Reverse Mergers: An Alternative for Going Public
Kenneth D. Polin, Partner, Foley and Lardner LLP
In its simplest form, a reverse merger refers to the process whereby a private company merges into and with an existing public company to establish itself as a public company. Typically, the public company, with which the private company merges—while it may have shareholders and some assets—is no longer a functioning business; hence it is often called a "public shell."
Still, it is typically a full reporting company to the Securities and Exchange Commission (SEC) and a public company for financing and trading purposes. A public company shell can take many forms—a company that trades over the counter to companies listed on NASDAQ, AMEX, or even the NYSE.
In years past, reverse mergers were associated with penny-stocks, which were viewed as subject to manipulation. The marketplace frowned upon them because of their high potential for risk and abuse.
The image of reverse mergers as a legitimate vehicle to go public has improved measurably in the recent years for several key reasons:
- IPOs have become tougher, riskier, and more expensive.
- New laws and regulations specifically dealing with penny stocks and reverse mergers have increased marketplace comfort with these transactions.
- PIPEs (or private investments in public entities) have become an increasingly popular vehicle for equity investments.
First and foremost, there are several reasons entrepreneurs desire to reap the benefits of a public company: access to public markets, increased liquidity for shareholders, and increased transparency and attractiveness as a company with which other companies want to do business. Reverse mergers are especially effective for companies seeking access to the PIPE market, comprised of investors who buy shares in earlier-stage companies only through public vehicles.
Entrepreneurs who take their companies public via a reverse merger can also expect to encounter fewer barriers. A well-structured, well-advised company should be able to close a reverse merger in about four to six months at a cost significantly less than a traditional IPO. Major costs include professional fees and the consideration paid for the public shell, which may include consulting fees, repayment of debt, and a percentage ownership of the public entity surviving the merger. The ownership interest can range from as little as 1 to 10 percent, depending on the relative bargaining strengths of the parties.
It's important to consider that following the reverse merger, the only shareholders typically able to trade in the open market will be the original shareholders of the public shell. If the private company acquires too much of the public entity or there are too few shareholders with freely tradable shares, there may be an inadequate public float and little, if any, trading activity. In addition to significantly lower costs and more predictable timeframes, the reverse merger is less subject to risk of derailment than an IPO due to changing political, economic, or market conditions.
Once an entrepreneur decides that a reverse merger makes sense for their company, a number of steps need to be taken before filing with the SEC.
- Locate a public company that meets minimum due diligence thresholds, which includes a company that fully reports to the SEC, is free of material actual or contingent liabilities, and has no history of other issues that could hinder the approval process. The best sources for locating public companies are service providers and select companies that make a market in public shells.
- Sign Letter of Intent to merge between the private and public company.
- Finalize a definitive merger agreement.
- Structure the transaction.
- Prepare documents, including board and shareholder consents that signify approval. To the extent corporate approval has been obtained by written consent as opposed to shareholder meetings, send an information statement to the remaining shareholders of the public company.
At the time the merger agreement is consummated, a Form 8-K describing the terms of the merger must be filed with the SEC. A second 8-K, including a brief description of the assets acquired and the nature of the shares of the public company's stock must be filed when the merger transaction closes. Finally, within four days after filing the second 8-K, an amendment, including two years of audited financials of the private target together with relevant pro formas of the combined entity, must be filed.
The SEC has expressed a dislike for reverse mergers, particularly those in which a newly formed subsidiary is merged into the private target with the private company surviving as the wholly-owned subsidiary of the public parent. This is not because the structure is inherently poor but because the disclosure framework that existed did not make enough information available about the acquired private target for public investors to evaluate at the closing. Thus, the new rules require full disclosure, including financials, within four days after closing.
Like a company utilizing the traditional IPO to become a public company, a company pursuing a reverse merger must consider all factors affecting a public entity post-closing. For example, it will be critical to consider obtaining market-makers for the company's stock, a corporate public relations firm to communicate public information available about the company, independent directors to serve in compliance with public company corporate governance requirements, as well as a whole host of additional rules, committees, and expenses associated with being a public company. This may involve the retention of more experienced, qualified outside certified public accountants and attorneys, as well as hiring of more experienced "public company" managers, including a qualified chief financial officer.
These factors are often overlooked in the rush to become a public entity via a reverse merger. Accordingly, a well thought out plan will have the most likelihood for success. If the company is successful in establishing itself as a public company pursuant to the reverse merger and then is able to demonstrate proper corporate governance and financial fundamentals, it may put itself in a position for additional growth and then transfer to a more visible trading exchange such as NASDAQ or AMEX. This can lead to greater liquidity opportunities. At that time, it would be more comparable to a company that had pursued a customary IPO.
The decision to go public via a reverse merger shouldn't be made in a vacuum and certainly without first considering whether being public is worth the pressures and expense that comes with it.
If, however, the answer is yes...
...and the company can close a private placement or an equity financing to avoid the burden of being public without the money that was sought in the first place...
...and the company has the financial results, management, governance, and legal, and accounting advice to attract investors and meaningful coverage by the investment analyst community...
...then a reverse merger can offer an efficient and less expensive way to access public markets and create liquidity.
© 2006 Ewing Marion Kauffman Foundation. All rights reserved.