Should You Take Your Company Public With a Reverse Merger? Here Are the Pros and Pitfalls

A reverse merger is a business transaction that merges a privately held company with a publicly traded corporation. It is a strategic maneuver that takes your company public without the expensive and time-consuming process of the traditional Initial Public Offering (IPO).

Reverse mergers, while rarer than the traditional IPO, are not unusual. Many well-known corporations have used them, including the New York Stock Exchange, Burger King, and Blockbuster Video.

An IPO is often a grueling process, requiring months and months of work and, in most cases, well over $1 million in upfront costs. It isn't surprising then that many companies would be attracted to a method that would cost far less and speed up the timetable considerably.

But a successful reverse merger is dependent on a number of factors, and there are numerous pitfalls that can tank both a merger and your company. Understanding how the process works is essential to determining whether or not a reverse merger is right for your business.

The Traditional IPO

Understanding the traditional IPO is a good starting point, because it illuminates how the IPO differs from a reverse merger. What follows is a simplified overview of the IPO process.

An IPO begins with a private company hiring an investment bank to act as an underwriter to the IPO. Think of an underwriter as a middleman between your company and potential investors. Underwriters like Morgan Stanley and Goldman Sachs are key to the IPO process.

Working with your underwriters, you will prepare a registration statement to submit to the Securities and Exchange Commission (SEC), the federal agency which oversees federal securities laws. This statement supplies the SEC (and the investing public) with an in-depth description of your company's assets, managers, and independently certified financial documents. The SEC will review your statement and investigate your company to ensure that the information is accurate.

While the SEC investigates, you and your underwriters prepare an initial prospectus (called a red herring) which will be shopped around to major investment companies. Many people believes that an IPO begins with the sale of stock to the public, but this is not true. The first investors are large investment firms that purchase large amounts of stock and provide stability for the IPO.

Once the SEC approves your registration, and your prospectus has been shopped to investment firms, you will work with your underwriters to determine the initial price of your stock. The amount of excitement and interest generated by your initial prospectus will also have a direct impact on your company's initial stock price.

This quick overview of an IPO makes clear that it is a multistage process with many key players. An average IPO takes as long as a year to complete, and the financial burden is heavy. There also is no guarantee that your IPO will be a success. The amount of interest from investors, the volatility of the market, and other factors out of your control can all contribute to a poor showing on your opening day.

The Reverse Merger

The main appeal of a reverse merger is that it bypasses the entire IPO process. Instead of a long, financially-strapping undertaking that may not succeed, your private company merges with an already public entity. Through this merger, your private company inherits public status.

Most reverse mergers happen when a private company buys out an inactive shelf company that is listed on a public market. While there are many myths surrounding shelf companies, in the case of a reverse merger they can be properly leveraged.

However, not all reverse mergers utilize shelf companies. One of the most famous examples is billionaire Warren Buffett's own Berkshire Hathaway. Berkshire began as a textile corporation, which eventually merged with Buffett's private insurance empire when Buffett bought a controlling interest in Berkshire's failing business. Buffett never changed the name, and later shifted Berkshire into a holding company that houses a multitude of business ventures.

The benefits of a reverse merger are obvious: time and money. Where an IPO can take a year or more to complete, a reverse merger can be completed in as little as 30 days. While a reverse merger is not exactly cheap ($500,000 is a fair estimate), it still comes in significantly below the average cost of an IPO.

In addition, a reverse merger limits uncontrolled factors. An uncertain stock market or unconvinced investment firms won't mean disaster because they are not even a part of the transaction.

Possible Pitfalls

This doesn't mean, however, that a reverse merger is nothing but smooth sailing. There are pitfalls which must be avoided.

For starters, it is important to remember that you are merging your business with another company. You will be assuming that company's liabilities, debts, and any outstanding legal issues. For this reason, due diligence is absolutely critical.

Merging too quickly is also a common mistake. Public companies must meet many legal requirements that private companies simply never have to consider. Management of a public company can overwhelm directors and CEOs who are unfamiliar with the process and unprepared to handle complex new roles.

Ready to Merge?

There are many important considerations to address before pursuing a reverse merger. Here are some of the most critical:

• Capital: Do you have sufficient funds? Not just for upfront costs, but for ongoing maintenance. The average public corporation spends roughly $1 million a year on compliance.


• Fundraising: An IPO is traditionally a fundraising venture, an opportunity to raise capital for a company that needs additional cash flow to conduct new business. A reverse merger will not bring in this infusion of capital, as it wholly avoids the initial sale of stock to investors.


• Preparation: Are your directors and corporate officers knowledgeable about all SEC regulations? Are they prepared to implement and maintain these new standards?


• Red flags: A reverse merger may bypass the SEC's normal investigation into your company, but that doesn't mean the SEC will completely ignore you forever. The SEC regularly investigates illicit reverse mergers and has even released an investor bulletin warning about investing in reverse merger companies.

Determining if a reverse merger is right for your company is a complex decision, one that should include your attorney and your accountant, as well as your shareholders and directors. When all is said and done, the move to go public is not simply about finances, it's about the culture of your company.

But if your business is ready, and you do your due diligence, there is no reason that a reverse merger can't work for you.

The post Should You Take Your Company Public With a Reverse Merger? Here Are the Pros and Pitfalls appeared first on AllBusiness.com

The post Should You Take Your Company Public With a Reverse Merger? Here Are the Pros and Pitfalls appeared first on AllBusiness.com.