It's a hard time to be a small company. One-fifth of the startups that receive venture capital funding in 1999 and 2000 have already gone bust. The Deal.com reports, 'Of companies first funded in 1999, only 2.9 percent had IPOs and only about 15 percent were acquired or merged?' With venture capital, IPOs, and mergers scarce, it's difficult to get investment capital for an emerging business.

For private companies looking for capital, going public is obviously a tempting proposition. In today's economy, however, making an initial public offering can be difficult, especially for small and mid-sized companies. In 1997, about 125 companies raised up to $25 million by IPO. In 2000, there were only 18 IPOs in that range, and in 2001 there were only six. A steep drop in IPO trading margins and regulatory changes have made small company IPOs less lucrative, causing the small brokerage houses that handled such deals to retreat from the marketplace. In their wake, smaller private companies are left to scramble for alternatives.

Making an initial public offering isn't the only way for a company to go public. There is another option: the reverse merger. In a reverse merger, a private company finds a public company, usually one that is almost defunct, or a non-operating shell. In exchange for cash from the private company, the public company issues a large number of shares, which it uses to buy the operating company. It issues so many shares to the company that it is 'buying' that the private company gains majority interest in the shell.

When the deal closes, the private company effectively owns the combined company formed by the merger, which is public. The combined company often takes the name of the private company.

Since the private company essentially buys a controlling interest in the shell company, the disadvantage reverse mergers have in relation to IPOs is fairly obvious. Reverse mergers cost money. When a company uses this tactic to go public, it can only hope that the transaction increases the value of the shell company's stock enough to cover the costs of the transaction. Being public can sometimes bring other advantages. Timothy Halter, president of Halter Financial Group, Inc., has said that since the IPO market is dead, a number of companies are looking to do reverse mergers to qualify for private investment in public equity (PIPE) deals.

In a traditional IPO, the underwriter can filter out companies too small or too inexperienced to thrive in the public market. Any private company that can afford to make the reverse merger deal, however, can go public, ready or not. In the past, this has given the reverse merger something of a shady reputation.

Increased regulatory scrutiny is helping make reverse mergers more credible with today's financial community. The Securities and Exchange Commission and National Association of Securities Dealers have begun to review filings for reverse mergers with the same critical attention they give to IPOs. This improves the quality of private companies that are considering reverse mergers, which in turn is removing the stigma associated with the reverse merger process. Margie Blackwell, vice president of Keating Investments, said 'We get inquiries from companies with actual trailing revenues, as apposed to startups looking to raise capital, as was the case before.'

One potential pitfall in a reverse merger is the shell company itself. The reputation of the shell company will likely continue in the combined company created by the reverse merger, as will any legal or financial entanglements it may possess. A good shell company would have shareholders who invested in a legitimate company in compliance with securities laws. As interest in reverse mergers increases, quality shell companies are in demand. David Nussbaum, chairman and CEO of private-equity focused investment bank EarlyBirdCapital Inc., said 'If someone has a shell company with substantial cash in it and access to deal flow, there is a tremendous number of solid operating companies that would like to merge with this company.'

The increased demand for shell companies has increased their selling price. Prices for shell companies are roughly double what they were in the mid-1990s, although they are lower than they were in the height of the Internet boom. The current market for public shell companies has become attractive enough for Nussbaum to consider entering it. 'We're thinking of engaging in a dialogue with the SEC and the NASD on this,' he said. 'We feel regulators' previous misgivings are misplaced now that disclosure rules for reverse mergers are just a thorough as for registration statements. The IPO market is so dead right now that there is little choice for companies that want to go public.'

As the reverse merger process becomes more mainstream, it will continue to provide a viable alternative to companies seeking to become publicly traded. Still, going public is a big step. Reverse mergers only provide a means to take that step; they can't guarantee success in the public arena.