The Reverse Merger: Considerations for Struggling Microcap Operating Listed Public Companies and Private Companies Seeking to Become Public

A reverse merger with a well-financed, preferably profitable private company can be a lifeline or exit strategy for owners of a microcap operating listed public company having difficulty in remaining a going concern.  At the same time, a reverse merger with a struggling listed public operating company can be a more feasible alternative to an IPO or direct listing for a microcap private company seeking to raise capital from investors.

As outside U.S. securities law counsel in several recent reverse merger transactions, we have insights into the process and certain legal and strategic considerations for companies that may benefit from a reverse merger.  This article shares several of these insights.

Background

A reverse merger is the acquisition of a public company by a private company, either by the private company itself, or by the owners of the private company.

A struggling microcap operating listed public company may agree to a reverse merger with a well-financed, profitable private operating company to achieve one or more of the following goals:

·      Quickly pivot the company from an unsustainable business condition to a financially stable and diversified enterprise.

·      End or reduce the threat of stock exchange delisting, by significantly increasing stockholders’ equity and, it is expected, a higher stock price.

·      Eliminate a going concern qualification from its audit reports.

·      Allow the founders and management to realize a fair ROI on their founders’ shares and equity compensation, after standard lock-up periods expire.

A microcap private company may agree to a reverse merger with a struggling operating listed company for a number of reasons:

·      An IPO may not be feasible, particularly following recent stock exchange rule or policy changes which have made it more difficult for microcap companies to become listed through a traditional IPO. For example, since September 2024, the NYSE American has informally advised that IPOs must raise a minimum of $10 million to qualify for listing. Likewise, in March 2025, a formal Nasdaq rule change now requires IPO listings to exclude shares held by pre-transaction shareholders and not being purchased by the IPO underwriters from its minimum $15 million market cap requirement for companies without a minimum of $750,000 net income, which generally means that a Nasdaq IPO must raise a minimum of $15 million unless other heightened listing standards are met. To the extent applicable, these thresholds are not realistically attainable for many microcap private companies, because major underwriters and institutional investors have traditionally declined to underwrite or invest in microcaps.

·      A direct listing may not be realistic for many microcap private companies due to minimum stockholder base or other listing requirements and the limits on investor solicitation on non-registered offerings of securities.

·      A reverse merger offers a relatively streamlined legal pathway toward the private company. It can become a listed company itself by acquiring the public company’s public stockholder base needed to meet stock exchange listing requirements, or by transferring control of the public company to the private company’s owners and making the public company their former private company’s holding company.

·      As long as the public company has a clean legal record and is in relatively good standing with its stock exchange, its financial difficulties can often be addressed through cooperative financings.  If the public company’s business is understood by both parties to be unsustainable, they can agree to take appropriate actions to terminate the pre-transaction public company’s business upon the closing of the reverse merger.

Overview of the Reverse Merger Process

The process for a reverse merger generally has a number of components which may vary significantly depending on the structure of the reverse merger. Below is an overview of these components.

Preliminary Meetings and Preliminary Due Diligence

First, meetings will take place between public company and private company candidates and each party’s or both parties’ investment banks. The parties will usually conduct at least preliminary business and legal due diligence. See below for a discussion of the due diligence items that should be addressed. This process can take approximately two to four weeks.

Non-Binding Letter of Intent

Second, the parties will negotiate and enter into non-binding letter of intent (“LOI”). The LOI will usually address the expected valuation of each company, which will determine the expected exchange ratio for the public and private companies’ shares. In general, the private company will have a significantly higher valuation than the public company, so the post-merger combined company’s owners will own most of its shares.  The LOI will outline the expected transaction structure for the reverse merger. The LOI may also leave the transaction structure undetermined. For a discussion of potential reverse merger structures, see below under “—The Definitive Agreement – Reverse Merger Structure”.

