What are Reverse Mergers – Its Working, Examples and Benefits
There are various approaches to going public with a business. A reverse merger also referred to as a reverse takeover or a reverse IPO is a tactic used by private businesses to open up access to their stocks to the public.
Reverse mergers are a completely legal way to float a company, despite the reputational harm they may have done at the time of the early 21st-century reverse merger boom, which saw hundreds of Chinese firms acquire American companies.
Read on as we discuss everything you need to know about reverse mergers.
What Are Reverse Mergers?
In a reverse merger, a privately held company acquires a public company. After the acquisition is finished, the owners of the private company take over control of the public company and restructure the latter’s assets and operations to incorporate the former private firm. In contrast to the typical IPO scenario, the idea of a private company purchasing an existing public company is why the term ‘reverse’ comes into the picture.
How Do Reverse Mergers Work?
You may want to go public once your privately held business reaches a certain size. The disadvantage of going public, however, is that anyone will be able to buy stock in your business, which may reduce your control. If you’re concerned about the disadvantages of going public through an IPO, you could use the reverse merger process to take your company public.
In a reverse merger, the private business would acquire a majority stake in a public company before merging with it. Either a public operating company or a public shell company may be the company you can merge with. The US Securities and Exchange Commission (SEC) lists three characteristics of a shell company:
- It is traded publicly
- It either has nominal operations or none at all
- It only has cash assets, nominal assets or no assets
The shareholders of the private company will swap their shares for current or new shares in the public company during a reverse merger transaction. The former shareholders of the private company will hold the majority of the shares in the public company after the transaction is complete. The private company will then become the public company’s wholly-owned subsidiary if the process is successful.
A controlling shareholder of the public company prior to the merger will typically return their shares so that they can be cancelled; otherwise, the shareholder may also transfer their stock to the private company. This process results in the private company becoming a public company without the need for an IPO.
Why Would a Company Face a Reverse Merger?
It’s essential to understand the initial reasons behind a company’s decision to go public. Companies raise their brand recognition and gain access to more sources of funding than are typically available to private businesses by selling shares to the general investing public. Traditionally, an IPO is used to accomplish this.
IPOs, however, are complicated, drawn-out processes that frequently involve hiring an investment bank to issue shares and underwrite the deal. Additionally, there is a lengthy due diligence procedure, a tonne of paperwork, and regulatory reviews that follow. Reverse mergers can take a business anywhere from a few weeks to four months to complete while IPOs can generally take anywhere between six and twelve months if not more. Moreover, even with all of that, unfavourable market circumstances that are out of any company’s control may make it difficult to predict whether or not an IPO will take place.
However, none of the expenses and challenges associated with a typical IPO applies in a reverse merger, making it possible for private companies to quickly go public. This is crucial for businesses that might lack the resources or know-how to manage an official IPO.
Also Read
Process of a Reverse Merger
It is common for over-the-counter (OTC) markets to list shares of numerous public companies that have little to no active operations or assets. These are referred to as “shell companies,” and reverse mergers typically target them.
The owners of the public company must purchase at least 51% of the stock of a shell company as the first step in a reverse merger. Once they hold a majority stake, they exchange the existing or newly issued shares of the public shell company for the stock of the private company. The private company eventually becomes a shell company’s wholly-owned subsidiary.
However, it’s important to note that a reverse merger does not involve the raising of fresh capital, unlike a traditional IPO. They can be finished more quickly because there is no need to generate publicity for the transaction and attract institutional or retail investors.
Example of Reverse Merger
One of the famous reverse merger examples was the 2002 merger of ICICI and its arm ICICI Bank. At the time, the balance sheet of the parent company was more than three times larger than that of its subsidiary. The reverse merger was justified by the need to establish a universal bank that could provide credit to both industry and retail borrowers.
Reverse mergers can result in the new entity adopting either the name of the larger or smaller company. The brand name for the new entity was ICICI Bank, which was retained by the ICICI Group. However, looking at another reverse takeover example, when Godrej Soaps, which was profitable and had a turnover of Rs. 437 crore, reverse merged with Gujarat Godrej Innovative Chemicals, which had a turnover of 60 crores but was loss-making, the firm was named Godrej Soaps in 1994.
Features of Reverse Mergers
- The assets of the large company must be worth more than the assets of the small company
- The large company’s net income attributable to its assets would exceed that of the small company
- The share capital to be provided as an acquisition fee must be greater than the small company’s equity share capital prior to the acquisition
- Priorities for the reverse merger are well-established before the deal is signed
- Meeting the fair purchasing value is a must
- The merger should be of public concern
Insurance Needs for a Reverse Merger
After a reverse merger, the new business and its owners need to be ready for ongoing regulatory compliance, which usually entails evaluating and possibly upgrading their insurance coverage. Depending on the nature of the company’s operations, this may involve insurance for property, tax liabilities, cyber liabilities, and others.
However, reverse mergers are less reliant on the general state of the market because they are not looking to raise capital in the same way.
Advantages of a Reverse Merger
1. Owning stock in a public company
Holding a public company has many advantages given that the complexity of the regulatory and compliance requirements isn’t too much of a burden. Alongside upgrading the company profile, it would help the company be better able to make acquisitions by using its shares as consideration (payment) and be able to access liquidity faster due to the fact that public companies typically trade at higher multiples than their private counterparts.
2. No middleman
Reverse mergers, unlike IPOs, do not call for an investment bank to act as an underwriter. Instead, the public company and the private company are the only parties to the agreement.
