A reverse merger allows private companies to become publicly traded companies without conducting an initial public offering. Find out how to spot these deals early.
A reverse merger, or reverse takeover, occurs when a private company acquires a larger, publicly traded business. It is a cheaper and faster alternative to an initial public offering (IPO). And this process is at the heart of the strategy used by special purpose acquisition companies (SPACs).
In 2021, 398 reverse merger transactions were executed and valued at $134.8 billion1. And 246 of these transactions involved a SPAC. But while reverse mergers can provide investors with exciting new opportunities, there are some drawbacks to consider.
What is a reverse merger?
As mentioned, a reverse merger occurs when a private entity acquires a majority stake in a publicly traded company. Barring a SPAC or shell company, a reverse merger can sometimes involve struggling publicly traded companies ready to be taken over.
The process begins when the private entity becomes the majority shareholder of the public company. After that, the acquirer begins to integrate.
For a public shell company, this part of the process is easy. After all, there are no operations to mix. But if a struggling company has been acquired, a corporate restructuring almost always ensues. The company will evaluate the quality of the assets and will get rid of everything it considers economically unviable.
Going public via a reverse merger is significantly faster than going public with an IPO, taking an average of five weeks compared to a year. There is much less regulatory oversight, there is no need for an investor roadshow, and the company does not have to hire an underwriter. That is why the process is much cheaper and increasingly popular.
How to detect an incoming reverse merge
Identifying reverse mergers before they are announced can be a complicated process. But the returns can be tremendous for investors who buy shares upfront. After all, acquisitions are almost always executed at a premium. And this can translate into impressive double-digit returns in a relatively short space of time.
So what are the most common signs?
- balance sheet weakened – Distressed public companies are often the target of acquisitions and reverse mergers. Often the struggle can arise from being overburdened with debt obligations. Buying companies with enough capital to service the loans and a strategy to turn things around may decide to buy a debt-ridden company at a discount. However, too much debt and the hassle may not be worth it.
- Working capital requirements – Some public companies may invite reverse merger offers to increase working capital. Companies looking to raise at least $500,000 or more due to inadequate cash flows can be entertaining prospects.
- Adequate market capitalization – Large-cap stocks often have a market capitalization that is too large to be a viable candidate for a reverse merger. But small-cap stocks often trade at a premium due to excitement about their long-term potential. That’s why most non-SPAC reverse mergers have historically occurred with mid-cap stocks.
Advantages of a reverse merger
A reverse merger provides many benefits to the acquiring private company.
- simplified process – Through a reverse merger, listing is much easier, making it significantly faster and cheaper than a traditional initial public offering.
- no insurer – Reverse mergers eliminate the need to hire an investment bank underwriter.
- lower risk – IPOs are not always successful and are highly dependent on general market conditions. In fact, it’s not uncommon for entire deals to be cancelled, wasting valuable time and money. However, with a reverse merger, stock market conditions are much less critical to success.
- raise capital – After the successful acquisition of the public company, the private company takes its place and becomes public. This gives you access to the financial markets, where you can issue new shares to raise capital at any time.
- Fiscal benefits – Every time a company suffers financial losses, a percentage of these losses can be carried forward as tax protection. After a reverse merger is complete, the private company now benefits from this tax shield, protecting some of its profits from future taxes.
Disadvantages of a reverse merger
While a reverse merger can greatly benefit companies, it has several significant drawbacks for investors.
- Due diligence – Unlike an IPO, reverse mergers do not have to disclose as much information to regulators to go public. Therefore, there can often be a lack of transparency with the operations, finances, and other critical factors of the merged company. Therefore, investors should carefully examine and verify all available information that may be in short supply.
- Lack of experience – Running a public and private company are very different tasks. And a private company that has no board experience going public could result in significant learning problems, often reflected in a volatile share price. This is especially true when you browse regulatory compliance after being publicly listed.
- Stocks may be dumped – Mergers always bring uncertainty, especially larger ones. Therefore, it is not uncommon for shareholders to jump ship if there are signs of trouble, resulting in a rapidly declining market capitalization.
The bottom line
The reverse merger process is relatively cost-effective for companies that want to list but lack the funds for an initial public offering process. However, the acquiring company and investors must exercise caution and properly scrutinize the acquisition process to avoid fraud, loss, and other mismanaged risks.
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Article sources
- Bloomberg Law. “ANALYSIS: Reverse mergers hit record high (even without SPAC)“
This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment depends on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor should consider his or her individual financial circumstances and contact an independent financial adviser if necessary.
Edited and verified by
Master of Science Zaven Boyrazian
Zaven has worked in various industries throughout his career, from aircraft factories to game development studios. He has been actively investing in the stock market for the better part of a decade, managing over $1 million across multiple portfolios.
Specializing in corporate valuation, Zaven employs a modern version of the principles established by Benjamin Graham to find new opportunities at fair prices.
