Author: Priya Cherian Huskins
Reverse mergers seem to be coming back into vogue, particularly for biotech and life science companies.1
A reverse merger may offer a private company a faster path to the public markets, but it doesn't offer a shortcut around the liabilities that come with being public. The company still needs to prepare for public-company governance, potential securities litigation and a fundamentally different D&O insurance program.
Just like for a conventional initial public offering (IPO), directors' and officers' responsibilities and potential liabilities evolve after a reverse merger. As a result, the company's D&O insurance strategy needs to evolve as well.
What is a reverse merger?
Going public through a reverse merger (also known as a reverse takeover) happens when a private operating company acquires a publicly listed company, resulting in the private company's shareholders taking control of the public company.
Reverse merger transactions commonly involve a public shell company or a small public company with relatively limited operations.
Although the public company remains in existence after the transaction, the owners of the formerly private company become the controlling shareholders.
This is normally followed by a reorganization of the combined company's assets, operations and board of directors.
Why would a company choose a reverse merger?
The standard path to going public usually involves an IPO, which is often a complicated and time-consuming endeavor.
There's hiring an investment bank that will be central to the entire process, an extensive due diligence process, an enormous amount of paperwork and a guarantee of multiple rounds of regulatory reviews.
Importantly, even after a company has undergone all these steps, it may still encounter unfavorable market conditions that impact the IPO timing.
A reverse merger, however, offers a company a faster way to go public while compressing many of the time-consuming and complex steps of the traditional IPO.
While reverse mergers remain a viable alternative to a traditional IPO, they're less common than they once were. Reverse mergers became less prevalent after a period of reverse-merger transactions in the early 2010s garnered heightened regulatory scrutiny.2
More recently, the SEC adopted additional rules affecting certain reverse mergers involving shell companies, such as expanding certain financial statement requirements.3 These new rules were designed to protect investors and the integrity of US capital markets, but they inevitably also increased the regulatory burden on certain reverse merger transactions.
Ultimately, whether a reverse merger is the right path depends on a company's capital needs, its growth strategy and overall readiness to operate as a public company.
Like any route to the public markets, reverse mergers do have trade-offs.
Key considerations before moving forward
For the right company, a reverse merger can offer several advantages over a traditional IPO:
- Faster path to going public: Compared to conventional IPOs, reverse mergers can move very quickly.
- Less exposure to market timing: Going through the traditional IPO process doesn't automatically ensure that a company can go public. A number of factors can hinder or cancel the process, including adverse market conditions. Taking the reverse merger route can minimize the risk of a canceled IPO and help avoid the prospect of wasting significant financial resources and time.
- Lower transaction costs: It's still an expensive process, but arguably at least somewhat less expensive than a conventional IPO.
- Public company opportunities: The end goal of a reverse merger is for a private company to become publicly listed. Going public offers potential benefits, including more access to capital, greater liquidity, faster growth through acquisitions using public company stock as currency and the ability to attract and retain top talent by using public company equity as part of the compensation package.
While a reverse merger offers many potential benefits, some challenges may include:
- Legacy liabilities: Despite the simplified process compared to an IPO, a large amount of due diligence is required for reverse mergers. Both the private and public companies should thoroughly vet the motivations for the acquisition and investigate any pending liabilities, including possible litigation. In some cases, the public shell company may simply be looking for someone else to take over ownership of their looming issues — which may be severe.
- Shareholder sell-offs: Investors of the public shell company may sell off large portions of their shares immediately following the merger's completion, which can negatively affect the company's value and stock price. In some cases, this risk can be reduced by including clauses in the merger agreement that explicitly outline holding periods for certain shell investors.
- Limited market visibility: The reverse merger process minimizes the market excitement and attention that a conventional IPO typically receives after going public. Original investors may see little demand for their shares if the acquiring company is viewed as lacking in terms of finances and operations.
- Public company obligations: Managers of the formerly private company may be inexperienced with the burdensome regulatory and compliance requirements that accompany being a public company.
Above all, the greatest benefit of a reverse merger is arguably also the greatest risk: The private company ends up being a public company. Thus, at the end of a reverse merger process, directors and officers will find themselves in a position of greater scrutiny and more exposure to potential securities litigation, shareholder derivative actions and regulatory investigations, just like at any IPO company.
This exposure is why Directors and Officers (D&O) insurance should be incorporated into merger planning early. Early planning is the best way to ensure the combined company has appropriate protection in place when it begins operating as a public company.
Building the D&O insurance program alongside the deal
As companies prepare for a reverse merger, they should concurrently build a D&O insurance strategy that can support the transition to life as a public company.
While every transaction is different, companies should expect D&O insurance planning to begin several months before closing and evolve alongside any legal, financial and regulatory developments.
Ideally, the D&O insurance process moves in tandem with the merger transaction, from signing through closing.
Pre-signing: Before signing the deal, companies should review their existing D&O program, identify potential coverage issues and, of course, review the other side's insurance programs. Pre-signing is a good time to model potential insurance program limits and develop an insurance budget.
Between signing and closing: This is where a disciplined process makes a big difference. Your broker should assemble the underwriting package, prepare you for the D&O insurance underwriting meeting and prepare program options for management and the board to consider.
Closing: The go-forward company binds the D&O insurance program, and any needed run-off or tail policies are also put into place.
Post-close: Brokers and companies should stay close to ensure any changes in the business — or potential claims — are handled appropriately.
Protecting directors and officers in a reverse merger
While a reverse merger can potentially simplify the process of becoming a public company, it doesn't reduce the risk directors and officers face when serving a publicly traded company.
Building a D&O insurance program alongside the transaction helps ensure that directors and officers have the appropriate protection before, during and after the company enters the public markets.
