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By: Paul M. Rodel, Nicholas P. Pellicani, and Joel D. Salomon, Debevoise & Plimpton LLP
This article examines market trends in reverse mergers by addressing recent notable transactions, deal structure and process, deal terms, disclosure trends, and legal and regulatory trends, and provides a market outlook for 2019.
OVER THE LAST DECADE, A SIGNIFICANT NUMBER OF PRIVATELY held companies have transitioned to public company status via a reverse merger with an existing public company with no or nominal operations and assets (a shell company) as an alternative to an initial public offering (IPO). Although the existing public company is typically the surviving legal entity, the privately held company’s shareholders gain control of the resulting entity, which is referred to as a surviving reverse merger company. For purposes of this discussion, a reverse merger means a combination (whether through merger or share exchange) of a privately held company and an existing reporting shell company, but does not include a transaction involving a special-purpose acquisition company.
Reverse merger activity in 2018 continued to decline from a high point in transaction volume in 2010. The strong IPO market in 2018 did not spark a revival of the reverse merger market, but it did slow the rate of decline. Reverse merger transactions decreased 6% in 2018 compared to 2017, compared to a 16% decrease in 2017 versus 2016.
The analysis discussed in this article is based on a review of 217 reverse mergers completed between January 2015 and December 2018 (the Reviewed Transactions) for which a Super 8-K (as defined below) was filed, as identified by Private Raise, a service that monitors and researches reverse merger activity. While the reverse merger market is not known for high-profile and large dollar value deals, included in this group of Reviewed Transactions are 59 surviving reverse merger companies that had a post-closing market capitalization of at least $75 million (Notable Transactions).
Reverse merger market transaction volume declined to 46 transactions in 2018 from a high of 256 transactions in 2010, the year prior to enforcement actions by the Securities and Exchange Commission (SEC) against several Chinese companies due to poor accounting practices (as discussed in further detail below). The following table summarizes the total number of reverse mergers by country based on where the business of the surviving reverse merger company was located for the years indicated.
Reverse mergers are completed across industries, with at least 40 sectors represented between January 2015 and December 2018. Based on an analysis of the Reviewed Transactions, the most active sectors were:
Among Notable Transactions, the healthcare/biotech industry represented 46% of these larger deals. Industry sector trends among the Reviewed Transactions were largely consistent with the industries represented by companies undertaking IPOs for the same period (minus tobacco, cannabis, and related), although a larger percentage of IPOs was represented by companies in the technology industry.
Deal Structure and Process
The timeline for a reverse merger can vary considerably from transaction to transaction; however, there are key events and requirements that generally apply to all reverse mergers.
Similarly, while the market capitalization and industries of surviving reverse merger companies vary, there are a number of common structural and legal deal terms, as discussed below.
Note: The timing above as it relates to signing a merger agreement and closing is illustrative only and depends on a number of factors, including the history and shareholder base of the shell company and deal structure.
Identifying a Shell Company
The definition of a shell company is provided in Rule 4051 under the Securities Act of 1933, as amended (the Securities Act), and Rule 12b-22 under the Securities Exchange Act of 1934, as amended (the Exchange Act). Shell companies generally fall into one of three categories:
A central concern for privately held companies when identifying the shell company with which to execute a reverse merger is whether the shell company is free of liabilities. Upon consummation of the merger, the surviving reverse merger company will bear all liabilities of the shell company and, as discussed below, post-closing indemnification for these liabilities from shell company pre-closing shareholders is unlikely to be available. Therefore, comprehensive due diligence is essential, especially in the case of development stage and natural shell companies, with particular attention to be paid to securities law compliance, accounting controls, and legacy tax, employee, environmental, and tail liabilities that may arise from prior transactions by the shell company.
Smaller Reporting Companies
A smaller reporting company is currently defined under Rule 405 of the Securities Act as an issuer with public float of less than $250 million. Companies with public float of less than $700 million also qualify as a smaller reporting company if they have annual revenues of less than $100 million. The large majority of surviving reverse merger companies meet the definition of a smaller reporting company and make use of the significant flexibility afforded to smaller reporting companies. A summary of accommodations available to smaller reporting companies is provided as Annex A. Most notable are:
The majority of Reviewed Transactions were structured as share exchanges, where a shell company acquires a privately held company in exchange for shares of the shell company. Less common are reverse triangular mergers, whereby an acquiring shell company forms a wholly owned subsidiary to merge into the privately held company, which then survives as a wholly owned subsidiary of the acquirer. Bespoke structures (e.g., asset purchases) are also used in certain circumstances. Regardless of structure, upon consummation of the reverse merger, owners of the privately held company receive equity, most often representing a control position, of the post-closing public company.
