Reverse Mergers: What Are They?

A reverse merger is when a smaller, private company acquires an already-public company in order to become public.

A Reverse Merger's Definition and Example

A reverse merger involves a smaller company acquiring a publicly traded company—typically a small public company with few operations. While the public company "survives" the merger, the private company's owners take control. They reorganize the merged entities according to their vision, which usually entails replacing the board of directors as well as modifying assets and business operations.

Reverse takeover and reverse IPO are other terms for the same thing.
RTO is an acronym

For example, if private company A wants to go public, it may not be willing to put in the time and money required upfront. Instead, it strikes a deal to buy a controlling stake in publicly traded company B. When the deal is completed, all of B's shares are merged with A's, the company retains its publicly traded name, and the new owners have complete control over the company's direction.

What Are Reverse Mergers and How Do They Work?

A typical initial public offering (IPO) takes months at the very least and sometimes more than a year. Because it avoids the Securities and Exchange Commission's procedures, a reverse merger allows a private company to go public much more quickly (SEC). In a reverse merger, a private company acquires a smaller, existing company by purchasing more than half of the stock of the public company. The private company can begin merging operations once it has gained effective control of the public company. Note: Because the public company in this scenario often has few (if any) operations of its own, it is sometimes referred to as a "shell company." It's merely a "shell" into which a private company can enter to gain access to the public market. It's important to remember that, unlike an initial public offering (IPO), a reverse merger does not result in immediate capital raising. Reverse mergers are only appropriate for privately held businesses that don't need money right away because it expedites the process of going public but also limits their applicability. Companies that want to raise money as they go public should pursue an IPO, which is the traditional route.

What Does This Mean to Individual Investors?

The Securities and Exchange Commission (SEC) has made a point of emphasizing the dangers that reverse mergers pose to investors. According to the report, many reverse mergers fail or struggle to stay afloat. When a private company buys a public company, the shareholders' composition changes, which is something to keep in mind if you're invested in a smaller public company; because the private company is acquiring the public one, the controlling interest in the company changes hands. As a result, your new company's shares may not provide you the same benefits as your old company's. The new company may also fail to meet the listing requirements for the exchange where the public company's stock was traded. The stock's trading may be halted, the company may be required to re-register, or the newly merged company may be required to go through the exchange's approval process again. Note: Look for free SEC filings on EDGAR if a company you own appears to be undergoing a reverse takeover or if you're looking to invest in one that is. Some businesses are exempt from filing. Companies that do not file with the SEC should be avoided. Foreign companies can use reverse mergers to gain access to U.S. investors, which is something that investors should be aware of. While there's nothing wrong with that, foreign companies that gain access to U.S. markets through reverse mergers aren't subjected to the same level of scrutiny as companies that go through the traditional IPO process, which means there's a higher risk of fraud. Even though it's not always simple to determine whether a reverse merger involves organisations with solid finances and good intentions, a few key inquiries can be useful:

What is the company's motivation for pursuing a reverse merger, and what are its objectives?
What information do we have on the existing public company? Is it a legitimate, money-making company or a dormant corporation that has never been delisted from a stock exchange?
What do we know about the executives' backgrounds and experience?
Who conducted the financial audit of the company? Does the auditing entity appear to have the resources necessary to conduct a thorough and accurate audit of the company?

Patience is essential when it comes to investing in reverse mergers. If you suspect a company is planning a reverse merger, resist the urge to act immediately. Allow time for the merger to complete, then keep an eye on the company's performance. Investigate the company's products and services and the management team. Keep a close eye on the company's revenue and expenses. You'll be able to tell whether the company is financially sound over time.

Important Points to Remember

Reverse mergers occur when a private company acquires a publicly traded company.
A reverse merger allows a private company to go public without having to go through the lengthy and expensive IPO process.
Reverse mergers are risky for investors because the companies aren't subjected to the same level of scrutiny as traditional IPOs.