Reverse Merger

Introduction

With the idea of the world as a ―Global village and Globalization being the buzzword, new practices are being adopted and accepted by the financial world so as to save time; increase the existing benefits and expedite the processes involved in various operations.

Reverse Merger is the aftermath of such innovative practice adoption over the already existing traditional IPO route to become a public listed company. It helps a private company to get rid of the hassles involved in the IPO process and speeds up the process for Public listing. The main difference between an IPO and a Reverse Merger is that an IPO allows a company to go public and also helps it to raise capital; whereas Reverse merger allows it only to go public. However, a reverse merger is preferred nowadays mostly by a large number of small firms who are in a hurry to get listed without much effort and lengthy listing requirements involved in IPOs.

A reverse merger is often suggested as one of the best options to provide greater access to the capital markets, increase the company’s visibility in the investment community, and offer the opportunity to utilize its stock to make acquisitions. Whether it be time saving, avoidance of the initial lengthy listing requirements, fast fund raising, cost savings are some of the positives involved with this method.

This method is basically a stock swap technique through which a privately owned company is acquired by a defunct public company. The public company is either a company that is not involved in real activities anymore or a SPAC created specifically for the purpose of Reverse Merger.

The final result is that the privately held company becomes a public listed company in a very short period of time. This further creates an opportunity for the new public listed company to generate finances using PIPE financing methods, FPOs etc.

In a reverse merger, the investors of the private company acquires a majority of the shares of a public shell company, which is then combined with the purchasing entity. Investment banks and also financial institutions typically use shell companies as vehicles to complete these deals. These simple shell companies have the provision to be registered with the Securities and Exchange Commission (SEC) on the front end (prior to the deal), making the registration process relatively straightforward and less expensive. To consummate the deal, in exchange for the shell’s stock the private company trades shares with the public shell, transforming the acquirer into a public company.

Advantages

Being a public company has numerous advantages for a family business. A public company generally has more credit worthiness with customers, suppliers, and capital providers.

Enhanced Exit Strategies: The Promoters/Co-promoters of the company might want to withdraw from the business, and having publicly traded provides greatly enhanced exit strategies through secondary market or a private sale. Withdrawal, or the desire to diversify investments of family members or partners, creates family business valuation problems.

Greater Access to Capital: A main reason for becoming a public company is to significantly enhance opportunities to raise the funds needed for new product development and expansion. A public company has great access to the capital markets through stock and debt offerings as well as banks. Therefore, this access allows the company to grow, either through internal expansion or through acquisition. It is said to have become more attractive to potential business partners, and future expansion or strategic alliances can be accomplished through the issuance of stock rather than the use of needed cash.

Enhanced Executive Recruitment and RetentionManagement and all the other key employees are putting increased emphasis on stock options, or the potential thereof, in making employment decisions. A public companycan offer share-based compensation plansbecause of which it is better able to attract and retain key personnel.

Timeliness and Expense: An IPO is a time-consuming and also expensive process. In a reverse merger,the process takes comparatively less time and money. In fact, it can at times be accomplished in 45 days instead of the year or more frequently needed for an IPO. The reduced time frame helps the key executives concentrate more on continuing operations and planning for the future and less on meeting with underwriters, lawyers, and outside accountants.

Marketability: In cases where a company’s product or service is a new, untested concept, a successful IPO can be difficult at best. On the other hand, the business of the company may be mundane, albeit profitable, and have a good historical record but not be of great interest to investors. Even if the company is able to sell brokers it’s ideas, there’s still no assurance that the public will buy the share. However, the uncertainty of market acceptance increases the risk that the time and money spent for an IPO may be wasted.

Public Company Disadvantages

A public company is said to be subject to more government regulation and outside scrutiny. It must meet Securities & Exchange Board of India (SEBI) and other reporting requirements and incur the additional expense of providing such information. As it will be under the scrutiny of the investing public, analysts, and others, the companies will most likely need to employ an investor relations firm or, at a minimum, internal public relations personnel. It’s hard to sell your share if the market doesn’t know you’re there. Another disadvantage which was observed is that the promoter ownership of the company will be diluted, and the promoter’s ability to control may be lessened. Also, the possibility of a hostile takeover exists. The family should initially control enough of its shares for this to be of minimal concern, and steps can be taken to avoid such a takeover as the promoter’s ownership is diluted. In addition to this, the value of the company and the wealth of promoters will be impacted by the volatility of the market and by other forces and events, not under their control. Many times, these events aren’t even related to the nature of the business or its immediate operating environment.

