What is a Reverse Merger?

A reverse merger occurs when a smaller, private company acquires a larger, publicly listed company. Also known as a reverse takeover, the “reverse” term refers to the uncommon process of a smaller company acquiring a larger one.

Why Would a Company Undergo a Reverse Merger?

The standard path for a private company going public typically involves an initial public offering (IPO), which is often a complicated and timely endeavor. The IPO procedure usually involves hiring an investment bank to underwrite the financing and issue shares, along with an extensive due diligence process, a large amount of paperwork, and regulatory reviews. Unfavorable market conditions can also affect the timing of the IPO. The reverse merger, however, offers a company a faster way to go public while bypassing many of the time-consuming and complex steps of the traditional IPO.

It is common for the process to involve acquiring a small-scale public company with a relatively low level of operations. Although the public company remains intact after being acquired, the owners of the (formerly) private company transition to being the controlling shareholders. This is generally followed by a reorganization of the company’s assets and operations and a new board of directors.

The Reverse Merger Process

The first phase of a reverse merger involves a mass purchase of the public company’s shares by the private company—at least 51% or more. The public company effectively acts as a shell company by ceding these shares to the private one. The deal is completed when the private company trades shares with the public shell in exchange for the shell’s stock, making the acquiring company a public one.

There is no immediate capital raised during this time, which helps speed up the process of being publicly listed. This is the opposite of a traditional IPO, making reverse mergers suitable only for companies that are not in need of cash in the short term.

Possible Advantages of a Reverse Merger

  • Cheaper Process – Reverse mergers bypass the need for the private company to raise the significant capital needed to go public with an IPO.
  • Timing – Compared to conventional IPOs, which can take several months to complete, reverse mergers can be finalized in just a few weeks.
  • Less Risk – Going through the traditional IPO process does not automatically ensure that a company can go public. There are a number of factors that can hinder or cancel the process, including adverse market conditions. Taking the reverse merger route can minimize the risk of a canceled IPO and help avoid the prospect of wasting significant financial resources and time.
  • Public Company Benefits – The end goal of a reverse merger is for a private company to become publicly listed, opening up potential benefits like easier access to capital, greater liquidity, faster growth through acquisitions, and retaining or attracting top industry talent.

Potential Disadvantages of a Reverse Merger

  • Potential Liabilities – Despite the simplified process compared to an IPO, a large amount of due diligence is required for reverse mergers. Both the private and public companies should thoroughly vet the motivations for the acquisition and investigate any pending liabilities, including possible litigation. In some cases, the public shell company may simply be looking for someone else to take over ownership of their looming issues—which may be severe.
  • Dumping of Stocks – Investors of the public shell company may sell off large portions of their shares immediately following the merger’s completion, which can have a negative effect on the company’s value and stock price. This risk can be reduced by including clauses in the merger agreement that explicitly outline holding periods for the shell investors.
  • Low Share Demand – The reverse merger process minimizes the market excitement and attention a conventional IPO typically receives after going public. Original investors may see little demand for their shares if the acquiring company is viewed as lacking in terms of finances and operations.
  • Difficulties with Regulations and Compliance – Managers of the formerly private company may be inexperienced with the burdensome regulatory and compliance requirements that accompany being a public company. In a worst-case scenario, this can lead to underperformance and stagnation that deters new investors.

Insurance Needs for a Reverse Merger

Following a reverse merger, the new company and its ownership should be prepared for ongoing regulatory compliance, which typically includes an analysis and potential upgrade of its insurance coverage. This can involve property insurance, tax liability insurance, cyber liability insurance, and others, depending on the company’s business.

Woodruff Sawyer is a nationally recognized leader when it comes to Representations and Warranties Insurance (RWI), a crucial aspect of the merger process. Woodruff Sawyer is also a leading insurance broker in the SPAC market, protecting more than $18 billion in SPAC assets.

Read more about Mergers & Acquisitions, including SPACs, reverse triangular mergers, and shell companies.


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