For owners of private companies, the prospect of becoming a publicly traded corporation holds considerable allure. Companies of the same size and type typically have higher market value if their stock is publicly traded instead of privately held. Public stock has inherently higher liquidity. A public company can use its stock to acquire other companies and compensate employees.
The traditional process of going public involves an initial offering. That process can take six months to a year or more, and cost $2 million in fees and other expenses.
A reverse merger offers a faster, cheaper alternative, taking as little as a month to complete and at a cost of about $500,000. In a reverse merger, the owners of a private company that wants its stock publicly traded buys a majority of the shares of a shell company that is already publicly traded. Then the two companies merge. After the transaction, owners of the formerly private entity control the new public entity. The process can be done in less than a month and cost roughly a quarter of the cost of an initial public offering (IPO).
Chad Gumm, national tax director in the Moss Adams office in San Francisco, has advised companies in nearly a dozen reverse mergers over the past 15 years. He shows clients how to avoid or manage taxes in a reverse merger.
Most of the deals Gumm worked on involved established companies — not startups. Usually the acquiring private company and the acquired shell company are in similar businesses, though not always, as occurred in this issue’s cover story about the August 2015 reverse merger between Mount Tam Biotechnologies and cigar company Tabacalera Ysidron.
In the 1980s and 1990s, reverse mergers often came with a taint. Many business owners were skeptical about acquiring a public entity that might have faltered in its business, carrying a reputation that was not necessarily pristine. “People weren’t comfortable with that,” Gumm said. “They would just go through the traditional IPO route.”
As more established companies embarked on reverse mergers in the ensuing years, the taint lifted. “Through the 2000s, it became more popular,” Gumm said, and was often done to gain access to capital by selling shares of the emerged company.
“Particularly in the last five years, it’s definitely much more prevalent. But many people are keenly aware of some of the risks. You can mitigate those risks through diligence procedures” by investigating the shell company.
“You need to go through all the legal diligence,” Gumm said, “the financial diligence and the tax diligence process. As long as you do that, it’s a viable strategy.”
Financial problems crop up more often than tax or legal troubles, in Gumm’s experience. That was the case with the Mount Tam Biotechnologies reverse merger. “They may not have all their financial documents in order,” he said. “If you didn’t do your financial diligence, all of a sudden you get in trouble with the SEC during or after the process. What you thought you were getting into was not the case from a financial perspective.”
Shell companies are usually defunct for a reason, Gumm points out. “The proliferation of Chinese shell companies has greatly exacerbated that concern,” he said. “The SEC has started to crack down on some of those.”
A 2014 study by Charles Lee, professor in the Stanford University business school, looked at these companies. “Since the end of 2000, hundreds of Chinese companies have gone public on U.S. stock exchanges, most doing so through a reverse merger,” and some of these companies were accused of accounting fraud, Lee wrote.