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The reverse merger has varied definitions depending upon the actual restructuring option applied. It can be a profit making company merging into a loss-making company, a bigger company (higher asset base) company merging into a smaller one or an unlisted company merging into a listed company and so on. Worldwide, “Reverse merger” relates to an unlisted company merging into a listed/public shell company to avoid lengthy procedure of going public. This widely accepted definition will be discussed at length.

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The reverse merger means the acquisition of a listed/public company by an unlisted/private business to bypass the lengthy and complex process of going public. The transaction typically requires a reorganization of capitalization of the acquiring company.

A reverse merger is a simplified, fast-track method by which a private company can become a public company. A reverse merger occurs when a public company that has no business and usually limited assets acquires a private company with a viable business. The private company “reverse merges” into the already existing public company, which now becomes an entirely new operating entity and generally changes the name to reflect the newly merged company’s business. Reverse mergers are also commonly referred to as “Reverse Takeovers”, or RTO’s.

Going public (in any way) is attractive to companies because after going public, the company can use its stock as currency to finance acquisitions and attract quality management; capital is easier to raise as investors now have a clearly defined exit strategy; and insiders can create significant wealth if they perform.

The reverse merger is an alternative to the traditional IPO (initial public offering) as a method for going public.

Unlisted company merging into a private company

• Process In a reverse takeover, shareholders of the private company purchase control of the public shell company and then merge it with the private company. The publicly traded corporation is called a “shell” since all that exists of the original company is its organizational structure. The private company shareholders receive a substantial majority of the shares of the public company and the control of its board of directors. The business of 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. One other advantage is that the private company does not need to raise equity from public at this stage either because it does not need finance at this stage of business and/or valuation is not acceptable. Post listing it will be easier to dilute and raise funds at comparatively much higher valuation when business is more matured and there is a history as listed company.The transaction involves the private and shell company exchanging information with each other, negotiating the merger terms, and signing a share exchange agreement. At the closing, the shell 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 the shell company by contributing their shares in the private company to the shell 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.The benefits of being public outweigh the drawbacksAs a public company, the promoter’s wealth and liquidity will almost always be increased. The company will have greater access to capital, increased ability to expand and acquire other companies, and a new “negotiable” instrument that can be used for a variety of purposes.The process of “going public” through an initial public offering (IPO) is time-consuming, expensive, and a drain on executive time and talent. An alternative is a reverse merger in which a privately held company acquires a controlling interest in a publicly traded company that is dormant, or nearly so, and usually has few assets. In 1950, Armand Hammer “fathered” the reverse merger strategy by merging his oil company into a shell, thereby creating Occidental Petroleum. Ted Turner used this procedure in 1970 to launch the Turner Broadcasting System by merging into the failing Rice Broadcasting. And more recently, in 1996, Muriel Siebert took her brokerage firm public by merging it into J. Michaels, a defunct furniture company.In India, a formation of shell company is not carried out as a routine to finally sell to private business at a premium. However, before changes in listing guidelines and post SEBI era, it is not possible to create a SHELL Company considering stringent requirements for listing in relations to promoters’ background, viz. Merchant banker certificate, a minimum size of capital and a minimum number of shareholders etc…However, there are some old listed companies on Bombay Stock Exchange with small capital, minimum assets, and virtually no business. SEBI and stock exchanges examine all reverse mergers microscopically and call for almost all details as required at the time of IPO through RHP.

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. From a family business perspective, the primary advantages of becoming a public company are enhanced exit strategies, greater access to capital, and enhanced executive recruitment and retention.

