In recent years, reverse mergers have become a popular mechanism for going public. While reverse mergers can offer many advantages to private companies seeking access to the U.S. capital markets, they can present unique challenges. CFOs should understand the advantages and disadvantages of reverse mergers so they can make informed decisions about what is best for their organization.

What is a Reverse Merger?

A reverse merger is generally defined as any merger transaction in which the acquirer for accounting purposes is different than the acquirer for legal purposes. The legal acquirer in a merger transaction is generally the issuer of equity interests. The acquirer for accounting purposes is generally the entity that takes control over the surviving entity following the merger, but that is not always an obvious determination.

When used as an alternative path to go public, the legal acquirer in a reverse merger is often a public vehicle such as a special purpose acquisition company (SPAC) or a dormant public operating company. A SPAC is typically formed with minimal capital by a group of experienced investors and managers known as “sponsors,” who raise money in an IPO and then have up to two years to identify and merge with a suitable private operating company (de-SPAC).

By contrast, a dormant public operating company is an established issuer that has mostly ceased operations and is looking for an alternative business strategy. Reverse mergers are often accompanied by a private investment in public equity (a PIPE offering) to raise additional capital.

What CFOs Need to Know About Reverse Mergers

Price Negotiation

In a reverse merger, the acquisition price of the private operating company will be negotiated upfront and established in a merger agreement as opposed to a traditional IPO in which the underwriters set a range that can fluctuate until the closing date based on market conditions. If the reverse merger is consummated using the issuer’s shares, an exchange ratio is typically used to back into the agreed-upon value of the private operating company being legally acquired.

Faster Process

Timing can be an advantage of reverse mergers. A de-SPAC transaction or a reverse merger with a dormant public operating company can be completed in as few as four months from the kickoff meeting. Factors such as the financial statement staleness dates under SEC rules, SEC comments and regulatory approval, shareholder approval, and market conditions for a PIPE offering can all impact the time to closing. However, in our experience, the biggest driver to closing a reverse merger quickly is the private operating company’s readiness to be a public company.

Lower Fees

De-SPAC transactions and reverse mergers with dormant public operating companies are typically less costly, in part due to their shorter runway to closing but also because underwriter support is not required to consummate the merger itself and become a publicly traded company. However, note that underwriting fees were paid against the proceeds of the registrant’s initial IPO and may be required in a PIPE offering.

Redemption Scenarios

In the case of a de-SPAC transaction, the SPAC has typically already raised capital in its IPO which will be released from a trust account when the reverse merger closes. The approval of the public shareholders in the SPAC is required to consummate the merger. The public shareholders have the right to redeem their common shares if they do not want to invest in the surviving issuer.

The public shareholders’ decision on whether to redeem their shares is separate from the vote to approve the merger. This type of redemption feature can create significant uncertainty as to how much cash will be left in the surviving issuer post-merger. A minimum cash balance is usually negotiated as a condition to closing.

Dilution

The cost of dilution should be considered in all capital raising transactions, but the cost of dilution in a de-SPAC transaction can be particularly complicated, and the economics are often misunderstood. The equity issued to the SPAC sponsors at formation typically amounts to 20% of the post-IPO capitalization and is issued at nominal cost. Additionally, when SPAC shareholders redeem their shares prior to the closing of a de-SPAC transaction, they receive their initial investment plus interest (and typically keep warrants) even though underwriting fees were paid on the initial IPO proceeds.

The combined result is a cash value per share that is significantly less than the stated value of shares issued in the de-SPAC transaction. As such, it is not uncommon to see the surviving issuer’s share price decline sharply following the de-SPAC transaction (approaching the cash value per share) unless the sponsors and management team can close the value gap.

Unlike a traditional IPO, the lack of underwriter support in promoting and marketing the stock before and after the de-SPAC transaction may also contribute to price volatility following the merger.

New Rules & Regulations

On January 24, 2024, the SEC adopted final rules to enhance disclosure and provide additional investor protections related to SPAC IPOs and de-SPAC transactions. The new rules require additional disclosure about SPAC sponsor compensation, conflicts of interest, dilution, the target private operating company, and other information that is important to investors in SPAC IPOs and de-SPAC transactions. In certain situations, the new rules also require the target private operating company in a de-SPAC transaction to be a co-registrant with the SPAC (or another shell company) and thus assume responsibility for the disclosures in the registration statement filed in connection with the de-SPAC transaction.

Accounting & Financial Reporting Considerations

The accounting and financial reporting implications of reverse mergers can be complex. If registered shares are issued to consummate the reverse merger, a registration statement on Form S-4 needs to be filed with the SEC. The Form S-4 can also be combined with a proxy statement if a shareholder vote is required to approve the merger.

Although SEC rules don’t directly address reverse mergers, the SEC staff has taken a position that de-SPAC transactions are in substance capital transactions rather than business combinations. As such, de-SPAC transactions are treated as reverse recapitalizations for accounting purposes. On the other hand, a reverse acquisition of a public operating company could be considered a business combination or a reverse asset acquisition depending on the circumstances.

The historical financial statements of the private operating company also need to be prepared under public company GAAP and Regulation S-X and audited under PCAOB standards given that the private operating company is typically deemed to be the predecessor and legal successor to the registrant’s SEC reporting obligations. Pro forma financial statements under Article 11 of Regulation S-X are also typically required pursuant to SEC rules.

Compliance with the requirements of the Sarbanes-Oxley Act of 2002 following the reverse merger is also important to keep in mind. While the surviving issuer in a de-SPAC transaction generally can exclude management’s assessment of internal controls over financial reporting from its first Form 10-K following the transaction, a reverse acquisition between two operating companies may require consultation with the SEC staff to determine whether exclusion of management’s assessment is appropriate.

Final Thoughts

Reverse mergers can offer an alluring alternative path to becoming a public company. They can be executed quickly and often at a lower cost. However, the cost of dilution and price stability post-merger should be factored into the equation. Due diligence over the public vehicle used to consummate the reverse merger is also important, as is vetting its investors and managers, who will likely continue to have a stake in the surviving issuer.

The accounting and reporting considerations of a reverse merger with a public vehicle are no less rigorous than a traditional IPO, and with recent regulatory changes, may carry similar levels of liability for the private operating company. In short, there is no free lunch when it comes to reverse mergers. The specific facts and circumstances of the deal will be the driving force behind a CFO’s decision to pursue a reverse merger.