Reverse IPOs occur when private companies merge into public companies, generally “shell” companies used explicitly for the purpose of taking the private company public. It is a means of making a private company’s shares publically traded, without the headache or regulation of an IPO. This method of going public has been especially popular with Chinese companies, who , for numerous reasons, prefer to trade in American markets, and would like to avoid the scrutiny of the IPO process.

Q. So, it seems that a “reverse IPO” should actually mean a going private transaction, but I guess not…
A. You are right, the nomenclature is a little misleading. A reverse IPO, also called a reverse takeover or reverse merger, happens when a private company mergers into a dormant public company, a shell that once was a real company that flamed out and is now just a penny stock listing. The private company is thus the dominant partner. It’s management takes over the combined operation, and its shareholders wind up with nearly all of the combined stock. That way, the private company’s shares effectively become public shares: a reverse IPO.

Q. Well that sounds like a very quick way to get your shares registered, since you avoid all the normal red tape and time sink of an IPO…
A. There are still complex filing requirements, but, yes, essentially this is a shortcut to a public listing. Of course, one thing it doesn’t do is actually raise any capital for the firm going public this way, which is historically the point of an IPO.

Q. There have been hundreds of Chinese firms that have taken this route to a US listing. Why, since they don’t get the IPO proceeds?
A. Superb question. Partly, its probably a commentary on the poor quality of the Chinese markets themselves; its very difficult to get a listing there, and some of these companies probably figure some listing is better than none. Others, I suppose, think it will be easier to do secondary offerings and raise cash with public shares. But I’m afraid that an unpleasantly high number of those deals have involved a lot of shady dealing… in fact, a couple of smart hedge funds have made a lot of money by shorting reverse Chinese IPOs after uncovering questionable accounting, then releasing their findings and profiting when the stock crumbles. Sino-Forrest is the classic example of that.

Q. So, would you say this is a type of company that should get extra investor attention before investing?
A. Well, forget what I say: the SEC says that. And recently the exchanges have also taken some steps to limit the ability of reverse IPO companies to be listed. The fact is, of course, that an awful lot of these deals are completely legitimate and have good stories behind them. But one bad apple spoils the bushel, and there have been several bad apples of this type recently.