Reverse Takeovers 101

Here's a primer on an alternative way of going public.
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You may not have ever owned a stock that has gone through a reverse takeover. In fact, most investors have probably never heard the term before. However, despite their seeming obscurity, reverse takeovers (or RTOs) are a fairly common occurrence on Wall Street.

What Is a Reverse Takeover?

Reverse takeovers are another way for private companies to become publicly traded. They're like the estranged second cousin of the

IPO.

So how does a RTO work? Let's say Company A is publicly traded but is experiencing hard times, while Company B is privately held, has a lot of cash and wants to go public. With a reverse takeover, Company B gains control of Company A and forces it to absorb Company B as a subsidiary. Company B then essentially becomes publicly traded using Company A's

ticker symbol.

There are a few ways that Company B (private) can assert control over Company A (public). The most prevalent (and ethical) is for Company B to purchase enough stock in Company A to hold a controlling interest in the business (usually over 50%).

Company B can also control Company A through some sort of special relationship: If Company A has substantial

liabilities that are owed to Company B and is in risk of

default, Company B might be in a position to enter into a reverse takeover with Company A. More unconventional methods of gaining control of the public company are especially prevalent in

penny stocks.

Why a Reverse Takeover?

There are two main reasons for a company to pursue a RTO instead of an IPO. First, an IPO isn't cheap:

Underwriters,

exchanges, lawyers, accountants and others all need to be paid when a company takes the IPO route (

"Booyah Breakdown: ABCs of IPOs"). With an RTO, the private company avoids paying the hefty fees associated with getting public status. Second, with a RTO, companies that wouldn't be attractive IPO candidates to an underwriter are able to go public.

For a private company, the primary disadvantage of doing a reverse takeover is the fact that it loses out on the cash that investors invariably shell out for a new IPO. In this "A" and "B" situation, the owners of the private Company B can (and often do) generate cash by selling off some of their stake in the public Company A after the

merger is completed (see

reverse merger).

How Common Are Reverse Takeovers?

Reverse takeovers are probably more common than you think. While seeing a RTO go down in the

blue-chip world is a real oddity, they're actually pretty common in stocks that trade

over-the-counter (

"What Happens When My Stock Is Delisted?").

That's not to say that RTOs never take place on the big exchanges; there have been lots of situations where major companies have become public through a reverse takeover. Companies such as

Occidental Petroleum

(OXY) - Get Report

,

Time Warner

(TWX)

and even

NYSE Euronext

(NYX)

all have some type of history with reverse takeovers.

However, for the most part, reverse takeovers elicit notions of penny stocks, where the practice is more common and bears less on the mainstream investing public. Some of the wheelings and dealings of these companies have contributed to the somewhat maverick image that reverse takeovers have today (

"Ask TheStreet: In the Pink").

What Should an Investor Do?

There are a couple of things to keep in mind if you're thinking about investing in a company that has just completed (or is about to complete) a reverse takeover.

Since the public company was probably in a pretty bad spot to begin with, many

shareholders will probably see a reverse takeover as a welcome change in management (

"Talking to Management").

On the other hand, RTOs can also be hostile. Since a private company can take control of a public company without owning 100% of the public company's stock, even if some of the remaining shareholders are against the RTO, it's really out of their hands. If you're an existing shareholder and you're not a fan of the new company's direction, it might just make sense to sell your stake.

In general, companies that go through RTOs offer higher

risk than those who go public through a regular IPO. Because of this, it's essential to make sure that you completely understand the goals and prospects of the new company before you invest in it.

While reverse takeovers aren't the most common mode of taking a company public, they aren't bad in and of themselves. Quite often, floundering public companies are salvaged by the leadership of the newly formed company.

To learn more about takeovers, check out Booyah Breakdown: Tackling Takeovers.

Jonas Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.