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A First Take on Reverse Mergers

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What it is: A privately held company acquires a "shell company" -- a publicly traded but often dormant company. Through the merger, the private company becomes publicly traded.

How it works: This process is best for an established private company with millions of dollars in annual revenue and profits -- a company that is already following generally accepted accounting principles and could better transition into the Securities Exchange Commission's (SEC) financial reporting requirements.

Most metropolitan areas have a law firm with a securities practice. One of the partners likely has a dormant public company lined up for a prospective reverse merger client to buy. Odds are, the prospective shell company is not listed on a national securities exchange such as Nasdaq, but is instead traded in a less glamorous setting such as the OTC Bulletin Board.

Your law firm, accountant and potentially a financing consultant will guide you through the regulatory hoops, which culminate in the filing of an SEC Form 8-K that discloses the transaction to the public.

The 8-K is often accompanied with filings including a potential name change, corporate restructuring, and hopefully an infusion of capital from investors the company has already lined up. That includes the Private Investment in Public Equities (PIPE) deals that involve large institutional investors buying up blocks of a public company's stock.

Related: Alternatives to IPOs

Upside: A reverse merger allows a private company to go public within weeks, versus the months or years involved with an IPO. By becoming public, a company becomes a more attractive investment opportunity to a wider range of investors. The supply of equity capital is more abundant for public companies than for private ones.

This financing technique works best for companies that have a strategic reason to quickly become a public company. Are you confident that the business will experience substantial enough growth to develop into a real public company?

Downside: It has only been in recent years that reverse mergers started to lose some of their tarnish. There were too many stories of shareholder fraud in the shell companies and similar issues.

It is important that due diligence is performed to ensure that there aren't any unresolved liabilities or other issues associated with the shell company that could come back to haunt you.

When it comes to bringing in private capital, the deal must also be carefully structured. Specifically, the amount of stock owned by investors that the new owners do not know and cannot influence must be diminished so that a stable quote can be established. Usually, this is done by reducing the percentage of the total number of shares these investors own. By doing so, as an added incentive, the private investors can be offered stock at a discount to the market.

And while reverse mergers are cheaper than IPOs, also note that they still cost a lot of money. The Labrecht Group, a law firm based in Irvine, Calif., and Salt Lake City, says reverse mergers can run anywhere from $150,000 to $550,000, depending on the price and quality of the shell company.

Related: Going Public

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