'A reverse merger works for a private company that wants all the advantages of going public, but doesn't need to raise capital,' says Timothy P. Halter, president of Halter Financial Group Inc., a Dallas company that specializes in the transactions.

What exactly is a reverse merger?

It's when a private company buys the empty legal shell of a defunct public company, thus creating a new company. The private company provides the assets and the liabilities. The public company provides the legal license to trade the company's equity on public markets through common stock.

The new company may be retooled to fit the needs of its new owners.

'The surviving company can become whatever the private company needs it to be,' Halter says. 'You can change the name, the industry it serves, anything. A reverse merger is not a straitjacket.'

Reverse mergers are more common than you might think, with hundreds taking place across the nation each year.

'The number of reverse mergers rivals that of IPOs,' Halter says. 'It's Wall Street's little secret they don't want you to know. If you invest actively, there's a good chance that you've owned shares in a company that went through a reverse merger, but you didn't know it.'

Not everyone is a fan of the reverse merger.

'It's not the traditional way to properly finance a company,' says Steve Turner, managing partner at Capital Key Advisors, an online investment bank based in New York City. 'It gives you quicker access to the public markets. But it's hard to attract the large institutional investors, the ones who really can move the price of a stock.'

Beyond capital Halter readily admits that a reverse merger isn't right for every company that wants to go public. To be able to attract investors on the public market, he says, a reverse-merger company must show a history of solid performance, offer a clear business plan and have a minimum market value of $20 million.

'But the real key is, are you going public to raise capital or to gain the benefits of going public?' he says. 'If you're after the capital, then an IPO is the way to go. But if you don't need the capital, then a reverse merger is usually better.'

There are major advantages to being a public company that go beyond raising capital, Halter says, and a reverse merger provides all of them.

First, publicly traded stock puts an identifiable value on the company, known as the market cap. For example, if a public company has 10 million shares on the market and those shares trade for $25 per share, then the company has a market cap of $250,000,000.

'That puts the value of your company out there for all to see,' Halter says.

Second, going public provides public stock, which a company can use as currency for making acquisitions. That's particularly important for companies that grow by rolling up small companies in highly fragmented markets.

Third, public stock provides shareholders with a readily available method for selling their ownership in the company. They simply sell their stock on the open market, which is a much faster process than selling a stake in a private company.

Fourth, a public company can fetch a higher sales price than most private companies.

'A public company will sell for around 25 times its trailing earnings,' Halter says. 'But a private company generally sells for between four and six times its cash flow. That's a big difference.' Fifth, public stock gives a company an easy method of providing incentives to its employees through stock options.

Lower cost, more control

The reverse merger also offers advantages over an IPO.

One is cost. A reverse merger generally costs between $100,000 and $400,000 to complete. IPOs can run much higher.

Another is company control. In an IPO, a company generally gives up between 50% and 95% of the company. In a reverse merger, the ownership can give up between 2% and 10% of the company.

Yet another advantage is speed. It simply doesn't take as long to execute a reverse merger and you seldom have to worry about the deal falling through.

'For an IPO to work, there must be a receptive audience at a certain price,' Halter says. 'Many are withdrawn because the audience isn't there.'

But the reverse merger also presents its own list of disadvantages.

The most obvious is: It won't raise capital. That's a problem for owners and investors who consider going public as their reward for years of hard work and risk-taking.

There are other disadvantages.

Reverse mergers don't get the same respect from Wall Street as IPOs. They don't get the pre-IPO publicity that can boost a stock into mainstream investing, plus they don't get the backing of the market makers.

Also, there's the danger that the reverse merger will cause more problems than it will solve.

'There are often skeletons in the closet,' says Robert A. Shuey III, Institutional Equity Holdings, a stock brokerage in Dallas. 'If a company should have gone bankrupt, that's not a good shell to buy.'

The cure, Halter says, is to be very careful in picking a shell.

'You've got to do the due diligence,' he says. 'You've got to make sure the shell is proper, legal and clean. You want to know for sure that you're not buying someone else's problem.' t.

Rusty Cawley Staff Writer