Although mergers between different companies is quite a common occurrence around the globe, not everyone is familiar with the different forms of mergers. In this article, we explain the concept of reverse mergers, key features, benefits and risks, while also explaining the process in which reverse mergers take place in India.
What is the difference between a merger and a reverse merger?
A merger may be defined as a legal unification of a small company with a larger company, where all the assets, activities, liabilities, and ownership of the former is overtaken by the latter. However, in case of a reverse merger, large private firms fuse with smaller public companies and essentially dissolve themselves.
Note: When an unlisted public company attempts to be listed in the foreign stock exchange by merging with a public company in that foreign country, this type of unification is known as ‘Cross-Border Reverse Merger’.
Few key features of reverse mergers are:
- The bigger company’s assets must have a bigger value than the smaller company’s assets.
- The net income credited to the large company’s assets would be more than the income generated from small company’s assets.
- The share capital presented as an acquisition fee must be more than the share capital of the small company prior to the acquisition.
- The priorities behind reverse mergers are defined well before joining the deal.
- A fair purchase value must be paid.
- When the reverse merger is complete, the small company shall continue its activities while the bigger one will cease to exist.
- The unification shall be of public concern.
Reverse Merger Challenges
- Potential Risk to Shareholders: It has been quite often found that shareholders of public companies often sell their holdings for all the wrong reasons, which may include purposeful failure to report major responsibilities and dishonest corporate governance. It is imperative to conduct due diligence to defend against such risks.
- Failing to Make Public Disclosure: If retroactive takeovers adhere to the disclosure requirements, the management flexibility could be significantly reduced. The business could potentially be harmed by leaking vital details to customers, suppliers, competitors, and business partners.
- Organizational Revamping Issues: The management of the unlisted company might not have enough or no experience at all in handling the activities of a listed company. Besides, there will be new domestic and external problems faced by the companies once the transaction is complete.
Pros of Reverse Mergers
- Simpler Process: Reverse merger allows private companies to become public without having to increase their capital, making the entire process much more simpler. While it can take several months for an IPO to materialize, reverse mergers do so in a matter of a couple of weeks. This not only saves money but valuable time that would have been spent on management.
- Reduces the Risk: In an IPO model, the business will eventually be made public. However, while managers are open to spending numerous hours planning and preparing for an IPO, if the market seems to be unpredictable, they shall revoke the IPO offering. In case of reverse mergers, you do not come across this risk.
- Less Dependency on the Market: Considering reverse merger is simply a method of unification between a public company and a private company, it is relatively less dependent on the market conditions.
Cons of Reverse Mergers
- Need for Due Diligence: Reverse mergers demand that due diligence of the acquisition company must be conducted, where its management, shareholders, financial institutions, operations, and any neglected responsibilities shall be reviewed.
- Regulatory and Enforcement Expenses: Reverse mergers might pressurize the acquired company’s managers with new regulatory and compliance requirements, which the managers might not be familiar with. This can be quite a heavy burden for them and may lead to a weak initial performance due to all the managers being focused on administration rather than conducting the required business activities.
Potential Risks of Reverse Mergers
Combined Organizations Risks
Reverse mergers require a public shell company for the transaction to take place, for which, two different kinds of public shell companies can be used. The first one being a public company that used to operate once but does not anymore. However, it is still listed on the stock exchange with the status of it being a public entity. The second kind of company that may be used for reverse mergers is a newly formed entity with no history of operations and which has solely been created for such a transaction. Such a company is also referred to as a ‘clean’ company.
The bigger risk in reverse mergers is associated with the unification of a private company with a public company shell that used to conduct operations at some point of time. Since such a company basically ran an unsuccessful business and may have old outstanding liabilities, litigation and potential of litigations becoming major risks in the future, a clean, new public company is the ideal choice to go for, as there are no risks associated with them.
