Is Reverse Merger Allowed in India?

Mergers are the key to enable quick inorganic growth for businesses around the globe. It basically refers to a legal unification of two companies and combining the ownership, risks, assets, responsibilities, and functions of both the entities. It generally occurs when a smaller business merges with a bigger company by exchanging cash or shares. However, if the company buying another business is weaker or lower than the latter, such a merger shall be referred to as a ‘reverse merger’.

Reverse merger via reverse IPO is a procedure where a business with a private limited company registration acquires a public company. A major private corporation must merge with smaller listed companies to go public without offering an IPO. Shareholders of the Private Limited Company exchange their shares for the public company shares to ensure that the private company is traded publicly without the time and process needed for an IPO. Besides, it is significantly cost-effective as well.

Note: Reverse Mergers are also known as Reverse Take Over (RTO).

One of the most popular examples of reverse mergers in India is ICICI’s merger with its wing ICICI Bank in 2002 to setup a universal bank that caters to the needs of both the industry and the retail borrowers.

Another example would be of Godrej Soaps, who were profitable with a whopping turnover of INR 437 crore. The company later decided on a reverse merger with Gujarat Godrej Innovative Chemical Limited, which was a loss-making company. The merger led to a company named Godrej Soaps Limited, which turned profitable and had a turnover of INR 60 crore.

When an unlisted company tries to be listed in the foreign stock exchange by merging with a company of a foreign country, such a merger is known as cross-border reverse merger.

Key Features of Reverse Mergers

• The bigger company’s assets must be more than the smaller company’s assets.
• The net income credited to the assets of the bigger company would be more than the smaller company.
• The share capital provided as an acquisition fee must surpass the small company’s existing equity share capital.
• Goals of a reverse merger are defined well before joining the deal.
• A fair purchase value of the smaller company must be paid.
• Once the merger is complete, the smaller company will keep carrying out its processes, while the bigger one shall shut down.
• Such a merger shall be of public concern.

Benefits of a Reverse Merger

• Simplified Process: Reverse mergers allow a private company to become a public company without increasing their capital, which extensively simplifies the overall process. Although traditional IPOs can take several month to come to fruition, reverse mergers take just a few weeks. This helps save a lot of valuable management time and money.
• Minimizes the Risk: If you consider the traditional IPO model, the business will not be made public. Managers and the team may spend hundreds of hours planning an IPO, however, if the conditions are not adequate or are unpredictable, the IPO will be revoked. Reverse merger reduces this specific risk.
• Less Market Dependent: As reverse merger is simply a process of unification for two companies, the process is less dependent on market conditions.

Reverse Merger Challenges

• Risks to Shareholders
  It has been often found that shareholders of public corporations often sell their shares due to ill intentions. These may include failing to report major liabilities, such as an ongoing litigation and dishonest corporate governance. You need to carry out your due diligence to tackle this hindrance.
• Failure to Make Public Disclosure
  If retroactive takeovers adhere to the disclosure needs, the management flexibility can be reduced and the business could be harmed by leaking crucial details to competitors, suppliers, customers, and business partners.
• Business Transformation Issues
  The management team of the unlisted company might have enough or no experience in managing the dealings of a listed company. New internal and external issues will also be experienced post-merger.
• Demand for Due Diligence
  Due diligence must be conducted of the company being acquired, its management process, shareholders, operations, financial institutions, and potential outstanding liabilities.
• Regulatory and Enforcement Expenses
  Reverse merger can lead to new regulatory and compliance requirements being placed on the acquired company’s managers and team, who may not be experienced enough. They can be under substantial pressure and the initial attempt to enforce additional regulations may lead to weak business performance.

Potential Risks of a Reverse Merger

Combined Business Risks

A public shell company is a vital aspect of the transaction of a reverse merger. Such a transaction can be completed with two different kinds of public shell companies. First, a public company that used to operate once but is no longer functioning but still has its name listed on the stock exchange with the status of being public. The second type is one that is a newly formed company with no operation history and that has been formed solely for the purpose of entering into a reverse merger transaction. Such companies are referred to as ‘clean’ companies.

The bigger risk lies in merging with a public shell company that was formerly operating, i.e., the first kind of company mentioned above. Considering such a company was basically an unsuccessful business and could potentially have history of liabilities, litigation, etc., they can turn out to be huge risks in the future. On the other hand, the second kind – ‘clean’ company mentioned above – is formed for the sole purpose of reverse merger transaction and has no risks associated.

The Risk of Being New

Another significant risk companies may encounter is the possibility of coming across the new creditor when the new company is formed as a result of a reverse merger transaction. In such transactions, the public company involved may turn out to be a badly performing company with little or no profit. When the new company is formed out of a reverse merger and new capital is transferred to this company, old creditors may leverage the opportunity to get their money back, which they considered to be as ‘credit losses’ prior to the reverse merger.

As a result, it may become quite difficult for the new company to take the new creditors into consideration, as they were not there when the due diligence was carried out. At such a point, even if the public company moves the business processes to a new subsidiary, it is vital that these responsibilities follow into the subsidiary.

Thus, to minimize any potential risks, due diligence must be conducted at this stage, which may include the tax, legal and financial aspects.

In addition to the above, risk of low liquidity with respect to stock trading is also observed in the case of reverse mergers. The financial controls, compliance requirements and costs involved in the transaction, as mentioned above, are worth it if the company’s stocks have a value after the reverse merger transaction is complete. Besides, this value must be supported and increased in the market, so that stockholders have more liquidity for their stock. However, in case of reverse mergers, this is not really the case.

Although the reverse merger is carried out to bring more capital into the company, it is not usually the case, as it raises significantly less capital than an IPO, which is definitely not enough to take the company to the next level of profitability. Therefore, a significant drop in the stock prices of the company will be observed, where the price might not even go above the value at which the transaction took place. The trading volume of the company’s stock will decrease as well, as a result of which there will be little or no liquidity for the company’s stock.

Conclusion

Reverse mergers, unlike IPOs, do not really generate ample funds to help boost the company’s position. However, it does allow the entity to list their stocks without having to go through the tedious due diligence needed for an IPO. The wide range of pros and cons associated with reverse mergers and the different effects they have on different people that are associated with both the parties must be considered and reviewed to ensure there are no disputes or dissatisfaction once the transaction is complete.


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