Merger/Share Exchange Agreement
The applicable merger or share exchange agreement will generally resemble a typical mergers and acquisition (M&A) agreement. Below is a brief summary of key provisions based on a review of the merger and share exchange agreements of the Notable Transactions.
Representations and Warranties; Indemnification
Key representations and warranties include:
In addition, such agreements may contain certain additional representations and warranties customary for M&A transactions, such as with respect to compliance with applicable laws, the absence of litigation, material contracts, and tax and employee matters. The scope and detail of the representations and warranties will depend on the circumstances of the deal; the nature and history of the shell company; the desire on the part of the privately held company to obtain additional formal disclosure with respect to the shell company; and the negotiated remedies in the event of breaches of, or inaccuracies in, the representations and warranties.
Monetary remedies in the event of breaches of, or inaccuracies in, representations and warranties or failure to perform covenants may be difficult to obtain from shell company shareholders unless a portion of the purchase price is payable in cash and can be held back or deposited into escrow at closing. Some parties choose to include alternative remedies, including specific performance, termination rights, and closing conditions relating to the accuracy of representations and warranties and performance of covenants.
No-Shops and Break-up Fees
State corporate law may impose a fiduciary duty on the board of a shell company to change its recommendation in favor of the reverse merger transaction under certain circumstances (e.g., a bona fide superior proposal). To that end, parties to merger and share exchange agreements may bargain for no-shop provisions. Example provisions that may be included in such a covenant include an obligation to:
Additionally, the privately held company may attempt to bargain for a termination fee in the event that the agreement is terminated in certain circumstances. If the shell company resists such a termination fee in a customary amount given a scarcity of available funds, the parties may negotiate alternatives, such as a smaller fee or a reimbursement of the privately held company’s transaction expenses.
As a primary purpose of a reverse merger is to enhance a privately held company’s access to capital, many transactions are accompanied by a private investment in public equity, or PIPE, transaction. These PIPEs typically involve a shell company issuing common stock to accredited investors prior to, or concurrent with, the closing of the reverse merger. Based on an analysis of the Reviewed Transactions, approximately 26% include a PIPE, with a higher percentage for Notable Transactions. The average total PIPE amount for Notable Transactions is $8.9 million, which is approximately $3.1 million more on average than the entire group of Reviewed Transactions.
The surviving reverse merger company ordinarily provides these accredited investors in a PIPE with anti-dilution rights as well as registration rights requiring the surviving reverse merger company or any successor to register the shares for public resale. Registration rights are important, as under Rule 144(i)3 of the Securities Act, if a company has ever reported being a shell company, investors in the entity cannot sell unregistered shares under Rule 144 unless the issuer has been current in its SEC reporting obligations for the preceding 12 months.
In a business combination effected primarily by exchanging equity interests, the acquirer usually is the entity that issues its equity interests. However, in some business combinations, the issuing entity is instead the acquiree and the non-issuing entity is the acquirer for accounting purposes.4 The SEC staff generally considers the type of reverse merger referred to in this discussion to be a capital transaction for accounting purposes. As a result, the privately held company’s financial statements are used and reported at historical cost basis.
In reverse mergers where the shell company is deemed to be the accounting acquirer, however, purchase accounting methodology, which requires a determination of assets at fair market value, must be applied. This valuation exercise involves additional time and expense. Some factors to consider when determining which party is the accounting acquirer according to ASC paragraphs 805-10-55-12 and -13 are:
Item 105 (formerly Item 503) of Regulation S-K5 requires a discussion of the most significant factors that make an offering speculative or risky. Surviving reverse merger companies commonly disclose in their risk factors:
Based on SEC comments to disclosures related to the Reviewed Transactions, including in the Form 8-K filed upon the completion of a reverse merger, risk factors should reflect the following:
A surviving reverse merger that involves a shell company triggers the filing of a Form 8-K within four days of the closing of the reverse merger.6 The Form 8-K must contain all the information required by Form 10 under the Exchange Act. Form 10 disclosure includes, among other items:
Form 8-K inclusive of the Form 10 disclosure is sometimes referred to as a Super 8-K. The most frequent SEC comment to Form 8-K disclosure for the Reviewed Transactions was to include the required Form 10 disclosure in the closing Form 8-K. Other SEC comments to Form 8-K disclosures for the Reviewed Transactions include requests to provide:
SEC comment. “It appears from your disclosure that you were a shell company as that term is defined in Rule 12b-2 under the Exchange Act prior to the acquisition, as you had no or nominal operations and no or nominal noncash assets. Please tell us whether the transaction reported on this Form 8-K resulted in a change in your status as a shell company. If so, pursuant to Item 2.01(f) of Form 8-K, please amend your Form 8-K to provide the information that would be required if you were filing a general form for registration of securities on Form 10 under the Exchange Act. If you believe your status as a shell company has not changed as a result of the current transaction, please confirm that going forward, you will appropriately mark your Exchange Act filings to identify yourself as a shell company.”
