Reverse Mergers – Advantages and Disadvantages
Posted by Attorney Laura Anthony on November 14, 2016
Reverse Mergers – Advantages and Disadvantages – First the Advantages of a Reverse Merger. The primary advantage of a reverse merger is that it can be completed very quickly. As long as the private entity going public has its “ducks in a row,” a reverse merger can be completed as quickly as the attorneys can complete their due diligence review and the paperwork. Having your “ducks in a row” includes having all of the information to complete a Super 8-K organized and available, including completed audited financial statements for the prior two fiscal years and reviewed financials for the quarters up to date (or from inception if the company is less than two years old). From the public company standpoint, a data room should be set up that includes all necessary due diligence on the company and its shareholders.
Another benefit is the existence of a shareholder base – a shareholder base is necessary for any company to have active trading and liquidity in its stock. The more shareholders generally the more active the trading in a stock and the less volatile the stock price will be from ordinary buying and selling pressures. In addition, a minimum number of shareholders is necessary to qualify to list on an exchange such as NASDAQ or the NYSE MKT. Also, existing shareholders are often an overlooked, but great source for capital raises via shareholder rights offerings.
Another benefit is the existence of a trading symbol. Generally in an IPO process onto OTC Markets, a trading symbol is not issued until the S-1 process has been completed and closed out and a market maker completes a 15c2-11 process with FINRA. The 211 process can be lengthy. A trading symbol is a necessary precondition to a secondary trading market and a precondition for many active capital investors.
Similarly a trading history can be seen as beneficial. Although really any pre-reverse merger trading history should not be indicative of future trading activity it does show how active the public vehicle shareholder base is, and experience shows that it is easier for an active trading market to develop where one has previously existed.
Finally, since a reverse merger is a going public transaction – the newly public company will have all the benefits of being public, including the ability to use stock and stock option plans to attract and keep higher-level executives, use stock as currency to make acquisitions and of course to access capital markets and capital investors.
The primary disadvantage is the restriction on the use of Rule 144 where the public company is or ever has been a shell company. Rule 144 is not available if the public vehicle is a shell company until 12 months after the filing of the Super 8-K and then only if the company is current in its reporting obligations. Even if the public vehicle is not a shell at the time of the reverse merger, if it ever was a shell in its history, it carries the stigma forever and Rule 144 will only be available if the company is current in its reporting obligations.
Of course there is the issue of potential undisclosed liabilities, lawsuits or other issues with the public shell. Accordingly, due diligence is an important aspect of the reverse merger process, even when dealing with a fully reporting current public shell.
The third primary disadvantage is that the reverse merger is not a capital-raising transaction (whereas an IPO or DPO is). An entity in need of capital will still be in need of capital following a reverse merger. The fourth disadvantage is immediate cost. The private entity generally must pay for the public shell with cash, equity or a combination of both.
Next is trading history which can be both an advantage and disadvantage – an inactive or volatile trading history may repeat itself.
Next, is consideration of the seasoning rule. The National exchanges prohibit a reverse merger company from applying to list until the combined entity had traded in the U.S. over-the-counter market for at least one year following the reverse merger transaction, has filed at least one annual report and remained current in its reporting obligations.
Finally FINRA can be very difficult when applying for a new trading symbol following a reverse merger. Further concurrently with obtaining a new symbol or completing a name change DTC may request an updated eligibility letter which may not be able to be rendered if the public vehicle was a shell and is not Rule 144 eligible.