Press Release Announcing the Letter of Intent

Although standard practice is not to issue a press release announcing the LOI, the LOI may provide for, or the parties may otherwise informally agree to issue, a press release announcing the LOI. Many microcap public companies decide that the benefits of the publicity of the LOI outweigh the risks of the market reaction if the parties do not agree to a definitive agreement. The press release will typically describe the highlights and other terms of the proposed transaction, the expected post-transaction business of the private company, and any expected synergies between the pre- and post-transaction businesses of the parties. The press release will also include statements that the transaction will be subject to negotiation and execution of the definitive agreement, due diligence, and closing conditions.

Further Due Diligence

Following the LOI, the parties will conduct comprehensive business and legal due diligence.  From the private operating company’s perspective, it will need to confirm that the public company is fully compliant with stock exchange requirements, that its corporate entity is in good standing with its state of incorporation, and that there are no significant regulatory or legal concerns.  The public company will need to confirm that the private company is well-financed, preferably profitable and debt-free, and has no significant regulatory or legal problems.

Obtain a Fairness Opinion

Generally, the public company will obtain a fairness opinion as a standard precondition to entering into the definitive agreement for the reverse merger.  The public company will first engage an independent financial advisor. The financial advisor will review the parties and the proposed transaction, and then render the fairness opinion to the public company’s board of directors. The fairness opinion will state that the consideration is fair, financially, to the public company’s stockholders based on certain assumptions.

The proxy statement/prospectus (see “—Filing of Form S-4 (or F-4)” below) for the transaction will also be required to contain certain disclosures about the fairness opinion, assuming that one is obtained. The disclosures will include the full text of the fairness opinion as an annex and the process that was taken to prepare and deliver the fairness opinion. The typical process will take from two to six weeks.

The Definitive Agreement

The definitive agreement will provide the structure of the reverse merger, and certain other provisions.

Reverse Merger Structure

A number of transaction structures are feasible. Some of the more common structures, and one alternative structure, are discussed below.

1.     Private Company Becomes Subsidiary of Public Company

Historically, a typical reverse triangular merger structure has been used in reverse mergers. In this structure, the public company merges the private company into a newly-formed subsidiary and the private company’s owners acquire a majority of the public company’s shares. The board and management of the public company would be replaced and designated by the private company’s owners. The pre-transaction public company business, if any, would either be transferred to a separate subsidiary of the public company, or would be spun off or sold, depending on the terms of the merger agreement. The public company entity would remain the listed company, and the private company’s stockholders would own a majority of the public company along with the pre-transaction public company’s stockholders.

2.     Private Company Becomes Parent of Public Company

In one alternative to the traditional reverse merger structure, the private company could merge a newly-formed subsidiary into the public company, with the pre-transaction private company as the pre-transaction public company’s new parent. The board and management of the pre-transaction public company would either continue in place and its business would continue largely as before, or could be terminated and replaced by the parent’s management or other designees, depending on the terms of the merger agreement. The pre-transaction stockholders of both the private company and the pre-transaction public company would become the stockholders of the former private company, with the pre-transaction stockholders of the former private company in majority control. The former private company would become a listed company upon approval of a listing application at the same time as the merger. The pre-transaction public company, now owned by a single stockholder (the former private company), would become private and either remain in place or eventually dissolved and wound up. It should be noted that if this structure is used, the former private company, as the successor registrant to the former public company, may be considered ineligible to use short-form Form S-3 (or F-3) for capital-raising or other purposes until at least 12 months after the merger if the former private company’s net assets are significantly greater than the former public company’s at the time of the merger.

3.     Two-Step Reverse Merger

If the private company is closely-held or a majority of it is owned by only one or a few owners, as is typically the case, the structure could also be separated into two steps to allow the public company to acquire, on a contingently reversible basis, the private company and consolidate the private company’s financial statements and business almost immediately and without stockholder or stock exchange approval. With the consolidated financial statements and, if necessary, after effecting a reverse stock split, the combined public company may be positioned to remain in compliance with stock exchange listing and other regulatory requirements long enough to allow the second step of the reverse merger to proceed, in which control of the listed company would transfer to the private company’s former owners.

A two-step reverse merger could be structured in several ways. One structure that some of our clients have used or agreed to use has been an acquisition of majority control over the private company in the first step without a change of control over the public company, followed in the second step by a change of control upon obtaining stockholder and stock exchange approval to list the post-transaction company. A more detailed discussion of this structure follows immediately below.

