Tuesday, November 8, 2016

Why Understanding Reverse Mergers is Important to Penny Stock Investors

If you invest in or are interested in investing in penny stocks then you must learn about reverse mergers. Reverse mergers are when a private company take over control of a public company and input it's management and business into the public company. Basically the private company purchases a majority of all outstanding shares in the public company and merge into the public company to become a public company. A reverse merger is considered an alternative to an IPO or an initial public offering.

A reverse takeover or reverse merger takeover (reverse IPO) is the acquisition of a public company by a private company so that the private company can bypass the lengthy and complex process of going public. The transaction typically requires reorganization of capitalization of the acquiring company. -Wiki

If you look within the OTC markets you will see many penny stocks that have no operations and only one manager or executive. Many of these companies are shell companies even though the OTC markets does not classify them as such. These companies are formed solely for the purposes of a reverse merger. Basically a founder or team of founders forms a company and pays all the fees and files all the necessary documents to take the company public. Once the company is public it has no operations or business plan except for it is looking for a private company to merge with.

Normally when this private company purchases all of the outstanding shares of the public company, the team or executive that formed the public company or public vehicle as it is sometimes called, is compensated by an increase in the purchase price. Basically if the founder of the public company paid $100,000 to file the paperwork with the Securities and Exchange Commission and the OTC markets to list the company, a potential purchaser would buy the public company for an amount greater than that.

Sometimes the public company simply promises to ensure its business plan and create liquidity by bringing more shareholders into the public company. This raises the price of the public company and if the original founders are left with stock they are hoping that the stock is worth more than the cost of creating the public company or what is sometimes called a public company vehicle.

You will hear the term shell company or SPAC which is an abbreviation for "special purpose acquisition company" used a lot in the penny stock arena. The only purpose of these companies is to acquire another company thus acting as a shell until a company with operations is inputted into the shell.  This is important to know because many companies that have no operations or no value or trading activity are waiting for a reverse merger candidate.

Once a private company acquires a public company and inserts its operation and business plan into the company the stocks' volume generally begins to move. This is due to many factors including an increase in shareholders or an investor relations campaign or an increase in investments into the company now that there is actually an operating company in the public vehicle or shell company.

Many penny stocks and micro cap companies that are public became a public company via a reverse merger. These reverse mergers happen often and they are sometimes called pipe transactions (PIPE stands for private investment in a public entity). There are great opportunities to buy a stock extremely cheap before a reverse merger and have a large gain in the stock price once the company merges with a legitimate business.

Buying into a penny stock which can be classified as a shell company or as a SPAC also known as a special purpose acquisition company is very similar to buying into a pre IPO company. At least the mechanics work very similar. In essence you are buying stock before a new valuation is inserted into the public company.

Many times after a reverse merger a new market capitalization is inserted into the public company and or new shares are issued thus changing the market capitalization of the company. If you buy prior to a reverse merger there is a good chance that the stock price will either go up or that the volume which is generally very little before a reverse merger will go up. This is considered the expert level of investing in penny stocks.

Most sophisticated penny stock investors are part of teams that put together reverse merger deals. Many sophisticated investors create the shell companies or public companies that will eventually merge with a private company. This is also the reason why many penny stocks and micro-cap companies change their name or change their stock ticker at some point in their life. If you do not understand reverse mergers you should take extreme caution when investing in penny stocks.

The Securities and Exchange Commission which regulates the sale and transactions of public markets requires that companies that are listed without operations be classified as a shell company or as a special purpose acquisition company. But because of special rules that limits certain activities within these type of entities, many companies simply classify themselves as operating companies but in fact have no operations and do not plan to have any operations. They simply plan on looking for an adequate reverse merger candidate; which for all intensive purposes makes them a shell company. 

A reverse merger can look something like this; the founder/originator of the company incorporates a corporation and files with the Securities and Exchange Commission to take the company public. The company has been taken public on a stock exchange generally a stock exchange with lower criteria such as the OTC markets or a lower-tier NASDAQ Stock Exchange. Once a reverse merger candidate is found, the founder transfers a majority of the stock to the private company and keeps a small percentage of the stock for themselves. It is also the case that sometimes the entire outstanding shares are sold for a dollar amount. Once the private company has been reversed merged into the public company (the shell or SPAC) and there is volume and active trading, the original founders (sometimes called incorporators) sell out their shares of the company in the public markets. 

Hope this helps you become a better penny stock investor.

-Nick Coriano

About the Author: Nicholas Coriano, JD is an Entrepreneur &  Business Consultant.  He has worked at Merrill Lynch, The New York Stock Exchange and is currently a partner at Cervitude Intelligent Relations.  Learn more about him here. He is the author of Rules For Entrepreneurship available now on Amazon.

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1 comment:

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