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Reverse Mergers, Reverse Takeovers, and Reverse IPO’s

by | Jun 3, 2020 | Corporate/M&A Practice

In this weak economy created by the onslaught of the Covid-19 worldwide pandemic, many companies are trying to gain the stability and credibility that is normally associated with the status of a public company but without the costly and timely process of raising funds from the public market through an initial public offering (“IPO”). There are of course other options for a company to raise funds from the marketplace, such as a direct placement offering, a JOBS Act Regulation A+ mini-IPO, or a JOBS Act crowdsourcing offering. A reverse merger or reverse takeover, which allows a privately held company to become publicly held at a lesser cost and with less stock dilution, is also an attractive alternative to the full IPO.

What is a Reverse Merger or Reverse Takeover?

A reverse merger or reverse takeover is a transaction where a private company acquires or merges with (or into) a public “shell” company in order to become publicly listed. The primary motivation for such a transaction is that it is much less expensive than a full IPO with its extensive S-1 Registration Statement (and disclosures) and the detailed guidance and approvals with the United States Securities and Exchange Commission (SEC) or similar agencies in other jurisdictions. Another advantage is likely the ability to not hire an underwriter for the offeror’s stock. As a result, the reverse merger is a way to enter the United States capital market without engaging an underwriter and investment banker. The public company target in this type of transaction is usually a “shell” company since all that exists of such company is its organizational structure with little or no active operations, assets, or liabilities, but listed on a nationally recognized stock exchange and not necessarily actively traded.

A principal assumption for undertaking this kind of transaction is that the private company does not need liquidity or capital access immediately. While the process of going public and raising capital is combined in an IPO, in a reverse merger/takeover, these two functions are separate. So, in this sense, a reverse merger/takeover is not a capital-raising event although the transaction could involve the filing of an S-1 Registration Statement or other securities regulatory filings once certain steps are complete. You could also elect to raise capital through the reverse merger in a reverse merger going public transaction, in which case you may wish to engage a small investment bank to assist with marketing the offering on the OTC.

Once the private company identifies a public shell company that is willing to undergo a merger at an agreed-upon acquisition price, a transaction is commenced for the reverse merger/takeover. The process usually involves two steps: first, the acquirer commissions the mass-buying of the publicly listed company’s shares. The goal is to gain control of the target company by acquiring 50%+ of the outstanding voting shares although to obtain certain tax benefits, most buyers look to control 80% or more of the target shares. In connection with undertaking this transaction, tax advisors and accountants should be consulted for more particulars.

It is the next phase that leads to the merger (or takeover) and public listing. The process involves the private company’s shareholders engaging actively in the exchange of its shares with those of the public company. The public company – which is now effectively a shell company – cedes a large majority of its stock shares to the private company’s shareholders, along with control of the board of directors. They pay for the shell company with their shares in the private company although a portion of the consideration could be cash.

As a result of such transaction, the shareholders of the formerly public company will benefit by owning shares of a company with growth potential, as opposed to a corporate shell with little to no activity of growth prospects.

What are the Potential Drawbacks and Risks of Reverse Merger/Takeover?

A reverse takeover presents the following potential drawbacks:

1. Masquerading public shell companies. Some public shell companies present themselves as possible vehicles that private companies can use to gain a public listing. However, some are not reputable firms and may entangle the private company in liabilities and litigation.

2. Liquidation mayhem. A private company willing to go public using reverse merger/takeover should ask itself, “after the merger, will we still have enough liquidity?” The company may have to deal with a possible stock slump when the merger unfolds. It is critical that the new company has adequate cash flow to navigate the transition period.

Reverse mergers/takeover will also involve a significant amount of legal and compliance risk. Failure to conduct proper due diligence and/or if the reverse merger/takeover transaction is not properly structured, the post-transaction company could potentially end up becoming a private company but having public company reporting requirements and expenses. Other risks include SEC, FINRA, and OTC investigations or violations, undisclosed liabilities, litigation, and potential litigation. As a result, the post-transaction company will face increased compliance costs and regulations. Traditionally, the general perception in the securities industry among regulators is that a reverse merger/takeover transaction is used as a vehicle for fraud either by stock promoters or others including lawyers and business brokers since the securities are not registered with the SEC via a S-1 Registration Statement or via a Form 211 with FINRA. Companies must work closely with their legal and tax advisors to manage the legal and compliance risks associated with a reverse merger/takeover transaction.

What are the Benefits of a Reverse Takeover?

