What Is A Reverse Merger, and How Does It Work?

A reverse merger, or reverse takeover, occurs when a private company acquires a larger, publicly-listed business. It’s a cheaper and faster alternative to an initial public offering (IPO). And this process lies at the heart of the strategy used by special-purpose acquisition companies (SPACs).

In 2021, 398 reverse merger transactions were executed and valued at $134.8bn¹. 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 controlling stake in a publicly listed firm. Excluding a SPAC or shell company, a reverse merger can sometimes involve struggling publicly-traded businesses ripe for takeover.

The process commences when the private entity becomes the controlling shareholder of the public company. After that, the acquirer begins to integrate itself.

For a public shell company, this part of the process is easy. After all, there are no operations to blend. But if a struggling firm has been acquired, corporate restructuring almost always occurs. The firm will assess the quality of the assets and dispose of anything deemed economically unviable.

Going public through a reverse merger is significantly faster than performing an IPO, taking an average of five weeks versus up to a year. There is far less regulatory oversight, no need for an investor roadshow, and the firm doesn’t have to hire an underwriter. That’s why the process is so much cheaper and becoming increasingly popular.

How to spot an incoming reverse merger

Identifying reverse mergers before they are announced can be a tricky process. But the returns can be tremendous for investors who snatch up shares in advance. 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 signals?

• Weakened Balance Sheet – Struggling public companies are often the target of acquisitions as well as reverse mergers. Often the struggle can emerge from being overburdened with debt obligations. Acquiring firms with enough capital to satisfy the loans and a strategy to turn things around may decide to pick up a debt-riddled company at a discount. However, too much debt and the hassle may not be worthwhile.
• Working Capital Requirements – Some public companies may invite reverse merger offers to raise working capital. Firms seeking to raise at least $500,000 or more due to inadequate cash flows may be entertaining prospects.
• Appropriate Market Cap – Large-cap stocks often have a market capitalisation 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 a lot of benefits to the acquiring private company.

• Simplified Process – Through a reverse merger, becoming listed is far more straightforward, making it significantly faster and cheaper than a traditional IPO.
• No Underwriter – Reverse mergers eliminate the need for hiring an underwriter from an investment bank.
• 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 far less critical to success.
• Raise Capital – Upon successful acquisition of the public company, the private firm takes its place and becomes public. This gives it access to the financial markets, where it can issue new shares to raise capital at any time.
• Tax Benefits – Whenever a company suffers financial losses, a percentage of these losses can be carried forward as a shield against tax. After a reverse merger is completed, 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 enormously benefit businesses, they have several significant drawbacks for investors.

• Due Diligence – Unlike an IPO, reverse mergers don’t have to disclose anywhere near as much information to regulators to go public. Therefore, there can often be a lack o transparency with the merged company’s operations, financials, and other critical factors. Therefore, investors must thoroughly vet and verify all available information which may be scarce.
• Lack of Experience – Running a private and public enterprise are very different tasks. And a private firm that has no experience on its board in being public could result in significant learning pains, often reflected in a volatile share price. This is especially true when navigating regulatory compliance after becoming publicly listed.
• Stock May Get Dumped – Mergers always carry uncertainty, especially larger ones. Therefore, it’s not uncommon for shareholders to jump ship if there are signs of trouble, resulting in a rapid decline in market capitalisation.

The bottom line

The reverse merger process is relatively cost-effective for companies who want to get listed but lack the funds for an IPO process. However, the acquiring company and investors should be cautious and properly scrutinise the acquisition process to avoid fraud, losses and other mismanaged risks.

Article sources

1. Bloomberg Law. “ANALYSIS: Reverse Mergers Reach Record High (Even Without SPACs)“

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent 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 must consider their individual financial circumstances and reach out to an independent financial adviser if necessary.

The post What Is A Reverse Merger, and How Does It Work? appeared first on The Money Cog.