Why Do a Reverse Merger Instead of an IPO?

A reverse merger (also sometimes called a reverse takeover or a reverse IPO) is often the most expedient and cost-efficient way for a private company that holds shares that are not available to the public to begin trading on a public stock exchange. Prior to the rise in the popularity of reverse mergers, the vast majority of public companies were created through the initial public offering (IPO) process.

In a reverse merger, an active private company takes control and merges with a dormant public company. These dormant public companies are called "shell corporations" because they rarely have assets or net worth aside from the fact that they previously had gone through an IPO or alternative filing process. 

It can take a company from just a few weeks to up to four months to complete a reverse merger. By comparison, the IPO process can take anywhere from six to 12 months. A conventional IPO is a more complicated process and tends to be considerably more expensive, as many private companies hire an investment bank to underwrite and market shares of the soon-to-be public company.

Benefits of a Reverse Merger

In most cases, a reverse merger is solely a mechanism to convert a private company into a public entity without the need to appoint an investment bank or to raise capital. Instead, the company aims to realize any inherent benefits of becoming a publicly listed company, including enjoying greater liquidity.

There may also be an opportunity to take advantage of greater flexibility with alternative financing options when operating as a public company.

The reverse merger process is also usually less dependent on market conditions. If a company has spent months preparing a proposed offering through traditional IPO channels and the market conditions become unfavorable, it can prevent the process from being completed. The result is a lot of wasted time and effort. By comparison, a reverse merger minimizes the risk, as the company is not as reliant on raising capital.

The expediency and lower cost of the reverse merger process can be beneficial to smaller companies in need of quick capital. Additionally, reverse mergers allow owners of private companies to retain greater ownership and control over the new company, which could be seen as a huge benefit to owners looking to raise capital without diluting their ownership. For managers or investors of private companies, the option of a reverse merger could be seen as an attractive strategic option. 

Special Considerations

One of the risks associated with a reverse merger stems from the potential unknowns the shell corporation brings to the merger. There are many legitimate reasons for a shell corporation to exist, such as to facilitate different forms of financing and to enable large corporations to offshore work in foreign countries.

However, some companies and individuals have used shell corporations for various illegitimate purposes. This includes everything from tax evasion, money laundering, and attempts to avoid law enforcement. Prior to finalizing the reverse merger, the managers of the private company must conduct a thorough investigation of the shell corporation to determine if the merger brings with it the possibility of future liabilities or legal entanglements.