reverse merger strategy to go public and become well-known and successful organizations.

Example 1: Armand Hammer used the reverse takeover scheme to merge into Occidental Petroleum

Example 2: Ted Turner using a reverse merger as an alternative to an IPO to merge into Riche Broadcasting to form Turner Broadcasting.

Example 3: Archipelago Holdings acquired the New York Stock Exchange to form the NYSE Group.

Example 4: America West Airlines acquiring US Airways with the objective of removing it from Chapter 11 bankruptcy.

Example 5: Entercom acquiring CBS Radio with the objective of spinning it off from CBS Corporation.

Example 6: Warrant Buffet bought a textile manufacturing company Berkshire Hathaway and merged it with his insurance company to form the Berkshire Hathaway company we know today.

Frequently asked questions

How do you spot a reverse merger?

Reverse mergers happen regularly in the market.

According to Investopedia, to find reverse-merger candidates, you must:

  1. Look for companies having an appropriate capitalization
  2. Companies who are looking to raise at least $500,000 or more as working capital

An appropriate capitalization is companies that will have at least $20,000,000 in sales and have $2,000,000 cash on hand.

What is a reverse merger example?

One of the most notable examples in the American history is the reverse merger of Berkshire Hathaway.

In 1965, Warrant Buffet took control of a textile company called Berkshire Hathaway and used it to merge his insurance empire into it.

Berkshire Hathaway then became one of the most famous, profitable and prestigious investment companies in the world.

What happens in a reverse merger?

In a reverse merger, you have a private company looking to go public in a fast and cost-efficient manner.

A private entity acquires a public entity and merges the two entities into one where the successor entity remains public.

The reverse merger is essentially a mechanism to allow a private company to go public.

What does the reverse merger mean in stocks?

In a reverse takeover deal, the shares of a non-operating public entity are purchased by an operating private entity.

In essence, the shareholders of the public company lose their control in favour of the shareholders of the private entity.

From a stock valuation perspective, the buyer’s shares will generally slightly decrease in value while the seller’s shares increase in value.

How long does a reverse merger take?

A reverse merger can be completed in a matter of weeks, if not a few months.

On the other hand, an initial public offering can take nine to twelve months if all goes well and even potentially longer.

One advantage of a reverse merger is that it allows a private company to quickly accomplish the necessary formalities to go public.

Editorial Staff
Hello Nation! I'm a lawyer by trade and an entrepreneur by spirit. I specialize in law, business, marketing, and technology (and love it!). I'm an expert SEO and content marketer where I deeply enjoy writing content in highly competitive fields. On this blog, I share my experiences, knowledge, and provide you with golden nuggets of useful information. Enjoy!

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