3. Easier access to capital
Reverse mergers usually take 1-3 months to get through, whereas IPOs often take 6 months or more.
4. Cost-effective
Reverse mergers are less expensive than initial public offerings (IPOs) because they don’t require paying fees to financial institutions and are completed faster.
5. Less subject to changes in the market
Strong demand and media coverage are essential for profitable IPOs. However, reverse mergers are less reliant on the general state of the market because they are not looking to raise capital in the same way.
Also Read
Disadvantages of Reverse Merger
1. Due diligence
Both investors and the companies involved in a reverse merger should be aware of this. Considering that a reverse merger requires substantially less regulatory review than an IPO does, consumers should thoroughly investigate the company that results from the transaction.
2. Lack of interest and liquidity following the merger
Small businesses that frequently participate in reverse mergers might not be prepared to go public. Because of this, they might not have the size or viability to withstand the responsibilities of being a public company and maintain investor interest in their shares, which might make them more challenging to trade over the long term.
3. Investment risk
Reverse mergers don’t always receive a lot of press, aren’t frequently followed by Wall Street analysts, and might not generate the kind of sizable investment gains possible with a strong IPO company. And keep in mind that while even initial public offerings are not guaranteed to generate a profit for investors, reverse merger-based IPOs are even riskier.
What’s the Difference Between Special Purpose Acquisition Company (SPACs) and Reverse Mergers?
| Basis of Distinction | SPAC | Reverse mergers |
| 1. Redemption option and shareholders’ Vote | Stock prices typically have a floor up until the completion date of the merger because SPAC investors have the option to redeem their investment if they do not approve of the merger. Additionally, SPAC shareholders have the option to vote on the proposed merger, and if the vote fails to win their approval, the Sponsor will probably be required to liquidate the SPAC and return investor funds. | As for reverse mergers, the option to redeem isn’t available. |
| 2. Dormant shells | In a SPAC transaction, the private company acquires ownership of a clean shell with no prior operations or history. As opposed to dormant shell mergers, past operational activities have no potential liabilities attached to them. The SPAC sponsors also retain control which makes it more difficult for stock manipulators to use SPACs for pump and dump schemes because it gives SPAC investors the option to get their money back if they disagree with the merger. | A reverse merger is an alternative to the conventional IPO process for bringing companies public. The private company may go public by acquiring a majority stake in a dormant shell company, a thinly traded company that no longer conducts business or holds assets (or holds little assets), as opposed to a private operating company raising capital in the public market. The private company’s operations and typically its management continue to be part of the surviving public capital structure. |
How Does a Reverse Merger Affect an Investor?
The risks that reverse mergers pose to investors have received special attention from the US Securities and Exchange Commission. After a reverse merger, many businesses fail or otherwise struggle to remain profitable, according to them.
If you own stock in a smaller public company, one thing to watch out for is the fact that when a private company buys a public company, the shareholders’ composition changes. As a result of the private company acquiring the public one, the controlling interest in the company changes hands and one’s shares in the new company may not grant them the same privileges as those in the previous one.
The new business may not also satisfy the requirements for listing on the exchange where shares of the public company were previously traded. The exchange has the right to stop trading in the stock, demand that the business re-register, or demand that the newly combined business goes through the exchange’s approval procedure once more.
Look for the free SEC filings on EDGAR if a company you are interested in seems to be undergoing a reverse takeover or if you want to invest in one that is. Companies that don’t register with the SEC should be avoided, although there are some companies that aren’t required to file.
Investors should also be aware that foreign businesses may use reverse mergers to gain access to U.S. investors. While there is nothing fundamentally wrong with that, there are more opportunities for fraud because the foreign businesses that use reverse mergers to access American markets aren’t subjected to the same level of scrutiny as they would be during a traditional IPO process.
Everything has its pros and cons and so do reverse mergers. Despite their drawbacks, they provide an efficient way for a company to go public instead of going through the tedious process of opting for a traditional IPO. As for investors, the secret to investing in companies that have undergone reverse mergers is patience. Do not succumb to the urge to take immediate action if you learn that a company may be involved in a reverse merger.
Final Word
Watch the company’s performance after giving the merger some time to complete. Look into the company’s management team and its products and services. Pay close attention to the company’s earnings and costs. You’ll eventually discover whether the business is financially stable or not and whether it would be a good idea to invest.
FAQs
Ans. When a privately held company acquires a public company, it’s called a reverse merger. After the acquisition is finished, the owners of the private company take over control of the public company and restructure the latter’s assets and operations to incorporate the former private firm.
Ans. A private company collaborates with a financial institution to conduct an initial public offering (IPO), in which some of its stock shares are sold on a stock exchange and capital is raised. Conversely, under a reverse merger, the private business would acquire a majority stake in a public company before merging with it. Additionally, none of the expenses and challenges associated with a typical IPO applies in a reverse merger, making it possible for private companies to go public quickly.
Ans. Reverse mergers are prone to fraudulent activities and therefore, investors must exercise maximum caution before making any investment-related decision. Watching the company’s performance after giving the merger some time to complete and paying close attention to the company’s earnings and expenses can help discover whether the business is financially stable or not and whether it would be a good idea to invest in it.
Short code:
Want to put your savings into action and kick-start your investment journey 💸 But don’t have time to do research? Invest now with Navi Nifty 50 Index Fund, sit back, and earn from the top 50 companies.
Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
