Reverse Merger
A reverse merger is a non-traditional method of going
public. Instead of hiring an underwriter to market and sell the company’s
shares in an initial public offering (“IPO”), a private operating company works
with a “shell promoter” to locate a suitable non-operating or shell public
company.
1. The private operating company then merges with the shell
company (or a newly-formed subsidiary of the shell company).
2. In the merger, the operating company shareholders are
issued a majority stake in the shell company in exchange for their operating
company shares.
3. Post-merger, the shell company contains the assets and
liabilities of the operating company and is controlled by the former operating
company shareholders.
4. The shell company’s name is changed to the name of the
operating company, its directors and officers are replaced by the directors and
officers of the operating company.
5. Its shares continue to trade on whichever stock market
they were trading prior to the merger.
6. Hence, the operating company’s business is still
controlled by the same group of shareholders and managed by the same directors
and officers, but it is now contained within a public company. In effect, the
operating company has succeeded to the shell company’s public status and is
therefore now public.
REVERSE MERGER TRANSACTIONS
- POTENTIAL RISKS
- POSSIBLE REMEDIES
- POTENTIAL
RISKS
Combined
business risks: Every Reverse Merger requires a
public shell company to complete the transaction. As found, the transaction can
be competed with two different kinds of public shell companies. First kind is a
public company that once had operations but is no longer active but continues
to have its name listed on the stock exchange with the status of being public
and second kind is a newly formed with no operating history, which has been
formed solely for the purpose of entering into a Reverse Merger transaction
called as “clean” company. The greatest risk lies in entering into the Reverse
Merger transaction with a public shell that was formerly an operating company
i.e., shell companies of the first kind. Since this type of company typically
has run an unsuccessful business and could have a history of outstanding
liabilities, litigation and potential litigation they turn to be high risks in
future, whereas the second kind of “Clean’’ companies are opting for the
transaction and carries no risks with them.
The
Risk of Being New: Another
substantial risk a company may face is the possibility of encountering the new
creditor when the new company is formed out of a Reverse Merger transaction.
Mostly in few of such transactions the public company which is involved in the
transaction may turn out to be badly perforating company with little or no
profit. When the new company is created through a Reverse Merger and new
capital is transferred to the company this may offer a very good opportunity
for the old creditors to get their money back, which they treated as a credit
loss before the Reverse Merger. This becomes very difficult for the new company
to take into account the new creditors because they are not there when the due
diligence is done. Even if the public company shifts out the business activity
to a new established subsidiary, it is important that these responsibilities
follow in to the subsidiary. Therefore, in order to minimize such risks, it is
crucial to carry out a due diligence at this stage which can include the tax, legal
and financial aspects.
Risk
of low liquidity in terms of stock trading: The above mentioned compliance requirements, financial
controls and costs involved are worth if the company’s stock will have a value
after the compilation of the transaction. Further, that value is to be
supported and in fact increased in the market so that the company’s
stockholders will have a liquid market for their stock. Unfortunately, with
Reverse Mergers, this is often not the case. While a financing transaction to
inject capital into the company is typically part of a Reverse Merger, that
financing almost always raises significantly less capital than an IPO and is
certainly not enough to take the company to the next step of self-supporting
profitability. On the other hand, there is no involvement of an underwriter the
company’s stock publicly traded post-closing, and fails to gain long term
market support. Thus there will be a significant decrease in the company’s
stock price, even the price may not be able to go above the value at which the
financing transaction takes place, and the trading volume of the company’s
stock will also decrease, as result of which there is little or no resulting in
little or no liquidity for the company’s stock.
REMEDY
TO THE POTENTIAL RISKS
- Diligent
due diligence mechanism
It is evident that buying another company may generate some
risks for both the shareholders in the buying company and the acquired company.
