How Does a Reverse Merger Work? (With Definition and Guide)

By Indeed Editorial Team

Published June 1, 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Businesses may decide to join with other businesses to expand their operations. Although companies may combine in various ways, one option for a private company to become a public company is through a reverse merger. Learning about these mergers may help you decide if this option is right for a certain business or how the mergers of other companies may impact your workplace. In this article, we define what a reverse merger is, explain how it works, discuss some of its advantages and disadvantages, and review the differences between a merger and an acquisition.

What is a reverse merger?

A reverse merger, which some people also refer to as a reverse takeover or reverse initial public offering, is one method by which a small, private company might become public by acquiring control of a larger, public company. Companies often adopt this kind of merger to bypass the lengthy and sometimes costly process of a standard initial public offering (IPO).

While a traditional IPO might take months or even more than a year to complete and may require the appointment of several financial specialists to underwrite and issue the company's shares, a reverse takeover bypasses this procedure.

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How does a reverse takeover work?

A reverse takeover occurs when the private company's investors acquire sufficient shares in the public business to obtain majority ownership. After purchasing more than 50% of the public firm's shares, the private business controls the public company. The majority owner may now initiate the merger process, which often involves changing the board of directors and integrating the company's activities into the public corporation. The reverse takeover is a two-step process:

Mass purchasing of shares

During this first step of the process, investors from the private firm join in a mass purchase of the public company's shares. A share is an equity of ownership in a business. The more shares in a company that an individual or another company has, the greater influence they have over its operations. The private firm's objective is to acquire more than 50% of the shares in the public corporation. By acquiring the majority of a business's shares, a private company becomes the dominant owner and may merge its operations.

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Shareholder exchange of shares

Following their acquisition of the public company, shareholders can exchange shares between the two entities, with the private entity acquiring the majority of the public entity's stock. The shareholders of the private company may use their private company shares to purchase public company shares. This simplifies the merger process by transferring ownership units.

Advantages of a reverse takeover

Converting a private company to a public company via a reverse takeover provides a number of advantages. Some of these benefits are:

Simplified process

One of the primary benefits of the reverse takeover procedure is its simplicity in comparison to the IPO process. Before an IPO can take place, it's necessary for the company to obtain sufficient capital. A company can also complete a reverse merger faster. The IPO process might take many months, if not more than a year. A reverse takeover can take place in as little as 30 days, allowing the company's management team to focus on operating the business rather than the merger.

Additionally, initial public offerings need registration, but reverse takeovers don't. These aspects contribute to the reverse takeover process being more straightforward, cost-effective, and time efficient.

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Fewer risks

The success of an initial public offering might be dependent on the state of the stock market. While a company may spend considerable time preparing and implementing an IPO, if market circumstances deteriorate, the IPO may fail, and the company may not go public on the anticipated date. This might result in lost work hours. As reverse takeovers are not dependent on market circumstances, they have a reduced failure rate.

IPOs are market-sensitive, as they require the organization to obtain capital as part of the process. Raising capital requires public investors to purchase the company's equity. Investors may be less eager to acquire shares when market circumstances are adverse. Conversely, reverse takeovers circumvent this capital-raising procedure, removing the reliance on market conditions for success and thereby mitigating part of the risk.

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Easier entry into foreign markets

Converting a private company to a public one in a foreign state entails extra costs, international business registrations, and compliance with foreign regulatory requirements. A company that wants to become public in a foreign nation may streamline the procedure via a reverse takeover. As reverse takeovers don't need the appointment of an investment bank or the raising of money, they enable corporations to avoid some of the rules associated with an IPO in a foreign market.

Disadvantages of a reverse takeover

While reverse takeovers provide several benefits, it's necessary for businesses to exercise caution to minimize risk and account for the process's downsides. The following are some of the downsides of reverse takeovers and how businesses might mitigate their risk:

Shell companies

One potential downside of reverse takeovers is the necessity of negotiating with shell companies. A shell company has little to no operational or financial assets. They may hold passive assets and act as a conduit for legal communications. Due to their lack of assets, shell corporations may be fast and simple targets for private businesses wishing to merge. But some investors and company owners may misuse shell businesses.

It's essential for any company considering a reverse takeover to perform extensive research on the company they want to merge with, even more so if they intend to do it through a shell company. Due diligence is the method of thoroughly investigating all aspects of a possible merger before proceeding. Businesses may use due diligence to guarantee their merger is legally legitimate and effective, allowing them to continue growing their organization.

Related: How to Conduct a Risk Assessment (Tips and Definition)

Regulation differences

Another obstacle a company may encounter while shifting from a private to a public firm is adjusting to new rules. If a private company's management is unfamiliar with the standards governing public companies, it may take time and effort to adjust to these new expectations. This shift in learning may be particularly critical at the start of the merger. The business may seem to underperform in the first months or even years after the merger as its management adjusts to the new regulatory environment.

Business leaders may compensate for this early adjustment by researching public company legislation or employing a professional to assist with these administrative obligations. They may counteract some of the initial stagnation or recover more quickly by recruiting someone with more significant expertise managing the regulations concerning publicly listed companies.

Limited share demand

One risk associated with going public is the inability to recruit investors. Investors may be hesitant to acquire shares in newer, smaller public businesses as these companies may lack the reputation to separate themselves from more established firms. It may take time for newly public firms to establish a reputation and attract substantial investors.

To account for the time necessary to attract investors, it's critical that the organization has a strong financial foundation. Business owners may prepare for a merger by ensuring their company has strong fundamentals. By concentrating on their operations and guaranteeing the company's functionality, business leaders may ensure their firm has a strong basis, which may result in investor interest.

Merger vs. acquisition

A critical distinction between mergers and acquisitions is the concept of brand identity. Two parties combine and cease to exist as distinct entities in a merger. Rather than maintaining their own identities, they develop a new name and brand that encompasses both businesses. Mergers often benefit both sides, with each party increasing their worth as a result of the merger. Rather than one firm acquiring the other, both companies make compromises to expand their earnings and power.

Acquisitions are not always profitable to both parties. They are often the result of one company buying another and incorporating all its assets. Usually, the business that gets acquired loses its identity in merging with the acquiring business. Acquisitions are, in general, transactions rather than agreements. To finalize the transaction, the acquiring business often buys out the other company's outstanding shares.

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