In a traditional merger, a company may acquire another that is in a similar or complementary business in order to expand its footprint or reduce competition. A “reverse merger” works quite differently, and investors are eyeing the assets of a private company.
The acquiring company in a reverse merger is called a public “shell company,” and it may have few to no assets. The shell company acquires a private operating company.
This can allow the private company to bypass an initial public offering, a potentially lengthy, expensive process. In essence, the reverse merger is seen as a faster and cheaper method of “going public” than an IPO.
It can also be a way for foreign-based companies to access U.S. capital markets quickly.
What Is Investors’ Motivation?
Investors may purchase units or shares in a shell company, hoping their investment will increase once a target company is chosen and bought.
In other cases, investors may own stock in a publicly traded company that is not doing well and is using a reverse merger to boost shares for shareholders through the acquisition of a new company.
In either case, shareholders can vote on the acquisition before a deal is done. Once the deal is complete, the name and stock symbol of the company may change to represent that of the formerly private company.
How Does Reverse Mergers Work?
A shell company may have a primary purpose of acquiring private companies and making them public, bypassing the traditional IPO process. These types of companies can also be called special purpose acquisition companies or “blank check companies,” because they usually don’t have a target when they’re formed.
They may set a funding goal, but the managers of the SPAC will have control over how much money they will use during an acquisition.
An SPAC can be considered like a cousin of private equity in that it raises capital to invest in privately traded companies. But unlike private equity firms, which can keep a private company private for however long they wish, the SPAC aims to find a private company to turn public.
During its inception, a SPAC will seek sponsors, who will be allowed to retain equity in the SPAC after its IPO.
The SPAC may have a time limit to find a company appropriate to acquire. At a certain point during the process, the SPAC may be publicly tradable. It also may be available for investors to buy units of the company at a set price.
Once the SPAC chooses a company, shareholders can vote on the deal. Once the deal is complete, managers get a percentage of the profits from the deal, and shareholders own shares of the newly acquired company.
If the SPAC does not find a company within the specified time period—or if a deal is not voted through—investors will get back their money, minus any fees or expenses incurred during the life of the SPAC.
The SPAC is not supposed to last forever. It is a temporary shell created exclusively to find companies to take public through acquisition.
Are Reverse Mergers Risky?
Investing in a SPAC can be risky because investors don’t have the same information they have from a publicly traded company.
The lack of transparency and standard analytical tools for considering investments could heighten risk.
The SPAC itself has little to no cash flow or business blueprint, and the compressed time frame can make it tough for investors to make sure due diligence has been done on the private company or companies it plans to acquire.
Once a deal has gone through, the SPAC stock converts to the stock of the formerly private company. That’s why many investors rely on the reputation of the founding sponsors of the SPAC, many of whom may be industry executives with extensive merger and acquisition experience.
An Example of a Reverse Merger
SPACS have become a significant player in the IPO world in the past few years, and the number of SPACs spiked in the third quarter of 2020, according to FactSet.
Snack company UTZ went public in August 2020 through Collier Creek Holdings. When the deal was announced, investors could buy shares of Collier Creek Holdings, but the shares would be converted to UTZ upon completion of the deal. If the merger was successful, shareholders had the option to hold the stock or sell.
But sometimes SPAC deals do not reach completion. For example, casual restaurant chain TGI Fridays was poised to enter a $380 million merger in 2020 through acquisition by shell company Allegro Merger, a deal that was called off in April 2020 partially due to the “extraordinary market conditions” of the pandemic.
Allegro Merger’s stock was liquidated, while the owners of TGI Fridays—two investment firms —kept the company.
In September 2020, billionaire Richard Branson announced that he was raising money to form his own SPAC, called VG Acquisition, with 46 million units available at $10 each. The SEC filing states that the pandemic brought about “a rare opportunity to invest in fundamentally strong target businesses at attractive valuations.”
The SPAC has set a two-year limit to find the right business, which Branson has said will be in one of Virgin Galactic’s core sectors.
Investor Considerations About Reverse Mergers
Some SPACs may trade in exchange markets, but others may trade over the counter.
Over-the-counter, or off-exchange, trading is done without exchange supervision, directly between two parties. This can give the two parties more flexibility in deal terms but does not have the transparency of deals done on an exchange.
This can make it challenging for investors to understand the specifics of how a SPAC is operating, including the financials, operations, and management.
Another challenge may be that a shell company is planning a reverse merger with a company in another country. This can make auditing difficult, even when good-faith efforts are put forth.
That said, it’s a good idea for investors to perform due diligence and evaluate the shell company or SPAC as they would analyze a stock. This includes researching the company and reviewing its SEC filings.
Not all companies are required to file reports with the SEC. For these nonreporting companies, investors may need to do more due diligence on their own to determine how sound the company is. Of course, nonreporting companies can be financially sound, but an investor may have to do the legwork and ask for paperwork to help answer questions that would otherwise be answered in SEC filings.
Understanding reverse mergers can be helpful as SPACs become an increasingly important component of the IPO investing landscape. It can also be good to know how investments in reverse merger companies can fit financial goals.
Many investors get a thrill from the “big risk, big reward” potential of SPACs, as well as the relatively affordable per-unit price or stock share that may be available to them.
Due diligence, consideration of the downsides, and a well-balanced portfolio may lessen risk in the uncertain world of reverse mergers.
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