While most people in Kentucky and across the country understand what it means when a company goes public, a lesser-known process through which a business may accomplish this is a reverse merger. Unlike a traditional initial public offering (IPO), a private company that participates in a reverse merger does not go through the complex, expensive IPO process of registration with the Securities and Exchange Commission (SEC), although some filings will still be required.
Because reverse mergers do not undergo the same levels of professional and governmental scrutiny as do IPOs, the risk of fraud is higher in the reverse merger process, causing governmental regulators to take a closer look over time.
On the other hand, the reverse merger, also called a reverse takeover (RTO), is a legitimate, lawful option for going public when carefully planned and executed as well as usually being a faster and less costly undertaking with potential tax advantages.
What is a reverse merger?
In a reverse merger, a private company merges with a public one. Normally, the public corporation is a relatively small, “shell” company that usually has only one asset – money – and is rarely involved in operations in a particular industry.
By contrast, the private company is usually a going commercial concern that conducts business in a specific market and industry, with assets like production equipment, real estate, leases, inventory, supplies, accounts receivable, intellectual property and others, depending on the type of business. By merging with the smaller, publicly traded company, the private business brings its commercial activity and management to the new public business. Usually, the private company’s stockholders acquire a majority of shares in the new public entity through some type of swap.
Since the new, combined company will not have to go through the IPO process, there will be less regulatory oversight and likely more privacy throughout the process.
Risks of reverse mergers
The (SEC) warns that investors face several risks with reverse mergers, so any company considering an RTO should consider that this may make attracting investors more difficult. The company that emerges after a reverse merger could still fail, which is not uncommon. Over the years, the SEC has increased regulatory scrutiny, required greater transparency throughout the process and cracked down on RTOs created through fraudulent means.
For example, historically some foreign companies have used reverse mergers to gain access to U.S. investors and markets by cutting corners such as by submitting false information to the SEC like overinflated financials.
Get information and legal guidance
This is only an introduction to a complex process with many important considerations. Companies that would like to go public should talk to experienced business law attorneys about the options. A lawyer may help a business client understand whether the traditional IPO process may be a better option or if a reverse merger is a feasible choice. Legal counsel can then help the client conduct due diligence to make sure that any other company the clients are interested in for a reverse merger has been thoroughly vetted and is in good financial standing before the client moves forward.
An attorney can conduct reverse merger negotiations on behalf of their client and should be involved in either drafting or reviewing any merger agreement or related documents as well as overseeing required SEC or stock exchange filings. Even though the RTO process is less complex than an IPO, it is still significantly complicated and requires careful legal guidance.