Understanding Reverse acquisitions
Reverse acquisitions occur when a private company purchases a publicly traded company and shifts its management into the latter. This allows private companies to become publicly traded while avoiding the regulatory and financial requirements associated with an IPO. A reverse merger is an attractive strategic option for managers of private companies to gain public company status. It is a less time-consuming and less costly alternative to the conventional IPOs. A successful reverse merger can increase the value of a company’s stock and its liquidity.
Let’s look at an example of a reverse merger to understand it better:
Company A, a listed company with small operations has one million equity shares outstanding as on 30th June 2020. There is another private Company B with significant operations which has a share capital of 2 million equity shares outstanding as at 30th June 2020. On July 1, 2020, Company A issues 4 million equity shares in exchange for all of B’s two millions shares in the exchange ratio of 2:1.
After the transaction, shareholders of Company B get 80% of the equity shares of Company A (four million equity shares held ÷ five million total equity shares outstanding). Accordingly, shareholders of Company B obtain control over the Company A by virtue of the transaction. Although it appears that Company A issued equity shares to acquire Company B, the net result of the transaction is that Company B has in effect gained control over Company A. This is called a reverse acquisition which enables the shareholders of Company B to get listed without going through the long-drawn process of conventional IPOs.
Advantages and disadvantages
Advantages
Simple process
Reverse mergers allow a private company to become public without raising capital, which considerably simplifies the process. While conventional IPOs can take months (even years) to materialize, reverse mergers can take only a few weeks to complete. This saves management time and energy and regulatory hassles usually involved in the conventional IPO process.
Lower dependence on market conditions
The traditional IPO combines both the ‘listing’ and ‘capital-raising’ objectives of a company. On the other hand, the reverse merger is solely a mechanism to convert a private company into a public entity. Accordingly, the process is less dependent on market conditions (because the company is not proposing to raise capital). Since a reverse merger functions solely as a conversion mechanism, market.
Understanding reverse acquistions
conditions have little bearing on the offering unlike in the case of a traditional IPO where many a times the IPO is postponed or canceled after several months of working on account of an unexpected change in market conditions.
Benefits of becoming a public listed company
Once the reverse acquisition takes place, the company’s securities are traded on an exchange and they enjoy greater liquidity. The original investors gain the ability to liquidate their holdings. Public companies often trade at higher multiples than private companies. Significantly increased liquidity means that both the general public and institutional investors (and large operational companies) have access to the company’s stock, which can drive its price. Management also has more strategic options to pursue growth, including mergers and acquisitions. The shareholders of the listed company can use the Company’s equity shares as currency with which to either acquire target companies or issue stock options to their employees to retain top talent.
Disadvantages
Appropriate due diligence to be carried out
The private limited company must be very careful when dealing with the investors of the shell listed company. It will be important to understand their motivations for getting acquired. At times the shell listed company could have a lot of baggage for which the private company needs to do its homework to make sure the shell is clean and not tainted. The questions to ponder about are whether there are pending liabilities (such as those from pending litigations) or other unknown liabilities hounding the listed shell. If so, the private company may end up taking possession of these problems. Thus, appropriate due diligence should be conducted over the listed company before the transaction.
Lock-in for the shareholders of the listed shell
If the listed shell’s investors sell significant portions of their shares right after the reverse acquisition, this can materially and negatively affect the stock price. To reduce or eliminate the risk that the stock will be dumped, adequate safeguards in respect of lock-in periods need to be carefully built in.
Regulatory and Compliance Burden
The private company that suddenly goes public usually has teams who are often inexperienced in respect of the additional regulatory and compliance requirements of being a listed company. These burdens and associated costs can be significant.
To mitigate this risk, the private company can additionally hire experts with relevant compliance experience. The private company needs to ensure that the company has the administrative infrastructure, resources and cultural discipline to meet these new requirements after a reverse acquisition.
Understanding reverse acquistions
Accounting for reverse acquisitions
As discussed above, a reverse acquisition occurs when the entity that issues its shares or gives other consideration to effect the transaction is determined for accounting purposes to be the acquiree (also called the accounting acquiree or legal acquirer), while the entity whose shares are acquired is for accounting purposes the acquirer (also called the accounting acquirer or legal acquiree).
The accounting acquiree/legal acquirer generally continues in existence as the legal entity whose shares represent the outstanding common shares of the combined company. While the accounting acquiree/ legal acquirer continues to issue its own financial statements, those statements are often in the name of the accounting acquirer/legal acquiree because the legal acquirer often adopts the name of the legal acquiree.
The financial reporting reflects the accounting acquirer’s/legal acquiree’s financial information, except for its equity, which is retroactively adjusted to reflect the equity of the accounting acquiree/legal acquirer.
A few things to keep in mind:
- Accounting acquiree must meet the definition of a business as contemplated in IndAS 103.
- In a reverse acquisition, the accounting acquirer usually issues no consideration for the acquiree. Instead, the accounting acquiree usually issues its equity shares to the owners of the accounting acquirer. Accordingly, the acquisition-date fair value of the consideration transferred by the accounting acquirer for its interest in the accounting acquiree is based on the number of equity interests the legal subsidiary would have had to issue to give the owners of the legal parent the same percentage equity interest in the combined entity that results from the reverse acquisition.
- Measuring the accounting acquiree’s assets and liabilities, including goodwill needs to be ensured. All of the measurement principles applicable to business combinations in IndAS 103 apply to a reverse acquisition.
- Non-controlling interests – In a reverse acquisition, some of the owners of the legal acquiree (the accounting acquirer) might not exchange their equity interests for equity interests of the legal parent (the accounting acquiree). Those owners are treated as a non-controlling interest in the consolidated financial statements after the reverse acquisition.
That is because the owners of the legal acquiree that do not exchange their equity interests for equity interests of the legal acquirer have an interest in only the results and net assets of the legal acquiree ― not in the results and net assets of the combined entity. Conversely, even though the legal acquirer is the acquiree for accounting purposes, the owners of the legal acquirer have an interest in the results and net assets of the combined entity.
Understanding reverse acquistions
The assets and liabilities of the legal acquiree are measured and recognized in the consolidated financial statements at their pre-combination carrying amounts. Therefore, in a reverse acquisition the non-controlling interest reflects the non-controlling shareholders’ proportionate interest in the pre-combination carrying amounts of the legal acquiree’s net assets even though the non-controlling interests in other acquisitions are measured at their fair values at the acquisition date.
In summary
Reverse acquisitions are surely an easier and simpler process of accessing the capital markets and creating liquidity. However, private limited companies have to be cautious before undertaking such a transaction. They have to make sure that adequate diligence has gone into the process and that the Company is ready to comply with the regulatory requirements of being listed. Also it is important to ensure that they have understood the accounting implication of a reverse acquisition in order to avoid any unwanted accounting outcome from the transaction.
