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Start-ups can raise capital through angel investors, hard money lending institutions, or investments company. But, there is another way that can be just as effective: the reverse merger.
In fact, Warren Buffet who is one of the most successful investors in modern history created his company, Berkshire Hathaway through a reverse merger. Berkshire Hathaway was originally a textile company until Buffet transformed it into a holdings company.
What is a Reverse Merger?
A reverse merger is a situation when private firms merge with publicly traded entities. These public companies are often corporate shells. The Securities and Exchange Commission defines a shell company as a public reporting company that has little or no operations.
In this merger, the public firm survives, and the private firm becomes its subsidiary. Although the private firm is under the public one, it is the former shareholders of the private firm that controls the majority stake in the public company.
The private company’s management often takes over the board of directors and other executive positions of the public shell company. In addition, the assets and operations of the resulting entity after the reverse merger are primarily those belonging to the private company.
Benefits of a Reverse Merger
There are many reasons why a start-up company would want to become a publicly traded company. First, it is a way for a company to raise capital. The capital can be used to settle debts or expand the company. Going public can also be a good strategy to increase the visibility of the company.
However, the process of transforming a private company into a private one can be quite difficult and costly. A reverse merger is often seen as a shortcut to becoming a public company.
Instead of going through the Initial Public Offering (IPO) process, a company can simply use an existing public company. As a result, a start-up company can quickly enter the capital market.
The reportorial requirements are simpler. The public company is required to report the reverse merger with the Securities Exchange Commission, there are no registration requirements unlike with an IPO.
Aside from expediting the process, a reverse merger can also be cheaper. The legal and accounting costs are generally cheaper than an IPO.
How to Use a Reverse Merger
It is not unusual for start-ups to encounter the hurdle of financing. The competition for funding is often stiff, so there is a need to get creative when it comes to finding alternative means of raising cash.
For start-ups, one of the solutions to this problem is the reverse merger. Once the start-up undergoes the reverse merger, the start-up company can raise money through the public market.
It is important to note that a reverse merger does not automatically raise capital for a start-up. The company is still tasked to use secondary stock offerings and pique the interest of investors.
The SEC offers guidelines on how reverse merger company stocks are traded.
First, if the reverse merger company must meet the exchange’s initial listing standards to be listed. These standards must continuously be met for the company to remain listed. In addition, the start-up company must comply with federal securities laws and other statutes.
Start-ups should know that they should plan for future trading accordingly. Just because a reverse merger occurred, and the company ends up listed on the exchange, it is no assurance that they will be listed indefinitely.
If the stocks of the reverse merger get delisted, there is another option. The stocks can also be traded on an Over-the-Counter Market (OTC). The OTC is decentralized, without a single physical location, unlike the setup of the usual exchanges. Here, participants trade with each other directly.
Since the communication between dealers is done directly, other people can be in the dark when it comes to the final price of the transaction. There are fewer regulations, but also less transparency with OTC exchanges.
In fact, most of the public companies that can be purchased for a reverse merger are not listed on a national exchange like the Nasdaq. Most are traded OTC.
For the stocks to be traded OTC, the company that will buy and sell stock must first file the proper form – named Form 211 – with the Financial Industry Regulatory Authority.
If the original public company was an active participant in the OTC market before the reverse merger, the post-merger company can continue with the practice of trading without having to file the Form 211.
Start-ups should be aware that before they can use a reverse merger as a means of raising capital, they will spend money first. The cost of purchasing a shell public company is significant.
Risk and Risk Reduction in Reverse Mergers
A reverse merger is a double-edged sword. It has its benefits, but it also has its risks.
One of the biggest is that the regulatory requirements can be tricky to navigate. The owners and board members of the start-up have increased exposure to civil and criminal penalties from failure to comply with these requirements.
There is also the issue of a practice called “Pump and Dump”. The Pump and Dump refer to the fraudulent practice of inflating the price of stocks through false or misleading statements to sell cheap stock for a higher profit.
After the overvalued shares are sold, the price falls since its value was only artificially propped up. This means a loss for investors.
Start-ups can reduce the risk of fraud by practicing due diligence on the shell companies they are looking to purchase. The company needs to make sure that the stocks they are purchasing for the acquisition are fair.
Also, research the shell company before purchasing it. Some key information to obtain is whether it has been penalized with a trading suspension or subjected to delisting from an exchange.
The SEC filings of the company can be a valuable source of information. Filings are available through the SEC’s EDGAR filing system. If no information is found within the SEC, the company is known as a “non-reporting” company.
Non-reporting companies should sound off alarm bells for a start-up company thinking of a reverse merger. First, it is difficult to get transparent and up-to-date information on the company.
Second, and perhaps the most important consideration, is that the information of a non-reporting company does not carry over to the start-up in the event of a reverse merger. The start-up will still have to deal with the regulatory processes that they wanted to avoid through the reverse merger.
Sufficient research and due diligence are key aspects of a reverse merger. A start-up that is thinking of a reverse merger should not simply think of it as a means to circumvent the IPO requirements or a quick way to raise capital. It should approach it as a business decision that will have a major impact on the operations of the business.