In the first step, the public company would issue a combination of common stock and preferred stock to the private company’s principal owners that would, on a fully-diluted and as-converted basis, be equal to their post-merger majority ownership. The common stock portion would be limited to the threshold that would not trigger change of control requirements by the relevant stock exchange, which would typically be 19.99% of the pre-issuance outstanding shares for Nasdaq, NYSE and NYSE American-listed companies. The preferred stock portion would be non-voting, non-dividend, non-traded preferred stock that would not convert into common stock until the approval of the acquirer’s stockholders and the post-transaction public company’s listing application by the stock exchange. The private company’s management could become the public company’s management at this step, assuming day-to-day control of the combined company, as long as the pre-transaction public company directors retain ultimate control over the public company’s management.

In the second step, upon stockholder, stock exchange and other required approvals, the preferred stock issued to the private company’s principal owners would convert into common stock, the former private company’s stockholders would become the majority owners of the public company, and the private company would be merged into a newly-formed subsidiary of the public company.

The purchase agreement could have provisions providing that the new parent would not interfere with the new operating subsidiary’s business until the fulfillment of the conditions for the second step and the subsidiary’s former owners become the majority owners of the public company.

This structure could be the most expedient in some situations, but also may have some unique risks.

First, if the public company were listed on the New York Stock Exchange or the NYSE American, it would require approval of a supplemental listing application (“SLAP”) prior to the closing.  In one case, the stock exchange refused to approve the SLAP due to an issue with the private company that the exchange refused to explain. As a result, the purchase agreement had to be terminated. Since the closing did not proceed, the transaction did not need to be unwound, but significant time and expense that had been devoted to the transaction could not be recovered.  This risk would be an issue with any M&A structure. In any event, the SLAP process would need to be completed before the first step’s closing could proceed.

Second, if the closing of the first step were able to proceed, there would still be a risk that the transaction would need to be unwound if, for example, the listed company were unable to obtain stockholder approval or the stock exchange would not approve the listing application of the post-transaction listed company. Unwinding the transaction may be relatively simple logistically because only the limited actions taken to close the first step would need to be reversed – the return of the public company’s common stock and preferred stock that were issued to the private company’s principal owners, and the return of the private company’s stock that was transferred to the public company. However, at minimum, the public company would need to deconsolidate the private company, and the parties’ goals in entering into the transaction would not be met.

4.     Other Structures

Many other merger structures have been used, some of which involve the formation of an entirely new entity to function as the post-transaction listed company instead of either the pre-transaction public company or the former private company. The desired structure will depend in part on what listed entity would be the most appropriate post-transaction entity, what types of transactions would be permissible or preferable for each party under governing corporate and securities laws, contracts, and tax laws. Jurisdictional preferences, a need or desire to maintain an existing brand or to rebrand, to simplify the transaction by retaining existing entities or to begin with a fresh cap table, and other considerations may also be important.

Other Provisions

The definitive agreement will typically include provisions regarding:

·      the final share exchange ratio formula;

·      contingent value rights (CVR) or other provisions entitling the pre-merger public company’s stockholders to equity or cash payments based on the occurrence of certain post-merger events relating to the pre-merger public company’s business;

·      voting agreements to be signed by officers, directors, and other affiliates of the parties to vote in favor of the reverse merger transaction to obtain stockholder approval;

·      each of the proposals to be approved by the stockholders;

·      the post-transaction public company’s designated board and management;

·      stock exchange listing application approval;

·      cooperative efforts to finance and discharge the liabilities of the public company, with provisions for sharing funds between the parties that are not required to meet the public company’s fundamental operating requirements;

·      discharge and termination of all ongoing contractual and other financial obligations prior to closing, although these conditions can be tailored if the parties determine that some aspects of its previous business should continue post-transaction;

·      employment and severance arrangements for the public company and private company’s management and key employees following the transaction;

·      indemnification guarantees, limitation of liability protection in the post-transaction public company’s charter documents against certain fiduciary duty claims, and D&O liability tail policy coverage for the pre-transaction public company’s officers and directors with respect to matters that occurred prior to the closing of the reverse merger by the post-transaction public company;

·      lock-up agreements of the private and public companies’ directors, officers, significant stockholders and their affiliates to help stabilize the post-transaction company’s stock price;

·      exclusivity, termination, and break-up fee provisions, which are usually significantly negotiated and tailored to each transaction; and

·      the post-closing structure, including the formation and contribution of existing assets to one or more newly-formed subsidiaries of the public company to house the assets of either the pre-transaction public company or the pre-transaction private company.

