For entrepreneurs looking to take their business public, the process often involves a long and expensive journey through an Initial Public Offering (IPO). However, there is an alternative route that offers both speed and cost efficiency: the reverse merger. While not as well-known as a traditional IPO, reverse mergers can provide significant advantages, particularly for smaller or mid-sized businesses that want to go public without the time and expense of an underwritten offering.

In this article, we’ll break down what a reverse merger is, how it works, and why it could be a viable option for entrepreneurs looking to access public capital markets.

What is a Reverse Merger?

In a reverse merger transaction, management of a private company takes over a public company so it can easily go public, access funding in the U.S. Capital markets not available to private companies and provide their stockholders with future liquidity.

Here’s how it works: an entrepreneur who wants to go public buys majority control of a public company from the existing control block holder, the shareholders of the private company receive a significant majority of the shares of the public company, and once the merger is complete, the private company’s management typically takes over the operations and board of directors of the public entity. In essence, the private company becomes public overnight, and the process bypasses the underwriting and roadshow requirements of a traditional IPO.  Public companies undergoing reverse mergers are often called public “shells” because they have little to no operations and few assets. 

Why Choose a Reverse Merger?

A reverse merger offers several benefits to entrepreneurs who want to take their company public. Let’s explore some of the key reasons why this path might be attractive:

1. Speed to Market

One of the biggest advantages of a reverse merger is the speed at which a company can go public. A traditional IPO can take anywhere from six months to a year, sometimes longer, depending on market conditions and regulatory approvals. The process involves hiring underwriters, filing extensive paperwork with the Securities and Exchange Commission (SEC), conducting roadshows, and pricing the offering.

In contrast, a reverse merger can be completed in as little as a few weeks. Since the shell company is already publicly listed, the time-consuming aspects of an IPO are eliminated, allowing the private company to quickly transition into a public entity.

2. Lower Costs

Cost savings are another significant advantage of a reverse merger. A traditional IPO involves substantial fees, including underwriting fees, legal fees, accounting fees, and costs associated with investor marketing. These fees can add up quickly, with underwriters typically taking 3-7% of the total offering amount.

With a reverse merger, there are no underwriting fees. While there are still legal and accounting costs associated with the transaction, they are typically much lower than those incurred during an IPO. This makes reverse mergers an appealing option for small cap and microcap  companies that may not have the resources to cover the high costs of an IPO.

3. Access to Public Markets

A reverse merger allows companies to access public markets without the traditional barriers to entry. Once the merger is complete, the company is publicly traded, meaning it can raise capital through secondary offerings, attract institutional investors, and provide liquidity for its shareholders.

Being a public company also enhances the company’s credibility with potential customers, partners, and investors. Publicly traded companies are subject to more rigorous financial reporting and disclosure requirements, which can increase transparency and trust among stakeholders.

Key Considerations for a Reverse Merger

While reverse mergers offer many benefits, they are not without risks and challenges. Entrepreneurs considering this path should be aware of the following key factors:

1. Quality of the Shell Company

Not all shell companies are created equal. Some may have legal or financial issues that could cause problems down the road. It’s crucial to conduct thorough due diligence on the shell company to ensure that it is free from liabilities, lawsuits, or regulatory issues.  Often, these shell companies will have delinquent SEC and state filings, and unpaid invoices to transfer agents, accountants, Edgar agents, auditors, consultants and attorneys. 

Those outstanding fees need to be quantified prior to closing. Just like buying a house, these “repair” costs are typically subtracted from the asking purchase price of the shell, or escrowed to be paid at the closing out of the seller’s funds. Doing so allows new management to continue working with the existing professionals who know the company, its history, and financials well. 

Entrepreneurs should work with experienced advisors—both legal and financial—who can help vet the shell company and assess its suitability for the reverse merger. Ensuring that the shell company is “clean” and has a positive track record is essential to avoiding potential pitfalls.  

