Reverse Merger Primer

A reverse merger, sometimes referred to as a reverse takeover, is a process by which a private company can acquire a public company and thus becomes a traded public company - bypassing the lengthy process of a traditional initial public offering.  The reverse merger in and of itself is not a capital raising transaction, but a method by which a private company can greatly accelerate the process of becoming publicly traded and thus gain access to capital.  This form of going public can be attractive due to the speed and certainty of the process, which derives from the fact that there is not an underwriting firm involved acting as a judge and gatekeeper as to how changing market conditions may impact a proposed public offering, nor is there a lengthy regulatory review that precedes the closing of a reverse merger.

In a reverse merger, shareholders of the private company purchase control of the public shell company and then merge it with the private company. The publicly traded corporation is called a "shell" since all that exists of the original company is its organizational/legal structure. The private company shareholders receive a substantial majority of the shares of the public company and control of its board of directors. The transaction can be accomplished within weeks.

There are several ways in which the changes of ownership can be handled.  These include the issuing of new stock in the public company to the private owners, a stock swap, or a purchase, for cash, of a controlling interest by the private company in the public company. Generally, the simple cash transaction is the method of choice. In some transactions the historic business of the public company (its assets, liabilities and name) may revert to the former majority shareholder and is treated as a discontinued operation by the public company going forward.

Advantages

The advantages of being a publicly traded company include the possibility of commanding a higher price for a later offering of the company's securities. Going public through a reverse merger allows a privately held company to become publicly held at a lesser cost, and with potentially less dilution than through a traditional IPO. While the process of going public and raising capital is combined in an IPO, in a reverse merger, these two functions are separate. A company can go public without raising additional capital. Separating these two functions can greatly simplify the process.

In addition, a reverse merger is less susceptible to market conditions. Traditional IPOs can be risky for companies to undertake as completion of the offering relies on market conditions. If the underwriter deems that an offering may not be well received the underwriter may halt the offering.  In a reverse merger the transaction rests solely in the control of those controlling the public and private companies, market conditions have little bearing on the situation.

The traditional IPO process can last for many months, by contrast, a reverse merger can be completed in as little as thirty days.

In cases where a company is combining the process of raising capital with a reverse merger and attempting to complete both transactions simultaneously, or nearly simultaneously reference is sometimes made to the combined transactions as alternative public offerings, or APO’s.

Perhaps the greatest advantage of becoming a public company is the substantially greater number of financing options available to publicly held companies  -  access to the public capital markets.  In addition, the ability to utilize a publicly traded stock as a currency to make acquisitions and to incentivize and attract employees can be beneficial.
Notable companies that have utilized a reverse merger to become public include: Occidental Petroleum, Turner Broadcasting, Home Depot, America Online, Nucor, and in a variation on the theme the NYSE.

Challenges

A drawback and a significant challenge to successfully utilizing a reverse merger is identifying the reverse merger entity, or “shell”.  All reverse merger entities come with some history and it is vital to understand this prior to moving forward with a reverse merger.  Thus, the due diligence process must be undertaking very carefully.  Unlike typical merger due diligence where a purchaser has a significant concern about the fundamentals’ of a target company’s business, the focus of reverse merger due diligence relates more to the regulatory history of compliance of the target company, hidden or undisclosed liabilities and the history and evolution of its shareholding base.

“Shells” & Operating Entities

The standard approach is to complete a reverse merger into a public “shell” company. It is important to understand the definition of “shell” in two distinct ways.  First, the layman’s definition is simply a failed public company (not necessarily a bankrupt one).  A company whose business plan failed to pan out and which is languishing.  Often these companies declare themselves to be “shells”.  The regulatory, SEC, definition of a “shell” is a company with no stated business purpose, or operations.

In the event that the reverse merger entity is a “shell” as defined by the SEC, the issued and outstanding non-registered shares will never be eligible for sale under Rule 144.  An effective registration statement will always be required for the sale of these shares.  Rule 144 does operate normally once the entity ceases to be a “shell”. However, those historically issued shares do not cease to be tagged as “shell” shares.

In the case of the failed public company, completing a reverse merger is a due diligence and investigative challenge.  The main issues are balance sheet issues and shareholder issues.  For the question of the balance sheet it becomes what liabilities have “disappeared” from the balance sheet over time and will reappear post the completion of a transaction.  The shareholder issue is a question of finding them to purchase the shares on the one hand – they will not all be found- so one must assume a certain amount of dilution.  Those shares that cannot be found at the outset tend to come back into the market once there is any market success for the new business.  These shareholders could be viewed as toxic as they are likely to be selling shares at the first opportunity.

In the case of a reverse merger with a “shell” as defined by the SEC the transaction is subject to an accelerated filing requirement.  The 8-K announcing the merger has to be filed within 3 days of closing and is termed a “super 8-K” as it must be in substance as complete as a full registration statement.  Thus, there is a great deal of drafting and audit work that needs to be completed before closing.

An alternative to the shells described above is to complete a reverse merger with a public entity that is an operating business and fully reporting.  These are small companies where the owner is no longer interested in being public and is willing to entertain offers for the legal entity provided that he retains the operating business, its name, and its operating assets and liabilities.

In the case of a reverse merger with an operating entity, the transaction is not subject to the accelerated filing of a “super 8-K”.  The 8-K needs to be filed within 75 days of closing.  In the case of these transactions often substantially all of the outstanding shares can be accounted for and purchased.  In all cases the buyer leaves at least a small number of shares with the selling shareholders for listing purposes.

These operating entities have histories that are simple to document and all SEC and FINRA correspondence can be provided and reviewed, thus the due diligence is very quick and easy.  Ignoring the question of financing, a transaction with one of these operating entities can be completed in days.   Herein is the time benefit.  If an operating entity is available, a private company can become public in days.  However, the Form 8-K that would be filed within 75 days of the closing does require an audit report for the acquirer.  Thus it is important the acquiring entity either have its audit completed, underway, or is otherwise ready for its audit at the time of closing.

In some cases it may be possible to identify a reverse merger vehicle that is fully reporting, but does not yet have a trading symbol.  In these cases, upon completion of the reverse merger, or concurrently with the reverse merger process a Form 15c211 is filed with FINRA (the successor to NASD). The Form 15c211 is filed by a market maker on behalf of the company to initiate a quotation in the OTC Bulletin Board.  In the event that the circumstances merit it, application can be made to trade on the NASDAQ NMS.