Form 8-K (or 6-K) and Press Release Announcing the Definitive Agreement

The parties will issue a press release, either jointly or only by the public company, announcing the definitive agreement. It will be similar to the press release announcing the letter of intent, if any, but will typically contain additional details relating to the final terms of the proposed transaction. It will also contain other standard disclosures, such as those that may be required under Rule 425 of the Securities Act of 1933, as amended (the “Securities Act”). Rule 425 applies to written communications – including press releases – that constitute soliciting material in connection with business combination transactions, regardless of whether they are also deemed a prospectus. The press release will also include statements that the transaction remains subject to the satisfaction or waiver of closing conditions and obtaining all required stockholder, stock exchange, regulatory, and other approvals to the transaction.

In addition, the public company will file a Form 8-K (or Form 6-K if it is a foreign private issuer) fully disclosing the material terms of the definitive agreement.

Filing of Target and Pro Forma Financial Statements

After execution of the merger or acquisition agreement, if the public company will be the post-transaction public company and it is a U.S. company, it will be required to file financial statements audited by a PCAOB-registered independent auditor of the acquired private company and pro forma financial statements within 71 days of the Form 8-K deadline for disclosure of the acquisition or merger agreement.  If the public company is a foreign private issuer, it will not have a deadline to file target and pro forma financials. However, all Securities and Exchange Commission (“SEC”) registrants that will be the post-transaction public company must do so in order to use new or existing registration statements for registered securities offerings following the execution of the acquisition or merger agreement.  In addition, the pro forma financial statements must be updated until the private company’s financial statements have been reflected in the acquirer’s results for a certain number of months, which will typically be 12 months due to the degree of “significance” of the acquired business under applicable SEC rules.

For Two-Step Reverse Mergers, Filing of Private Company Business and Risk Disclosures

When a public company acquires a majority interest in a private company in the first step of a two-step reverse merger, it will generally constitute a material or fundamental change in its existing business.  Unlike in a reverse merger with a shell public company, there is no specific requirement for a reverse merger with an operating public company to file a “Super” Form 8-K with comprehensive “Form 10”-type information about the post-transaction company, or, if the public company is a foreign private issuer, a Shell Company Report on Form 20-F with such information. However, in order for the public company to conduct new or continue existing registered offerings (whether for capital-raising purposes under a Form S-1 or Form S-3, or other purposes, such as employee equity compensation under a Form S-8), it must update its public disclosures to comply with Securities Act requirements that registration statements and prospectuses contain materially accurate and complete disclosures about the issuer.

If the public company is eligible to use Form S-3 (or Form F-3 if it is a foreign private issuer), it can address this issue at least for certain capital-raising securities offerings by filing a Form 8-K (or Form 6-K if it is a foreign private issuer) containing updated business, risk factors, and any other material updates relating to the acquired business. This approach can also update existing Form S-8s for equity compensation offerings. Otherwise, it may need to include these disclosures directly in new or post-effective amendments to registration statements for its offerings, which may be subject to SEC staff review and comments.

Filing of Form S-4 (or F-4)

Based on the reverse merger structure, the post-transaction SEC registrant will file a Form S-4 (or Form F-4 if the SEC registrant is a foreign private issuer) with the SEC with a prospectus and proxy statement or joint proxy statements, depending on whether only the pre-transaction public company or both companies will require stockholder approval. The post-transaction SEC registrant will generally be the pre-transaction public company if it will be acquiring the private company with its shares, while the private company will generally be the post-transaction SEC registrant if it will be acquiring the public company with its shares.

