What happens to existing shareholders of a public listed entity when a reverse merger/reverse occurs?
These sorts of transactions are quite usual and there is a well trodden path which is a little bit different to how you describe the mechanics.
What actually happens is that the public company buys the shares in the private company from the private company's shareholders using its own shares as consideration. The existing public company shareholders keep their shares and then they are joined as shareholders by the shareholders from the private company (who have, effectively, swapped their private company shares for the public company shares).
The ratio between the holdings depends on the value ascribed to the public company and to the private company. Many shell companies have some cash in them, and maybe some assets. Let's, for example, ascribe a value of £1m to the public company. If the private company has a value of, say £9m, then the former private company shareholders will hold 90% of the enlarged group's shares.Clearly, other ratios are possible depending on the actual relative valuations of the 2 companies.
Some notes to keep in mind:
Shell companies are often valued at a premium to their underlying cash/asset value - so maybe £1m of cash will be valued at £1.2m. This is because the public quote is believed to have a value (not so - see 2.)
The enlarged group will almost certainly (definitely in the case of UK stockmarkets) need to re-apply to be listed - so it is just the same hard work and cost as a direct IPO of the private company - and maybe more expensive due to the premium paid for the shell in excess of fair asset value and the additional legal costs to effect the acquisition.
