What Are Reverse Mergers?

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DEFINITION

A reverse merger is a process by which a smaller, private company goes public by acquiring an already-public company.

Definition and Example of a Reverse Merger

A reverse merger strategy involves a smaller company acquiring a company that's already publicly traded—usually a relatively small public company with relatively few operations. While the public company "survives" the merger, the private company owners become the controlling shareholders. They reorganize the merged entities in their vision, which usually includes replacing the board of directors and altering assets and business operations.

  • Alternate names: Reverse takeover, reverse IPO
  • Acronym: RTO

For instance, if private company A wants to go public, it may not want to invest the time and money required upfront. Instead, it negotiates to purchase a controlling amount of publicly traded company B's stock. When the transaction takes place, all of B's shares are merged with A's, the company keeps its publicly owned name, and the new owners control the company's direction.

How Do Reverse Mergers Work?

A typical initial public offering process takes months at a minimum—sometimes, it takes more than a year. A reverse merger allows a private firm to go public much more quickly, because it bypasses proceedures set by the Securities and Exchange Commission (SEC).

In a reverse merger, a private company buys an existing, smaller company, generally by purchasing more than 50% of the public company's stock. Once the private company effectively controls the public company, it can begin merging operations.

The public company in this scenario is sometimes referred to as a "shell company" because it often has few (if any) operations of its own. It's simply a "shell" that the private company can step into and use to access the public market.

It’s important to understand that, unlike in an initial public offering (IPO), there is no capital being raised immediately during a reverse merger. That helps to expedite the process of going public, but it also means that reverse mergers are only appropriate for private firms that don’t need cash right away. Companies that are looking to raise funds as they go public are better off taking the traditional route of pursuing an IPO.

What It Means for Individual Investors

The Securities and Exchange Commission has made a point to highlight the risks that reverse mergers pose to investors. It says that many companies fail or otherwise struggle to remain viable after a reverse merger.

One issue to look for if you're invested in a smaller public company is that when a private company purchases a public company, the shareholders' composition changes. That means the controlling interest in a company changes hands, because the private company is acquiring the public one. As a result, your shares in the new company might not allow you the same privileges as the old one.

The new company also might not meet the listing criteria for the exchange the public company's shares were traded on. The exchange may halt the stock's trading, require that the company re-register, or require the newly merged company to go through the exchange's approval process again.

If a company you're invested in appears to be in a reverse takeover, or if you're looking to invest in one that is in the process, look for the free SEC filings on EDGAR. Some companies are not required to file. Be wary of companies that do not file with the SEC.

Another aspect for investors to be aware of is that foreign companies can use reverse mergers to gain access to U.S. investors. While there's nothing inherently wrong with that, the foreign companies gaining access to U.S. markets through reverse mergers don't go through the same level of scrutiny they would with a traditional IPO process, which means there are more opportunities for fraud.

It’s not always easy to tell when a reverse merger involves companies with solid financials and good intentions, but it helps to ask some key questions:

  • Why is the company engaged in a reverse merger, and what are its goals?
  • What do we know about the existing public company? Is it a legitimate, money-making business or simply an abandoned company that never got de-listed from a stock exchange?
  • What do we know about the executives and their backgrounds?
  • Who has performed the company’s financial audit? Does the auditing entity appear to have the resources required to audit the company accurately and thoroughly?

Patience is the key to successfully investing in reverse merger companies. If you learn that a company may be engaged in a reverse merger, avoid any temptation to act right away. Take time to allow the merger to complete, and then watch the company’s performance. Research its products and services, and learn about its management team. Pay close attention to its revenues and expenses. Over time, you’ll learn whether the company is on a solid financial footing or not.

Key Takeaways

  • Reverse mergers are mergers in which a private company takes over a public company.
  • A private company can effectively go public by conducting a reverse merger, without going through the arduous and expensive IPO process.
  • For investors, reverse mergers pose certain risks—the companies don't undergo the same rigorous vetting as traditional IPO companies.

Article Sources

  1. Securities and Exchange Commission. "Investor Bulletin: Reverse Mergers," Page 1.

  2. Securities and Exchange Commission. "Investor Bulletin: Reverse Mergers," Pages 2, 3.

  3. Securities and Exchange Commission. "EDGAR."