The Form S-4/F-4 will require disclosures about the merger or acquisition agreement that are typically much more detailed than in the Form 8-K (or Form 6-K) filed to report the transaction; the background to the merger or acquisition agreement; and information about the companies, particularly the private company if its business will be the only or primary business following the reverse merger. It will also be required to include financial statements of the pre-transaction private company that have been audited by a PCAOB-registered independent auditor and certain pro forma financial information.

The Form S-4/F-4 will also include all of the proposals required by the definitive agreement for stockholder approval and related comprehensive disclosures, including and in addition to a proposal to approve the definitive reverse merger agreement.  The proposals may include one or more proposals approving certain transactions relating to the reverse merger, such as the conversion of the preferred stock issued in the first step of a two-step reverse merger; the election of the new public company directors; the post-transaction public company’s corporate charter; and one or more reverse stock splits up to a certain maximum aggregate split ratio, such as 1-for-100, subject to the discretion of the board of directors.

The S-4/F-4 will typically receive a full SEC staff review and may require multiple amendments to address the SEC’s comments.  The SEC review process can be expected to take at least 90 days.

Submission of Listing Application

The post-transaction public company will submit a listing application with one of the major stock exchanges. The listing application process will depend on the rules and policies of the stock exchange. The majority of microcap reverse merger companies apply to list the post-transaction public company on either The Nasdaq Capital Market, the Nasdaq tier intended for smaller-cap companies, or the NYSE American, which is likewise intended for listings by small public companies.

To apply to list on Nasdaq, the company will complete a standard online listing application and execute a Listing Agreement and other standard documents. The listing application will contain general company information, and information about its securities, any offering in connection with the reverse merger, its directors, certain regulatory and litigation proceedings, its history of equity financings, and, perhaps most importantly, a detailed plan and timeline with specific dates for how and when it expects to attain compliance with all of the initial listing requirements upon consummation of the reverse merger.[1]

To apply on the NYSE American, a company must first participate in a confidential pre-application eligibility review by the exchange in order to determine whether it meets the exchange’s listing criteria. Once a company has cleared such review, it may submit an original listing application. In practice, the pre-application eligibility review has been the main application stage. Although the requirements at this stage of the process may vary in each case, typically the company will need to submit a letter with a description of the history of its operations and securities issuances, financial projections of the post-transaction company for 18 months, certain regulatory and litigation disclosures, and other information as needed to demonstrate that it will meet all of the NYSE American’s initial listing requirements upon consummation of the reverse merger.[2]  After clearance of the pre-application portion, the original listing application will require a breakdown of the shares being listed.

In either application process, the stock exchange will review the Company’s Form S-4 (or F-4) and request additional information to the extent that it believes necessary to address its regulatory concerns.  This process can be expected to take approximate 90 days, but the timeline often varies significant.

Holding the Stockholder Meeting

After effectiveness of Form S-4 (or F-4), the parties must obtain stockholder approval to approve the reverse merger transaction.  The public company will typically be required to obtain stockholder approval because even if it is the nominal acquiror in the reverse merger, under stock exchange rules, stockholder approval is required prior to an issuance of securities in connection with a change of control or an offering that exceeds a threshold (typically 19.99% of pre-issuance outstanding shares), unless the public company can utilize an exemption from such requirements, such as home country practice exemptions for foreign private issuers. In order to obtain stockholder approval, the public company will need to comply with applicable SEC and state of incorporation proxy solicitation and filing requirements relating to the stockholder meeting, unless the majority or other required threshold of ownership is held by its insiders and other parties to the voting agreements, in which case the company would follow the SEC and state of incorporation requirements applicable to a public company’s consent solicitation.  The private company will also typically be required to gain stockholder approval of the reverse merger transaction under the laws of its state or jurisdiction of incorporation, assuming that it is a corporation, though if it is closely held, it may be able to obtain such approval by written consent, but in either case must follow any procedures required by its state of incorporation to do so. The parties will use the disclosures in the Form S-4 (or F-4) in each proxy or consent solicitation as applicable.

