What Are Backdoor Listings? Definition and How It Works

By Rebecca Lake · August 14, 2023 · 6 minute read

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What Are Backdoor Listings? Definition and How It Works

A backdoor listing can allow a private company to become publicly traded, without having to pursue an initial public offering (IPO). This strategy can be less time- and cost-intensive for companies that are interested in being listed on a public stock exchange.

There are different ways backdoor listings can occur. A key question for investors is whether it makes sense to invest in stocks associated with a backdoor company.

What Is a Backdoor Listing?

In most cases, a company that wants to make its shares available for trade on a stock exchange would go through an initial public offering, or IPO. This process, regulated by the Securities and Exchange Commission (SEC), ensures that companies meet certain requirements before they can be listed on the Nasdaq or the New York Stock Exchange (NYSE).

A backdoor listing allows companies to list shares of stock on a public exchange while circumventing the traditional IPO process. These companies effectively go through the “back door” to get their shares listed. Some investors also call this process a reverse listing, reverse IPO, a reverse takeover or a backdoor to the trade.

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How Do Backdoor Listings Work?

Generally speaking, a backdoor list transaction allows companies to go public without the usual IPO requirements. There are typically three strategies private companies use to pursue a backdoor listing.

•   Reverse merger/takeover. In a reverse merger or reverse takeover, a private company purchases a majority shareholder interest in a publicly-traded company in exchange for shares in the public company. The two companies then merge, operating under the name of the publicly-traded company going forward.

•   Shell company. In some cases, the backdoor company may wish to continue doing business independently, even after completing a reverse merger or takeover. To do this, they create a shell company, that allows both the formerly private company and the publicly-traded company it acquired or merged with to continue operations.

•   SPAC. This strategy essentially combines the other two. A SPAC is a “special purpose acquisition corporation,” a shell company created specifically to purchase a private company. The SPAC goes public and then uses the proceeds from its IPO to purchase a private company.

Recommended: What You Need to Know Before Investing in SPACs

Each approach offers a shortcut to trading on a public exchange for private companies. In the case of a reverse merger, the private company would gain control of the public company’s board of directors. Depending on the terms of a backdoor listing, this can result in a restructuring or reorganization of the public company it acquired.

Backdoor Listing Example

It can be helpful to have a real-world example of a backdoor listing to better understand how they work. One high-profile instance of a backdoor listing over the last decade involved the reverse merger of T-Mobile USA with MetroPCS in 2013.

In that deal, MetroPCS declared a 1-for-2 reverse split of its stock, while paying out $1.5 billion in cash to its shareholders. T-Mobile USA assumed a 74% ownership stake in the company, a deal approved by MetroPCS shareholders. Following the reverse takeover, MetroPCS stock began trading under the symbol TMUS.

Using a more general example, Company A may wish to go public but not meet the SEC’s IPO requirements for size or valuation. Instead, it chooses to buy a majority ownership stake in its competitor, Company B, which trades on the NYSE. Following the reverse merger, Company A assumes Company B’s name and is now a publicly-traded stock.

Advantages of Backdoor Listings

Private companies may prefer a backdoor listing for several reasons, including:

•   Capital preservation. Filing an IPO involves numerous costs, including underwriting fees and SEC registration fees. This can amount to millions, or tens of millions of dollars in some cases. Choosing a backdoor IPO could yield substantial cost savings for private companies.

•   Speed. The traditional IPO timeline can take anywhere from six months to a year to complete, owing to the various steps in the process that must be completed. On the other hand, companies can complete a reverse takeover, in as little as a few weeks, allowing private companies to go public at a much faster pace.

•   Avoiding IPO valuation rules. The SEC has some strict guidelines with regard to things like how IPO valuations are set. By going through the backdoor to the trade, companies can sidestep these requirements altogether.

•   Skipping the lockup period. Early investors and employees typically can’t trade their stocks during a certain period before and after a traditional IPO. Companies that use a backdoor IPO typically don’t impose such restrictions on shareholders.

•   IPO failure. Companies may also turn to a backdoor listing if they had an unsuccessful IPO.

There can also be advantages for the original shareholders of a backdoor company. If a reverse IPO boosts the share value of the newly merged company, that can increase the value of shareholders’ equity.

Disadvantages of Backdoor Listings

Backdoor listings also pose some potential problems for the private company executing it and the publicly-traded company it acquires. Some of the key issues that may result from a backdoor listing include:

•   Share dilution. Share dilution occurs when a public company issues new shares to the market, which can sometimes happen in a reverse takeover. This may decrease the value of equity for shareholders who already own stock in the company.

•   Incompatibility. It’s also possible that a backdoor listing fails to yield sufficient benefits for both companies involved.In that case, rather than driving profits up, a reverse IPO could result in financial losses.

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What Do Backdoor Listings Mean for IPO Investors?

Buying IPO stocks may appeal to investors who want to get in on the ground floor of a company that’s going public. If an IPO takes off, early investors could reap significant rewards later if they’re able to sell their shares at a profit down the line.

Backdoor listings can mean fewer opportunities to invest in IPOs. They’re not, however, shut out from trading stocks upon completion of the merger. Say, for example, there’s a private company you’ve been hoping will go public. Instead of launching an IPO, the company chooses to execute a reverse takeover instead.

You may be able to capitalize on that by purchasing shares of the public company it plans to merge with ahead of a reverse IPO. Or you may wait until the dust settles on a backdoor listing to invest in the newly merged company. In either case, the opportunity to invest in the private company you had your eye on isn’t lost. It simply takes on a new form.

Recommended: SPAC IPO vs. Traditional IPO: Pros and Cons of Investing in Each

The Takeaway

Backdoor listings allow a private company to become publicly traded, without having to pursue an IPO through traditional means. There can be advantages to going public via a backdoor listing, and it may be used as a way to speed up the process or to IPO in a less expensive way.

For investors, knowing about backdoor listings can simply be another way to be privy to new company shares hitting the stock exchanges. But investing in companies that are fresh to public markets has considerable risk. It can be attractive, but investors would do well to think their investment choices through before investing. It may also be worthwhile to speak with a financial professional for advice.

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Photo credit: iStock/NeoLeo

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