Matheau J. W. Stout, a securities attorney with 20 years’ experience representing entrepreneurs and publicly traded companies in mergers and acquisitions, says that due diligence of the public shell is paramount before any reverse merger transaction is considered.

“Clean, audited public companies with no history of delinquent SEC filings are routinely sold to entrepreneurs for $450,000, while a public shell with an unknown history, past due filings, and unpaid vendors can sometimes be bought for as low as $100,000. Forget the asking price. The only way to find out what it’s worth is through due diligence.”

2. Ongoing SEC Compliance

Once the reverse merger is complete and the company becomes public, it will be subject to SEC reporting requirements, like filing 10-Qs every quarter, 10-Ks at the end of each fiscal year, and 8-Ks within 4 business days of any material event. This means filing regular financial statements, maintaining corporate governance standards, and adhering to other regulatory requirements. Failure to comply with these requirements can result in penalties, fines, or even delisting from the stock exchange.

Entrepreneurs should be prepared for the additional costs and responsibilities that come with being a publicly traded company. Having a strong team of accountants, legal advisors, and compliance officers is critical to ensuring that the company meets its ongoing obligations.

3. Limited Access to Capital

While a reverse merger allows a company to go public quickly and with lower costs, it does not guarantee immediate access to capital. In a traditional IPO, underwriters help raise funds by selling new shares to institutional investors. In a reverse merger, the company does not automatically raise any new capital at the time of the transaction.

If the primary goal of going public is to raise capital, the company may need to conduct a secondary offering by filing an S-1 Registration Statement or Regulation A Offering,  or pursue other financing options after the merger, including the private sale of convertible promissory notes, restricted common or preferred stock, or warrants. It’s important to have a clear post-merger financing strategy in place to ensure that the company can access the capital it needs to grow.

Steps to a Successful Reverse Merger

For entrepreneurs considering a reverse merger, preparation is key. Here are some steps to ensure a successful transaction:

1. Work with Experienced Advisors

Having the right team in place is essential for navigating the complexities of a reverse merger. Entrepreneurs should work with an experienced securities lawyer, accountants, and PCAOB auditors who understand the intricacies of public market transactions and can guide the company through the process. 

2. Conduct Thorough Due Diligence

As mentioned earlier, conducting thorough due diligence on the shell company is critical. Entrepreneurs should verify that the shell company has no outstanding liabilities, legal issues, or regulatory problems that could create obstacles post-merger or quantify the costs to correct those issues ahead of time, so that current management pays the costs at closing.

The best deals for entrepreneurs looking to go public may initially appear to be public companies with obvious repairs needed, but because public shells are typically sold “as is” by the departing control block holder, when the deal closes, any hidden problems that come to light could be the buyer’s responsibility. 

“You’d be surprised how many times we’ve found undisclosed skeletons in the closet of public shells during due diligence.  Knowing what to look for requires experience.  Entrepreneurs looking to go public should be prepared to walk away from any transaction. Sometimes the purchase price really is too good to be true,” said Matheau J. W. Stout.

3. Prepare for Life as a Public Company

Going public is not the end of the journey—it’s the beginning. Entrepreneurs should be prepared for the ongoing responsibilities that come with being a public company, including regulatory compliance, investor relations, and financial reporting. Building a strong internal infrastructure and hiring the right team are essential for long-term success.

Conclusion

A reverse merger offers a compelling alternative to the traditional IPO, providing entrepreneurs with a faster, more cost-effective way to take their company public. By bypassing many of the time-consuming and expensive aspects of a traditional offering, a reverse merger can help entrepreneurs access public markets, enhance their credibility, and provide liquidity for shareholders.

However, reverse mergers also come with their own set of challenges, and success depends on careful planning, thorough due diligence, and the right team of advisors, including an experienced securities attorney. For entrepreneurs who are well-prepared and have a clear strategy in place, a reverse merger can be an excellent way to achieve their growth and financing goals, but as the old saying goes, “buyer beware.”

Published by: Nelly Chavez