In recent years, a variety of alternative paths to public ownership and trading liquidity have emerged. The reverse merger is among one of the oldest alternatives to a conventional IPO for a private company seeking to become publicly traded and, due to a confluence of factors, has recently gained greater marketplace acceptance. Reverse mergers are a potentially attractive transaction structure in particular for private companies with significant cash needs, such as life science companies that, for various reasons, may not be able to immediately access the IPO market.

A “reverse merger IPO” is a mechanism for a private company to become a public company. The mechanism is referred to as a “reverse” merger because, as a practical matter, the private company effectively acquires the public company with the pre-merger stockholders of the private company owning a majority of the stock of the combined company, even though the public company is nominally the legal acquirer.

Typically, the parties to a reverse merger have taken the view that the public company is not, as a technical matter, a “shell company,” even if it is actively looking for a merger partner and not prioritizing its historical business. "Shell company” is defined in Rule 12b-2 of the Exchange Act as a registrant that has:

1. no or nominal operations; and
2. 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.

Because the public companies involved in reverse mergers typically have had more than “no or nominal” operations or assets, generally still employed a management team and other personnel, and owned assets other than cash and cash equivalents, including intellectual property assets, most recent reverse merger transactions have historically proceeded on the basis that the public company was not a “shell company.”

The SEC has begun to challenge those assumptions, however, with significant consequences. In the adopting release for the SEC’s final rules related to “Special Purpose Acquisition Companies, Shell Companies, and Projections,” issued in January 2024, the SEC specifically stated, when discussing new Rule 145a under the Securities Act, that the rule will apply to any “company that has assumed the appearance of having more than ‘nominal’ assets or operations,” and further that the applicable shell company rules will apply “in situations where, in substance, a shell company business combination is used to convert a private company into a public company,” including to “any company that sells or otherwise disposes of its historical assets or operations in connection with or as part of a plan to combine with a non-shell private company in order to convert the private company into a public one.” This would include the increasingly common “fire sale CVR,” in which the public company issues, in a pre-closing dividend to its pre-closing stockholders, a contingent value right (CVR) with respect to the right to receive the proceeds of the sale or other monetization of any and all legacy assets of the public company. The Staff has indicated that it views this sort of arrangement as essentially ensuring that the public company is a shell company. To that end, companies should be prepared for the Staff, as part of its review of a reverse merger Form S-4, to ask for an analysis concerning whether the public company is a shell company or whether it could become one prior to closing.

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 upon completion of the merger;
• 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 postclosing ownership split, although this is subject to
  compliance with SEC and exchange listing rules and negotiation;
• 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.

If one of the parties in a business combination transaction is deemed to be a “shell company,” other than a “business combination related shell company” (i.e., a SPAC), then there are a number of consequences, including:

• Form S-3: The combined company will not be eligible to use a registration statement on Form S-3 until 12 months after the business combination/reverse
  merger, meaning the combined company must use a registration statement on Form S-1 within the first 12 months. In addition, the combined company will be ineligible to satisfy the disclosure requirements of Form S-1 through incorporation by reference until three years after the completion of the transaction.
• Form S-8: The combined company will not be eligible to use a registration statement on Form S-8 for any equity plans or awards until at least 60 calendar days after the filing of the Super 8-K for the transaction.
• Super 8-K: The combined company must file, within four business days of the closing of the transaction, a “Super 8-K,” which is a Form 8-K that contains all the information required by Form 10 to register a class of securities under the Exchange Act.
• Financial Statements: The combined company must file the financial statements for the acquired company within four business days of completion of the business combination/reverse merger (with no available extensions).
• “Ineligible Issuer”: The combined company will be an “ineligible issuer” for three years following closing of the business combination/reverse merger. During that three-year period, the combined company cannot, among other things:
  • qualify as a well-known seasoned issuer (WKSI), meaning it may not file an automatically effective shelf registration statement on Form S-3 even if the
    combined company had a public equity float greater than $700 million;
  • rely on the safe harbor under Rule 163A, which establishes a broad exemption from quiet period restrictions for certain communications made more
    than 30 days prior to the public filing of a registration statement; or
  • use a free writing prospectus, including term sheets and bona fide electronic road shows.
• Rules 144 and 145: Importantly, affiliates of the private company that receive shares of the public company in the merger are presumptively deemed to be statutory underwriters with respect to resales of those securities pursuant to Rule 145, and as a result, those securities may not be included in the Form S-1 resale registration statement and would only be eligible for resale under Rule 144, if available, or in a fixed price offering in which such investors are named as underwriters in the prospectus. Pursuant to Rule 145, Rule 144 will not be available for the resale of restricted securities until one year after the date the Super 8-K is filed and then only if, among other things, the company has filed all reports required to be filed under the Exchange Act for the past 12 months (other than Form 8-K reports). These requirements will remain in place for the life of the former shell company. This means that an investor reselling restricted securities of the company must always verify that the company is current in its Exchange Act reporting before relying on Rule 144 for the resale.
• Investment Bank Coverage: Securities Act Rules 137 through 139 provide safe harbors from certain communications being “prospectuses” or distribution of such communications being deemed to be participation in an offering by an issuer. Former shell companies, and communications regarding such issuers, are not eligible for such rules until three full calendar years after ceasing to be a shell company. This likely will not prevent the combined company from obtaining coverage from investment banking analysts. However, those investment banks that do provide coverage may take a more cautious approach to publishing research about the company, particularly in close proximity to an offering of securities by the company.

While none of these restrictions will prohibit a company from raising capital, they will impact the speed with which a company can raise capital and the methods by which a company communicates information in connection with an offering.

As a result, care should be taken early in the structuring discussions regarding a potential reverse merger transaction to prevent the public company merger partner from being deemed a “shell company.” For example, the parties should consider what personnel and operations are at the public company, how the value of the public company is determined in the transaction (including whether any value is ascribed to the company’s legacy assets and operations), and whether the combined company will retain any of the legacy assets or operations following the closing instead of including a CVR that contemplates all legacy assets being liquidated, with the proceeds being distributed to pre-closing stockholders.

With the change in administration in 2025, it remains to be seen whether the SEC will adopt a different approach with respect to SPACs and shell companies. Of note, in January 2024, the now-current Acting Chairman of the SEC, Mark Uyeda, issued a dissenting statement on the final rules related to “Special Purpose Acquisition Companies, Shell Companies, and Projections” when they were adopted.

STOCK EXCHANGES

Nasdaq and the NYSE impose more stringent listing standards on companies that become public through a transaction that is treated by the exchange as a reverse merger, generally requiring that the company trade on a regulated exchange and file all required Exchange Act reports, including audited financial statements, for at least one year following the reverse merger, and that the company maintain the requisite minimum share price for a sustained period, and for at least 30 of the 60 trading days immediately prior to its listing application.