By: Tom Zanki
Law360 (September 16, 2022, 2:30 PM EDT) -- As market appetite for special-purpose acquisition companies fades, some transactional lawyers expect reverse mergers to rise as an alternative vehicle for taking companies public, partially picking up slack left by the decline of SPACs.
In a typical reverse merger, a publicly listed vehicle with few or no operations acquires a private company, which inherits the public entity's stock listing. Target companies may consider this route a faster way of going public than a traditional initial public offering.
Smaller companies often pursue alternatives from a traditional IPO, a lengthy process that can take six or more months to complete. Traditional IPOs also tend to benefit larger companies that can command higher valuations and attract major underwriters.
For the past few years, SPAC mergers have served as the main alternative to traditional IPOs until market fatigue and regulatory scrutiny hammered the market. Lawyers who advise companies considering IPO alternatives say they are getting more queries about reverse mergers now that SPACs have cooled.
"We have had a number of private company clients that need capital start looking at potential reverse merger candidates as a way to go public," said Mintz Levin Cohn Ferris Glovsky and Popeo PC member Jeff Schultz. "And we would expect a number of transactions to occur given the current slowdown in the SPAC market."
The term "reverse mergers" can refer to several types of deals. At one end are mergers involving over-the-counter shell companies that have no operations. A private company can merge with such an entity and assume its stock symbol, but must jump through further regulatory hoops if it wants to uplist onto a major stock exchange.
Schultz also referred to "fallen angel" reverse mergers, which describe deals involving early-stage biotechnology firms that are listed on a major exchange like the Nasdaq but have seen operations stall after a failed clinical trial or other setback.
Merging with a "fallen angel" offers the target a more direct route to public markets since the acquirer already trades on a major exchange. Schultz noted that deals with exchange-listed companies are viewed more favorably by the market since many institutional investors won't invest in OTC stocks.
And if the listed entity still has cash on its balance sheet, the merger target could benefit from access to funds. Companies can also raise fresh capital in a separate financing with the merger.
Schultz cautioned that reverse mergers are not inexpensive or simple paths to public markets. Regulators must still sign off on target companies' registration statements and other proxy flings just as they would under a SPAC transaction.
"It's not a cheap and easy way to go public," Schultz said. "There's still a fair amount of cost, time and work involved. But it's another way."
SPACs were a popular vehicle to public markets during their boom, promising their merger targets a public listing plus fresh capital. Often called blank-check companies, SPACs are shells that raise money in IPOs with the intent of acquiring and merging with a private company. The target assumes the SPAC's listing and goes public minus certain rigors associated with a traditional IPO.
Funding for SPAC targets stem from the blank-check company's IPO proceeds and can be supported by additional private financing rounds known as PIPEs, or private investment in public equity.
But as the market sours, more SPAC investors are cashing out before mergers are completed. Redemption rates rose to 80% earlier this year — meaning four of five shares were redeemed before the target was acquired, according to venture capital database CB Insight Corp. — thus draining IPO proceeds that SPACs hold in trust. Plus, private financing rounds are becoming harder to raise as investors become more cautious.
Many SPAC mergers are still getting done despite the choppy environment, but several deals have also collapsed in final stages as parties were unable to finalize terms. Sichenzia Ross Ference LLP partner Greg Sichenzia said he's spoken to a technology company that was courted for a SPAC merger that didn't pan out and is now considering a reverse merger with a Nasdaq-listed entity.
Sichenzia said reverse mergers could be viewed as more of a "straight-up negotiation" between the acquirer and target. SPAC mergers require the consent of multiple parties, including a sponsor that is negotiating for a slice of the target company's equity, plus various groups of shareholders whose backing is needed.
"It's a much easier negotiation; there's less moving parts," Sichenzia said of reverse mergers.
Reverse mergers also have drawbacks, which has some lawyers skeptical they will rise to significant levels.
Schulte Roth & Zabel LLP partner John Mahon said reverse mergers typically don't offer much fresh capital for target companies, likely limiting potential candidates. Even as SPAC funds dwindle, Mahon noted participants are finding other ways to raise capital besides PIPE offerings, including through convertible notes or forward purchase agreements, which promise targets additional funds if certain milestones are met.
"The current regulatory uncertainty around SPACs at the moment, though, somewhat dampens creativity in the space generally," Mahon said.
The SEC is proposing new rules governing SPACs out of concern that investors of such vehicles don't receive the same safeguards afforded by traditional IPOs. The SPAC market, which had already shown signs of stress in early 2022, has slowed further since the SEC unveiled its proposal in March. The agency has yet to vote on final rules.
Reverse mergers tend to be smaller deals than SPAC mergers, where targets often list at values at more than $100 million. Data provider Dealogic reports 152 reverse mergers in 2022 at a total value of nearly $335 million, or about $2.2 million per deal.
Most reverse mergers fly under the radar, though some attract attention. Hemp manufacturing company Hempacco Co. undertook a reverse merger last year with Green Globe International, a tobacco business then traded over the counter. Hempacco has since listed on Nasdaq with a fresh offering that raised $6 million last month.
Baker McKenzie partner Perrie Weiner said he expects to see more reverse mergers in the coming months with PIPE offerings as capital source. Yet Weiner is not counting SPACs out either, saying deals could resume once regulatory uncertainty gets resolved.
Weiner noted many SPACs have recently gained deadline extensions from shareholders and are working with investment banks eager to complete deals.
"I also would expect SPACs to resume their prominence and place in the capital markets as soon as things get sorted out, in the next six to nine months," said Weiner, who chairs the law firm's North American securities litigation group.
Jeffrey Selman, who chairs DLA Piper's SPAC practice, is not expecting a big increase in reverse mergers, noting that targets face obstacles before they can become publicly traded. If a target merges with a company that trades over the counter, it must comply with SEC reporting requirements a year before it can uplist on the stock exchange.
The SEC enacted such rules in 2011, concerned about a wave of fraud following a reverse-merger boom in the late 2000s. Regulators also require that reverse merger targets maintain a minimal stock price for a certain time before uplisting onto an exchange.
"Is it doable? Yes," Selman said. "Is it an easy path? No, particularly if you are going to end up starting on the OTC."
Selman said a reverse merger with a publicly listed "fallen angel" that is not fully dormant and has cash could be a viable IPO alternative for a private company. Selman said companies in those circumstances should consider whether they can maintain the listing under the exchange's requirements.
Such companies should also consider any merger-related costs and lingering liabilities they may inherit from their merger partners and then compare those costs with a SPAC merger or other capital-raising options, he said.
Selman added that capital-raising options for private and public companies have also expanded in the decade or so since the passage of the Jumpstart Our Business Startups Act of 2012, while direct listings have also emerged as IPO alternatives. Given the wider choices available to companies today, Selman said he would be "hard-pressed" to advocate for a reverse merger.
"From a capital-raising standpoint, there's a lot more flexibility for a company" nowadays, Selman said.
Lawyers note that a traditional IPO underwritten by reputable investment banks, which can provide access to a wider pool of investors and research coverage from analysts, remains the preferred path for most companies going public.
Yet the current IPO market is also slumping and may be out of reach for companies with limited resources or following, forces that keep a reverse merger on the table for select companies.
"It doesn't replace the traditional IPO," Schultz said. "But it is a fallback option if market conditions don't permit you to do a traditional IPO."
--Editing by Philip Shea and Alyssa Miller.