The SEC also comments in cases where it believes there has been an unreported change in shell company status.
SEC comment. “We note disclosure in Item 5.06 and elsewhere in your report that you believe you exited shell company status as a result of the merger agreement described under Item 1.01. A shell company, as defined under Rule 12b-2 of the Securities Exchange Act of 1934, as amended, is a company that has no or nominal operations and either: (i) no or nominal assets; (ii) assets consisting solely of cash and cash equivalents; or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets. We note that you are a developmental stage company with an aspirational business plan and you have not yet begun any operations or generated any revenues as of March 31, 2015. Accordingly, please provide us with a detailed analysis whereby you determined that you are no longer a shell company as defined under Rule 12b-2. For guidance, refer to SEC Release No. 34-52038.”
Item 9.01(c) of Form 8-K requires financial statements and financial information to be filed in a Super 8-K. If such financial statements and information are not included, the SEC will often issue a comment requesting an explanation as to why a company believes it was not a shell company at the time of the reverse merger transaction.
SEC comment. “Please provide us with your detailed analysis as to why you believe you were not a shell company at the time of the acquisition, requiring that the financials be filed with the initial report. Please refer to Item 9.01(c) of Form 8-K.”
It is important for the surviving reverse merger company to be prepared to provide adequate disclosure and make timely filings immediately following the completion of a reverse merger.
In 2011, the SEC took enforcement action in several reverse mergers, which led to the SEC suspending trading in several surviving reverse merger companies and even revoking the Exchange Act and Securities Act registration of surviving reverse merger companies for failing to make the requisite periodic filings. The actions cited:
The SEC continues to monitor reverse mergers and take enforcement action.
Stock Exchange Listing Standards
Surviving reverse merger companies are subject to heightened listing requirements. Both the NYSE and Nasdaq enacted rules in 2011 requiring surviving reverse merger companies to complete the following prior to listing on the exchange:
In light of these requirements, surviving reverse merger companies typically list on an OTC market during their trial period prior to listing on the NYSE or Nasdaq. Two of the most common OTC markets for such a listing are the Pink Sheets and the OTC Bulletin Board (operated by the Financial Industry Regulatory Authority), which have fewer listing and reporting requirements.
On June 28, 2018, the SEC increased the financial thresholds for smaller reporting company status as set forth below:
In a change from the proposed rules, companies will also qualify as a smaller reporting company if they have a public float of less than $700 million and annual revenues of less than $100 million.10 The changes expand the number of companies eligible to qualify as a smaller reporting company, thereby potentially increasing the appeal of the reverse merger transaction structure.
Paul M. Rodel is a corporate partner and a member of Debevoise & Plimpton LLP’s Capital Markets, Banking, Private Equity and Latin America Groups. He represents U.S., Latin American, and European companies in the financial services, energy, banking, and media industries in registered, private, and offshore capital markets transactions. Mr. Rodel is a frequent speaker and author on securities regulation and corporate governance issues, including recently on the disclosure and reporting approaches taken by companies affected by cybersecurity events, multijurisdictional disclosure requirements with regard to environmental and climate change issues, the impact of proxy advisors on corporate governance, recent developments in insider trading, current trends in cross-border tender offers, recent developments in growth company initial public offerings, and regulation of conflicts of interest in analyst research, as well as key disclosure issues for banking organizations. Nicholas P. Pellicani is a corporate associate and a member of the firm’s Capital Markets and Banking Groups. Mr. Pellicani joined Debevoise & Plimpton LLP in 2011. Joel D. Salomon is a corporate associate and a member of the Mergers & Acquisitions Group. Mr. Salomon joined Debevoise & Plimpton LLP in 2016.
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1. 17 C.F.R. § 230.405. 2. 17 C.F.R. § 240.12b-2. 3. 17 C.F.R. § 230.144. 4. See Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) paragraph 805-10-55-12. 5. 17 C.F.R. § 229.503. 6. See Item 2.01(f) of Form 8-K, which is available at https://www.sec.gov/forms. 7. 17 C.F.R. § 229.301. 8. 17 C.F.R. § 229.303. 9. 17 C.F.R. § 229.305.