The public company’s proxy solicitation process will typically take approximately 45 days, but may require more time if needed to attain a majority approval (or other applicable threshold), especially if the voting agreement parties do not own the required threshold to unilaterally approve the reverse merger and other proposals. In some circumstances, such as in a two-step reverse merger transaction in which the first step of the transaction was not subject to stockholder approval, the parties may agree to require specific efforts to be made to hold the stockholder meeting within a certain number of days of either the closing of the first step or of the effectiveness of the Form S-4 (or F-4), to engage one or more proxy solicitor firms to increase stockholder awareness and assist in obtaining stockholder approval, and requirements to reconvene the meeting or hold a new meeting if stockholder approval is not obtained at the initial meeting.

Reverse Stock Split

After receiving stockholder approval, the pre-transaction public company may need to conduct a reverse stock split in order to meet the applicable stock exchange minimum bid price requirement prior to receiving approval of the post-transaction public company’s initial listing application.  The minimum bid price requirement is $3.00 ($2.00 if other heightened listing requirements are met) per share for the NYSE American, and $4.00 (or $3.00 if other heightened listing requirements are met) per share for Nasdaq.  In setting the reverse split ratio, care must be taken to set it high enough to ensure that the stock price will remain above the minimum long enough to gain stock exchange approval, especially for Nasdaq-listed companies, which are now subject to immediate delisting if they have conducted a reverse stock split within the past year, and then fail to maintain compliance with Nasdaq’s $1.00 minimum bid price requirement. At the same time, the split ratio should not be set so high that it may cause the public company to lose compliance with other applicable listing requirements, including the required number of shares in the public float and either the number of public shareholders (for NYSE American listings), the number of round lot shareholders (for Nasdaq listings), or stock exchange rules prohibiting reverse stock splits that cumulatively exceed a certain ratio over a certain time period (e.g., for NYSE American-listed companies, 1-for-200 or more within a two-year period; for Nasdaq-listed companies, 1-for-250 or more within the prior two year if the company then fails to maintain compliance with the minimum bid price requirement).  In most situations, assuming that the public company has obtained stockholder approval to a reverse stock split in connection with obtaining approval of the reverse merger transaction, the process to complete a reverse stock split can take approximately 30 days from the date that the public company’s board approves the split to the market effectiveness date, and will generally require that the company comply with multiple stock exchange submission and SEC disclosure requirements, file an amendment to its corporate charter, and gain DTC eligibility for its post-split common stock.

Closing, Press Release and Form 8-K (or 6-K) Filings

After all stockholder, stock exchange, and other required regulatory and corporate approvals are obtained, the closing (or in the case of a two-step reverse merger transaction, the second step) may proceed, usually within a few days. The pre-transaction private company will either become a public company itself and the pre-transaction stockholders of the pre-transaction public company will become its minority stockholders, or its former owners will become the majority stockholders of the post-transaction public listed company and the pre-transaction private company will become its subsidiary.  The pre-transaction public company will either remain listed and will be majority-owned and controlled by the former owners of the private company in addition to its pre-transaction stockholders, or it will delist its shares and become a subsidiary of the pre-transaction private company/post-transaction public company. The post-transaction public company will issue a press release announcing the closing and file one or more Form 8-Ks (or Form 6-Ks if it is a foreign private issuer) reporting certain disclosures relating to the results of the stockholder meeting or consent solicitation, the reverse stock split, the closing of the reverse merger transaction, and the historical and pro forma financial statements of the acquired company (i.e., the post-transaction subsidiary of the post-transaction public company).

Conclusion

A reverse stock merger can be a solution to an existential crisis or an exit strategy for many struggling microcap operating listed public companies, while offering an opportunity to achieve the capital-raising aspirations of microcap private companies that would otherwise be shut out of the capital markets.

If you are interested in learning more about planning a reverse merger, please contact Joseph J. Kaufman at joseph@bevilacquapllc.com or (202) 869-0888 (ext. 113). You can also contact us through our general information email at info@bevilacquapllc.com.

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This post contains general information. This post is not intended: (a) to convey or constitute legal advice on any subject matter; (b) to establish an attorney-client relationship; or (c) to be a solicitation. Also keep in mind that prior results in a legal matter do not guarantee a similar outcome in another legal matter.