A merger is an agreement in which two companies combine to operate as a single company through the exchange of shares or other capital means. The goal is to expand the business to new markets, gain access to a larger customer base, diversify products and services, and reduce risk and competition. Such transactions usually happen between two businesses that are about the same size or when a small corporate entity folds into a large corporate entity. However, if the acquiring company is smaller in size or weaker than the one being acquired, it is termed as a reverse merger. If you are also considering a reverse merger for your own business, knowing its risks and benefits will help you make an informed decision. Here is everything you need to know about reverse mergers:
Understanding Reverse Merger
Also referred to as reverse initial public offering (IPO) or reverse takeover, a reverse merger is a corporate strategy that involves the acquisition of a dormant, loss-making public company by an active, profit-making private company. A parent company merging into a subsidiary is also an example of a reverse merger. A reverse merger is an easy, quick, and less- expensive way for private companies to go public without going through the lengthy and time-consuming process of conventional IPO. The dormant public company, called “shell corporation”, rarely has assets or net worth, but they previously had gone through the complex IPO process. This feature makes it an attractive deal for private companies that want to go public while saving time, energy, and capital.
In this merger, the private company trades shares with the shell corporation in exchange for its stock, acquiring all the inherent benefits of the publicly listed company and becoming a public company itself.
Benefits of a Reverse Merger
Simple and Time-Saving: A reverse merger allows the private company to become a public traded company without needing to hire an investment bank or raise capital. This makes the process a lot simpler than traditional IPOs that are very costly to execute.Moreover, whereas the conventional IPO process can take anywhere between six to twelve months, a reverse merger can be completed within just a few weeks.
Low Risk: Conventional IPO process is dependent on market conditions. If stock market performance dampens, the deal may be canceled, which means all your efforts, time and capital spent planning for a traditional IPO will go in vain. This makes it a very risky proposition. A reverse merger minimizes this risk as the process is less dependent on stock market conditions.
Tax-Saving: Using the public company as a tax-saving opportunity can be another benefit of reverse mergers. Shell corporations are in this state because they have experienced continuing losses and are financially unstable. The private company undergoing a merger can take advantage of these losses and depreciation by referring them to its future tax statements and get some tax relief.
Risks of a Reverse Merger
Due Diligence Necessary
One of the risks associated with the reverse merger is the potential liabilities shell corporation brings to the acquirer. These liabilities that may include litigation, environmental, safety issues, and labor issues are deal-breakers as the merger could also mean taking ownership of all these problems. Without investigation, all these liabilities could simply slip away from the eyes of acquirers and they fell prey to malicious intentions of public company’s shareholders. Appropriate due diligence is required to uncover all these liabilities and safeguard the interests of the company. Transparent disclosure is expected from both companies to prevent future liabilities or legal predicaments.
Transitional Challenges
The additional regulatory and compliance requirements of a public traded company can result in the underperformance of the newly combined company formed from the merger. Private companies have little experience in managing these compliance burdens, which makes reverse mergers a complex endeavor for them. This can also affect the speed of the merger process. New problems and challenges that arise after the merger could mean more focus on administrative tasks and less on executing core business operations that drive profitability.
Reverse Stock Split
During the merging process, shareholders may decide to reduce their number of outstanding shares in the market and distribute new shares to their shareholders. This measure is called reverse stock split. It is done to raise the company’s share price and prevent the possibility of being delisted from the stock exchange. However, a reverse stock split can be an undesirable proposition for the original shareholders.
Conclusion
Reverse Mergers could be one of the best ways for unlisted companies to go public or gain access to capital markets without going through the cumbersome process of IPO. There are certain risks associated with it, but a comprehensive investigation and well-planned process can avoid most of the drawbacks and contingent liabilities arising from the merger. It is imperative that the information sharing between both parties is transparent and the merger agreement is free from loopholes.
Zackary L. Ruiz 