30 Years 30 Years in securities law

Reverse Mergers

A reverse takeover occurs when a publicly-traded smaller company acquires ownership of a larger or similar size company with substantial business operations. It typically requires reorganization of capitalization of the acquiring company.

In the event that the larger company is not publicly traded, the reverse takeover results in a privately held company becoming a publicly held company without going the traditional route of filing a registration statement and prospectus and undertaking an initial public offering (IPO). Rather, it is accomplished by the shareholders of the private company selling all of their shares in the private company to the public company in exchange for shares of the public company.

Process

In a reverse takeover, shareholders of the private company purchase control of the public company and then merge it with the private company. The private company shareholders receive a substantial majority of the shares of the public company and control of its board of directors. The transaction can be accomplished within weeks. If the target company is an SEC-registered company, the private company does not go through an expensive and time-consuming review with state and federal regulators because this process was completed beforehand with the public company.

The transaction involves the private and public company exchanging information on each other, negotiating the merger terms, and signing a share exchange agreement. At the closing, the public company issues a substantial majority of its shares and board control to the shareholders of the private company. The private company's shareholders pay for acquiring control of the public company by contributing their shares in the private company to the public company that they now control. This share exchange and change of control completes the reverse takeover, transforming the formerly privately held company into a publicly held company.

Benefits


The advantages of public trading status include the possibility of commanding a higher price for a later offering of the company's securities. Going public through a reverse takeover allows a privately held company to become publicly held at a lesser cost, and with less stock dilution than through an initial public offering (IPO). While the process of going public and raising capital is combined in an IPO, in a reverse takeover, these two functions are separate. A company can go public without raising additional capital. Separating these two functions greatly simplifies the process.

In addition, a reverse takeover is less susceptible to market conditions. Conventional IPOs are risky for companies to undertake because the deal relies on market conditions, over which senior management has little control. If the market conditions are not desirable , the underwriter may pull the offering. The market also does not need to plunge wholesale. If a company in registration participates in an industry that's making unfavorable headlines, investors may shy away from the deal. In a reverse takeover, since the deal rests solely between those controlling the public and private companies, market conditions have little bearing on the situation.

The process for a conventional IPO can last for a year or more. When a company transitions from an entrepreneurial venture to a public company fit for outside ownership, how time is spent by strategic managers can be beneficial or detrimental. Time spent in meetings and drafting sessions related to an IPO can have a disastrous effect on the growth upon which the offering is predicated, and may even nullify it. In addition, during the many months it takes to put an IPO together, market conditions can deteriorate, making the completion of an IPO unfavorable. By contrast, a reverse takeover can be completed in as little as thirty days.

Additionally, many public companies participating in reverse take-overs carry forward what is known as a tax-loss. This means that a loss incurred in previous years can be applied to income in future years. This shelters future income from income taxes. Since most active public companies become dormant public companies after a string of losses, or at least one large one, it is more likely that a small public company will offer this tax shelter.

It is highly unusual to preserve any benefit from the tax loss carry forward in a small public company. The tax regulations normally reduce the loss carry forward by the percentage of the change in control. In a well structured reverse merger, the private company should end up with 95% or more of the stock after the merger, thus reducing the tax loss carry-forward by this amount.

Drawbacks


Reverse Takeovers always come with some history, and some shareholders. Sometimes this history can be bad, and manifest itself in the form of currently sloppy records, pending lawsuits and other unforeseen liabilities. Additionally, these public companies may sometimes come with angry or deceitful shareholders who are anxious to "dump" their stock at the first chance they get. One way the acquiring or surviving company can safeguard against the "dump" after the Reverse Takeover is consummated, is by requiring a lock-up on the shares owned by the group they are purchasing the public company from, otherwise there very likely will be a stock dump. Other shareholders that have held stock as investors in the company being acquired pose no threat in a dump scenario because the number of shares they hold is not significant and, unfortunately for them, they are likely to have the number of shares they own reduced by a reverse stock split that is not an uncommon part of a Reverse Takeover. Possibly the biggest caveat is that most CEO's are naive and inexperienced in the world of publicly traded companies, unless they have past experience as an officer or director of a public company. Due diligence and experienced advisors can overcome all of these drawbacks. RTO's can be explosive vehicles for corporate growth, but they are not to be taken lightly.

Future financing


The greater number of financing options available to publicly held companies is a primary reason to undergo a reverse takeover. These financing options include:

    * The issuance of additional stock in a secondary offering
    * An exercise of warrants, where stockholders have the right to purchase additional shares in a company at predetermined prices. When many shareholders with warrants exercise their option to purchase additional shares, the company receives an infusion of capital.
    * Other investors are more likely to invest in a company via a private offering of stock when a mechanism to sell their stock is in place should the company be successful.

In addition, the now-publicly held company obtains the benefits of public trading of its securities:

    * Increased liquidity of company stock
    * Higher company valuation due to a higher share price
    * Greater access to capital markets
    * Ability to acquire other companies through stock transactions
    * Ability to use stock incentive plans to attract and retain employees