Risk of Being a New Entity
Another major risk of reverse mergers is that a company may face the new creditor when the company is formed as a result of a reverse merger. Mostly in such transactions, the public company involved in the transaction might be a poorly performing entity with little or no profit at all.
When a new company is formed as a result of a reverse merger and new capital is transferred to this company, the old creditors can leverage this excellent opportunity to get back their money, which they considered as ‘credit loss’ prior to the merger. However, while this is a boon for old creditors, the new company might face several complications as a result of this. The new company may find it very difficult to take such creditors into account, as they had not considered them when due diligence was conducted for the merger.
Besides, even if the public company moves out the business to a new subsidiary, the responsibilities must follow in to the new subsidiary as well. Therefore, it makes it vital to conduct a due diligence at this stage – which shall cover the tax, legal and financial aspects of the entities.
Low Liquidity Risk with respect to Stock Trading
The above-mentioned financial controls, compliance demands and costs involved are worth if the company’s stocks have a value after the completion of the transaction. In addition, the value must be supported and even increased, so that the company’s shareholders have some liquidity in the market. However, in case of reverse mergers, this is not what usually happens.
Although a financial transaction is a vital part of reverse mergers, it does not raise as much capital as IPOs, and which is surely not enough to take the business to the next level of growth and profits.
Remedies for Potential Risks
Thorough Due Diligence Process
It is quite obvious that buying another company does have certain risks for shareholders of both the companies, i.e., the buying company and the acquired company. Such risks can be mitigated by taking some actions, i.e., through an accurate and precise due diligence process. If done at the appropriate time, this due diligence will not entirely eliminate but minimize the potential risks associated with reverse mergers.
When preparing for the reverse merger, advisors of both companies must evaluate the potential risks and attempt to minimize the risks as much as possible. This due diligence process not only helps analyze the performance and economic situation of the company but aids in realizing the unanticipated challenges, which may occur when the new management takes over, as well. In case any unforeseen expense arises, say advisory or audit costs, the old or new management must be able to settle it immediately. In addition, if the old company offers incentives based on performance, the new management might have issues integrating and managing this aspect of the business. An efficient sales and purchase agreement can be significantly helpful in minimizing such risks of reverse mergers.
A popular piece of advice for reverse mergers is to consult with the domestic tax agency prior and during the process to ensure you are aware of and avoid any potential problems that can arise in future.
Better Organizational Governance via Increased Shareholder Voting Rights
- Acquiring public companies is usually accompanied by negative or insignificant returns for the buyers, especially in terms of value. And certain value-degrading purchases can raise red flags to the shareholders. However, such value-degrading purchases can be handled through various organizational governance mechanisms. When you consider this aspect, the role of the voting rights of shareholders is significant.
- Acquisition transactions allow shareholders to exercise their authority over business decisions. In the majority of corporate laws, shareholder voting rights are limited to electing directors and approving extraordinary topics. In addition, shareholder voting rights in takeovers are limited as well. Thus, all acquisitions must be approved by shareholders as such investments can ultimately lead to sales of target firms.
- In addition, structuring the transaction as a reverse triangular merger may eliminate the need to get the approval of the shell company’s shareholders to close the transaction. This would enable the shell company to avoid holding a shareholders’ meeting and save valuable time and resources that would be used to organize the same.
What is the Effect of Reverse Merger on Shareholders?
The shareholders of the public firms involved in a reverse merger usually benefit from the transaction. As mentioned before, reverse merger transactions involve the public firm acquiring all the shares, assets and business operations of the private firm.
- As a form of payment, the public firm issues a large number of shares that have voting rights in the company to the private firm’s owners. In addition, this payment may also include consideration in the form of cash, stock options, convertible notes, etc.
- The choice to go for a reverse merger rather than a traditional IPO offers different benefits and costs to different classes of shareholders. These shareholders include the ‘promoters’, who hold the majority of shares, and the ‘bystanders’, who control only a small part of the entity in reverse merger transactions.
