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.

“In June 2011, the SEC issued a blanket warning to investors against investing in firms listing via reverse mergers,” Lee said. In that year, more than 20 firms that went public through reverse mergers were delisted or halted from trading or targeted by short sellers.

“The recent waves of negative publicity have not only tarnished the reputation of Chinese reverse mergers but also directly impacted the pricing of other Chinese companies listed in the United States,” Lee said, “including many that have not been accused of any wrongdoing.”

While reverse mergers are usually cheaper and quicker than traditional initial public offerings, the amount of capital raised in a reverse merger is “much less than would be available from an IPO,” Lee wrote, and “in the aftermarket, liquidity can be minimal. In addition, as a publicly listed firm, a new reverse merger faces significant ongoing regulatory costs, which can be onerous for a small firm with cash constraints.”

Firms that opt for reverse mergers “tend to be at an earlier stage and more speculative than their IPO peers,” Lee said, and “typically face tighter financing constraints. Many also have a pressing need to provide their employees with liquidity for their equity stake in the firm. They have self-selected into the reverse-merger process not because they would not have preferred to go public via an IPO, but because for most of them, an IPO was never a realistic option.”

Due diligence done thoroughly can ferret out shell companies with problems that might later haunt an acquirer. With shell companies, “a lot of times their financial books were not in good shape,” Gumm said. “They weren’t necessarily recording everything properly. You can run into a lot of trouble with those. The SEC is keenly aware of that now, and they’re starting to monitor them much more closely.”

The reverse mergers in which Gumm advised clients all went well, with no significant problems arising from troubled shell companies, he said. Some struggled later with their core business operations, unrelated to the reverse merger.

“When they come to me, they pretty much have decided” on a reverse merger, Gumm said of clients. “They might ask what are some of the tax risks,” such as unfiled or inaccurate documents for the shell. Most clients want to ensure that the reverse merger is a tax-free transaction, which is usually possible, he said.

“There are not usually any tax concerns,” Gumm said. “You know what kind of consideration they’re going to issue,” he said, typically using shares for the merger rather than cash. “They can do cash, but then it’s going to be a taxable transaction,” he said. “If they want to do something funky, like sell off assets or move the company around if there are other entities, you could do something where the IRS would look at it and say, we’re going to recast the transaction as something different.”

Often a reverse merger is structured by having the shell company set up a new subsidiary, then the subsidiary merges with the formerly private company, and “the big company survives,” Gumm said. “You want that old company to survive so you don’t have to worry about contracts.”

Because most shell companies have minimal assets, obtaining legal indemnification is tough. In effect, the acquiring company, formerly private, ends up indemnifying itself.

In the purchase agreements for reverse mergers, language is commonly added to prohibit shareholders of the shell company from selling their shares immediately. Such lockup agreements typically last six months to a year, Gumm said. “You’re trying to get additional capital. It would look bad if all of a sudden” many shares are dumped.

For many companies that accomplish a reverse merger, the additional SEC-regulation compliance is the most difficult aspect of the transaction. “If it’s a fairly new startup,” Gumm said, “the employees are inexperienced. It’s burdensome. Internal accountants are distracted dealing with all these SEC reporting requirements.” As a result, there are “internal deficiencies because they haven’t built up that infrastructure internally.”

Another reason to do a reverse merger is that “it allows their shareholders to have more liquidity in their shares,” Gumm said. In a private company, there is no market for shares. With public shares, “you’re more attractive to hire better talent and to retain better management employees.”