Delancey Street specializes in providing creative solutions to business owners. If you’re interested in going public, then a reverse merger might be a great solution for you. Our company can help you go public, by advising you about the benefits of going public, and can help structure the deal for you – from beginning to end.
Reverse mergers are a common method of going public. They are an alternative to an IPO, or DPO, for a company interested in going public. Reverse merger shells allow a privately held company to go public by getting a controlling interest in a public shell – and then merging with it. The SEC defines a shell company as a publicly traded company with no/nominal operations, and with either no/nominal assets consisting solely of cash, and equivalents.
In a reverse merger, a private company’s shareholders exchange their shares of the private company for new/existing shares of the public company. At the end of the transaction, the shareholders of the private company now own a majority of the public company, and the private company becomes a subsidiary of the public company. The pre-closing controlling shareholder of the public shell, returns their share to the company for cancellation – or transfers them to people associated with the private company. The public company then assumes operations of the private company. At the closing of the transaction, the public company has effectively gone public by getting a controlling interest in a public company, and the public company assumes all operations.
Reverse Triangular Mergers
Reverse mergers are often structured as reverse triangular mergers. In these mergers, the public shell creates a new subsidiary, which then merges with the private business. At the closing of the private company, shareholders then exchange their ownership for shares in the public company, and the private company becomes a subsidiary of the public company. The main benefit of this merger is it’s easier to get shareholder consent. This is because the sole shareholder of the acquisition subsidiary is the public company; and the directors of the Public company can approve the transaction on behalf of the acquiring subsidiary.
The SEC mandates that public companies file Form 10 type information on the private entity within 96 hours of completing the merger transaction (a super 8-K). After completing the transaction, and filing the Form 10, the private company is considered public. Form 10 refers to the information contained in the Form 10 Registration Statement. The Super 8-K is an 8-K with a Form 10 included. Like any transaction that involves the sale of a security, the issuance of securities to the shareholder’s of the private company have to be registered under Section 5 of the Securities Act, or use an exemption from registration. Shell companies generally rely on Section 4(a)(2) or Rule 506 of Regulation D under the Securities Act for such an exemption.
How are reverse merger shell transactions done
Reverse mergers are essentially mergers. The one exception is, in this case – the target ends up owning a majority of the acquirer. The documentation, and process, for the transaction is the same as a forward merger. Generally, the first step is signing a confidentiality agreement and a letter of intent. The documents can separate, or combined. If the parties exchange information before reaching a letter of intent stage of a transaction, then a confidentiality agreement should be executed ASAP.
In addition to requiring that all parties keep info confidential, the confidential agreement setups important parameters on the transaction. For instance, a reporting entity might have disclosure obligations when it comes to the initial negotiations for a transaction, which have to be exempted from the confidentiality provisions. In addition, the agreement might contain provisions unrelated to confidentiality, such as prohibition against solicitation of customers, or employees, or other covenants. Exclusivity is another item which can be included – where the confidentiality agreement is separate from the letter of intent.
The letter of intent, also known as the LOI, is a non-binding agreement. When conducting a reverse merger, this agreement discusses the broad parameters of the transactions. Specifically, the LOI helps you identify and resolve key issues that are in the negotiation process, and narrows down any outstanding issues prior to spending time, and doing due diligence. The goal of an LOI is to set the price/price range, the parameters of the due diligence, and to go over pre-deal capitalizations, confidentiality, exclusivity, time frames, and other necessary items which must be discussed for the deal. Along with an LOI, the attorneys of both parties prepare a transaction checklist, which has a “to-do” checklist, along with “who does it.”
After the LOI, both parties prepare an agreement which is titled either a “Share Exchange Agreement,” or a “merger Agreement.” The Merger Agreement discusses the financial terms of the transaction, the legal rights, and obligations of both parties involved in the transaction. Moreover, the merger agreement also discusses closing procedures, preconditions to closing, and post-closing obligations. It also sets out representations and warranties, for both parties, and the rights and remedies if the representations and warranties aren’t accurate.
After the LOI is done, the parties create an agreement which is titled “Share Exchange Agreement,” or “Merger Agreement.” Essentially, the merger agreements purpose is define the financial terms of the transaction, the legal rights, and the obligations, of all the parties in the transaction. Moreover, the merger agreement sets closing procedures, preconditions to closing, and other post-closing obligation. It sets out representations, and warranties.
The main components of the reverse merger shell agreement and a description of each are below:
- Representations and Warranties – These provide both buyer and seller with a snapshot of the facts of the deal. From the seller, all facts related to the business are disclosed, such as the seller has title to the assets, there aren’t undisclosed liabilities, there’s no pending litigation, or other adversarial situation that could result in litigation. The agreement should also cover that taxes are paid, and there are no issues with employees. From the buyer’s side, the facts in the agreement cover legal capacity, authority to enter, ability to enter, into a binding contract. The seller also represents and warrants that he/she has the legal ability to enter into the agreement.
- Convenants – This governs the parties actions for a period prior to, and following, the closing. An example of a convenient is the private company has to continue to operate the business in an ordinary manner, and maintain assets pending closing, and if there are post-closing payouts then the seller continues in the same fashion. All convenants require good faith, in terms of completion.
- Conditions – Conditions refer to pre-closing conditions like shareholder/board of director approvals, and that certain 3rd party consents are obtained, and the proper docs are signed. Closing conditions have to include payment of the compensation by the buyer. Generally, if all the conditions precedent aren’t met, then the parties are allowed to cancel the transaction.
- Indemnification – This provides the rights, and remedies, of the parties in the case of a breach of the agreement. It also includes material inaccuracies in the representations, and warranties, or in the case of a 3rd party claim – related to the agreement or business.
