A reverse merger occurs when a privately-held business buys a publicly-held shell company. The outcome of a reverse merger is that the privately-held entity mergers into the publicly-held shell. The private entity is eliminated and the shell company becomes the sole remaining entity. This is a faster and less expensive alternative to the initial public offering. By taking this approach, the owners of a privately-held business can take their company public. Since the transaction means that the owners of the acquiree essentially take over the legal acquirer, it is considered a reverse merger.
Pros and Cons of Reverse Mergers
The advantages of using a reverse merger are as follows:
- Smaller monetary investment. A privately-held business can take itself public with a relatively small investment in a shell company, and within a short period of time.
- Smaller time investment. The management of the privately-held business will invest far less time in taking the company public, since no road show is required.
- Market independent. A reverse merger can take place even during a decline in the market, since the company is not trying to raise capital.
- Share value. Once its shares are registered, they can be traded, and so are more valuable to investors.
- Stock options. The value of stock options granted to employees is higher, since they can now sell their shares (once the shares are registered).
However, there are a number of disadvantages associated with reverse mergers, including the following:
- Undocumented liabilities. There may be undocumented liabilities associated with the shell company, which now become the liabilities of the new owners.
- No fund raising. No fund raising has been accomplished as part of going public. The company must now file with the Securities and Exchange Commission (SEC) to register shares, which is usually a lengthy process.
- No stock exchange. The shell is probably not registered on a stock exchange, so trading in the company's stock is likely to be sparse.
- Expenses. The company must now spend a considerable amount on filings with the SEC, upgrading its controls, and investor relations.
Given these issues, a reverse merger is generally not recommended, though many organizations still use it every year. The approach will work best for those organizations that do not have an immediate need to raise capital, and which have sufficient profits to offset the costs of being publicly-held.