A Reverse merger, or reverse takeover, is the acquisition by a public company (Pubco) of a private company (Privco) pursuant to which the Privco shareholders obtain a controlling interest in Pubco and have the power to appoint the directors and officers of Pubco. As part of the transaction, the shareholders of Privco give up their shares in Privco in exchange for shares of Pubco. For legal purposes, the Pubco entity does not change, only the composition of the shareholders, however, for accounting purposes, Privco is considered the acquiring company and the financial statements of Privco become those of Pubco.
Many companies choose to go public by entering into a reverse merger rather than the traditional initial public offering (IPO). In addition, many Privco’s will do a simultaneous private placement in public equity (PIPE) transaction in connection with the reverse merger, which is known as an alternative public offering (APO). There are numerous benefits to reverse mergers, including shorter time process, lower costs, less commitment of management resources, less dilution to the Privco shareholders and an existing shareholder base. Upon closing the reverse merger, Privco becomes a public entity, whereas an IPO requires an often long registration and comment period before effectiveness. With a shorter period of time, this allows management to stay focused on running the company. Typically, the shareholders of Privco will receive between 90-99% of the outstanding shares of Pubco upon completion of the reverse merger, with the remaining 1-10% consisting of the shareholders of Pubco prior to the merger.
Reverse Triangular Mergers
One of the most common types of reverse merger is the reverse triangular merger. With this structure, Pubco incorporates a wholly-owned subsidiary (Merger Sub) in the jurisdiction of Privco. On closing, the holders of Privco exchange their Privco shares for shares in Pubco and Merger Sub is merged with and into Privco. At that point, the Merger Sub dissolves by operation of law and Privco is the surviving entity and becomes a wholly-owned subsidiary of Pubco.
The biggest advantage of using a reverse triangular merger is to avoid the need of Pubco to obtain shareholder approval for the reverse merger, which saves time and money. State law may requires shareholder approve to enter into a merger or acquisition. To obtain shareholder approval, Pubco would need to make filings with the Securities and Exchange Commission (SEC) and hold an annual meeting, which can be a costly and time-consuming process. In a reverse triangular merger, the sole shareholder of Sub is Pubco, and thus the shareholder approval is achieved through a board resolution of Pubco authorizing Sub to enter into the reverse merger.
In addition, under state corporate law, Pubco would be required to offer dissenters rights to those shareholders who vote against the merger. The procedures for offering dissenters rights varies from state to state, but typically involves Pubco providing all shareholders with adequate information regarding the proposed acquisition or merger and letting such shareholders know that they have the right to have their shares purchased for fair value if they dissent from the transaction. What constitutes fair value is often subject to disagreement and can lead to lengthy and costly litigation.
Share Exchange/Share Acquisition
The other most common reverse merger structure involves a share exchange or share acquisition, whereby Pubco acquires Privco as a wholly-owned subsidiary through the issuance of Pubco shares, cash or a combination of both. It is similar to a triangular merger in that after the merger is completed, Privco is a wholly-owned subsidiary of Pubco. The advantage of a share exchange rather than a triangular merger is the lack of additional state filings in connection with the formation of Pubco’s wholly-owned subsidiary and the filing of the merger documents. In addition, share exchange agreements are typically used where Privco is not a U.S. based company, as cross-border mergers are nearly impossible and may be prohibited under the laws of Privco’s incorporation.
The biggest disadvantage to share exchange agreements is that it requires all of the shareholders of Privco to enter into the agreement, unlike a triangular merger, which only requires a majority vote of the shareholders. As a result, it gives a significant power to minor shareholders to resist executing until the last moment, hoping to gain further concessions or change the terms of the deal. As well, there can sometimes be the logistical problems of simply gathering the executed signature pages of each Privco shareholder, as often the transaction documents are being changed right up until the closing.
A true merger, also known as a statutory merger, occurs when Privco merges with and into Pubco. Privco becomes extinct and Pubco is the surviving entity. As shareholder approval is required for any type of merger, this process usually only occurs when there is no exemption for the issuance of shares in the transaction and Pubco needs to file an S-4 registration statement, which will also include a proxy statement by which the Pubco shareholders will vote to approve of the reverse merger. Besides the registered shares, there are very few benefits of a statutory merger.
Forward Triangular Mergers
A forward triangular merger is similar in structure to a reverse triangular merger, except that on closing, Privco is merged with and into Sub and Sub is the surviving entity. While it has the same advantages of a reverse triangular merger, the loss of Privco as an operating entity is a distinct disadvantage. Privco typically has certain goodwill and name/brand recognition that disappears in a forward triangular merger. In addition, Privco may have certain contracts or licenses that cannot be assigned or transferred, which would be lost in connection with a forward reverse merger. As a result, forward triangular mergers are rarely used.
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