In recent years a variety of alternative paths to public ownership and trading liquidity have emerged. The reverse merger is both one of the newest and among the oldest alternative to a conventional IPO for a private company seeking to become publicly traded.

The New Reverse Merger

Despite some abuses of the technique, reverse mergers remain a legitimate transaction structure for smaller private companies with significant cash needs in high-risk industries, such as life sciences, that lack the financial profile or other attributes demanded by the IPO market. Public companies that are attractive reverse merger candidates typically have the following attributes:

• material net cash, replicating the proceeds that would be raised in a traditional IPO;
• limited operations, and limited, and known, liabilities;
• given its stockholder base, a reasonably high degree of confidence that it can deliver the requisite stockholder votes to approve the transaction; and
• a national securities exchange listing (preferably Nasdaq or the NYSE) that will remain following completion of the transaction.

When their valuations decline significantly or their business plans falter, public companies may become suitable reverse merger candidates. Since the fourth quarter of 2021, the number of such candidates has grown dramatically as more and more life sciences companies find themselves trading at valuations below their cash on hand. For example, since the fourth quarter of 2021, the number of life sciences companies trading at valuations below their cash on hand has increased dramatically.

This trend, coupled with challenging conditions in the traditional IPO market, has led to a significant uptick in reverse mergers with publicly held life sciences companies since the beginning of 2022. These transactions have originated most frequently with pre commercial life sciences companies that are listed on a major exchange and suffer a scientific setback or other disruption leading to a restructuring (or winding down) of operations—often while holding significant amounts of cash. In these circumstances, the reverse merger transaction results in the public company effectively reinvesting its cash into the business of the private company, giving the public company’s legacy stockholders the opportunity to continue to hold stock in a new business, while the formerly private company takes advantage of the public company’s existing cash and stock exchange listing.

Basic Structure of a Reverse Merger

In a typical reverse merger:

• a privately held company merges with a publicly listed company;
• the pre-merger stockholders of the private company own a majority of the stock of the combined company;
• the management and other employees of the private company become the management and employees of the combined company;
• the composition of the combined company board reflects representation proportional to the post-closing ownership split;
• the business of the private company becomes the business of the public company; and
• the combined company changes its name to that of the private company.

In many cases, the combined company will seek to raise additional capital (either privately, concurrently with the completion of the merger, or publicly, following the merger) to extend its cash runway.

Transaction Considerations

Exchange Ratio

The exchange ratio for a reverse merger transaction is typically based on the relative valuations of the public and private companies. Although the private company’s valuation is often tethered to the valuation from its most recent private financing, the final valuation will ultimately be the product of negotiations between the parties. The public company’s valuation, by contrast, will typically equal its anticipated available net cash at closing (after customary deductions and excluding any capital concurrently raised by the combined company) plus a negotiated premium for its public stock listing.

SEC Filing and Review

A reverse merger transaction typically requires a merger proxy statement and/or a Form S-4 registration statement to be prepared and filed with the SEC. The merger proxy/Form S-4 is usually more complicated and time intensive than the Form S-1 for a conventional IPO for several reasons:

• The merger proxy/Form S-4 must include separate audited financial statements for each company, plus pro forma combined financial statements reflecting the combination of the two companies.
• The merger proxy/Form S-4 must include detailed descriptions of each company’s process leading up to execution of the merger agreement and its board’s reasons for recommending approval of the merger. A description of the fairness analysis provided by the public company’s financial advisor to the board (including relevant inputs to the fairness analysis, such as financial projections for the private company) must also be included.
• Scrutiny by the SEC staff of merger proxy/Form S-4 filings for reverse mergers has been increasing, particularly in the background, fairness analysis and financial projections sections. The staff often focuses on the process undertaken by each company, including measures taken by the public company to mitigate potential conflicts of interest, the reasons why the public company elected to pursue a reverse merger rather than a liquidation, wind down or other alternative, and the reasons why the private company decided to pursue a reverse merger rather than a traditional IPO.
• Merger proxy/Form S-4 filings often attract strike lawsuits claiming deficient disclosures and/or an inadequate board process, and activist investors sometimes publicly state their intention to vote against the transaction unless the terms are modified—in either case introducing delays until a resolution is reached.

