What Is a Reverse Merger?

A reverse merger occurs when a private company buys out a public company, allowing the private company to go public in the process. This can be a quicker way for the private company, which generally takes over the public company's operations and supplies the board of directors, to go public than by doing it through an initial public offering, or IPO. Going public via a reverse merger often makes investors take a higher valuation of the company and avoids some of the hassles that can hold up an IPO. The downside for the private company is that the public company, also known as a shell company because it has no real assets of its own and serves as the "shell" for the private company, may have costly baggage from its past existence.

Many companies desire the benefits and prestige that go along with being a publicly-traded company on a stock exchange. The normal process for this to occur requires an initial public offering, which necessitates finding a brokerage house to underwrite the maneuver and extensive disclosure of records to regulators. By contrast, simply buying out an existing public company in a reverse merger can significantly streamline this process.

Although regulators demanding financial transparency have made the reverse merger process a bit more time-consuming in recent years, it is still a generally quicker route to public status for a private company than an IPO. One reason is that an IPO can be dependent on market conditions, which, if poor, can scare an underwriter off from going through with the process. On the other hand, a private company that buys out a public company can be relatively sure that the transaction will go through.

Once the private company completes a reverse merger, it takes control of the majority of existing shares of the shell company. It also gains the decision-making power on the public company's board of directors. In addition to the better valuation status that being a public company affords, the buying company can also use the past financial struggles of the shell company to decrease future tax liability.

Still, companies considering a reverse merger should be aware that this process doesn't always go smoothly. The shell company may have allowed its record-keeping to become sloppy and could even be the subject of litigation. In addition, existing stockholders of the public company may be distressed by the merger and may choose to dump their stock once its price goes up. That type of stock dump can significantly alter the value of the new company on the market.