Reverse Mergers

If your company is looking to go public, an initial public offering (IPO) is not the only way to become publicly traded. Every year, a few private companies use reverse mergers to become public companies without going through the IPO process. This article defines reverse mergers, provides some of the advantages and disadvantages of a reverse merger, and lists a few notable reverse merger transactions.

What is a reverse merger?

Put simply, a reverse merger is when a private company becomes public through a merger with or acquisition of a public company. This usually happens in one of two ways: (1) a private company acquires a public company or (2) a public company acquires a private company with the intention of taking it public.

Under the first scenario, a private company acquires enough shares of a public company to gain control of the company and its board. The private company then exchanges its private shares for the public company’s shares and effectively goes public if it meets the qualifications for listing on a stock exchange.

The second scenario almost always involves a special purpose acquisition company (“SPAC”), which is a public “shell” company that does not actively generate revenue. A SPAC is an investment vehicle with the sole purpose of acquiring a private company and taking it public. SPACs are initially formed by a group of investors who contribute cash or other assets. The SPAC is then taken public through the Securities and Exchange Commission (“SEC”) registration process. However, because the SPAC does not actively generate revenue, the registration process is often quicker and simpler than it would be for other revenue-generating companies.

Registering the SPAC triggers a fixed period—typically 2 years—during which the SPAC managers must find a suitable company to acquire that will be approved by investors. When a target company is chosen, the public company makes a deal with the private company to exchange its public shares for the shares and/or cash of the private company. This takes the private company public without going through the IPO process.

What are the advantages of a reverse merger?

Access to capital markets

The purpose of a reverse merger is to help a private company gain access to a public market in a way that is more efficient than going through an IPO. Public markets provide liquidity to private company shareholders, increase the private company’s investor base, and make it easier to obtain future equity and debt funding.

Speed

While a reverse merger still requires preparation and due diligence, the process can be quicker than going through an IPO. The IPO process involves creating financial statements, having the financial statements audited, drafting an S-1, getting the S-1 approved by the SEC, pitching to potential investors, and many other tasks.  A reverse merger may avoid some of these formalities because the public company is already registered with the SEC. Additionally, a reverse merger is not technically a capital raising transaction, so the private company may save time by not needing to go on a roadshow and pitch to potential investors; however, companies that go through a reverse merger may still choose to go on a roadshow and raise capital as part of the reverse merger.

Less costly

In a reverse merger, the private company purchases the public company using either cash or equity, but the overall transaction may be less expensive than an IPO, assuming the private company does not employ investment bankers to market new securities. The private company may need to hire outside service providers like lawyers and accountants to facilitate the reverse merger. But if no additional securities are being offered at the same time as the merger, the amount of work (and therefore the cost) may be reduced.

What are the disadvantages of a reverse merger?

SEC compliance

While a reverse merger helps avoid some aspects of the cumbersome IPO process, it does not alleviate the burdens of being a SEC-registered public company. This means that the acquirer needs to hire a firm capable of doing a public company audit, prepare annual and quarterly financial statements, and develop proper internal controls. The Sarbanes-Oxley Act (SOX) requires that a public company’s internal controls be audited in addition to its overall financial-statement audit. It also assigns a company’s upper management the responsibility of overseeing and attesting to accurate financial reporting and increases reporting and disclosure requirements. Companies going through a reverse merger may not be prepared for the increased regulatory compliance that is required of public companies.

A reverse merger also has the possibility of affecting a company’s status as an emerging growth company (EGC) under the JOBS act. Emerging growth companies have fewer requirements when going public as outlined in our article The JOBS Act. However, to qualify as an EGC you must meet certain criteria, most notably having revenues less than $1 billion in the last fiscal year. A company also cannot be considered an EGC if it completed an IPO prior to December 8, 2011.

Market perception

Reverse mergers are generally not viewed as favorably as IPOs by current and future investors. Some investors view reverse mergers as a loophole that investment banks have created to make a quick profit. IPOs, on the other hand, are often celebrated as a huge accomplishment for a private company and a sign of growth and progress. Additionally, company performance has historically dropped following a reverse merger. Because of this historic pattern, investors may be hesitant to invest in a company that has recently gone through a reverse merger. While no company should completely base its actions on public perception, management should keep in mind that a reverse merger creates a very different narrative than an IPO.

Seasoning requirements

Just because a private company goes through a reverse merger, the private company may not have immediate access to a stock exchange, such as the NASDAQ or NYSE. To prevent unprepared companies from abusing access to national stock exchanges, the SEC approved rules in 2011 that toughen listing standards. These standards require that private companies go through a “seasoning period” before listing on an exchange. During the seasoning period, a company must trade its securities using an over-the-counter (OTC) market for at least one year and maintain a minimum share price for 30 of the last 60 trading days prior to applying to list on a national exchange. Private companies are exempt from these requirements if either (a) the acquired public company has previously filed at least four annual reports and associated audited financial statements or (b) the private company uses an investment banker to underwrite its securities and develops significant investor interest during the reverse merger process.

Notable reverse mergers

New York Stock Exchange – In 2006, the New York Stock Exchange Group ditched its not-for-profit status and became a public company through its $10 billion acquisition of Archipelago Holdings Inc.

‍Jamba Juice – In 2006, Jamba Juice merged with Services Acquisition Corp., a SPAC, and became a publicly traded company.

‍Burger King – In 2012, Burger King was absorbed by Justice Holdings, a public shell company. Justice Holdings received a 13 percent share in the company. This reverse merger happened less than two years after Burger King initially left the stock market.

Conclusion

An IPO is not the only way to go public. While reverse mergers are uncommon, a few companies choose reverse mergers to go public each year. Reverse mergers come with their own unique advantages and disadvantages in addition to the usual pros and cons of being public. If you are hoping to take your company public without going through the IPO process, you may want to consider a reverse merger.

Resources Consulted

• InvestmentBank: Reverse Mergers
• SEC: Investor Bulletin - Reverse Mergers
• SEC: SEC Approves New Rules to Toughen Listing Standards for Reverse Merger Companies
• SEC: Jumpstart Our Business Startups Act Frequently Asked Questions
• Legal & Compliance, LLC: Guide to Reverse Merger Transaction
• FindLaw: Reverse Merger - Small Business Funding Alternative to IPO
• The Bradshaw Law Group: Reverse Mergers - A Basic Primer
• Stock News Now: The Current Status of the Reverse Merger Market
• Williams Securities Law Firm: Going Public & the New JOBS Act - Emerging Growth Company
• Elllenoff Grossman & Schole LLP: Becoming a Publicly Trading Company Via Reverse Mergers and Self-Registrations