Is A Reverse Merger The Way To Fund Your Startup?

With the uptick in the economy, as an active startup mentor, I’m seeing a new surge of entrepreneurs and startups, with the commensurate scramble for funding. There just aren’t enough Angel investors and VCs to go around. Thus I’m getting more questions on new mechanisms, like crowd funding, and an old one long out of favor, the so-called “reverse merger.”

A reverse merger is the acquisition of an already public company (usually a dormant shell) to avoid the Initial Public Offering (IPO) process and cost, to quickly get your startup on a public exchange for fund raising through visibility and selling stock. It sounds like a great way to raise money, but here are some of the challenges you need to consider before trying it:

1. Make sure the shell you choose is squeaky clean. The image of shell companies has long been tarnished by true stories of shareholder lawsuits and “pump and dump” schemes. I recommend you work only with financial and broker organizations who have done the due diligence required, and who have a track record of success.

2. It takes real money to get into the game. The cost of the shell, plus the cost of navigating the process, can now easily exceed a half-million dollars, depending on the shell company, according to The Labrecht Group, a law firm based in Irvine, California and Salt Lake City. This approach is not for entrepreneurs already out of money.

3. Being a public company isn’t cheap or easy. Is your startup really ready to play in the corporate world? It better be an established company, with millions of dollars in annual revenue and profits, following generally accepted accounting, reporting, and audit procedures. Experts estimate the burden of public companies at up to $1M a year.

4. Increased jeopardy and less fun for the entrepreneur. The increased exposure and opportunity of a public company comes with a higher risk to you and your Board of severe civil and criminal penalties for regulatory mistakes and non-compliance. These looming constraints can turn your startup dream into a nightmare, all to increase funding.

5. Reverse mergers may not get your startup on the Nasdaq. Most public shells ready for sale are not listed on a national securities exchange, but are instead traded in a less glamorous setting, such as the OTC Bulletin Board. Of course, they can be renamed and moved, but that may negate the cost and time advantages originally sought.

6. Make sure that your team can motivate shareholders. The reverse merger process itself doesn’t raise any capital. That still requires a business team and story that continually motivates stock brokers and public stockholders. You may no longer have the option of investing all earnings into growth, or servicing your special corporate cause.

Yet reverse mergers are not all bad. Even the New York Stock Exchange did one with the acquisition of Archipelago Holdings via a “double dummy” merger in 2006 in a $10 billion deal to create the NYSE Group. Some people believe that reverse shell mergers may soon become the preferred IPO approach for emerging high-growth companies.

In fact, the quality of companies taking the back door into a public exchange seems to be getting stronger, and has become the avenue of choice for Asian companies seeking to go public in the American market. Being public makes the company more visible to shareholders and potential acquirers, and provides a presumption of future liquidity.

Other than raising money, the reverse merger may be the quickest way to get you to other benefits of a public company. These include the ability to offer meaningful stock options to employees, the use of liquid shares to purchase other companies, and the credibility and public access to information you need to attract key customers and suppliers.

In summary, a reverse merger, or going public through the “normal” IPO process should never be seen as just a way to fund your startup. It is a strategic decision that may indeed attract more funding, but also will likely change the culture and focus of your company, and your role from an entrepreneur to a corporate executive. What price are you willing and ready to pay for funding?

Marty Zwilling