The primary purpose of the reverse merger is to take a company public. The smaller company acquires a public company, referred to as a “shell”, and merges with the company. Once the two companies merge, the smaller company no longer exists. The new public company is operated as the smaller company was when it existed. The public company basically takes on the identity of the small company.

What is a reverse merger shell?

A shell company is a public company. The public company is usually an entity that is not fully operational. The shell company’s financial standing and track record is leveraged by the acquiring company during the reverse merger. The shell expands the acquiring entity and increases the liquidity of the private company. Before the shell company is selected, it is vetted for compliance and liability issues.

Auditing and best practices in merger

General Acceptable Accounting Practice standards must be observed during this process. Audited financial statements are also a requirement to finalize the transaction. The process requires that the audited statements of the private company be combined with the public entity’s records to satisfy auditing standards. For the purposes of the merger, the financial statements of the acquirer should consist of three years of reporting.

Role of the Form 8-K

The Form 8-K must be filed within four days of closing the merger. In this form, the transaction must be described. The documentation includes information about the company’s risks, ownership, and leadership. Audited financial reports are also submitted at the time the form is filed. Details on the potential name change and the new structure of the company are also provided during the process. Once the form is filed, the company will be responsible for adhering to compliance requirements set forth by the Securities Exchange Act of 1934.

Understanding the transaction

The reverse merger process is considered an acquisition, which consists of a public shell and private company. The public shell may form a subsidiary and begin negotiating with the shell company to discuss the prices and terms for the merger. The shares are then exchanged, and the public shares are issued to the private company. The stockholders of the private company position themselves for controlling interest in the shell company. Ideally, the shareholders will own at least 90 percent of the shell company. Controlling interest is all that is required.

Key disadvantages of a reverse shell

One of the most common issues with a reverse shell is that there are liabilities that may have not been reported. These undocumented liabilities have to be resolved by the new owner. The registration process with the SEC may be cumbersome and time consuming, since the company is now required to register its shares. If the company was not previously active on the stock exchange, it may be difficult to stimulate trading activity. The company will now have to wield support among investors to boost confidence in the new entity.

What companies could consider a reverse merger?

Companies that generate millions in revenue annually are generally a good fit for this type of merger. Companies who are already observing accounting best practices would have no problem transitioning into a much more public role. A company whose leadership and key stakeholders are fully on board with the reverse merger since internal support and solidarity are needed to generate investor interest. Companies seeking the most cost-effective route to go public may also consider this option.

The key benefits of a reverse merger is that it is more cost-effective than completing the IPO process. It is also a quicker process with some transactions being finalized in under a month. The market conditions don’t affect the success of the merger because capital is usually not the primary aim of such a transaction. Once completed, the shares can be publicly traded, and stock incentives can be offered to employees.