What Is Reverse Merger, And Is It For Everyone? Part 1
A reverse merger is a type of corporate reorganization in which an operating company merges with a private or public company. The term "reverse merger" was originally coined by Frank Quattrone of Deutsche Bank and refers to the fact that the smaller, private firm is absorbing the larger, typically public firm into which it has merged.
The goal of a Reverse Merger is for the smaller firm to immediately enjoy certain benefits associated with going public without several years worth of regulatory scrutiny and expense. A Reverse Merger is also viewed by many as a more attractive alternative to an IPO for private companies because it allows them time to solidify their public company strategy before being forced into a public offering.
Reverse mergers have become increasingly popular with smaller and less-developed companies looking for a fast path to liquidity, capital markets, and independence. In recent years, there has been a marked increase in the number of "reverse mergers" between private companies and their larger publicly traded peers. In the 1980s through 1990s however, reverse mergers were extremely rare because they required expensive lawyers who were able to navigate corporate law and SEC regulations while also providing counsel on capital formation matters.
Reverse mergers are also a popular strategy for foreign companies interested in merging with a publicly listed US partner in order to take advantage of the SEC's Regulation S exemption. This exemption allows foreign companies not listed on the US exchanges to sell their stock to investors without the standard registration requirements and fees.
The reverse merger process involves acquiring a public company through purchasing its stock or assets (if it is being bought out). The original management team at the target company is usually replaced after the acquisition, while new management hires directors and officers at both target and acquirer, although this is not always the case. The operating business of both firms will become one under common control; essentially becoming two divisions of one business. The company being acquired, the "target company", is often a shell corporation that is no longer actively operating. The target company will very often be in a different sector than the acquirer, but may also be in a related industry. For example, if an acquirer is in the retail sector, it might target a wholesaler.
In the merger of equals transaction, both companies contribute an identical percentage of stock to the merger entity and continue to exist as separate public companies until shares can be distributed to shareholders outside of exchanges (i.e., pink sheets or bulletin board). The initial public offering (IPO) of the new publicly traded entity is structured as a reverse merger, followed by a public offering, with the original management and board members continuing in their roles at the target company.
A reverse merger can be accomplished by taking an existing private company and either buying it out entirely or transferring its stock to another entity. The related companies will then become one through a transfer of shares. The private company simply acquires a shell corporation in an effort to gain access to capital markets and liquidity but, at this stage, has no intention of eventually going public.
The company taking over the company usually makes immediate changes at the senior level or consolidates all functions (e.g., human resources, accounting, etc.). A reverse merger can also be structured as a corporate acquisition by the acquirer's shareholders. To avoid confusion with a stock transfer to another shell corporation, a private company may decide to change its name to that of its target.
In an acquisition of shares transaction, both companies contribute new shares to the new public entity and continue to exist as separate public companies until rights can be given back to shareholders outside of exchanges (i.e., pink sheets or bulletin board). The initial public offering (IPO) of the new publicly traded entity is structured as a stock transfer to another shell corporation, followed by a public offering. The original management and board members continue in their previous roles at the target company.
The earliest reverse merger transaction was the 1982 merger of Pillsbury with General Mills. At the time, 80% of U.S. publicly listed companies were overcapitalized, with a market capitalization greater than the company's book value; or in other words, too expensive for other prospective acquirers. Reverse mergers became more popular after the 1986 United States v. Topco Associates U.S. Supreme Court ruling allowed companies to merge with publicly traded shell corporations in order to avoid registration requirements.
Reverse mergers are often used in a corporate strategy known as creeping tender offer. A company attempts to take over a public company without going through an expensive and time-consuming tender offer process by merging with it instead. The regulatory burden of a tender offer is far greater than that of reverse merger because the publicity involved in disclosing the bid encourages resistance from independent shareholders at both the target and acquiring companies, who can use their stock holdings as bargaining chips.
A company's stock and assets are transferred to an acquiring entity, which is often a shell company in order to create a public shell corporation that can then apply for an "emerging growth company" (EGC) investment designation. Through the EGC process, shares of newly issued stock can be sold to large investors without registration or offering costs. As of 2009, there were over 1,000 companies with the EGC exemption on the New York Stock Exchange and NASDAQ exchanges. The EGC designation could allow a company's shares to be traded without having to register its ownership with securities regulators.
Reverse mergers are also used for tax purposes. The purchase of a company by another company, which is then merged into the acquiring company, is considered a taxable event. As a result, the IRS charges tax on the purchase and the acquisition within one year of the reverse merger transaction. This is more common in reverse merger transactions involving private companies, but it can also happen through an acquisition of shares. To avoid this situation, some investors will hold off on buying such shares for one year after the reverse merger transaction has been finalized to reduce their tax burden.
Reverse mergers may expose both target and acquirer companies to risks that are typically not present when a public company acquires another public company (i.e., the target company has gone through a reverse merger before it is acquired). The buyer in a merger of equals transaction may face the risk of investing in a target company that is more poorly managed.
The buyout side of a transaction usually incurs an immediate debt burden by taking on the liability associated with the target's liabilities (e.g., debt, pension, etc.), which can be problematic if the acquirer’s cash flow and/or credit ratings are lower than those of its targets. This is more often encountered with private companies where the acquiring entity does not have access to many capital markets; however, it can still occur with public companies.
Conclusion
Mergers and acquisitions are inevitable in the world of business. With that said, the consolidations of companies could become more complicated if proper planning is not undertaken. The proper accounting treatment, timing, and tax implications can be a great asset to businesses who are currently contemplating mergers, acquisitions or even reverse mergers.
This article was contributed by Patrick J. Kiley, CPA/PFS and Mary Hetrick-Jaffe, CPA/PFS at Baker Tilly Virchow Krause LLP (Baker Tilly).