Reverse Merger Transactions: Key Features and Considerations

A reverse merger transaction results in a smaller private company being absorbed by a larger public company. This effectively enables the private company to become a publicly traded company while bypassing the traditional initial public offering (IPO) process. A reverse merger is sometimes referred to as a reverse takeover (RTO).

It is important to note that a reverse merger differs from a reverse triangular merger. In a reverse triangular merger transaction, a subsidiary entity formed by the acquiror merges with and into the target company, with the target company as the surviving corporation. A reverse triangular merger structure can involve a number of tax benefits.

The reverse merger process begins when a private company buys at least 51% of the shares in the publicly traded company. The public reporting company often has limited operations and effectively acts like a shell company. Once the private company has gained control through buying enough shares, the private company’s shareholders will exchange their shares in the private company for shares in the public company. This effectively results in the private company becoming a public company. The private operating company’s management team usually assumes management of the public shell company. Additionally, the combined company will often assume the name of the private company.

The exchange ratio in a reverse merger transaction is determined based on the relative valuations of the two companies. The public company’s valuation is typically based on its estimated net cash at closing plus a premium paid for access to its public stock listing. The private company’s valuation can be heavily negotiated between the parties since it is less clear. The private company’s valuation is usually based on its financial statements and recent private financings.

The merger agreement in a reverse merger transaction often contains a minimum net cash closing condition, which specifies the minimum amount of net cash the public company must have at closing. If the amount falls below this threshold, the private company can refuse to close the transaction. As a result, the definition of net cash is usually heavily negotiated.

One of the key advantages of a reverse merger is that it is a significantly cheaper and faster way to take a company public than a standard IPO process. Reverse mergers can be completed in just a few weeks or months, whereas a typical IPO process takes 6-12 months. Also, while the public shell company must disclose the reverse merger transaction on a Form 8-K at closing, it avoids the lengthier process of filing multiple rounds of Form S-1 registration statements with the SEC that is characteristic of an IPO process. However, a merger proxy/Form S-4 registration statement may have to be filed with the SEC, which could be scrutinized by the SEC.

While reverse mergers can be a shortcut to the time-consuming IPO process, there can be drawbacks to using a reverse merger structure. The board of directors of each company should carefully assess if any conflicts of interest exist.

If the SEC determines that the public company is a “shell company” at the time of the reverse merger, the combined company will face a number of restrictions including:

  • Delay in Form S-3 eligibility: Post-closing, the combined company will not be eligible to use a Form S-3 registration statement until 12 calendar months have passed.
  • Delay in ability to file Form S-8: Post-closing, the combined company will have to wait at least 60 calendar days before it is able to file a Form S-8 registration statement to register equity awards and employee benefit plans.
  • Inability to use incorporation by reference: Post-closing, the combined company will not be able to use incorporation by reference if it files a resale shelf registration statement on Form S-1.
  • Rule 145(c) restrictions on resale shelf registration statement on Form S-1: Post-closing, affiliates of the private company who received securities of the public company in the reverse merger will not be eligible to register those securities on a resale registration statement on Form S-1.

In addition, reverse mergers can expose weaknesses with the private company’s management team and practices. The private company’s executives may have limited or no prior experience with running a publicly traded company. This may negatively impact the company’s long-term performance. A lack of public company management experience may also inadvertently lead to violations of federal securities laws or regulations, which could subject the company to fines or regulatory actions. Insufficient public company experience could also result in a failure to meet accounting requirements and an inability to maintain effective internal controls over financial reporting.