Reverse mergers are a non-traditional strategy for companies to raise capital. Dealmakers use this method to take their companies public without the need to go through the IPO process.
As a result, they can avoid the time and cost typically involved with an IPO. This is why reverse mergers are also termed reverse initial public offerings (IPO). Both public and private companies initiate such transactions to acquire capital and make their stock available to the public, respectively.
Reverse mergers have several advantages for participating companies, though they also come with their share of downsides. Read ahead for detailed information about how these M&A deals work and their execution procedures.
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Shell Corporations Can Leverage Their Listings
Existing shell corporations that have no products, no prospects, and no operations can leverage their final asset–their listings. Such companies are very much in demand for dealmakers looking to go public mainly because these deals are less susceptible to market conditions.
Investors are increasingly wary of IPOs and the uncertainty of the funding they can raise. For instance, in the case of biotechnology companies that need to go through extensive research and development and clinical trials.
These companies need infusions of high amounts of capital before they are ready to release products for sale. If the R&D is unsuccessful, or their treatment does not get FDA approval, their share prices could drop. This situation makes them an ideal candidate for an acquisition.
Partnering with a private company is an excellent move, especially since they have leftover capital available that acquirers can use. The fact that a reverse merger is shorter, streamlined, and cheap is an additional advantage.
Understanding What Reverse Mergers Are
To understand what reverse mergers are, you’ll start off by exploring traditional IPO processes. During an IPO, a private company hires an investment bank and assigns the task of underwriting and issuing its shares. Hiring a reputable banking firm helps build recognition and a presence in the market.
The investment bank’s job is to file the regulatory paperwork and run it through the relevant agencies for approval. By underwriting the stock, the investment bank establishes interest in the stock, so investors are encouraged to participate.
Most importantly, the bank advises the appropriate initial pricing structure for the stock. Essentially, the IPO not only takes the company public, but also raises capital for it. Reverse mergers combine the two processes and effectively make the deal an attractive proposition for investors and managers.
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How Reverse Mergers Proceed
The purchasing private company acquires a majority of the shares of the public company, which can be 51% or more. Next, the acquirer combines these shares with their own company. Shell companies are registered with the Securities and Exchange Commission (SEC) before the deal closes.
The buyer can leverage this factor, which makes the new registration procedure more economical and straightforward. Finally, they close the deal by trading shares with the shell company’s stock. Once the acquisition is complete, the private company’s owners become the controlling shareholders of the public company.
The buyers also gain voting power, and their management takes over the management and board of directors of the public shell company. The next step is to reorganize the public company’s assets and operations and combine them with the former private company.
Once the process is complete, the private and public companies combine to form one publicly traded company. Or the private company becomes a wholly owned subsidiary of the shell company.
Dealmakers need not publicize the transaction or get media attention for it, as in the case of an IPO. That’s because acquiring companies typically don’t need to pitch for capital in the immediate future. Since there is no fundraising activity for new capital, the M&A deal concludes quickly.
Most importantly, acquiring companies need not navigate complex paperwork and documentation and regulatory compliance requirements. They’ll also eliminate the risk of uncertain and unfavorable market conditions that can negatively impact the IPO.
Private companies that lack the resources, capabilities, or inclination to run an IPO can opt for reverse mergers. That’s the next best alternative. However, dealmakers may have to ensure that the targeted company’s shareholders approve the transaction, which could cause hurdles.
Upsides for a Reverse Merger
Reverse M&A transactions have several advantages over a traditional IPO. Here’s a quick look:
- Releasing an IPO typically involves paying fees to financial institutions, which you can avoid in reverse mergers, making them economical.
- Dealmakers can complete reverse mergers within one to three months. However, IPOs can take more than six months to one year to conclude.
- Companies entering into reverse M&A deals need not hire the services of an investment bank to act as an underwriter. Such deals are conducted between the buyer and seller without the need for middlemen.
- Unlike IPOs, companies need not have a market presence or reputation for a reverse merger to be successful. Nor are such deals dependent on uncertain stock market conditions that may result in the deal falling through.
- Releasing an IPO does not guarantee that the company will successfully go public. Without an adequate response, the company may have to cancel the IPO, resulting in lost money and time.
- Management can save on the time and energy for an IPO and divert resources to running the company.
- Companies can leverage this simple method to go public with the least amount of risk and the need to raise capital.
Downsides of a Reverse Merger
Despite the upsides, reverse mergers come with their share of hurdles, which are more complex than the pros. Make sure to assess them thoroughly.
Need for Extensive Due Diligence
Although reverse mergers are relatively simpler to execute than IPOs, participants of the deal should undertake extensive due diligence. Dealmakers should engage the services of professional teams to explore every facet of the company before the merger.
The key areas of focus include investigating any ongoing litigation and liabilities. Since the public company is a shell, acquirers need to determine the reasons why its operations are stagnant. They should also understand their owner’s objectives for putting the company up for an acquisition.
