What is a Reverse Acquisition?

A reverse acquisition occurs when there is a business combination in which the entity issuing securities is designated as the acquiree for accounting purposes. This arrangement usually takes place so that a privately-held company can be acquired by a smaller shell company that is publicly-held, resulting in a combined entity that is publicly-held. Subsequent to the reverse acquisition, the management of the formerly private company takes over the combined business, and issues all public filings expected of a publicly-held entity.

Advantages of a Reverse Acquisition

The main advantage of a reverse acquisition is the avoidance of the substantial costs of an initial public offering. These costs can be a major burden for a smaller entity, and especially one with minimal cash reserves. In addition, the newly-public business can issue shares to acquire other businesses, though doing so will require a lengthy stock registration process with the Securities and Exchange Commission. Finally, shareholders will be able to sell their shares over an extended period of time, though this depends on onerous SEC rules and the existence of a liquid market for the company’s shares.

Reverse Acquisition Risks

There are three major risks to consider when engaging in reverse acquisitions, which are as follows:

Undocumented liabilities. The shell entity may contain undocumented liabilities. If these liabilities are substantial, it is possible that the acquiring business will now be liable for them, and will suffer severe losses while paying or disputing them.
No new funds. The resulting public entity has not yet raised any money, as would have been the case with an initial public offering (IPO). This means that the acquiring entity has undergone the expense of buying the shell company, but has not benefited from any fresh inflow of funds from new investors.
No market for shares. There is unlikely to be much of a market for the entity's shares, making it difficult for investors to sell their shares. They may still be able to do so, but it may take a long time by selling small quantities of shares each day.

Given the issues just noted, reverse acquisitions tend to be used only by smaller organizations that cannot afford the cost of a full IPO.