If you are looking to raise money through the capital market, then you may have considered a reverse merger. How is it different from a direct initial public offering (IPO), and what does the legal process entail? What are the pros and cons of listing on a public exchange as opposed to making a private offering? Here, we will go over the basics of reverse mergers.
Reverse Merger or IPO?
In a reverse merger, a private company “takes over” a public company through a merger to list on a public exchange. The public company changes its name and business to those of the private company, reflecting a change of control in management. In most reverse mergers, the shareholders of the private company acquire enough equity in the public company to take control of its board of directors of the public company. Nonetheless, the management of the public company may retain key positions in the merged company, especially if the businesses of the private and public companies were similar prior to the merger.
In an IPO, a private company lists on a public exchange from the ground up. That is, it is not taking a company that is already public, but preparing the necessary filings and legal documents to list on its own. Compared to a reverse merger, which makes use of a public company that already exists, an IPO can take many months longer and involve larger legal costs.
So why do private companies even consider IPOs in the first place? First, because reverse mergers allow private companies to dodge the formal regulatory requirements of IPOs, there is heightened stigma and scrutiny attached to them. Second, reverse mergers are frequently done on small caps, which can produce volatile stock prices post-merger, even if the merged company is managed meticulously. And finally, while it is cheaper and simpler to acquire a public shell than to make SEC filings from scratch, dealing with the management of the public company can prove challenging if there is significant discord or disorganization.
What Is the Legal Process of a Reverse Merger?
There are several steps to a reverse merger. First, attorneys must perform due diligence on target public companies to select a shell that is free from liabilities or other barriers to a merger. Then, they must prepare a merger agreement (and supporting documents) and make an S-4 filing with the SEC. As part of this filing, audited financial reports of the private company, the public company, and the merged company must be prepared, along with extensive disclosures that can comprise more than two hundred pages. Finally, once the SEC approves of the reverse merger, the private company and public company must take a number of steps to effect the merger. The process can take up to three months, which is significantly shorter than an IPO, which can take over a year.
Public vs. Private Offerings
What are the pros and cons of listing on a public exchange as opposed to making a private offering? You may have heard of alternatives such as Regulation D or Regulation A, both of which require shorter filings than reverse mergers. Reverse mergers broaden the scope of fundraising by allowing investors to acquire shares with just a click, so long as a ticker symbol exists for the merged company. Regulation D and Regulation A are more restrictive, either by:
- Requiring issuers to execute subscription agreements on a one-by-one basis with investors,
- Limiting the amount that can be raised, or
- Limiting the type of investors eligible to invest.
If you are unsure about which option to pursue, you may want to consider your fundraising strategy, your budget, and how soon you want to be able to raise money. If you are a smaller startup with a limited budget and in urgent need of cash, you may want to consider one of the alternatives to reverse mergers. If you want to be able to raise money with limitations and have both time and cash to spare, reverse mergers may be more for you.
Wrap-up
If you decide that a reverse merger fits best with your fundraising strategy, then you may want to do your own due diligence on target public companies. While lawyers can assist with the paperwork, there are softer components to mergers that require business acumen. For example, you will need to understand the management dynamics of a prospective shell to see if you will be able to work with the existing C-suite post-merger. At its core, a reverse merger is the same as any business partnership: it is two teams of people dealing with each other and working to find a solution that helps them both.