Understanding the issues the distressed company is facing is critical since the buyer will assume its liabilities. Dealmakers and their team should also examine financial statements and interview investors, the management, and the board of directors.
Given the stress on environmental, social, and governance (ESG), dealmakers may want to look into possible violations and regulatory non-compliance. If the company is dealing with labor issues or workplace safety hazards, buyers will want to know about them.
Making sure there is complete transparency in the deal before it closes is important to identify any possible instances of fraud or abuse. However, completing the due diligence process within the short time frame of a few weeks to three months is not exactly possible.
That’s the interval within which typical reverse mergers conclude. And incomplete intelligence of the pros and cons of the deal can lead to unexpected issues later.
Need to quick overview on how to navigate the due diligence process? Check out this video I have created. You’re sure to find it helpful.
Liquidating Risky Stock
Investors in the public shell company may quickly liquidate large portions of their stock right after the merger. This action can result in the stock prices plummeting and the surviving company’s value being negatively affected.
Including clauses in the merger agreement can lower or eliminate this risk entirely. As M&A advisors recommend, the clause will outline the holding period for which investors must retain their stock.
Lack of Hype Results in Low Share Demand
An IPO release typically generates hype and publicity in the market, enticing investors to purchase the stock. Although the probability of sizeable investment gains cannot be assured, market visibility and Wall Street coverage is always an advantage.
On the other hand, reverse mergers may not attract coverage and attention from Wall Street analysts. As a result, potential investors may be hesitant to invest in the surviving company’s stock. Chances are also that despite its listing, the acquired company may come across as falling short of finances and operations.
On their part, the private company entering into the deal may not be ready to go public. It may not have the capability, talent, or resources to scale quickly. If the company is not stable enough, the objective behind the reverse M&A transaction may be lost entirely.
Before exploring the option of entering into a reverse merger, the private company should explore options to achieve stability. Once it is stable operationally and financially, getting coverage from Wall Street analysts should be much easier.
When the company releases an IPO organically, getting investment proceeds seamlessly. Presenting robust financials and other metrics to show viability will attract funding quickly.
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Complying with Regulatory Requirements is Challenging
As stated above, once the reverse merger is complete, the acquirer’s management team takes over the public company. It also replaces the board of directors. However, managing a public company involves experience and expertise that the private firm may lack.
Managing the regulatory and compliance requirements of a public concern can prove to be complex and expensive, not to mention time-consuming. Not being able to handle the requirements can lead to the surviving company underperforming and running into legal hurdles.
In the case of cross-border transactions where a foreign private company acquires a US-based shell company, regulations are more complex. Complying with federal, state, and local requirements and SEC registration laws can be a lengthy process.
Diverting too much time and effort toward administrative tasks can take away from operational efficiency. If the company is unable to show sustained growth, attracting further investment becomes challenging.
A practical solution to counter this risk is to build a new management team. This board of directors and executives should include members from both companies who are familiar with the workings.
Onboarding employees from the publicly traded company, and hiring trained consultants who have the relevant legal expertise is also advisable. Post-merger managers should work on rebuilding the surviving company’s infrastructure and achieve synergies with a well-planned integration strategy.
Instituting an amalgamated work culture, setting up uniform salary structures across the board, and open communication channels ensure success. Once the company demonstrates success, its stock value and liquidity automatically increase. As a result, it will have access to a larger pool of investors.
Why Private Companies Enter into Reverse Mergers
Once private companies start earning revenues worth $100M and above, going public is the next step. The company’s stock and securities are open for trading on the exchange, thus providing liquidity. As long as it remains a private company, it will only have access to private equity which limits its growth potential.
The company’s founders and original owners now have the option to liquidate their holdings and exit. That’s because the publicly traded company is now in a position to purchase its shares back. The access to capital markets enables the management to issue secondary offerings as additional stock.
If the company has issued warrants in the past, stockholders get the right to buy additional shares. This offer is available to them at prices pre-determined in the agreement. As a result, the new firm gets a fresh injection of capital that can further boost growth.
Now that the company has gone public, its stock trades at higher multiples. The general public, large operational companies, and institutional investors can purchase shares from the open exchange, which drives up prices.
At this point, the management can enter into M&A deals and strategic alliances to scale the company. High-value shares can prove to be the currency for acquiring targets. The ability to offer stock options and incentives to attract top talent and skill sets is another positive. This is why private companies enter into reverse mergers.
Although the downsides of reverse mergers may seem to be more complex and extensive, such deals can be beneficial. Private companies can accelerate growth with fresh infusions of capital within a short time.
Being aware of the downsides allows dealmakers to prepare to counter them with strategic decisions and well-planned approaches. That’s how they can ensure stability, scalability, and long-term profits.
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