The profession of investment banking has become quite innovative over the years. Traditionally, raising capital was an expensive as well as time-consuming process. However, over the past few years, investment banks have devised ways to help their clients raise funds. These ways are neither time consuming nor expensive. A reverse merger is one such innovative way using which investment banks help their clients raise money.

In this article, we will have a closer look at what reverse mergers are. The advantages and disadvantages of reverse mergers will also be discussed in this article.

What is a Reverse Merger?

Reverse mergers are backdoor mechanisms used by companies to go public. This is the reason why they are often referred to as reverse initial public offers (IPOs) as well. These transactions involve a public company merging with a different private company. Since one of the entities involved is a public company, the newly formed company also becomes public. Some examples are listed below:

A public company buys a controlling stake in a private company. The private company then becomes the subsidiary of the public company. Hence, it also becomes public. Instead of issuing new shares via IPOs, companies can simply sell some of the shares that they have, the valuation of which will become high after the merger.

A private company can also buy out a public company. This often happens with the help of a stock swap. At the end of such transactions, the private company emerges as the largest shareholder in the combined entity. This is the reason why they are able to gain control over the combined entity.

Advantages of Reverse Mergers

The reverse merger method of going public has some distinct advantages, which is why it is used by many top companies as a means to go public. Warren Buffet’s company, Berkeshire Hathaway, went public with the help of a reverse merger. In fact, the global fast-food giant Burger King, also used this method to go public. Some of these advantages have been mentioned below:

1. Faster: The process of going public is tedious and time-consuming. There are many steps in the process, such as preparing a prospectus, marketing the company, doing roadshows, book-building, etc. Hence, the fastest that a company can actually reach the capital market is about a year. However, this is not the case with reverse mergers. With reverse mergers, companies can reach the market in as little as a few weeks. They can simply bypass the entire process. This is important for many companies who want to raise finances at the earliest using the capital markets.

2. Cheaper: The IPOs are not only a time-consuming process, but they are also very expensive. Each of the steps mentioned above costs a lot of money. The floatation costs involved with an IPO are upwards of 5% in most of the cases. Also, the company often has to pay money to public relations companies, which generate positive word of mouth for the company. All in all, it becomes an expensive affair. The entire expense can simply be skipped aside if a reverse merger takes place. Investment banks take an advisory and legal fee to help with the merger. However, it is much lesser than floatation costs.

3. Flexibility: In the case of public sale of shares, timing is often the most important factor. The performance of the company is not the only factor that influences its valuation. There are a lot of other factors that stem from the macroeconomic environment and over which the company has no control.

   In the case of IPO, the issuing company does not have flexibility with regards to timings. The issue dates are more or less fixed. If the market sentiment turns negative close to the issue date, then the issuing company is bound to take a loss.

   On the other hand, in the case of a reverse merger, there is no fixed date. The sale of stock by the combined entity is treated just like any other regular sale of stock. Hence, the issuing company can choose the most opportune time to sell its shares, which allows it to get the maximum valuation.

4. Less Regulation: Since the procedure to be followed in case of reverse mergers is quite less, so are the regulatory requirements. The Securities and Exchange Commission does not interfere too much with these mergers. Now, complying with regulations costs a lot of time and money. Hence, the absence of regulations helps save both time as well as money.

Disadvantages of Reverse Merger

There are several disadvantages to the reverse merger process as well. Some of them have been listed below:

1. Lower Valuation: During an IPO, investment bankers are able to influence the macro environment. They are able to create a positive image of the company’s business. This helps them in getting a higher valuation.

   IPOs are known to be sold at very high valuations all over the world! This is not the case with reverse mergers. This negates the lower cost advantage of reverse mergers. The net amount of money received in hand works out to be the same in reverse mergers as well as IPOs!

2. Possible Manipulation: Lower regulatory requirements might seem like a good idea at first. However, it is important to remember that they do open the floodgates for possible fraud and manipulation. This sends a negative signal to the stock market, which makes the investors more cautious and brings down valuations.

The bottom line is that the reverse merger method is a viable alternative to an IPO if one of the companies being merged is already listed.