Traditionally, private companies become publicly traded filing a registration statement under the Securities Act of 1933, as amended. Another established method for private companies go public is through a Reverse Merger ("Reverse Merger") with a public shell company.
The general perception in the securities industry among regulators is that Reverse Mergers are used as vehicles for fraud either by stock promoters or others including securities lawyers who manufacture them. Securities issued in Reverse Mergers are not registered on a registration statement.
In a Reverse Merger, a private operating company or its business operations are acquired by or merges into a publicly traded shell company ("Public Shell Company"), often inactive with negligible operations and assets. Hard return Reverse Mergers can be structured a variety of ways but the end goal is the same - to take a private company or its operations public without filing a registration statement with the SEC or Form 211 with FINRA.
Risks of Reverse Mergers
Despite success stories touted by shell brokers, reverse mergers involve a significant amount of legal and compliance risk. Additionally, failure to conduct proper due diligence and/or if the Reverse Merger transaction is not properly structured, the post Reverse Merger Company can end up to be a private company with public company reporting requirements and expenses. In addition to the traditional Reverse Merger risks including SEC investigations or violations, undisclosed liabilities, litigation and potential litigation, companies now face increased compliance costs and regulations.
Direct Public Offerings vs Reverse Mergers
Private companies are learning the hard way that it is easier and more cost effective to simply file a registration statement with the SEC and complete a direct public offering ("DPO") than to encounter the uncertainty and risks inherent in Reverse Merger transactions.
The Myths of Reverse Mergers.
There are many misconceptions about Reverse Mergers that shell brokers use to entice private companies into purchasing a public shell company including but not limited to those set forth below.
Reverse Mergers are Inexpensive and Fast.
Stock promoters often compare the price of an initial public offering ("IPO") with that of a Reverse Merger. This is misleading because with an IPO, a company pays an underwriter to sell securities to the public and develop an active market after the company becomes public. A Reverse Merger is not a capital raising transaction. A private company can go public and file their own Registration Statement for a cost of between $35,000 and $100,000. A public shell for a Reverse Merger can cost as much as $450,000 and 5% of the Shell Company's outstanding securities. In addition to the time it takes to perform due diligence, negotiate the Reverse Merger agreement, and close the Reverse Merger, recent SEC and FINRA requirements eliminate the timeliness benefit of the Reverse Merger.
In 2005, new rules were adopted that require former Shell Companies to file "Form 10 Information" with the SEC within four business days after the completion of a Reverse Merger. This information is substantially equivalent to that found in a Form 10 or SEC registration statement and requires comprehensive disclosure of the company's business plan, risk factors, financial condition, management, properties, and audited financial statements.
Prior to the rule change, Shells avoided disclosure of much of this information for up to seventy-five days after the Reverse Merger was completed. Now Form 10 Information must be filed within four days after the Reverse Merger, and closing must be delayed to allow for preparation time of typically thirty to sixty days.
Recently passed Rule 6490 requires that corporate acts frequently associated with Reverse Mergers obtain FINRA approval before effectiveness. This approval takes approximately a month to obtain.
