Put It In Reverse

The Drawbacks

Reverse mergers aren't for everyone, however. There are several drawbacks to this financing technique. Among the disadvantages:

  • Image: Reverse mergers have accumulated their share of controversy over the years for a few reasons. First, most reverse mergers start with dormant public companies. Usually they fell into dormancy because of failure in their line of business. As a result, there may be an angry group of shareholders somewhere in the deal. Furthermore, the chances of some irregularity occurring in the trading, most likely unknown to the company, are high. That's because most reverse transactions initially trade on the Pink Sheets or the OTC Bulletin Board, the least regulated tiers of the market.
  • Unknown shareholders: At the end of the day, the private company that acquires a public one is left with an unfamiliar shareholder base with which it has had no previous interaction. These shareholders can place a significant downward pressure on the company's stock by continually selling their shares as a new trading market develops. Also, creditors or other parties that suffered in the past because of the failures of the predecessor company can come out of the woodwork and make claims against the new management.
  • Indirect route to capital: Reverse mergers represent a way to open avenues to financing for a company without actually financing it. Though they are theoretically quick and easy, like any securities transaction, reverse mergers contain enough wrinkles to draw out the process. But in most instances, just consummating the reverse merger transaction is only the halfway point in a company's pilgrimage to growth capital. When it's done, the company must still go out and beat the bushes for the cash it needs.
  • Difficulty becoming a real public company: An exciting private company may have taken control of a dormant public company, but that doesn't necessarily mean other investors will sit up and take notice. In fact, the only investors who tend to care about the change of control are those who invested in the original company. Often their interest is mercenary: They simply want to know when the new company will succeed to the point where they can recoup their money.

As a result of their relative obscurity, most reverse mergers find that their stock doesn't trade much. Moreover, company executives and principals have a hard time attracting enough investors to their stock to create the kind of trading and liquidity that is the benchmark of a conventional public company.

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This article was originally published in the June 1999 print edition of Entrepreneur with the headline: Put It In Reverse.

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