A reverse merger is a process by which a smaller, private company goes public by acquiring an already-public company. It's known as a "reverse" merger because it's less common for a private company to overtake a public company.
Here's what you need to know about reverse mergers, why they happen, and some past examples of reverse mergers.
What Are Reverse Mergers?
When a private company wants to go public, it’s usually a complicated process. There’s the work of hiring an investment bank to underwrite and issue the shares. There are regulatory approvals, a long due diligence process, lots of paperwork, and that's all assuming the market conditions are favorable for a public offering at that time.
There is, however, a faster way to go public, and it's known as a reverse merger. This strategy involves a smaller company acquiring a company that's already publicly traded—usually a fairly small public company with relatively few operations. While the public company "survives" the merger, owners of the private company 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
While it can be advantageous for some private companies to go public with a reverse merger, the practice has also been abused by companies engaged in fraud and scams.
How Do Reverse Mergers Work?
A typical initial public offering process takes months at the minimum, and the process can sometimes take more than a year. A reverse merger allows a private firm to go public much faster. It also saves the firm on legal and accounting fees.
With a reverse merger, a private company merges with an existing, smaller company that’s already listed on an exchange. This is usually done by buying more than 50% of the public company's stock. Once the private company effectively controls the public company, it can begin the process of merging its operations with the public company's.
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 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 looking to raise cash as they go public are better off taking the traditional route of pursuing an IPO.
Cases of Fraud and How to Spot Them
The Securities and Exchange Commission (SEC) has made a point to highlight the risks that reverse mergers pose to investors. The agency says many companies fail or otherwise struggle to remain viable after a reverse merger.
Another thing for investors to be aware of is that reverse mergers can be used by foreign companies to gain access to U.S. investors. While there's nothing inherently wrong with this, 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—that 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 delisted from a stock exchange?
- What do we about the executives and their background?
- Who has performed the company’s financial audit? Does the auditing entity appear to have the resources required to accurately and thoroughly audit the company?
When examining a reverse merger, ask yourselves these questions. If you don’t like the answers you are getting, it’s probably best to stay away, or at least wait until you get more information.
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, 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 strong financial footing or not.
- Reverse mergers are mergers in which a private company takes over a public company.
- By conducting a reverse merger, a private company can effectively go public 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 that traditional IPO companies go through.