To reduce these potential risks some actions can be taken i.e., by an accurate
and precise due diligence. This due diligence if it is done at the right time
will definitely minimize, but not eliminate the risks that are prevalent in any
Reverse Merger transaction. During the preparations for the Reverse Merger the
two company’s advisors should analyse potential risks and try to minimize them
by an accurate due diligence. This due diligence process helps in analysing the
performances and the economic situation of the company, and also reveals the
unforeseen difficulties. When the control is transferred from the old
management to the new these problems may occur. Most of the potential risks are
generated during this time. Even if the unforeseen costs (Like advisory and
audit costs) comes up, the same has to be settled immediately either by the old
or the new management. The old management can also have a performance based
incentive program which the new management can have some problems handling
program. Further by having an effective sales and purchase agreement risks can be
minimized. This agreement has to be well drafted avoiding questions of which
part that should be responsible for the costs that are involved in the transaction.
If the agreement is drafted properly the unforeseen costs like extra audit and
advisory and the risks associated with them can be reduced. Thus it is very
crucial to analyse the balance sheet before the Reverse Merger is carried out.
A good thing is to have a consultation with the domestic Tax Agency before and
during the process in order to avoid indistinct problems come up later on.
- Better
Corporate Governance through Increased Shareholder Voting Rights
Acquisitions of public firms are usually associated with
negative or insignificant announcement returns for acquirers especially in
terms of value. And some value -destroying acquisitions rise red flags to the shareholders.
However, these value-destroying acquisitions can be mitigated through a number
of corporate governance mechanisms. In this context the role of shareholder
voting rights in acquisitions is significant. Interestingly, acquisition
transactions offer an opportunity to the shareholders to exercise direct
oversight and control over business decisions. In most of the jurisdictions’
corporate laws, shareholder voting rights are limited to the election of
directors and approval of extraordinary matters. Shareholder voting rights in
takeovers are also limited. Therefore, all acquisitions must be approved by
target shareholders because such investments might lead to eventual sales of
target firms. This is essentially required beside the approval of the
shareholder of the acquirer company. Additionally, structuring the transaction
as a reverse triangular merger may eliminate the requirement of getting Shell
Co shareholder approval to close the transaction. This would allow Shell Co to
avoid holding a shareholders’ meeting and therefore the time and expense
associated with filing for review and mailing to its shareholders a detailed
proxy statement and other materials as required.
REVERSE
MERGERS IMPACT ON THE SHAREHOLDERS
Shareholders of public firms engaged in Reverse Merger gain
from such transactions. As we have seen before, generally Reverse Merger
transactions are structured as an acquisition by a public firm of all the
shares in or assets and business operations of a private firm. As
consideration, the former pays for the acquisition by issuing a large quantity
of new shares with voting rights in the company to the owners of the latter.
The consideration shares may be supplemented by other forms of consideration,
which include cash, stock options, convertible notes and earn-outs (e.g.,
performance shares) The decision to opt for Reverse Merger as opposed to
traditional methods of going public with an initial public offering offer
different benefits and costs to different class of stakeholders such as
management of the private entity, the private shareholders and the shareholders
of the combined, post-transaction corporation. These shareholders include both
the “promoters” who hold the vast majority of shares as well as the
“bystanders” who control only a tiny slice of the entity in Reverse
Merger transactions. Promoters and bystanders would not be implicated in an
IPO, since the private company would issue shares directly to the public in
such a transaction, rendering a shell unnecessary. Recognizing that the
benefits and risks of Reverse Mergers impact various groups differently, the
study addresses each functional party individually below.