• Enhanced Exit Strategies Promoters/Co-promoters 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.Typically, the principal or founding parties in an unlisted company enter into a buy/sell agreement between them at the time or very near the time the business is established. Such agreements usually become outdated and do not reflect the current value of the business or the proper valuation method, so a business valuation expert is usually employed to determine the value.Even when this is done, though, both sides of the existing transaction may not agree with the valuation. The business valuation expert will typically look at both these and other values, assigning a weight to each. While most observers and practitioners consider this method to be the most valid, there is still a great deal of subjectivity in the weighting and the “other” factors. This can result in animosity between the parties and can lead to legal action, which becomes more time-consuming and expensive. The obvious question, then, is, “Where does the money come from for the actual buyout?” The company may be forced to divert valuable cash from operations.With a public company, there’s no question of value because market forces set a value for it, and the company keeps its cash because the existing party can either sell their shares in the open market or in a private transaction.
• Greater Access to CapitalA primary 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 much greater access to the capital markets through stock and debt offerings as well as banks. This access allows the company to grow, either through internal expansion or through acquisition. It becomes 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.Several avenues exist for public companies. Additional shares can be issued in a secondary offering to the public or through a private offering. In a private offering, investors know that they have a way to “cash out” when the company is successful because the company is already public. With a successful private company, the investor can’t be sure that a market will exist for its shares because market conditions, the economy, the industry, and the like may not be favorable when an IPO is planned.A third avenue for raising funds is through share warrants, which are certificates that the company may distribute to shareholders and management that let them buy additional shares at a specified price. When the warrants are exercised, additional funds flow into the business. Occasionally the principal shareholders of the acquired company are willing to invest in the acquiring company once the transaction has been completed.Another alternative is to use the company’s share to acquire other entities or part of an entity. The company being acquired is more likely to view a share or partial share transaction favorably when the acquiring company’s share is actively traded. This provides the acquired company’s shareholders with a realistic exit option as well as tax benefits.
• Enhanced Executive Recruitment and RetentionManagement and other key employees are putting increased emphasis on stock options, or the potential thereof, in making employment decisions. A public company is better able to attract and retain key personnel because it can offer share-based compensation plans. Everyone is aware of all of the millionaires and billionaires that have been created through stock incentives at companies such as Microsoft, Dell, Apple, Infosys, and Wipro.At times, key executive talent seems more interested in future share payoffs than current salary and benefits. Only a public company can offer meaningful share ownership benefits to potential and current employees, and this provides much greater flexibility in compensation packages and is a competitive advantage. Stock-based plans can be effective in reducing cash compensation as well as employee turnover, thereby decreasing costs and increasing productivity. The ability to use its stock greatly enhances the public company’s position in the ever more competitive executive marketplace.
• Timeliness and ExpenseAn IPO is a time-consuming, expensive process. In a reverse merger, the process takes significantly less time and money. In fact, it can sometimes be accomplished in 45 days instead of the year or more frequently needed for an IPO. The reduced time frame lets key executives concentrate more on continuing operations and planning for the future and less on meeting with underwriters, lawyers, and outside accountants. The more management is distracted from their normal duties and functions, the more likely there will be a detrimental effect on the company’s operations. Such effects can be particularly disastrous at the time of an IPO and immediately thereafter. The extended period of time in an IPO also increases the risk that market or industry conditions may deteriorate and eliminate the window of opportunity…On the expense side, a reverse merger may be accomplished at a cost of 10% of an IPO. These estimates do not include savings in management time spent on a reverse merger instead of an IPO.
• MarketabilityIn cases where a company’s product or service is a new, untested concept, a successful IPO may be difficult at best. On the other hand, the company’s business 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 its ideas to brokers, there’s still no assurance that the public will buy the share. The uncertainty of market acceptance increases the risk that the time and money spent for an IPO may be wasted.
  

  Example
  IPOs are risky for companies because they depend on the economy, the stock market, and other factors over which the company has no control. If the market drops, the company or the underwriter may suspend the offering. Even if general market conditions are favorable, bad press regarding a company’s industry may dramatically impact the appeal and success of the offering. A reverse merger isn’t as subject to market conditions because its success rests with whathappens after the shell is acquired.

  This isn’t the case with a reverse merger because the shell company is already public. A shell company is one that has suspended operations and has little or no assets but is still registered.

