How startups can use reverse mergers to go public?

By Leeds Brown Law | September 5, 2018

For new startups that are looking to go public, the most common route to achieve a public listing is through an initial public offering. But IPOs, as they are known for short, come with some extremely high costs and tough-to-mitigate risks. The costs of going through with an IPO may in fact be so great that doing so ceases to make sense for companies that are operating on a more constrained budget. And this is often the condition of many new startups. 

But the good news is that there is an alternative to IPOs that often produces better results, for only the tiniest fraction of the cost, and with little to no real risk. Known as a reverse merger, this form of taking a private company public has been gaining in popularity over the past few decades. While reverse mergers still have a bit of a tarnished reputation as a result of some shady operators in decades past who abused this useful method of gaining a public listing, the SEC has addressed many of the shortcomings. Today, reverse mergers are a well-established and recognized legitimate means of taking companies public. And they can often make far more sense when the company seeking a public listing is a new startup. 

Reverse mergers versus IPOs when you need hard money

While almost everyone who is remotely familiar with the world of business will immediately recognize the term initial public offering, fewer people are well versed on what exactly is meant by reverse mergers. This arcane-sounding term has actually been around since at least the 1950s. And despite the poor reputation surrounding the concept, many of the most famous names in business have passed through at least part of their lifecycle by means of reverse merging with larger companies. 

One of the most famous examples, which is also a great way to illustrate how these restructurings operate, is the case of Warren Buffet’s Berkshire Hathaway. Starting in the 1950s, Warren Buffet formed his famous investing partnership. This company was structured as a limited partnership, comprised by Buffet himself and a number of doctors, lawyers and other professionals from around the Omaha area who had placed their money and trust in Buffet’s then-unproven hands. But as the 1960s dragged on, it became clear to Buffet that, for a variety of reasons, he would need the latitude offered by controlling a public company in order to carry out many of his trading strategies. 

Buffet eyed an old textile manufacturer called Berkshire Hathaway, which had been in continuous operation since 1838. He originally bought the company because he viewed it as a good cigar butt stock. That is, he was able to buy it for far less than its book value. Buffet, however, also wanted the tax write-offs that came with the purchase of the company due to its previous years of operating losses. It turns out that tax write-offs can be one of the most attractive features of a reverse merger, potentially saving the acquiring company hundreds of millions of dollars in tax liabilities for years to come. 

Before long, it became clear that Berkshire Hathaway’s business was in terminal decline. By 1970, the core business of Berkshire, textile manufacturing, had been completely shuttered. But the Berkshire Hathaway name continues to be the one under which Buffet’s multinational juggernaut trades. While the core business of Berkshire was of little importance to Buffet, he was able to use the existing corporate shell of the firm to get tax write-offs and, later, to use as a vehicle to begin acquiring some of the most profitable insurance companies in the United States. In the process, he took his private limited partnership and turned it into a completely legitimate publicly traded company. This is a typical example of some of the benefits that can accrue to a company that chooses to go public through a reverse merger. 

The bottom line

But why, besides potential tax write-offs, shouldn’t a company just go through with an IPO? One of the biggest problems that small startups that are considering going through with an IPO face is the sheer cost and risk of doing so. In the United States, IPOs must be underwritten by major investment banks. These banks charge large fees for this service. And these fees are rarely available on a purely contingency basis. This means that the company attempting the IPO will need to pay for a large portion of those fees out of its cash flow or reserves. 

Another huge source of costs with IPOs is the byzantine complexity of the legal issues surrounding such deals. A typical IPO is one of the most complex legal maneuvers in business. That’s why it normally takes between six months and a year for a company to prepare for its initial public offering. Massive due diligence is needed as well as deciding on exactly how the deal will be structured. IPOs usually involve not just the raising of capital but the paying off of debt, issuance of new senior and junior bonds as well as issues of how equity owners, debt holders and other principals will be compensated. This can involve the issuance of stock options, warrants, special debt instruments and a dizzying array of other financial and legal structures that can take thousands of man-hours to hammer out. All told, a typical IPO has a base cost in the millions to tens of millions of dollars. And many small startups simply don’t have the cash reserves to finance such activity. 

Perhaps worst of all, after all that preparatory work has been done, the fate of the IPO will hinge on the whims of the market in the weeks around which it is supposed to take place. Wall Street history is littered with the husk of dead IPO deals, where companies paid out millions and millions of dollars preparing for them, that died in the crib and were never revived again. 

A reverse merger, on the other hand, can be reviewed by a single lawyer, completed in less than a month and often runs at a total cost of less than $200,000. But aside from the dramatic reduction in up-front costs, a reverse merger has the potential to raise even more money than an IPO while allowing ownership of the acquiring company to retain full control. 

That’s because when the company is taken public, if everything is executed according to plan, the valuation of the company may increase by hundreds of percentage points by simple virtue of the company becoming publicly listed. Although it can take longer, more capital can potentially be raised through a reverse merger than an IPO. And the startup’s entrepreneurs can retain full control of the firm.

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