While an initial public offering (IPO) is the most common way to take a company public, other options exist for making a firm's shares available to the public markets. One of those is through a reverse takeover (RTO) or reverse merger.
Reverse Takeover Explained
An RTO or reverse merger is a process where a private company goes public by acquiring a publicly-held shell business. The acquisition makes the owners of the private firm the controlling shareholders of the existing public business.
Upon completing the transaction, the owners absorb the once private entity through reorganization of the public company's assets and operations. In other words, the private company is restructured or eliminated, making the already public shell business the sole entity.
Reverse Takeover and Initial Public Offering
Many companies decide to make a public listing, so they can sell their shares to the overall investing community to become more well-known and tap on financial sources that were previously inaccessible to them as a private business.
That is where an IPO usually comes in. However, this approach can be complicated and time-consuming and often requires assistance from investment banks in underwriting the agreement and issuing shares.
Moreover, the IPO involves broad due diligence, a great deal of paperwork, and regulatory assessments. And once that is all done, there are poor market situations that are out of the company's hands to consider since such unfavorable conditions can get in the way of a successful IPO.
But in an RTO, private companies don't need to undergo such a comprehensive process, which allows them to go public more quickly than they can with the traditional IPO route.
That is a huge help for private entities that cannot perform an official IPO. Plus, they can take themselves public through reverse mergers with a relatively small amount of money.
How a Reverse Takeover Works
Many publicly-listed companies' ongoing operations or assets, which usually trade over-the-counter (OTC), can be quite few or sometimes none at all. Such entities are referred to as shell companies, and they are the ones commonly used for RTOs.
To conduct a reverse merger, owners of the public firm must first purchase approximately 51% of the shell company's shares.
Once they have a majority stake, they exchange the private entity's shares for the public shell company's existing or new shares. The private company then becomes the shell company's wholly-owned subsidiary.
Unlike an IPO, reverse mergers allow companies to go public without generating new capital, making the process easier and faster to complete. It also eliminates the need to raise publicity and capture institutional or retail investors' interests.
The Major Risk of a Reverse Takeover
Considering the regulatory oversight and number of investors are less in an RTO, this method can carry fraud and compliance risks.
That is why a reverse merger needs more due diligence than a conventional IPO. Additionally, RTOs tend to fail because many of the companies that take this route only do so when they can't raise funds in private markets and don't have sufficient publicity to conduct an IPO.
The Securities and Exchange Commission (SEC) has indicated the fraud risks of some RTOs, saying public firms that were a product of an RTO can collapse or otherwise have a hard time staying attractive and valuable.
Despite that, several companies still try to perform a reverse merger. The method could work best for companies that are not in a rush to raise new capital and have enough profits to counter the costs of being publicly listed.
