There are many companies that perform reverse mergers, also known as reverse takeovers, as opposed to other, more traditional forms of raising capital. A reverse merger is when a private company becomes a public company by purchasing control of the public company. The shareholders of the private company usually receive large amounts of ownership in the public company and control of its board of directors (B of D). Once this is complete, the private and public companies merge into one publicly traded company. Read on to find out how investors can profit from these situations by understanding the risks and drawbacks. (For more, see The Wacky World of M&As.)

Advantages of Reverse Mergers
The following are the many advantages to performing reverse mergers.

  • The ability for a private company to become public for a lower cost and in less time than with an initial public offering (IPO). When a company plans to go public through an IPO, the process can take a year or more to complete. This can cost the company money and time. With a reverse merger, a private company can go public in as little as 30 days.
  • Public companies have higher valuations compared with private companies. Some of the reasons for this include: greater liquidity, increased transparency and publicity, and they have a faster growth rates compared to private companies.
  • Reverse mergers are less likely to be canceled or put on hold because of the adverse effects of current market conditions. This means that if the equity markets are performing poorly or there is unfavorable publicity surrounding the IPO, underwriters can pull the offering off the table.
  • The public company can offer a tax shelter to the private company. In many cases, the public company has taken a series of losses. A percentage of the losses can be carried forward and applied to future income. By merging the private and public company, it is possible to protect a percentage of the merged company's profits from future taxes.

Disadvantages of Reverse Mergers
The following are the disadvantages of a reverse merger:

  • Some reverse mergers come with unseen circumstances, such as liability lawsuits and sloppy record keeping.
  • Reverse stock splits are very common with reverse mergers and can significantly reduce the number of shares owned by stockholders.
  • Many chief executive officers (CEOs) of privately traded companies have little or no experience running a publicly traded company.
  • Many reverse mergers do little of what is promised and the company ends up trading on the OTC bulletin board and providing shareholders with little to no additional value or liquidity.

Signals of Reverse Mergers
The following are potential signals that you can use to find you own reverse merger candidates:

  • Appropriate capitalization. Generally, reverse mergers succeed for companies that don't need the capital right away. Normally, a successful publicly traded company will have at least sales of $20 million and $2 million in cash.
  • The best companies for a possible reverse merger are those that are looking to raise $500,000 or more as working capital. Some good examples of successful reverse mergers include: Armand Hammer successfully merging into Occidental Petroleum (NYSE:OXY), Ted Turner's completion of a reverse merger with Rice Broadcasting to form Turner Broadcasting, and Muriel Seibert taking her brokerage firm public by merging with J. Michaels, a furniture company in Brooklyn. (For more, see The Merger - What To Do When Companies Converge.)

To be successful in identifying reverse mergers, you must stay alert. By paying attention to the financial media, it is possible to find opportunities in potential reverse mergers. It is also wise to participate in opportunities that are trying to raise at least $500,000 and are expected to do sales of at least $20 million during the first year as a public company.

There are many benefits and disadvantages to investing in reverse mergers. To be successful, you must ask yourself if you can handle investing in a company that could take a long time to turn around. You should also understand how the merger works and in what ways the reverse merger would benefit shareholders for the private and public company. While this can be a time-consuming process, the rewards can be tremendous - especially if you find the diamond in the rough that becomes a large, successful publicly traded company.

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