Here’s a great article by Delancey Street,. When there is an increase in economic activity, the number of businesses startups also increases. It’s a time when entrepreneurs are looking for funding sources. Some look into a reverse merger to see if it could help them. This involves a private company acquiring a company that is already public. In most cases, the public company is a dormant shell. Doing this will make it possible for an entrepreneur to avoid all the costs and the process involved with creating an Initial Public Offering (IPO) company. It involves a private company trading shares with the public shell company. When this is done correctly, it will turn the acquiring company into a public company. A reverse merger is a great way to raise money, but there are many things that must be kept in mind when considering it.

History

Reverse mergers have occurred since the 1950s. They had a bad reputation in the time prior to 1999, which caused this type of transaction to be significantly underutilized. There was a time when reverse mergers were uncomfortably unregulated. When it came to disclosure requirements, only minimal amounts were required. This caused the reverse mergers prior to 1999 to be used in questionable securities investments and investors lost large amounts of money with them. Starting in 1999, the SEC put in place many new rules and regulations specifically designed to cover reverse mergers. It caused this type of transaction to be considered safe. It increased reverse merger transaction transparency. This was made possible because of an increase in due diligence requirements for investors and the private companies. This has given reverse mergers credibility and made it an attractive transaction. It now makes up a significant portion of capital fundraising.

Increased Risk

A reverse merger enables a private company to be a public company within weeks. When companies go the IPO route, it could take months or even years to become a public company. An entrepreneur with a public company will have increased exposure to problems for the company owners and their new board. It is important for financial and legal professionals to be involved. There are very serious civil, as well as criminal penalties, for any type of mistake involving non-compliance or failure to follow any Securities and Exchange (SEC) regulations and more. This can make using this funding method a bit of a challenge.

Due Diligence

When choosing a shell company, it is important to make certain there is nothing wrong with it. The shell company should be checked out to make certain there are no pending shareholder lawsuits and more. When a reverse merger is proposed, it is common for investors of the shell company to perform due diligence on the private company. They will want to learn about the private company’s management, financials, operation, any pending liabilities and more. Getting a shell company from a financial broker organization may be a good idea. A financial broker should be chosen for their track record of success and performing complete due diligence.

Money

This is not an approach for an entrepreneur who has limited funding for their project. It has been estimated that purchasing a shell company combined with following the process can cost more than $500,000. This cost can be more depending on what type of shell company was purchased. Having a public company is not cheap. Financial experts state according to accepted audit procedures and accounting reporting, the cost of operating a public company is over a million dollars annually.

Deal Structure

A reverse merger is a transaction designed to provide large amounts of private capital. In order for this to be successful, it must be carefully structured. The amount of stock owned by old investors and new investors can’t be permitted to influence the price. This must be done to establish a stable quote. In many situations, this can be accomplished by decreasing the percentage of total shares the old and new investors own. It creates more of an incentive for private investors to actively purchase the stock as it is being sold at a discount.

Benefits

A concern when trying to do a reverse merger is for the investors in the public shell company to sell large segments of their shares immediately after the deal is completed. In most cases, to prevent this from happening, the merger agreement will contain a clause covering designated required holding periods. This means the shareholders of the shell company stock will not be able to sell their share for a designated period of time.

Market Conditions

A reverse merger is a tool used to transform a private company into a public company without regard for market conditions. This process is much less dependent on market conditions when compared to a traditional IPO. Since a reverse merger is simply a tool for transformation, it is not impacted by what is occurring in the market.

Required Holding Periods

A concern when trying to do a reverse merger is for the investors in the public shell company to sell large segments of their shares immediately after the deal is completed. In most cases, to prevent this from happening, the merger agreement will contain a clause covering designated required holding periods. This means the shareholders of the shell company stock will not be able to sell their share for a designated period of time.

Inexperienced Managers

One of the challenges with a reverse merger involves the managers of a private company not being experienced with the increase of compliance and regulatory requirements they will be expected to follow as a publicly traded company. These additional responsibilities can result in a significant expenditure of time and money. Managers will be required to invest more time in compliance and less time performing their regular duties. This can cause the new public company to be stagnant and underperform. The way this is often overcome is by having managers from the private company partner with the those in the public shell company who have the necessary experience. It can also help if the private company hires additional employees with relative compliance and regulatory experience. This will make certain the newly created public company has the resources, infrastructure and more to meet its new legal requirements.

Any small private company trying to obtain investment capital should speak with financial and legal professionals before determining if a reverse merger would be in their best interest. It is important for all the liabilities, costs and other burdens associated with going public are fully realized and appreciated by the small private company. A reverse merger has been used many times to successfully obtain important financing during a difficult investment capital market. It has proven to be an effective strategic decision that could attract significant amounts of funding. It will also change the focus and culture of the formerly private company.