Reverse Merger into a public shell 

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Reverse Merger Disadvantages and Risks


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Reverse Merger Disadvantages

Naturally, going public with a reverse merger has all the disadvantages of going public any other way: the cost of annual audits, SEC filings and disclosure, investor relations expenses. These costs weigh heavily on any new venture that is short of capital and income.

For reverse mergers in particular, as opposed to an initial public offering or self-registration IPO, the following discusses the disadvantages.

First, when you buy a shell company, you have the expense of paying for the shell, which I includes the cash you pay and the amount of the company you have to give up to the shell shareholders.

Second, you have the risk of merging into a shell with a hidden defect. These defects could undisclosed legal judgments against the company, other liabilities, undisclosed shares of stock that will be dumped on the market, undisclosed warrants to buy cheap stock, contracts that create liabilities, lawsuits that will show up only after the company has assets, etc.

Third, the shell company may have bad or missing records that prevent the company from being audited. This limits the options and growth of the operating company.

Fourth, in decades past there was a stigma associated with reverse mergers, the idea that if you were a real company you would do an IPO. That stigma dissipated with the use of public shells for PIPE (private investment in public equity) financings. However, the reverse merger stigma has returned from the recent discover of a number of Chinese reverse merger frauds, most certainly after the SEC warning to investors about any kind of reverse mergers. This is important because as raising money is the primary goal of a reverse merger, the willingness of investors to invest is a paramount consideration.

Creating a Market

All these disadvantages are well known, but the biggest problem with reverse mergers, as well as self-registrations, is the creation of a trading market in the stock.

The importance of creating a trading market in the stock is often ignored by shell merchants and attorneys attempting to sell their wares.

Kindly be advised that while your company has substantial value, there is also value in having an active trading market.

Without an active investor interest in the stock, you cannot find large investors who will give you money. These investors want to know that they have an exit strategy to sell their stock. They will not purchase stock privately or even publicly without a market for their investment down the road.

I have seen actively trading companies command as much as $1 million in market value beyond the value of the company alone.

Even a large shareholder list with little volume will have value.

Knowledgeable CEOs will spend hundreds of thousands of dollars in stock or cash for investor relations to create the market because they know that having that market will create millions in market value for their shareholders.

Developing a trading market using investor relations firms is not only a cost in money, it has a cost in time. When you do a reverse merger with a shell what has few shareholders and little or no volume, you may spend months to get the stock widely held and actively traded. These months will be spent telling the story of the company and getting people to buy stock. The time will be spent on large campaigns of publicity and investor relations.

During this period, your company will have to survive more and more scrutiny from investors. Not only must the story be good, it must be true.

Short Sellers


If your stock becomes over-priced, you may find that you are under attack from short sellers, another disadvantage of going public that can happen to all public companies no matter how they went public.

Those companies that have to continually sell stock to raise money are the favorite prey of short sellers because by driving the price down, the shorts can drive the company out of business and profit.

Another favorite of the short sellers are companies using fraud, whether it is false claims, undisclosed past bad histories of the promoters, or whatever. Short sellers will do intense investigations of their targets and broadcast whatever bad news they find.

This was the case with the recent campaign of short sellers on Chinese reverse mergers. The lack of business ethics in these Chinese companies opened the door to a huge campaign by the shorts sellers using planted media articles and other public relations techniques.

Generally, your company will be on the short sellers radar if it has a high market value in relation to the book value and earnings of the company.

Failure of Reverse Merger Companies

As I found out in researching my book “How to Pick Hot Reverse Merger Penny Stocks,” most reverse merger stocks will end up declining after a few years.

However, as I found out researching stocks to find home run stocks, most initial public offering stocks will face the same black future. This includes IPOs from some of the biggest names in investment banking. Many of these stocks were supported by their bankers for 3-4 years before being allowed to sink into oblivion.

In my opinion, the problem is in the nature of business. New ventures often fail.

As I found out in years of searching for venture capital money, most venture capitalists lose money in nearly all of their ventures.

The justification for this apparent waste is naturally that without venture capital, IPOs and the stock market, there would be no economic growth.

In my opinion, the reverse merger model is a better model for providing venture capital in that it gives the investors liquidity and gives the entrepreneurs control over their destiny. It does rob vulture capitalists of the chance to squeeze new ventures out of equity, but that is a good thing. I know of worthy ventures that were allowed to die because their founders would rather do nothing than pay extortionate profits to the venture capitalists and hand over control to people who were not expert in their business.

Cost of Capital

Whatever funding model is used, venture capital, IPO, reverse merger or whatever, the cost of capital for new ventures will be high, but not as high as not having funding at all.



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About Us John Lux

John Lux, has been an OTC market maker in new issues, shells and other companies, a security analyst, an investment banker, and attorney. He is an investor in venture and public companies.


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Videos

The Venture Capital Process or Why VCs Lose Money

Why Go Public?

Why Go Public, Make an Initial Public Offering, or IPO, or Reverse Merger

What Types of Companies Should Go Public, Make an Initial Public Offering or IPO

How to Sell the Underwriter on Your Initial Public Offering or IPO

The SEC Process for Initial Public Offerings or IPO

Reverse mergers and other ways to get your stock trading in the public market

Problems with Venture Capital and Venture Funding

Marketing Stock -- Reverse Merger -- Public Offering

Need for Audited Financials When Doing an IPO or Reverse Merger to Go Public

Traps for the Unwary When Doing an Initial Public Offering, IPO, or Private Placement

Stops on Going Public, Making an Initial Public Offering, IPO, or Reverse Merger

The Rocket Ride -- Going from Start Up, through Seed Money, Venture Capital, IPO

SEC Rules and a Reverse Merger instead of an IPO

Public Shells or OTC Shells for a Reverse Merger

Problems with using a Public Shell or OTC Shell to Go Public with a Reverse Merger

New Venture Funding

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An Alternative to Venture Capital Funding - Give Control to the Company


The Real Purpose of Corporate Finance


OTC Shells and Reverse Mergers -- The Aftermarket is the Key


Rules For Securities Offerings and Private Placements


Registration Instead of a Reverse Merger to Go Public


Venture Capital Rocket Ride










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