Reverse Merger

6th Apr 2009
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Introduction

Reverse merger is an alternative method for private companies to become public, without going through the long and convoluted process

of traditional Initial Public Offering. In a reverse merger, a private company acquires a public entity by owning the majority shares of the public entity .The private company takes on the corporate structure of the public entity, with its own company name. The public “shell” is a vital aspect of a reverse merger transaction which is a publicly listed company with no assets or liabilities. It gets the name "shell" because the only thing remaining from the current company is its corporate shell structure. When a private company merges into this entity it becomes a shell. It is pertinent to mention here that selecting the right “shell” is of paramount importance. The cost of a “clean” shell involves huge financial inducement. Understanding the history of the shell , the current promoters and players involved in the shell, and the existing shareholder base are critical factors in the decision path to becoming a public entity through a reverse merger.

In a reverse merger, a healthy company merges with a financially weak company. The main reason for this type of reverse merger is due to the tax savings opportunities under the Income-tax Act, 1961. Section 72A of the Income-tax Act ensures the tax relief. This provision was introduced in the Act to save the Government from social costs in terms of loss of production and employment and to relieve the Government of the uneconomical burden of taking over and running sick industrial units. The healthy and profitable company can take advantage of the carry forward losses of the other company. The healthy unit loses its name while the surviving sick company retains the same. 

Forms of Reverse Merger

We may categorize the Reverse Merger under following three forms:

  • A public company acquires a proportion of the assets of a privately held company, giving in exchange the majority (above 51%) of the shares of the public company.
  • A public company may merge with a private company and, through a stock swap, the private company keeps control over the public company.
  • A public company acquires a proportion of the shares (i.e. acquires rights over assets, liabilities and financial flows) of the private company, giving in exchange the majority (above 51%) of the shares of the public company. Then the private company becomes a subsidiary of the public company and therefore also become public.

In all these cases, the privately held company obtains more than 51% of the shares of the public company, and thereby assuming the status of public company. Usually, the private company changes the name of the public company and removes its managers and board of directors. Legally, the activities of the public company (if any) continue until the new shareholders decide to cancel them.

Advantages of Reverse Merger

Reverse mergers provide several benefits when compared to traditional IPOs. Some these are listed below:

  • The costs are significantly less than the costs required for traditional IPO
  • The requisite time frame to secure public listing is considerably less than that for an IPO.
  • While an IPO requires a relatively long and stable earnings history, the lack of an earnings history does not normally keep a privately held company from completing a reverse merger.
  • The company does not require an underwriter.
  • There is less dilution of ownership control, compared to a traditional IPO.
  • Traditional IPOs generally require greater attention from senior management. 
  • The IPO may be withdrawn due to an unstable market condition even after most of the up front costs have been expended.
  • Ability to grow through acquisitions.
  • Ability to use liquid (in theory) stock options to attract and retain talent.

Disadvantages of Reverse Merger

  • An IPO generally raises more money.
  • Most companies that become public through a reverse merger often start out trading on the OTC bulletin board as opposed to a major market.
  • The IPO process makes it easier to create market support for a stock.
  • Pressure to produce short term results, often at the peril of the long term interests of the business.
  • Less Confidentiality and complete financial disclosure is required to become publicly held.
  • Reporting expense is greater because of the need for full disclosure.
  • More company visibility brings a higher level of liability exposure.
  • Higher costs of regulatory compliances for audit, legal and investor relations.

Conclusion

The primary purpose of a public company is to create long-term value for its shareholders, and only a select few companies are able to consistently perform that task. The majority of the benefits ascribed to the reverse merger process are beneficial to getting to the public markets quickly, but very few translate into benefits for the shareholders of the newly public company. While the number of reverse mergers increased manifold, but researches have concluded that there are few companies that succeed long-term shareholder value through the reverse merger process. While the route to the traditional IPO is expensive, time consuming and fraught with difficulties, it serves an important purpose: to keep companies that shouldn’t be public out of the public markets. The reverse merger all too frequently creates a “publicly traded private company” that has a small market cap, an illiquid stock, and little ability to raise additional funding without significantly diluting existing shareholders. A better option for smaller firms is to remain private and raise funds through a private placement or look to do a merger or an acquisition to get the firm to the next level.

Syed Burhanur Rahman, Attorney, New Delhi. E mail-talktosyed@rediffmail.com

Syed Burhanur Rahman is an alumnus of St. Stephen’s College and Campus Law Center, Delhi University. A Quiz aficionado, he has featured in premier T.V Quiz shows including Mastermind India(BBC),University Challenge Quiz(BBC) and Nat Geo Genius Quiz (National Geographic Channel).An Attorney working with INDUS G & D Law(Delhi),his practice areas include Corporate Law, IPR and Taxation Law .

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