These factors can contribute to a longer timeline—often 3–6 months (or longer) between signing of the merger agreement and closing of the transaction—than for a conventional IPO.

Board Process

A public company evaluating whether to engage in a reverse merger is often already in a difficult position. The company may be facing “stock-drop” lawsuits, may be attempting to monetize its legacy assets, and may be under significant investor pressure to increase stockholder value. Although a reverse merger presents the possibility of a “whole company” solution, the board—as in other strategic and change of control transactions—must run a thoughtful process, typically with the assistance of a financial advisor and outside legal counsel.

The board of a company contemplating a reverse merger transaction should establish a clear record of the process it follows and the determinations it reaches, including through carefully crafted board minutes. Thorough recordkeeping should begin with the initial consideration and evaluation of a potential transaction—which often starts with auction-style market outreach to multiple private companies—and continue throughout the duration of the process.

Addressing Conflicts of Interest

In many reverse merger transactions in the life sciences sector, a public company’s potential counterparties may include private companies in which venture capital firms (or other investment firms) affiliated with the public company’s directors are also investors, or for which one or more of the public company’s directors serve as a director, thus presenting actual or potential conflicts of interest.

While a board’s conduct is generally assessed under the deferential “business judgment” standard—which presumes that in making a business decision the directors acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company—the existence of conflicts of interest may result in a court reviewing a transaction under the “entire fairness” standard, which requires defendants to prove that the transaction was a product of fair dealing (how the transaction was structured, initiated and negotiated) and resulted in a fair price (a price that a reasonable seller would consider within a fair value range). Entire fairness is the most onerous standard of review under Delaware corporate law.

Accordingly, the board of each company should, at the outset of any process or negotiations (and continuously along the way), assess actual or potential conflicts of interest and consider whether to implement procedural safeguards that could result in greater judicial deference if the transaction is challenged. For example, Delaware courts have held that the “business judgment” standard of review of a conflicted transaction can be preserved by conditioning the transaction from the outset on approval by a fully empowered special committee of disinterested directors and approval by a fully informed, uncoerced vote of the holders of a majority of all shares held by disinterested stockholders (a so-called “majority of the minority” vote).

Even if the board concludes that conditioning the conflicted transaction on a “majority of the minority” vote is not viable, the board can shift the burden of proof to the plaintiff by establishing a fully empowered special committee at the outset, in which case the plaintiff must prove that the transaction is unfair.

Merger Agreement

In a typical reverse merger transaction, the merger agreement is structured as a “public style” agreement, in which there are no post-closing remedies for either party and the representations, warranties and covenants are, to a large degree, reciprocal. However, the following points typically are the subject of particular focus in negotiations:

• Minimum Net Cash Closing Condition: Most merger agreements for reverse mergers require the public company to have a specified minimum amount of “net cash” at closing (below which the private company could refuse to close), an adjustment mechanic to the exchange ratio if net cash is below a specified threshold, or both.
• Net Cash Definition: Given the minimum net cash closing condition and the importance of the amount of net cash to the premise and economics of a reverse merger transaction, the parties typically spend significant time understanding and negotiating the specific liabilities and obligations—including contingent or potential liabilities—that will be deducted from available cash to determine the amount of “net” cash at closing.
• Contingent Value Rights/Dividends: Because the valuation of the public company in a reverse merger transaction often ascribes no value to its legacy assets, it is not uncommon for the public company to issue to its pre-closing stockholders “contingent value rights” representing the right to receive proceeds, if any, from the post-closing monetization of its legacy assets. Depending on the amount of its available cash, the public company may also negotiate the right to pay a cash dividend to its stockholders prior to closing, subject to the minimum net cash closing condition.
• Termination Fees; Reimbursement of Expenses: The circumstances in which one party to a reverse merger must pay a termination fee and/or reimburse the other party’s expenses are broader than in the typical public M&A context.

This article was sourced from our 2023 IPO Report. Read the full report, and stay on top of all of our M&A updates by subscribing to the Material: WilmerHale M&A blog.