The private company that merges into a publicly listed company enjoys the following benefits:

1. No registration needed: Since the private company will acquire the public listed company through the mass buying of shares in the shell companies, the company will not need any registration, unlike in the case of IPO. However, you may elect to raise capital using this transaction, in which case you would need filing docs but not necessarily a full S-1. In some cases, you may decide to file a full S-1 registration statement and hire an investment banker to market the offering on OTC.

2. Less expensive. Choosing to go public through the issue of an IPO is not an easy task for a small private company. It can be prohibitively expensive. The reverse merger/takeover route typically costs only a fraction of what the average IPO costs.

3. Reverse merger/takeover saves time. The IPO process of registration and listing can take several months to even years. A reverse merger/takeover reduces the length of the process of going public from several months to just a few weeks.

4. Gaining entry to a foreign country. If a foreign private company wants to become a publicly listed firm in the United States, it needs to meet strict trade regulations, such as meeting the US Internal Revenue Service requirements. However, a private company can instead, gain access to a foreign country’s financial market by undertaking a reverse takeover.

By going public through a reverse merger/takeover, a private company also gains the advantages of being able to create liquidity for its shares and gains the ability to use its publicly traded shares as an alternative to cash for acquisitions or other business transactions, while increasing the company’s visibility and credibility among investors, suppliers, and customers. Finally, further advantages include less dilution of ownership control than in an IPO, increased valuation, ease of raising future capital, and more attractive to management and employees for options and other incentives.

Reverse takeover/merger transactions have also become increasingly popular among Chinese and other international companies that often find a higher stock price for their companies in the United States than they do in their home markets.

What is a Subsidiary Merger?

A subsidiary merger is a type of merger that occurs when the acquiring company uses its subsidiary company to acquire a target company. The acquirer may create a subsidiary company or use one of its existing subsidiary companies to execute the merger and acquisition transaction. In a subsidiary merger, the acquired company is merged with the subsidiary of the acquirer rather than merging directly with the acquiring company (the parent company) in a regular merger and acquisition deal.

Following the deal, the target company remains the surviving entity and becomes a wholly-owned subsidiary of the acquiring company, with the buyer (the parent company) as the sole shareholder. This means that the acquirer exerts control over the entity, potentially gaining control also of the latter’s non-transferrable assets and contracts. The main purpose of a subsidiary merger is to protect the buyer from the liabilities of the target company.

Types of Subsidiary Mergers.

Forward Triangular Merger. Forward triangular merger is an indirect merger where a subsidiary of the purchasing company completes the acquisition on behalf of its parent company. The subsidiary company acquires all the assets and liabilities of the target company. The acquired company then becomes a fully owned subsidiary of the purchasing entity. After the acquisition, the target company is liquidated, and the buyer becomes the sole shareholder of the combined entity. One of the reasons why buyers prefer a forward triangular merger is that it gives them more flexibility in terms of purchasing the target company. Buyers can use a combination of both cash and stock. Half of the consideration used to pay the target company’s shareholders must be at least 50% stock of the acquirer. If the consideration for the transaction was 100% cash, it would make the transaction taxable. On the downside, forward triangular mergers are less preferred than reverse triangular mergers due to issues regarding access to the target company’s licenses and authorizations. The properties will need to be reassessed, and some third parties may withhold consent to the acquirer gaining use of the target company’s contracts, licenses, and authorizations. The acquiring entity may incur additional costs in obtaining consent to the rights of the licenses and assignment of contracts.

Reverse Triangular Merger. A reverse triangular merger shares a lot of similarities with a forward triangular merger; however, they differ in the party that is liquidated. In a forward triangular merger, the target company is liquidated, whereas, in a reverse triangular merger, the special purpose vehicle (a “SPV”) created by the purchasing entity is liquidated. A reverse triangular subsidiary merger begins when an acquiring entity uses the SPV to acquire another company. After the acquisition, the SPV is absorbed into the acquired company, and the buyer (the parent company) becomes the only shareholder. The acquired company becomes a wholly-owned subsidiary of the acquiring entity, and the buyer acquires all the assets and liabilities of the acquired company. A reverse triangular merger retains the selling entity and liquidates the SPV that was created solely for the purpose of executing the acquisition. The acquired entity continues its regular operations as a subsidiary of the buyer, and the acquiring entity will not need to sign new contracts, licenses, and authorizations. This makes the reverse triangular merger more often preferred over a forward triangular merger.

It should be noted that, for the merger transaction to be tax-free, the acquiring entity must use its stock to acquire 80% of the target company’s stock. Cash and other non-stock consideration must not exceed 20% of the total consideration paid if the buyer wants to enjoy a tax-free acquisition transaction.