Reverse Mergers: A Cost-Sensitive Alternative to Venture Capital and IPO

For some businesses, the gap in sufficient capital funding can be one of the most growth-thwarting conundrums of trying to take a company to the next level. Newer, …

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For some businesses, the gap in sufficient capital funding can be one of the most growth-thwarting conundrums of trying to take a company to the next level. Newer, creative forms of financing have helped to fill the chasm and provide hype, but funding gaps persistently remain. In fact, some–in their efforts to reinvent the world of corporate finance–are diving headlong into unchartered waters with unweilding deal-structures and untried financing options (e.g. crowdfunding). The age-old adage, “don’t fix it if it ain’t broke” certainly applies here. It is in that spirit that the following discussion on performing a reverse merger into an existing public shell may be helpful.

There are a number of key benefits to performing a reverse merger over some of the other financing methods, including venture capital, private equity and traditional IPO (initial public offering).

A Primer on Reverse Mergers

Prior to delving into the benefits and downsides of a reverse merger, it would be first beneficial to give a little background. A typical reverse merger includes a public company whose entity still remains and is fully “tradeable” in the public markets, but whose shareholders may have walked away from the company for any number of reasons including bankruptcy, phase-out or general business malaise.

As an effective method for accessing the public capital markets, defunct public companies are often the M&A target of private companies in a growth spike. As part of a strategic reverse merger takeover, the shareholders of the private company surrender their shares in the privately-held business for new shares in the public company. In the controlling-interest purchase of the public company shares, the newly-controlling private company is then required to report its financial statements in replace of the former public company.

Other forms of reverse mergers, including reverse triangular mergers are typically meant to assist in deal-speed rather than liquidity for a private company in the capital markets. As a similarly-structured tool, they can play an important role in M&A, but are not as relevant for a discussion on raising capital for corporate growth.

Benefits of Reverse Mergers

There are several key advantages of performing a reverse mergers over other forms of capital finance.

  • Cost Savings. Unlike other forms of finance, including IPO, there can be significant cost savings in performing a reverse merger. The cost of many shell corporations are reasonable and in most cases reverse merging private companies are not required to pay some of the high investment banking fees required in similar transactions.
  • Enhanced Liquidity & Exposure. Just like any public company, being in the public market helps to create more liquidity through enhanced exposure to the firm, its capital structure and the underlying value-drivers for the business. Liquidity is further enhanced through the capital markets who now have a clear exit from the stock, if needed.
  • Stock as Currency. The company can utilize stock as a form of currency to help finance further growth through acquisition.
  • Limited Regulatory Hurdles. Reverse merger transactions typically require less stringent regulatory hurdles than other forms of financing. However, recent public scrutiny over Chinese reverse mergers has caused a push for more regulation in foreign firms entering the U.S. this way.
  • Time Savings. Initial public offerings are much more time-taxing than a foray into the public markets by reverse merger. That’s valuable time not spent by management, finance and accounting that is better used to help the company grow.

In the fight to obtain capital funding, reverse mergers also play a key role for businesses who wish to reach the next phase without sacrificing huge portions of the company to the likes of venture capitalists and return-sensitive private equity groups. It’s a deal-style difference between VC and PEGs that make reverse mergers a compelling alternative.

Reverse Merger Issues

In each of the benefits listed in the scenario above, there are some caveats that are helpful to keep in mind. Unlike an IPO, reverse mergers typically don’t involve a massive underwriting and marketing campaign put on by high-flying investment bankers. When a reverse mergers is performed, no immediate money flows into the company.

Another characteristic that some may find less-than-palpable in a public-shell merger is the fact that the stock in such transactions is typically not traded on a high-flying exchange like the NASDAQ. Instead, smaller Over-the-Counter BB and Pink Slip exchanges provide the venue for most reverse merger scenarios. In addition, some newly merged and formerly-private companies may find the reporting and regulation cost and time a bit of a deterrent.

Finally, increased scrutiny and regulation–mostly aimed at foreign companies looking to enter the United States capital markets–has not played well for many reverse merger shell opportunities in the last decade. Domestically-operated companies can still find opportunities, especially since the number of shell companies available in the last decade has expanded dramatically.

The sexy side of finance certainly receives the most acclaim and press-coverage. Fortunately, fundamental and time-tested methods for fully-accessing the capital markets are still available to the finance-savvy company willing to take the plunge.

About

Nate Nead is a Partner with Mergers.com, an M&A advisor network of middle-market deal-makers, investment bankers, investment advisors and private equity groups. The company’s partner network works in the private markets in assisting companies in merger, acquisition and asset divestment strategies.

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