- Schedules – It provides the foundation of what the seller is purchasing, like a list of customers and contracts, all equity holders, individual creditors, and more importantly the terms of the obligations. The schedule provides all details for this.
In case the parties haven’t entered into a letter of intent, or confidentiality agreement – which provides for due diligence review, the Merger Agreement can contain due diligence provisions. Likewise, the agreement can also contain provisions like no-shop provision, breakup fees, and non-compete and confidentiality provisions if they weren’t previously agreed to separately.
The next step of the process is the actual closing – where shares of stock and reverse merger consideration changes hands, and a Super 8-K is filed with the SEC.
Reverse Merger Consideration and The Cost of the Reverse Merger Shell
In a reverse merger shell merger, the private business has to pay for the public shell. The payment can be in cash, equity, or both. The cash price of a shell can vary, and changes over time, as does the value of the asset. The average value of a public shell with no liabilities, no issues, is between $200-$400k. The price can vary, and depends on many factors, like pre and post closing conditions; the ultimate % ownership which will be owned by the private operating company shareholders; how quick the transaction can close; whether the private entity has it’s ducks in a row; whether the entities have complete due diligence packages ready; and whether any broker-dealers or investment bankers have to be paid for the transaction.
When the private company is paying for the public shell with equity, the current shareholders of the public shell company keep a large portion of the pre-closing equity, and as a result – own a larger % of the new combined companies post-closing. As a result, the current public company shareholders have a lower level of dilution.
Here’s an example to illustrate this:
In a cash reverse merger shell transaction, the current control shareholders of the public company cancel, or divest themselves, of all their share ownership, and the post-closing share ownership is anywhere from 80/20 (%) to 99/1 (%), with the private company owning a majority of the shares. In equity transactions, the current control shareholders keep some, or all, of the current share ownerships. In the final post-closing, shares will be anywhere from 51-49, to 80-20, with the private company shareholders owning the majority of the stocks in the company.
The % of the ownership maintained by the public company shareholders depends on the value of the private company, and an expectation of what the value of the share ownership could be potentially. There is risk involved for public company shareholders. They have to decide whether to accept $300,000 today, or maintain stock ownership in the hope they will be worth more at some time in the future. From the private companies perspective, they are diluting their current ownership, and giving up a piece of the pie.
In an equity transaction, parties in the reverse merger shell negotiate the value of the private company. For businesses with operating history, revenue, profit margins, etc, the value is determined by math. For development stage or startups, the algorithms don’t exist. Valuation is based on negotiating, and guessing.
Establishing valuation for a dev stage, or startup, comes down to an investor’s perception of risk versus reward. When determining value, due diligence should be done on the following: market data, competition, pricing, assets, hidden liabilities, inflated assets, risks, technology risks, product dev plans, legal structure, documentation, corporate formation documentation and records, management, backgrounds of management, and assessments of the team.
Things to consider when determining valuation
The following things should be considered when doing research.
- Investment comps
- Market data
- Uniqueness of product/technology
- Pricing and Distribution Strategies
- Capital Investments to date
- Assets / Liabilities
- Technology Risks
- Product dev plans
- Legal structure
- Legal documentation
- Future financing
- Exit strategies
- Dev milestones
Advantages of Reverse Merger Shells
This is something which can be done quickly. Reverse mergers can be done as soon as attorneys complete the paperwork. You must have things done already, like audited financial statements, etc. The transaction isn’t a capital-raising transaction. Many companies do capital restructuring (like a reverse split), and a name change either prior/following a reverse merger.
Raising money is difficult especially in a pre-public stage. In reverse mergers, the public company shareholders become shareholders of the operating business, and no capital raising transaction has to be done for this process to be conducted. Many companies that are unable to attract capital financing, can use a reverse merger to go public and benefit from the influx of capital from promoting their stock. This means using stock, and stock option plans, to attract executives and consultants. Many companies use stock as currency.
Disadvantages of a reverse merger shell
There are several disadvantages. The primary is the restriction on the use of Rule 144 where the public company is/or ever has been a shell company. This rule is unavailable for the use by shareholders of any company that is, or was, at any time, previously a shell company unless various conditions are met. In order to use Rule 144, a company has to cease being a shell company, has to be subject to reporting requirements, file all reports and other materials, and many other items.
Reverse Subsidiary Cash Mergers – What are they?
This is a popular variation of the reverse merger. This occurs when a new company is formed, when an acquiring company creates a subsidiary. The purpose of the subsidiary is to purchase a target company – with the subsidiary being absorbed by the target company. Reverse triangular mergers are easier to do than direct mergers because the subsidiary has simply one shareholder – the acquiring company. The acquiring company can more easily get control of the target’s nontransferable assets and contracts. Reverse triangular mergers, like direct and forward triangular mergers, can be either taxable or nontaxable depending on how they are executed, and other complex factors viewable in Section 368 of the Internal Revenue Code. If the merger is nontaxable, then a reverse triangular merger is considered a reorganization for purposes of tax.
Because reverse mergers (triangular), can qualify as tax-free reorganizations where 80% of the seller stock is acquired with a voting stock of the buyer, nonstock consideration cannot exceed 20% of the total. In order to qualify for a reverse merger (triangular), the acquirer has to create a subsidiary which merges into the selling entity and is then liquidates, leaving the seller entity as the surviving entity – and a subsidiary of the acquirer. The buyer’s stock is then issued to the seller’s shareholders. Moreover, because the reverse triangular merger is able to retain the seller entity and the business contracts – the reverse triangular merger is used more often than a triangular merger. In reverse triangular mergers at least 50% of the payment is made in stock of the acquirer, and the acquirer gets all the assets and liabilities the seller has. Because the acquirer has to meet the bona fide needs rule, a fiscal year appropriation might be needed to be only only if a legitimate need actually arises in the fiscal year during which the appropriation is made.