• Possible Tax AdvantagesFrequently a shell company disposes of its assets because its operations were unsuccessful. Years of unsuccessful operations mean that the shell company may have “loss carry forwards”, which can provide excellent tax shelter opportunities for the family business. Such carryforwards may, in certain circumstances, be used to offset future income for 7 years from the year of loss. Such benefits mean cash savings for future operations. While large net operating loss carry forwards benefit the acquiring company, they are also a valuable negotiating chip for the shell company shareholders.

PUBLIC COMPANY DISADVANTAGES

A public company is 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. Because 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 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 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, 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 such 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 the shell company chosen, so great care is needed to minimize the detriments. Here are the primary disadvantages.

• Shell’s HistoryThe shell company is a “shell” for a reason. Most shells are 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 dangerous history and should have significantly fewer pitfalls.Frequently a company is a shell because it’s a failed company. As a result, remaining shareholders may have grievances with the company and its management. They may be reluctant to get into a reverse merger because they see it as a significant dilution of their equity in the company. Of course, a prudent investor would normally prefer a small piece of a valuable company to a large piece of a worthless company. Yet even when shareholders are convinced to sell most of their shares, or perhaps even invest additional funds, they may want to quickly recoup their investment and get out of the restructured company. To avoid this situation, the reverse merger agreement should contain some timing restrictions on the sale of stock. Another problem with a shell that has a history is the possibility of unknown liabilities. Efforts should be made to contact previous suppliers to make sure there are no outstanding claims against the company. Investigations also need to be made regarding any pending lawsuits, and the shell’s legal counsel needs to provide all relevant information.
• Equity DilutionThere is definitely a cost for acquiring a shell. The private company is 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 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 previously, 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 avoids the full IPO process. But not surprisingly, the SEBI is very skeptical of such mergers and may judge individual cases to be illegal, so it’s essential that the purchasing and subsequently the combined company strictly adhere to SEBI rules to avoid sanctions or even prosecution.
• WHY PURSUE THESE OPTIONS?There are many reasons for a private family business to go public. The primary ones are enhanced exit strategies for family members and business partners, greater access to capital markets, and enhanced opportunities in executive recruitment and retention. A reverse merger provides a vehicle that is quicker and less expensive than an IPO. And it isn’t subject to uncontrollable factors such as market volatility. While there may be some pitfalls with shell companies that have a less than stellar past, proper investigation and due diligence can overcome these adversities. A reverse merger is a powerful vehicle for taking a family-based business public, and its success depends more on the individuals involved than on the numerous uncontrollable factors involved in an IPO. It is an effective way to become public in a short period of time and without the hassles of an IPO.Future expansion or strategic alliances can be accomplished through the issuance of shares rather than the use of needed cash.

Years of unsuccessful operations mean that the shell company may have loss carryforwards, which can provide excellent tax shelter opportunities for the business.

Other Types of Reverse merger

1. Profit making Company merging into a loss making company:Transaction is the acquisition of loss-making company b profit making company but structured as if profit making company is acquired by loss-making company In this type of reverse merger, which is known as tax friendly reverse merger, as opposed to listing friendly reverse merger, profit making company merges into loss-making company to take tax break of losses of loss-making company without complying with stringent requirements of tax losses. In such a transaction capital becomes too large to service post-merger unless capital restructuring is also carried out at the same time. Further merged entity continues to remain saddled with the history of a loss-making company and the name also, (if a change of name is not carried out at the same time). There are many examples of this type of reverse merger in India .i.e. Kirloskar Oil Engines Limited into KG Khosal Ltd. Indian Seamless Metal Tubes Ltd into Kalyani seamless tubes Ltd etc.
2. Larger company merging into a smaller company: Transaction is obviously acquisition of the smaller company by larger company and internationally it is considered as an amalgamation and not a merger. But in any case, the structure is such that larger company merges into smaller company. Reasons behind this can be listing, tax break or even reduction of transaction costs or savings of future tax benefits or legal restrictions in transfer of the business of smaller company. To give example , if smaller company having long-term tax advantage like tax benefits of SEZ or backward area benefits etc with a condition that such benefits will be lost if the business is transferred

Conclusion

Business restructuring is an efficient way of using 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 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.

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