Key Takeaways

  • A reverse merger allows a private company to go public by merging with a public shell or operating company instead of pursuing a traditional IPO.
  • The process is faster and less costly than an IPO but does not itself raise new capital.
  • Reverse triangular mergers are the most common structure, often helping avoid proxy requirements.
  • Advantages include quicker market access, reduced underwriting costs, and potential for easier capital raising after going public.
  • Risks include less regulatory scrutiny during the transaction, inherited liabilities, and possible reputational concerns if the shell company had issues.
  • Reverse mergers are particularly popular in sectors like life sciences, where speed to market is often crucial.

A reverse merger transaction is an option for a company that has an interest in going public. Instead of making an initial public offering (IPO), the company will merge with another company that has already gone public.

How Does a Reverse Merger Work?

After your privately held company has reached a certain size, you may want to go public. However, the drawback of going public is that anyone will be able to purchase stock in your company, which can dilute your control. If you're worried about the drawbacks of going public by making an IPO, you could take your company public using the reverse merger process.

With a reverse merger, your private company would purchase a controlling stake in a public company and then merge with that company. The company with which you merge can either be a public operating company or a public shell company. A shell company has three characteristics according to the Securities and Exchange Commission (SEC):

  • It is publicly traded.
  • It has nominal operations or no operations at all.
  • It has nominal assets, no assets, or only cash assets.

During a reverse merger transaction, the shareholders of your private company will swap their shares for existing or new shares in the public company. Upon completion of the transaction, the former shareholders of your private company will possess a majority of shares in the public company. If the process is successful, your private company will be the public company's wholly owned subsidiary.

The shareholder who owned a controlling share of the public company before the merger will usually give their shares back so that they can be canceled. The shareholder may also transfer their shares to the private business. Once this has occurred, the public company takes over the private company's operations. The result of this process is that the private company has become a public company without having to make an IPO.

Risks and Challenges of Reverse Mergers

While a reverse merger can be an efficient way to access the public markets, it is not without drawbacks. Key risks include:

  • Inherited Liabilities: The private company may assume unexpected debts or pending litigation of the public shell.
  • Limited Scrutiny: Because reverse mergers bypass the lengthy IPO vetting process, investors may view them with skepticism, raising reputational concerns.
  • Liquidity Issues: Shares may initially trade at low volumes, making it difficult to attract institutional investors.
  • Regulatory Risks: The SEC has increased scrutiny on reverse mergers in the past, particularly after fraudulent transactions were uncovered in the early 2010s.
  • Dilution Concerns: If new shares are issued to facilitate the merger, early investors could see their ownership percentages reduced.

Triangular Mergers and Reporting Requirements

A reverse triangular merger is the most common form of reverse merger. With this structure, the public shell company creates a subsidiary company which then merges with the private company. Shareholders exchange their shares in the private company for those in the public company, and the private company is now a wholly owned subsidiary.

With a reverse triangular merger, it is usually easier to obtain consent from company shareholders because the new subsidiary company has only one shareholder: the public share company. Structuring a reverse merger in this way allows the public company to avoid the Securities Exchange Act's proxy requirements for mergers.

The SEC maintains multiple reporting requirements that apply to reverse mergers. Within four days after the reverse merger transaction is complete, the public company must file Form 10. The private company will not become a public company until they have done so.

Securities issued to shareholders of the private company should either register under the Securities Act or should use an exemption.

Industry Use Cases and Trends

Reverse mergers are especially common in the life sciences sector, where biotech and pharmaceutical companies often need rapid access to public markets to fund research and clinical trials. Instead of waiting months for IPO approval, a reverse merger allows these companies to secure public status quickly, then raise follow-on capital once trading begins.

Other industries, such as technology and energy, also use reverse mergers when market conditions make IPOs difficult or investor appetite is weak. Companies based outside the U.S. sometimes choose reverse mergers to establish a U.S. market presence more quickly.

Reverse Merger Advantages

If you're considering taking your private company public, learning about some of the advantages of reverse mergers is a good idea. Firstly, you can usually complete a reverse merger fairly rapidly. If the private company has everything in order, its attorneys should be able to complete the merger paperwork without any difficulty. Having everything in order basically means that the private company has up-to-date audited financial statements for the previous two fiscal years. The private company should have also prepared any documents the SEC would need to review.

An important thing to understand about reverse merger transactions is that they do not raise any capital. Because of this, private businesses typically raise capital at the same time they are completing the reverse merger. While this can be beneficial, it is not required. Some companies choose to restructure their capital either before or after a reverse merger, and also may decide to change their name.

Raising capital can be very difficult, particularly for small private companies. A reverse merger allows these companies to go public without assuming the expense of such an endeavor, and once the private company is public, it will be able to more easily raise capital with stock option plans.

Reverse Merger vs. IPO

When deciding between a reverse merger and an IPO, companies should weigh the following differences:

  • Speed: A reverse merger may take a few months, while IPOs often take a year or longer.
  • Cost: IPOs involve underwriting fees, roadshows, and extensive SEC filings, often costing millions. Reverse mergers can be significantly cheaper.
  • Capital Raised: IPOs raise fresh capital through share sales. Reverse mergers provide public status but typically do not raise funds directly.
  • Market Perception: IPOs undergo rigorous due diligence by regulators and underwriters, often giving investors more confidence. Reverse mergers may face skepticism if not paired with strong financial disclosures.
  • Control: Reverse mergers allow founders to maintain more control compared to the dilution that often occurs in IPOs.

Frequently Asked Questions

1. Why would a company choose a reverse merger instead of an IPO?

A reverse merger is faster, less expensive, and requires less regulatory approval, making it attractive for companies that need quick access to public markets.

2. Do reverse mergers raise new capital?

No. A reverse merger only changes the company’s status to public. Many companies arrange separate financing before or after the transaction.

3. What is the difference between a shell company and an operating company in a reverse merger?

A shell company has no operations or significant assets, while an operating company may have ongoing business activities. Both can be used in reverse mergers, though shells are most common.

4. Are reverse mergers riskier than IPOs?

They can be. Because they bypass the traditional IPO vetting process, reverse mergers may face more reputational concerns, regulatory scrutiny, and liquidity issues.

5. Which industries most commonly use reverse mergers?

Life sciences, technology, and energy companies often use reverse mergers when speed and cost savings are critical, or when IPO markets are unfavorable.

If you need help with a reverse merger transaction, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.