Reverse Mergers & Initial Public Offering (IPO)

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The dynamics in the financial market can make a company go public with an aim of raising new capital for expansion. Companies can go public either through reverse mergers or IPOs (Initial Public Offering). The reverse merger technique is common with private companies and it involves the use of a stock swap by a defunct public or shell company to acquire a private company (Feldman 2010, p. 16). A reverse merger does not help a company to raise capital but only allows it to go public. A reverse merger allows shareholders to install a new board of directors and even Change Company name after the acquisition process is complete. There are three major ways through which a reverse merger can be adopted. To begin with, a public company can exchange the majority of its shares normally 51 % with a certain proportion of assets owned by a private company (Feldman 2010, p. 16). Secondly, a stock swap can be used to merge a private company with a public company so long as the public company is under the control of a private company (Feldman 2010, p. 17). A private company can also become a subsidiary of the public company after being awarded the majority of shares by a public company.

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A reverse merger has quite a number of advantages compared to other methods of going public (DePamphilis 2011, p. 112). Reverse mergers take a maximum of three months to be completed depending on the type of public company that a private company merges with. An IPO takes up to 9 months to be effected which is quite a long time. The second advantage of a reverse merger is that it enables a company to enter the market easily since it does not need to meet the initial listing requirements (DePamphilis 2011, p. 112). This is the most important advantage because fulfilling all the listing requirements is a great challenge for many companies. Financial consultants see reverse mergers as an avenue of entering the stock market through the backdoor (DePamphilis 2011, p. 118).

Reverse mergers have some disadvantages that companies need to consider before deciding to use this method of going public (Feldman 2010, p. 68). To begin with, there is a possibility that a private company can enter into a reverse merger with a non-clean shell. Public companies may be having liabilities such as pending lawsuits and damaged financial statements that can affect the operations of a company after the merger (Feldman 2010, p. 68). It is therefore a great risk for a private company to enter into a reverse merger with a public company that is not completely clean. The second disadvantage of reverse mergers is the problem of dealing with old shareholders. The proportion of shares left by private companies is normally acquired by the shell company shareholders some of whom may not be genuine (Feldman 2010, p. 85). It is therefore necessary to conduct an audit to come up with an authentic list of the old shareholders. Since the shareholders of a shell company are the ones who are left with the acquired shares, it is advisable to audit the list of shareholders (Gaughan 2010, p. 135).

A reverse merger only helps a company to be listed but does not enable it to raise new capital (Gaughan 2010, p. 135). This shortcoming makes it difficult for private companies to issue any equity. Private or public equity placement is the only way a private company in a reverse merger can issue equity (Gaughan 2010, p. 136). Reverse mergers are seen as a strategy of entering the market through the backdoor since listing requirements are avoided. As much as this can be seen as an advantage, the reputation of a company is always at stake because a reverse merger is regarded as a backdoor means of entering the market (Gaughan 2010, p. 152). Using reverse mergers to go public can damage the reputation of a company and in the process affecting its performance. It is advisable for companies to seriously consider the effects of a particular method of going public before deciding to use it. The company condition determines the method it adopts in going public (Gaughan 2010, p. 152).

There are certain conditions under which a private company can decide to go public via a reverse merger. To begin with, companies that are not able to fulfill the initial listing requirements prefer to use a reverse merger as way of entering the market without meeting the initial listing requirements (Feldman 2010, p. 152). This strategy only works for a short period of time since the company may continue to face listing requirements with time (Carpentier 2009, p. 222). Companies that do not fulfill listing requirements are normally delisted from the market. Belonging to the market for a short period of time then being delisted is not good for the reputation of a company in a reverse merger. All quality firms that do not need to raise capital will prefer a reverse merger to an IPO (Carpentier 2009, p. 222).

An initial public offering (IPO) is another method that private companies can use to go public (Carpentier 2009, p. 222). An IPO involves the sell of shares to the general public on a securities exchange for the first time. An IPO transforms a private company into a public company with an intention of raising expansion capital. The investments of old private investors can only be monetized through an IPO. A company that is ready to offer its shares to the public does so with the help of an investment bank (Lipman 2008, p. 68). A private company enters into a contract with an investment bank that sells the shares to the public on behalf of the company. It is the duty of investment banks to look for investors to buy a particular company’s shares.The pricing and allocation of shares in an IPO takes place in different forms that include firm commitment contracts, best efforts contacts, bought deals and all-or-none contracts (Lipman 2008, p. 92). The investment bank commonly referred to as the underwriter is entitled to a certain proportion of investment proceeds as a fee for the services rendered in selling shares. The underwriting spread includes the underwriting fee, the management fee and the concession fee that goes to stock brokers (Lipman 2008, p. 98).

An IPO is the best method of public offering because it enables companies to raise new capital that is essential for expansion (Lipman 2008, p. 98). The other advantage of IPOs is that private companies are able to monetize the assets of old investors. An IPO allows a free exchange of money between public investors. IPOs have quite a number of disadvantages due to the lengthy process of completing an IPO. The first disadvantage of an IPO the cost involved in completing the process (Gaughan 2010, p. 113). Marketing, accounting and legal costs are some of the many costs involved in completing an IPO. A company that wants to go public using the IPO has to disclose all business and financial information. The other disadvantage of IPOs is that the management of a company spends a lot of time in facilitating an IPO. It can take up to 9 months to complete the IPO process (Gaughan 2010, p. 115).

