S-1 vs. Reverse Merger
A traditional S-1, also referred to as a Direct Public Offering (DPO), and a Reverse Merger are two ways a company can go public. Each approach is different and has different costs, benefits, and drawbacks to the process. Therefore, it is important that you understand and weigh each of these so that you select the process that is best for your company. To that end, we’ve put together the key points of a DPO versus a Reverse Merger along with a discussion of some of the finer points involved in each.
What Are They?
Reverse Merger
In a reverse merger, a private operating company and public company exchange shares so that the private company owns a majority of the public company, and the private company is a wholly owned subsidiary of the public company. It is often structured as a reverse triangle merger where a public shell forms a new subsidiary that then merges with the private company before shares are exchanged between the companies.
DPO (or S-1)
A DPO is similar to an IPO, but it is not underwritten by a broker. Instead, the company self-underwrites. The DPO process typically involves the following: (1) performing due diligence (i.e. an internal audit) (2) undergoing any necessary cleanup, (3) filing a Form S-1 to register shares with PCAOB-audited financials, and (4) obtaining a CUSIP# and applying for a ticker symbol.
What Do They Cost?
DPO
Due Diligence & Legal Fees: $100,000-$150,000
Reverse Merger
Shell Company: $250,000-400,000
Due Diligence & Legal Fees: $100,000-$150,000
Other Potential Costs: equity
Reverse mergers often involve due diligence costs prior to filing – at least if a company prepares well. This typically means auditing the company’s financials and corporate governance procedures, and then making any necessary changes so that the merger process goes smoothly. It is also key that companies find the right shell company to go public through. This can be expensive. Companies can offset their costs by offering equity in their own company to cover part of the acquisition costs, but giving up a piece of the company may not be palatable to other, current investors.
A DPO, by contrast, has a much simpler cost structure. The only costs for a DPO are due diligence costs and legal fees.
In either case, your legal fees will vary based on who you work with and the time it takes to complete the process.
What Are the Benefits?
DPO
Takes less time than an IPO
Money-raising transaction
No potential carry-forward liability issues from a public shell
No public shell restrictions
Reverse Merger
Process is quicker than a DPO
Can raise money after process is completed
The greatest benefit a reverse merger brings is speed. If your due diligence is performed well before-hand, a company that wishes to be fully trading and reporting can do so in a matter of weeks. Of course, there is always a cost to such speed.
While a DPO has many benefits, its greatest attribute is that it does not involve a shell company. Without a shell company, you have no skeletons in your closet, and you are not subject to restrictions that are applied to shell companies. This means that stockholders may freely sell unregistered shares after the six-month holding period.
What Are the Drawbacks?
DPO
Longer process
Reverse Merger
Greater due diligence required up front
Issues with the shell company carry into your merger
Often subject to rules that limit public shell companies
Recurring reporting requirements
New financing can be onerous
While the process of a reverse merger is faster than a DPO, the due diligence can take months and is not an easy task. Finding the right shell company, one that is clean (or as clean as possible), can take time and patience. You will search for the right shell company, perform a proper due diligence review, find a problem, and have to start all over again. This also leads us to the issues a shell company can bring after the process. No matter how clean a shell company may appear, it is likely that it has something to hide (e.g. litigation, regulator liabilities, convertible debentures, etc.). While there are some restrictions shell companies face, Shell Stockholders can resell their securities under Rule 144, contrary to popular belief (see our previous posts for more information about Rule 144). However, in order to take advantage of this, the company must remain current in all reporting requirements. This can also lead to difficulty with new financing. Private funding will often require that the shell company either (1) maintain registration effectiveness indefinitely, so that the investor holding shares can sell them in reliance on Rule 144 or (2) negotiate terms from a weaker position if they cannot invest the time and money in maintaining registration.
A DPO is typically a longer process than a reverse merger because forms and documents must be filed with, and reviewed by, the SEC. The entire process on average takes four to five months, much less time than a traditional IPO and not significantly longer than a reverse merger.
It should also be noted that, while DPOs and reverse mergers can both be great alternatives to a traditional IPO, they are not funding techniques. While you can gain money from the transactions, the process itself will cost you. If your company does not currently have sufficient revenue to carry it through the process comfortably, you should consider a separate financing transaction.
Conclusion
As you can see, both a direct public offering and a reverse merger have benefits and drawbacks. They are different processes with different costs, which means they will be right for different companies. Keep in mind that this article considers complicated points in very general terms. If your company is considering which of these would be right for you or what your long-term goals are, we would be happy to help you find the right path for you and your company.