Reverse Merger Disadvantages

As with any business event, there are both advantages and disadvantages. The disadvantages vary significantly with thechosenshell company, so great care is needed to minimize the detriments. Here are the primary disadvantages.

  • The shell company is called a “shell” for a reason. Most shells are the companies that have wound down or sold off their operating business, while some were formed for the sole purpose of being available for reverse merger opportunities. The latter does not have a long or we can say dangerous history and should have significantly fewer pitfalls.Frequently a company is called a shell because it’s a failed company. As a result, remaining shareholders may have grievances with the company and its management.
  • Equity Dilution: There is definitely a cost for acquiring a shell. The private company has been putting up its assets, reputation, and business to acquire the shell, but the shell’s owners want a continuing equity interest in the restructured company. This means that the private company owner’s equity and voting power both are diluted as a result of the merger. The amount of dilution will depend on the value of what the two parties are bringing to the table and their negotiating skills. As discussed earlier, a shell with significant loss carry forwards adds value to the transaction, and this will come at a cost to the private company.
  • Under SEBI PurviewIn a reverse merger, the purchasing company is said to avoid the full IPO process. But not surprisingly, the SEBI is very sceptical of such mergers and may judge individual cases to be illegal, so it’s essential that the purchasing and subsequently the combined company is said to strictly adhere to SEBI rules to avoid sanctions or even prosecution.

Conclusion

Business restructuring is an efficient way of using the present resources and safeguard interests of various stakeholders. Considering the same, if reverse merger creates value and safeguards interests of present stakeholders and create long-term sustainability of business, then there is definitely no reason to view such transaction with suspicion. The reverse merger shall be an acceptable mode of restructuring for a purely commercial reason. However, the same should not be at the cost of compliances and disclosure required for any listed business.

Frequently Asked Questions (FAQs)

  1. What is Reverse Merger?

A reverse merger is a merger in which a private company becomes a public company by acquiring it. It saves a private company from the complicated process and expensive compliance of becoming a public company. Instead, it acquires a public company as an investment and converts itself into a public company.

2. What happens in a reverse merger?

In a reverse merger, the investors of the private company acquires a majority of the shares of a public shell company, which is then combined with the purchasing entity. Investment banks and also financial institutions typically use shell companies as vehicles to complete these deals. These simple shell companies have the provision to be registered with the Securities and Exchange Commission (SEC) on the front end (prior to the deal), making the registration process relatively straightforward and less expensive. To consummate the deal, in exchange for the shell’s stock the private company trades shares with the public shell, transforming the acquirer into a public company.

3. Mention few advantages of reverse merger.

Being a public company has numerous advantages for a family business. A public company generally has more credit worthiness with customers, suppliers, and capital providers.

Enhanced Exit Strategies: The Promoters/Co-promoters of the company might want to withdraw from the business, and having publicly traded provides greatly enhanced exit strategies through secondary market or a private sale. Withdrawal, or the desire to diversify investments of family members or partners, creates family business valuation problems.

Timeliness and Expense: An IPO is a time-consuming and also expensive process. In a reverse merger,the process takes comparatively less time and money. In fact, it can at times be accomplished in 45 days instead of the year or more frequently needed for an IPO. The reduced time frame helps the key executives concentrate more on continuing operations and planning for the future and less on meeting with underwriters, lawyers, and outside accountants.

4. What are the disadvantages of public company?

A public company is said to be subject to more government regulation and outside scrutiny. It must meet Securities & Exchange Board of India (SEBI) and other reporting requirements and incur the additional expense of providing such information.

Another disadvantage which was observed is that the promoter ownership of the company will be diluted, and the promoter’s ability to control may be lessened. Also, the possibility of a hostile takeover exists.

5. Mention two disadvantages of reverse merger.

The shell company is called a “shell” for a reason. Most shells are the companies that have wound down or sold off their operating business, while some were formed for the sole purpose of being available for reverse merger opportunities. The latter does not have a long or we can say dangerous history and should have significantly fewer pitfalls.Frequently a company is called a shell because it’s a failed company. As a result, remaining shareholders may have grievances with the company and its management.

Equity Dilution: There is definitely a cost for acquiring a shell. The private company has been putting up its assets, reputation, and business to acquire the shell, but the shell’s owners want a continuing equity interest in the restructured company. This means that the private company owner’s equity and voting power both are diluted as a result of the merger.

References

  1. https://www.thehindubusinessline.com/opinion/all-you-wanted-to-know-about-reverse-merger/article7318779.ece.

2. https://www.investopedia.com/articles/stocks/09/introduction-reverse-mergers.asp.

3. https://efinancemanagement.com/mergers-and-acquisitions/reverse-merger.

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