Background
Historically, initial public offerings (IPOs) have been the dominant route to going public. However, the high costs, regulatory requirements, uncertainty and extended timelines associated with IPOs have motivated many companies to explore alternatives. One alternative is through reverse takeovers (RTOs), also known as reverse mergers or reverse IPOs. It’s called a reverse takeover because the public company and its stock survive, and the operations of the private company become the operations of the public company.
RTOs provide private companies with an alternative method of becoming publicly traded by merging with an existing public company. An RTO occurs when a private operating company acquires a publicly traded company, typically an entity with minimal operations but an active public listing. Once the transaction closes, the private company’s shareholders receive a controlling interest in the public entity (typically 80% to 95%), while the public company’s existing shareholders retain a minority position in the combined company. This allows the private company to convert its shares to shares that are publicly traded and typically listed on an exchange through the public company’s listing.
This approach offers faster execution, reduced market‑timing risk, and potentially lower upfront costs compared to a traditional IPO. However, reverse mergers also carry distinct disadvantages, including reputational challenges, ongoing compliance obligations, and risks associated with assuming the obligations of the existing public company.
Components of an RTO
First, a public company is selected based on its reporting history, regulatory status, capitalization structure, and absence of material liabilities. Once selected, the parties will usually enter into a letter of intent, and, subsequently, a merger agreement. Throughout this process, the parties will negotiate the valuation, share exchange ratios, governance structure, and post‑merger capitalization.
Once the merger agreement is signed, the parties will work to complete any documents or filings, such as an S-4 registration statement, prior to closing. At, or shortly after, closing, the shareholders of the private company exchange their ownership for a majority stake in the public entity. Additionally, the private company’s management will assume executive roles in the public company, and the public company’s leadership typically will resign. The public company will then effectively be owned and operated by the private company.
Advantages of RTOs
RTOs might be beneficial for companies that require expedited access to public markets, prefer to avoid the market‑volatility risk associated with IPO pricing, are not yet prepared for the scrutiny and cost of a large-scale public offering, or want to maintain greater ownership and governance control.
- Reduced Time to Market– RTOs can be completed within months, compared to the 12–24‑month timeline typical of IPOs. This is beneficial for companies facing competitive pressure, time‑sensitive market opportunities, or urgent capital needs.
- Lower Upfront Costs–While not inexpensive, RTOs avoid many IPO‑related expenses such as underwriting fees, roadshow costs, and extensive marketing campaigns.
- Less Exposure to Market Volatility–IPOs are heavily influenced by macroeconomic and market sentiment, which can affect pricing, demand, and offering success. RTOs, by contrast, involve negotiated transactions and are largely insulated from short‑term market disruptions.
- Greater Ownership Retention: In an IPO, companies typically allocate a substantial number of shares to institutional investors and underwriters. In an RTO, founders and early shareholders usually can retain majority ownership and control because the exchange ratio (which functions much like the IPO price) is largely fixed in the transaction documents.
- Immediate Public Company Status and Liquidity: Once the companies have merged, the private company automatically gains the public listing of the public company, which can provide better stock liquidity and access to institutional capital.
- Shorter Regulatory Process: While RTOs are still generally subject to regulatory review by the SEC and the national securities exchange of the public company, such review tends to take less time than a transaction that involves an IPO.
Disadvantages of RTOs
There are, of course, trade-offs and disadvantages to RTOs, including reputational challenges, ongoing compliance obligations, and risks associated with assuming the obligations of the existing public company.
- Reputational Challenges: Reverse mergers lack the public visibility associated with IPOs. Additionally, RTOs were widely linked to fraud in the early 2010s, creating a lingering stigma that may impact investor confidence and institutional participation.
- Low Investor Transparency: In contrast to an IPO, an RTO can occur without the full vetting process required for an IPO because there is no third-party underwriter vetting and conducting due diligence on the private company. As such, investors may feel the need for increased due diligence before making their own investment decision. For this reason, institutional investors usually prefer IPO-listed companies, so companies in the process of an RTO may struggle to gain institutional capital.
- Risk of Low-Quality Public Entities: Private companies looking into completing an RTO must look carefully at potential public entities. Sometimes these entities can have unresolved litigation, hidden liabilities, poor financial controls, or incomplete regulatory histories. If the RTO is completed, the private company can inherit these issues, which pose operational, financial, and reputational risks to the combined entity.
- Regulatory Burdens: When a combined entity becomes public through an RTO, they will be subject to SEC reporting requirements, annual audits, internal control evaluations, and shareholder communications immediately. Because of the accelerated nature of an RTO, a former private company may lack the resources, systems and expertise necessary to comply with the burdens and obligations of being a public company.
- Governance Challenges: Successful RTOs require robust post-transaction governance. Challenges can arise if the management teams lack public-company experience, if the financial reporting infrastructure is inadequate, or if the corporate governance structures are underdeveloped. In addition, management teams may find it difficult to adapt from operating a private company to operating a public company which inherently is more restricted and subject to greater disclosure and transparently obligations.
- Fundraising Challenges: Unlike in an IPO, RTOs do not raise money on their own, and companies that need to raise capital must raise additional financing separately. While there are several alternatives available to raise additional funds, generally the private company must wait until after the RTO is completed to secure the financing.
Considerations before structuring and conducting an RTO
RTOs offer a strategic, efficient pathway for private companies seeking to become publicly traded while avoiding the time, cost, and market‑timing risks associated with traditional IPOs. While they provide substantial benefits—including speed, lower upfront costs, and improved access to capital, they also carry reputational, operational, and regulatory risks that must be carefully managed. With proper due diligence and execution, reverse mergers can serve as a powerful mechanism for growth, liquidity and capital access. Private companies interested in pursuing an RTO should be sure to do the following:
- Conduct extensive due diligence on the public entity, including any legal liabilities, the capitalization structure, SEC filing history, and insider ownership. Merely relying on available public disclosure is inadequate, and business, legal and financial due diligence should be guided by experienced professionals who can assist a private company in properly vetting public company candidates.
- Prepare audited financial statements and internal controls to ensure no additional hurdles once the combined entity becomes public. Financial reporting for public companies is an ongoing process and the supporting infrastructure needs to be tailored to the operating company. While the public company target may have some resources in this area that may be helpful to the private company, the private company should expect to have to build this infrastructure independently.
- Develop a strong post-merger investor relations strategy. RTO companies will start public company life without the benefit of an IPO roadshow and a base of institutional shareholders. Therefore, proactive communication with investors is critical to building trust and market visibility, and for attracting long-term institutional investors that provide a strong foundation for a stable shareholder base.
Next Steps
If you have any questions, please contact a member of Harter Secrest & Emery’s Securities and Capital Markets group.