Promoters and bystanders would not involve in an IPO, as the private company would be issuing shares directly to the public firm in such a transaction, making a shell unnecessary.
Keeping in mind that benefits and risks of reverse mergers effect different groups in different ways, we have addressed each party below.
Shareholders of Private Company
- Shareholders of private companies encounter certain pre and post transaction expenses in making a private company public.
- Reverse mergers and IPOs are both dilutive, which means that each pre-transaction interest or share shall be a smaller piece of the post-transaction pie, irrespective of whether the pie grows or not.
- In reverse mergers, promoters retain approximately 2-8% equity while a part of the equity remains with the bystanders. The larger the part given to promoters and bystanders, the smaller shall be the amount of equity held by the pre-transaction shareholders.
- In IPOs, issuing new shares to the public makes IPOs fundamentally dilutive. Considering previous shareholders do not receive any part of the new shares that have been issued, their positions are significantly diluted.
- Shareholders must compare and consider the benefits and costs that they may face in IPOs and reverse mergers.
- Reverse mergers are commonly spoken of for being less expensive and to save valuable time.
- In reverse mergers, the costs often exceed the outlays prepared to buy the public entity and hire advisors for the transaction, as a part of the equity remains on the table for the promoters and bystanders.
- To fairly weigh the benefits of shareholders in reverse mergers as compared to IPOs, pre-transaction shareholders would have to compare the relative value of the pre-transaction equity to the post-transaction equity.
Shareholders of Public Company
- Shareholders of the public shell company may be deemed as promoters and bystanders.
- Promoters have good reasons to get involved in reverse mergers and control several shell companies solely for this purpose.
- Bystanders have probably never been closed out in a precarious situation in a public company that is closing its activities and basically sending the virtual stock price to ‘zero’.
- Promoters receive cash fees for their financial assistance related to the transaction along with a small part of the shares of the entity formed post-transaction.
- However, bystanders receive no such consideration and hold the same amount of stock before and after the transaction, while leveraging an economic benefit only through their equity holdings. This is due to them having to face no out-of-the-pocket costs for the deal, which they might not even be aware of until it has already been completed. Somehow, they only enjoy the growth in the value of their equity post-transaction.
Practicality of Reverse Mergers as Compared to IPOs in the Capital Market
- Small firms are especially intrigued by reverse mergers due to their low cost and short processing time. It allows entities, which would otherwise be incapable, to go public.
- Companies that are not ready for an IPO might not have the structure required to bear the pressure that comes along with public listing in the form of regular audits and increased disclosure requirements. They are more likely to fail after going public and thus, reverse mergers offer a better method of going public.
- A poorly performing organization with a significantly small turnover and short history would prefer reverse mergers over IPOs. However, this can be avoided when the shell companies are carefully examined during a clean transaction.
- Most of the IPOs are underwritten by an investment bank and the issuing firm significantly depends on the underwriter to guide them through the process. The investment bank shall price the stocks and offer them to potential investors, while also providing price support in the aftermarket period.
- The presence of an underwriter’s support for an IPO and the absence of an underwriter in reverse mergers results in higher survival rates of IPOs as compared to reverse mergers. As a result, reverse mergers are more volatile, have higher short-term stock returns, lower trading liquidity, and lower institutional ownership as compared to traditional IPOs.
- However, unlike an IPO, market conditions have a lesser effect on determining when a reverse merger may take place.
- Reverse mergers have a lower cost due to lower investment banking fees, lower professional fees, lower market discounts, and offer the potential for liquidity to existing shareholders. Although such benefits are alluring, business owners and management teams must carefully consider whether the private company is ready to go public.
Conclusion
Considering the increase in the number of companies that chose reverse mergers over IPOs in the recent years, it is quite evident that it will soon become a preferred method for companies to go public. However, in doing so, such companies must ensure due diligence and consider every aspect of both businesses involved in the transaction to draw profits rather than problems after the transaction is complete.
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