What is a Reverse Merger?

Posted by on November 01, 2016

What is a reverse merger?- A reverse merger is the most common alternative to an initial or direct public offering for a company to go public. A “reverse merger” allows a private company to go public by acquiring a controlling interest in a public operating or shell company. The SEC defines a “shell company” as a publically traded company with (1) no or nominal operations and (2) either no or nominal assets or assets consisting solely of cash and cash equivalents.

In a reverse merger process, the private operating company shareholders exchange their shares of the private company for new shares of the public company so that at the end of the transaction, the shareholders of the private company own a majority of the public company and the private company has become a wholly owned subsidiary of the public company. At the closing, the private company has gone public by acquiring a controlling interest in a public company. For tax reasons, a reverse merger is sometimes structured as a reverse triangular merger, where the public company forms a new subsidiary to complete the transaction with the private company. The end result is the same – the private company shareholders own a majority interest in a public company and the formerly private company is now public.

The public company must file a Form 8-K with the SEC reporting the reverse merger transaction. Where the public company was a shell company, that Form 8-K contains Form 10 registration statement information on the private company and is commonly referred to as a super 8-K. Like any transaction involving the sale of securities, the issuance of securities to the private company shareholders must either be registered or exempted from registration. Generally, the issuance relies on Section 4(a)(2) or Rule 506 for such exemption.

A reverse merger is a merger transaction with the difference being that the target company ultimately ends up owning a majority of the acquiring company. Generally the first step in a reverse merger transaction is to execute a confidentiality agreement and letter of intent. The initial confidentiality agreement generally: (1) contractually binds the parties to keep all information confidential so that due diligence can be exchanged; (2) may contain provision prohibiting solicitation of customers, suppliers or otherwise prohibit the use of proprietary information learned in the due diligence and negotiation process; and (3) may contain standstill and exclusivity provisions so that the parties don’t concurrently negotiate with other parties for the same or similar transaction. The Letter of Intent (or LOI) is generally non-binding and spells out the broad parameters of the transaction. The LOI helps identify and resolve key issues in the negotiation process and hopefully narrows down outstanding issues prior to spending the time and money conducting due diligence and drafting the transaction contracts and supporting documents. Along with an LOI, the attorneys prepare a transaction checklist which includes a “to do” list along with a “who do” identification.  Following the LOI, the parties will prepare a definitive agreement. The next Securities LawCast in this series will pick up discussing the definitive agreements used in a reverse merger transaction.