The advantages of going public with reverse mergers

The advantages of going public with reverse mergers

Startups and newer companies may seek to go public for a wide variety of reasons. Publicly traded companies often trade at much higher valuations than equivalent private firms. And going public affords a company a veneer of legitimacy and transparency that private firms simply don’t have. This often means that public firms have recourse to a large number of financial vehicles, including short-term debt issues at low interest rates, that private companies do not enjoy.

But ultimately, the main reason that a private company would seek to go public is to raise capital. There are two main ways that companies can go about this. The first, which is the most well known and widely used, is through an initial public offering, also known as an IPO. While IPOs are both common and potentially highly lucrative means of taking a firm public, they are also hugely expensive and involve a large amount of risk.

The second way that many private companies go public is through a more arcane and less well-known process. Termed a reverse merger, this is a way for companies to enjoy many of the benefits of going public without the large associated costs and risks of an IPO. While reverse mergers have gained a bad reputation over the years due to a number of high-profile abuses and scandals revolving around their use in decades past, today, they represent a completely legitimate form of taking a company public and raising capital. Here, we’ll take a look at some of the reasons that a company may want to consider going public through the use of a reverse merger instead of the more traditional route of an initial public offering.

Reverse mergers can act as a virtual IPO

One of the most compelling reasons for taking a company public is the potentially huge boost in value that often results. The gigantic disparities in valuations that often exist between roughly equivalent private and public firms can be illustrated by taking a real-world example. For instance, Google, one of the largest internet-based companies in the world, has historically traded at as much as 40 times earnings. This means that multiple of yearly earnings at which investors peg the company’s true value is 40 times what the company makes in a typical year.

On the other hand, sites like Empire Flippers often report that extremely solid web-based businesses get only three times their total yearly earnings at the time of final sale. While this is not a scientific comparison, it illustrates the fact that public companies can often trade at many times the value of private companies by the mere virtue of being public. This can have tremendous value for companies that are able to pull of a reverse merger skillfully and with a solid long-term game plan.

IPOs can often raise significant amounts of capital. However, as stated earlier, there are huge costs and risks associated with attempting an IPO. For starters, a typical IPO takes between six months and a year to complete. It also requires the company that is going public to hire attorneys that specialize in mergers and acquisitions law. On top of that, all IPOs in the United States are underwritten by one of the major investment banks. These banks take large fees that can eat into the profits from the IPO. All told, IPOs often run into the tens of millions of dollars in fees to lawyers, bankers and regulators. And these amounts can often be more than smaller companies can reasonably afford, especially considering that most of those fees will have to be paid up front. They cannot be structured on a contingency basis.

But the biggest problems with IPOs is the risk that is inherent in every deal. IPOs are almost always at the mercy of the markets. An IPO that took millions of dollars in fees and thousands of man-hours to prepare over the course of a year may ultimately hinge on what the stock market is doing the week of its planned offering. The business world is littered with stories of planned IPOs that were shelved at the last minute, never to be resumed again, due to markets taking a downturn. Any significant market disruption, from the macro- to the micro-economic level, can potentially thwart an IPO, causing it to be put indefinitely on hold.

For a small company, such an outcome could spell disaster, up to and including bankruptcy. This is where reverse mergers can start to look far more attractive.

A reverse merger can often be completed in as little as 30 days. Reverse mergers do not require underwriting from an investment bank and, in some cases, may be able to even be completed without the help of legal counsel. This means that a reverse merger can often be completed in just a few weeks and for a cost of less than $200,000. Reverse mergers are also completely independent from the vagaries of the market. No matter what the market is doing, the reverse merger will go through as long as the principals involved wish to continue.

The benefits of the foregoing can hardly be overstated. For small companies that don’t have massive cash reserves, these things can make reverse mergers the far more attractive option by themselves. However, the real payoff for going with a reverse merger is often the amount of money that can reliably be raised.

Although reverse mergers won’t always raise as much money as an IPO, the fact that the company is being brought public, by itself, is usually a strong indication that the firm’s valuation will be rising significantly. When done right, a reverse merger can cause a private company to gain in value by hundreds of percentage points. Once the company’s value has soared due to its new status as a publicly traded company, the principals can then issue new stock. This stock issuance is often able to raise far more capital than would have even be achievable with an IPO. The downside is that this process can take a number of years. So, a reverse merger is better viewed as a long-term play.

This sheds light on the final and, perhaps, greatest reason for entrepreneurs to take their startup public through reverse mergers; they figure to retain the vast majority of ownership in the company. Whereas an IPO is literally selling the company to the public, a reverse merger represents a purchase by the company being taken public of the target shell corporation. This means that even though the new conglomerate will have existing shareholders, the original owners in the acquiring firm will retain far more control than they would under an IPO.

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This article is by Delancey Street, a top rated hard money lending platform that services borrowers nationwide. We use artificial intelligence to help reduce our exposure to risky loans, and provide borrowers with loans faster.