- Shareholders
of Private Entity
Private shareholders face certain pre and post-transaction
costs in taking a private company public. Reverse Mergers and IPOs are both
dilutive, meaning that each pre-transaction interest or share will be a smaller
piece of the post transaction pie (regardless of whether the pie grows). In
Reverse Mergers, the promoter may retain 2% to 8% of the equity and a portion
of the equity also remains in the hands of bystanders, the larger the portions
that go to promoters and bystanders, the smaller the amount of equity that will
be held by the pre-transaction private shareholders. In IPOs, the issuance of
new shares to the public makes IPOs fundamentally dilutive. Since prior
shareholders do not receive pro-rata portions of the new equity, their
positions are diluted accordingly. Shareholders should consider the relative
costs and benefits that flow to them in IPOs vis-A-vis Reverse Mergers. Either
transaction will result in increased information disclosure, more liquidity,
and dilution.2Reverse Mergers are touted as being less expensive and involving
less time. Although generally ignored by promoters, the costs in Reverse
Mergers exceed the actual outlays to purchase the public shell and to hire
advisors to the transaction, as a portion of the equity stays on the table for
the promoters and bystanders. In order to fairly weigh the net benefits to
shareholders of pursuing a Reverse Merger versus an IPO, one would have to
compare, for both transaction types, the relative value of the pre-transaction
equity to the post-transaction equity held by pre-transaction shareholders.
- Shareholders
of Public Shell
Shareholders of the public shell entity may be categorized
as promoters and bystanders, promoters. They have good incentives to engage in
Reverse Mergers. They also control a stable of shell companies reserved for
that purpose. Bystanders, on the other hand, most likely have never closed out
a position in an operating public company that is wrapping up its affairs
sending the company’s common stock to a virtual zero prices. At this stage,
Promoters receive cash fees for their financial advisory services related to
the transaction as well as a small slice of the equity in the post-transaction
combined entity. And Bystander hold the same small amount of common stock in
the public shell both before and after the transaction, receive an economic
benefit only through their equity position. Since they have no out-of-pocket
costs related to the deal (indeed they are unlikely to even know of the deal in
advance). Interestingly, they only experience the upside of the increase in
value of their equity after the shell acquires assets and operations through
the Reverse Merger.
- Feasibility
of reverse merger as compare to IPO’s in the capital market
Reverse Mergers are intriguing because of their low cost and
the short processing duration therefore, they are attractive to small firms,
and in addition, it enables firms which are otherwise not ready for the market
to go public. Firms not ready for an IPO might not have the infrastructure to
withstand the pressures of public listing such as regular audits and increased
disclosure requirements, and are more likely to fail soon after they go public.
RMs provides a platform wherein, small firms can stand to become public.
A company with poor performance, relatively small turnover
and short history, prefers Reverse Mergers compared to IPOs. However, the same
can be avoided when the shell companies are subjected to a careful examination
coupled with clean transaction.
The vast majority of IPOs are underwritten by an investment
bank and the issuing firm depends largely upon the underwriter to guide them
through the process. The investment bank prices the offering, allocates it to
potential investors, and maintains price support in the aftermarket period. The
underwriter support for IPOs and the absence of an underwriter in RMs are manifested
in the higher survival rates of IPO firms as compared with reverse merged
firms. Because of which Reverse Mergers have higher short-term stock returns,
higher volatility, lower trading liquidity, and lower institutional ownership
as compared to traditional IPOs.
Unlike an IPO, market conditions have a low impact on
determining the timing of a Reverse Merger. Lower cost due to lower investment
banking fees and lower professional fees, Lower market discount (IPOs typically
require 10-20% discount at offering), potential for liquidity to existing
shareholders. While these are certainly attractive merits, owners and
management teams must carefully consider whether the private company is
prepared for a public investor base.
Conclusion
Seeing the importance Reverse Mergers are getting in the recent years, it is clear that in the time to come, it would become one of the most preferred methods of public listing all over the world. Both developed and developing countries are realizing that reducing time and cost are the best ways for companies to gain competitive advantage over their competitors, all the more highlighting the importance of such methods which serve both the objectives comprehensively. All in all, a country with a good corporate law with greater control and more credible auditing agencies is the best place where the benefits of Reverse mergers can be enjoyed to the fullest
Contributed By – Kulin Dave
Designation – Associate
King Stubb & Kasiva,
Advocates & Attorneys
New Delhi | Mumbai | Bangalore | Chennai | Hyderabad | Kochi
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