If given the choice between going public through a reverse merger and staying private, there is no question we would opt to stay private. Companies who enter into reverse merger transactions often do so without a complete understanding of the real costs and issues. For example:

1. The cost of the public shell.

Shells are priced with a cash cost and a share cost. Ask around and people will tell you that a “clean shell” (what exactly is a clean shell?) can be purchased for between $500,000 and $750,000. For that amount of money, you should be able to get 95% of the outstanding shares, which means that the shell also cost you 5% of your company.

Let’s examine the 5% owned by the public. These people either had stock in a real company they thought was going somewhere but became defunct and is now a shell – or, they bought stock knowing it was a shell, hoping the company would enter into a reverse merger transaction that would turn the company into something. Either way, the stockholders are the same….they are “sellers”.  They will sell every share they can, at any price they can, regardless of how magical your company is. They don’t know you or your business and they just want as much money as they can get for their shares.

So do the shares they hold constitute a “cost” in a reverse merger with a shell? Let’s assume your company trades at a $10 million valuation. The 5% you left the public shell stockholders with is worth $500,000. If it is not stock you kept, it is a cost. But it gets worse.

Since we know those stockholders are sellers and will take every opportunity to sell anything they can, your stock price will probably not increase until those people have sold all their shares. In fact, regardless of what you think about your company, your stock price might drop like a rock because those shareholders may own their stock at little or no cost, so any price they get is pure profit.

If you had any plans to acquire another business or raise investment capital, how interested do you think people will be if they see your stock falling? So, most companies who enter into a reverse merger end up spending a significant amount of time and money to attract buyers just to absorb the 5%+ owned by the shell stockholders. Why would any company subject themselves to this problem when they understand that this problem is virtually non-existent in a direct public offering?

2. The cost of reverse merger compliance.

Within a few days of consummating a reverse merger, you will need to provide the Securities and Exchange Commission with audited financial statements and a disclosure statement that contains all of the information required in a full-blown registration statement.

In the past, companies could enter into a reverse merger and could file minimal disclosures weeks later. No longer. The information required is now far more extensive and is required immediately. The days of a fast or easy reverse merger are over. If you have to spend the time and money to obtain audited financial statements and a full-blown registration statement, why go through the expense of a reverse merger when you can do a direct public offering instead?

3. The cost of contingent liabilities in public shells.

Most private companies seeking a reverse merger will thoroughly review the public shells financial statements. They need to pay special attention to the section titled “Contingent Liabilities”. Many of you know this…there is no such section. However, there is such risk.

A contingent liability generally stems from the actions or perhaps the lack of action that a company took in the past, but which can not be quantified by traditional financial statements or numbers.

For example, a shell company that previously sold toothpaste could ultimately be sued by a customer who bought one tube three years ago and claims that their cancer was a direct result of manufacturer defect. Why should you care? Because after the reverse merger, “you” are that same company!  Not only will you have to deal with the lawsuit, but are also responsible for the verdict and any damages!

It is often better to remain as a private company than to enter into a reverse merger transaction. However, if you have read this Q&A and still proceed with a reverse merger, we would love to hear how the transaction concluded. Please drop us an email three or six months after the closing to let us know if you would do it again.

We suspect we already know the answer, but would love to hear any examples of success (or failure).