Why Do a Reverse Merger Instead of an IPO?

Private companies are held privately, and they are almost always owned by the people who establish them. While they may have access to private equity, they are generally closed off from the public, including stock markets. Contrast that with public companies, which have access to capital markets by giving up a stake to public investors. Companies go through a rigorous process so they can go public. And there are several options that private entities have, including the reverse merger.

What Is a Reverse Merger?

A reverse merger is often the most expedient and cost-efficient way for a private company that holds shares that are not available to the public to begin trading on a public stock exchange. It is also often referred to as a reverse takeover or a reverse initial public offering (IPO), and is commonly done by smaller private companies that take over larger public ones.

In a reverse merger, an active private company takes control and merges with a dormant public company. These dormant public companies are called shell corporations because they rarely have assets or net worth aside from the fact that they previously had gone through an IPO or alternative filing process. 

It can take a company from just a few weeks to up to four months to complete a reverse merger. By comparison, the IPO process can take anywhere from six to 12 months. A conventional IPO is a more complicated process and tends to be considerably more expensive, as many private companies hire an investment bank to underwrite and market shares of the soon-to-be public company.

The vast majority of public companies were created through the IPO process before reverse mergers became popular.

Reasons to go Through a Reverse Merger

Private companies may decide to go through a reverse merger for different reasons. It allows them time to grow as a private company before they open themselves up to public investors and regulations. The following are some of the most common reasons for pursuing this option:

• It’s easier and cheaper. Going through a reverse merger cuts down the amount of time and expenses related to going public with an IPO.
• Access to capital and liquidity. By opening themselves up to the public, they can raise capital to continue growing. This means they can fund research and development (R&D), pay off debt, and increase production among other things.
• Greater ownership and control. Reverse mergers allow the management of private companies to retain more control over the new company, which could be seen as a huge benefit to owners looking to raise capital without diluting their ownership.
• Merging with an existing public company to go public allows the company to take advantage of a name that may already be front and center of investors’ minds. This public company may have a popular brand or product that the public is aware of and trusts.

Advantages and Disadvantages of Reverse Mergers

The goal of a reverse merger is to realize any inherent benefits of becoming a publicly listed company, including enjoying greater liquidity. Having said that, the process comes with a number of benefits and drawbacks, which we’ve listed below.

Advantages

Reverse mergers allow private companies to convert to a public entity cheaply. That’s because it doesn’t require the services of an investment bank or the need to raise capital. There may also be an opportunity to take advantage of greater flexibility with alternative financing options when operating as a public company. It’s especially beneficial for smaller companies that need access to quick capital.

The reverse merger process is also usually less dependent on market trends and conditions. If a company spends months preparing a proposed offering through traditional IPO channels and the market conditions become unfavorable, it can prevent the process from being completed. The result is a lot of wasted time and effort. By comparison, a reverse merger minimizes the risk, as the company is not as reliant on raising capital.

These transactions allow owners of private companies to retain greater ownership and control over the new company, which could be seen as a huge benefit to owners looking to raise capital without diluting their ownership. For managers or investors of private companies, the option of a reverse merger could be seen as an attractive strategic option. 

Disadvantages

One of the main drawbacks of going through a reverse merger is that it may not provide instant access to capital. There is never any guarantee that a company will be able to access liquidity through the stock market through a reverse merger (or even an IPO)—especially when a company has never traded before. Private companies don’t have to release financial statements, so investors may be unwilling to take a chance on an unknown name.

Running a public company is different from managing a private one. As such, a private company’s management team may lack the experience it needs to meet the demands of regulators, including financial reporting and meeting compliance standards. This may lead to issues just before and after the reverse merger is executed.

Going public through a reverse merger is like an IPO as it means the company’s owners must dilute ownership and give up a stake in the company to public investors. This means that they also give up a great degree of control over the future of the company and how it’s managed.

Reverse Mergers and Shell Corporations

Reverse mergers may require the use of shell corporations, which can bring some degree of uncertainty to the merger. There are many legitimate reasons for these corporations to exist, such as facilitating different forms of financing and enabling large corporations to offshore work in foreign countries.

Some companies and individuals use shell corporations for various illegitimate purposes. This includes everything from tax evasion, money laundering, and attempts to avoid law enforcement. Before finalizing a reverse merger, the management of a private company must conduct a thorough investigation of the shell corporation to determine if the merger brings with it the possibility of future liabilities or legal entanglements.

Example of a Reverse Merger

In June 2020, Phoenix-based Nikola completed a reverse merger with VectoIQ, a special purpose acquisition company (SPAC). The merger allowed Nikola, a private company established in 2015, to raise more than $700 million. Nikola said the capital would allow it to increase production of its electric batter and hydrogen fuel-cell vehicles. Shares began trading on the Nasdaq under the ticker symbol NKLA on June 4, 2020.

The Bottom Line

Running a private company allows the owners to have more control over how it is run and its future. But it does come with certain hurdles, including the lack of access to capital from the average investor. A reverse merger is one way that a private company can get access to public markets. It occurs when a private company takes over a public one without having to go through the challenges and costs of an IPO. But it can be risky—especially for investors who may not have a good handle on the private company’s background. If the company’s leadership isn’t experienced, it may lead to the loss of capital for investors.