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It is important to note that going public through an IPO is not a guarantee that a company will raise the expected capital (Gaughan 2010, p. 156). It is therefore a great risk to go public using an IPO with an aim of raising new capital. The other shortcoming associated with IPOs is that the information that is disclosed in the public may be used by a company’s competitors to their advantage (Capentier 2009, p. 144). A company can lose its investment through an IPO in an instance where the underwriter becomes dishonest. Companies with an intention of going public via IPOs have to meet all the listing requirements before being listed. Advance planning is essential for the success of an initial public offering (Carpentier 2009, p.144). The need to raise new capital is one of the conditions that can lead a private company to opt for an IPO. Companies that have a capacity to undertake an investment project are always in a good position to be listed via an IPO.

Some companies prefer a reverse merger to an IPO due to a number of reasons. To begin with, a reverse merger has lower costs compared to an IPO (Carpentier 2009, p. 166). An IPO is associated with extra management, accounting, legal and concession costs that make the process to be very expensive compared to a reverse merger. Another reason why some companies prefer a reverse merger to an IPO is the issue of time. It takes a maximum of three months to complete a reverse merger compared to a minimum of six months required to complete an IPO (DePamphilis 2011, p. 130). The legal and accounting processes take a lot of time in an IPO. Companies prefer a reverse merger to an IPO because they can be able to avoid fulfilling the listing requirements. Companies that go public through an IPO have to meet all the listing requirements. A reverse merger does not involve the dissemination of both financial and business information to the public which can be accessed by competitors (DePamphilis 2011, p. 130). Some companies do not prefer an IPO because it is mandatory to release all financial and business information in order to be listed. Although a reverse merger can not be used to raise capital, a company’s capital is always secure with a high probability of making profit in the future (DePamphilis 2011, p.152).

Companies incur some cost in the process of going public (Lipman 2008, p. 87). Comparing the two methods of going public, an IPO costs more than a reverse merger due to a number of reasons. To begin with, it is important to note that raising equity is not allowed in a reverse merger (Lipman 2008, p. 87). A reverse merger allows listing without having to raise any equity. Without considering seasoned equity offering, an IPO costs more than a reverse merger. The cost of a seasoned equity offering is normally incurred by a company that decides to go public via a reverse merger (Lipman 2008, p.87). It is estimated that the cost of a seasoned equity offering in a reverse merger ranges from 6.5% to 7% of the total amount of money raised in the process. A reverse merger cost that includes a seasoned equity offering is therefore almost the same as the cost of an IPO. The cost of a reverse merger is largely dependant on the initial condition of the shell company (Feldman 2010, p. 255). The cost of an IPO is estimated to be around 7% of the raised amount which is not far away from the cost of a reverse merger that includes a seasoned equity offering.

A reverse merger can only be cheaper than an IPO if a seasoned equity offering is not included (Feldman 2010, p. 255). Leverage buyouts are expensive compared to reverse mergers and IPOs because the money used to fund an acquisition is normally borrowed (Carpentier 2009, p. 79). Companies carrying out a leverage buyout get funds from loans and bonds which come with high interest rates that make the process very expensive. A company can end up losing its valuable assets if it fails to pay back the loan. Leverage buyouts are risky because the acquired company can become bankrupt (Carpentier 2009, p. 80).

In conclusion, reverse mergers and IPOs are the preferred methods of going public by private companies. The probability of a company to successfully fund future investment projects determines the method it uses to go public (Lipman 2008, p. 169). High quality firms with an intention of raising capital for expansion prefer to go public via an IPO. Reverse mergers are preferred in situations where a company does not have the capacity of fulfilling the listing requirements. Some companies prefer reverse mergers to IPOs because it is cheaper and quicker to complete a reverse merger than IPO (Lipman 2008, p.169). The cost of completing an IPO is almost the same as that of a reverse merger provided that a seasoned equity offering is included on the reverse merger cost. It is important to consider the cost of a seasoned equity offering in a reverse merger before comparing the cost of a reverse merger and that of an IPO (Feldman 2010, p. 256). The high interest rates from loans and bonds make leverage buyouts and IPOs more expensive than reverse mergers and IPOs.

References

Carpentier, C 2009, The value of capital market regulation: IPOs versus reverse mergers, CIRANO, New York, NY.

DePamphilis, D 2011, Mergers, acquisition, and other restructuring activities: An integrated…, Academic Press, New York, NY.

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Feldman, D 2010, Reverse mergers: And other alternatives to traditional IPOs, John Wiley & Sons, New York, NY.

Gaughan, P 2010, Mergers, acquisitions and, corporate restructuring, John Wiley & Sons, New York, NY.

Lipman, F 2008, International and US IPO planning: A business strategy guide, John Wiley & Sons, New York, NY.

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