Reverse Mergers in India

Due to the complexities and slowness of the IPO technique of going public, Reverse Mergers are increasingly taking up the area previously occupied by IPOs. The risks connected with reverse mergers could be reduced if they were done with adequate inspections.

The concept, essential requirements, advantages, and downsides of this concept, as well as the benefits from a tax viewpoint, shareholders, and private equities are all discussed in this article.

Concepts of Merger and Reverse Merger

A merger is a corporate strategy in which one company unites with another company to operate as a single legal entity, resulting in the consolidation of ownership, risk, assets, liabilities, and functions. A merger occurs when a smaller company unites with a larger one through the exchange of shares or cash. The company being acquired is known as the “shell company”.

But when the tables have turned and the ‘acquiring company’ is weaker or smaller than the one being acquired, this is termed a Reverse Merger. Typically, Reverse Mergers take place through a parent company merging into a subsidiary, or a profit-making firm merging into a loss-making one.

A Reverse Merger is a non-conventional manner of going public (Reverse IPO), because of the floatation cost associated with the IPO, making it more expedient and cost-efficient than IPO which usually takes 5 to 12 months to complete. Instead of hiring an underwriter to market and sell the company’s shares in an Initial Public Offering (“IPO”), a large private operating company works with a “shell promoter” to locate a suitable smaller company and go public.

1. The private operating company merges with the shell company (or a newly-formed subsidiary of the shell company).
2. In the Merger, the operating company shareholders are issued a majority stake (85–95%) in the shell company in exchange for their operating company shares, with the remaining 5–15% owned by the existing shell company’s shareholders.
3. Post-Merger, the shell company contains the assets and liabilities of the operating company and is controlled by the former operating company shareholders.
4. The shell company’s name is changed to the name of the operating company, and its directors and officers are replaced by the directors and officers of the operating company.
5. Its shares continue to trade on whichever stock market they were trading in before the merger.
6. Hence, the operating company’s business is still controlled by the same group of shareholders and managed by the same directors and officers, but it is now contained within a public company. In effect, the operating company has succeeded in the shell company’s public status and is therefore now public.

Another factor that may persuade the company's decision to prefer Reverse IPO is the disclosure requirement during the process of IPO. A private company may lose its competitive advantage according to disclosure during the process of IPO.

Another determinant that motivates small-sized companies to choose backdoor listing over IPO is SEBI (Issue of Capital and Disclosure Requirement) Regulation 2009. Regulation 6 enumerates ‘Eligibility Requirements’ to go public which needs to be complied with by the company that intends to get listed. It might be strenuous for small companies with limited financing and investing opportunities to fulfill the requirements to be eligible for IPO. In such a scenario, a private company prefers to get access to the capital market through the mechanism of Reverse Mergers.

A Cross Border Reverse Merger takes place when an unlisted company in one country tries to get listed on foreign exchange by merging with a public company of that particular foreign country. This strategy can be found being used in the Chinese market where Chinese Companies get listed on the US Stock Exchange. The procedure begins with both the companies entering into a “Share Exchange Agreement”.

Features/Essentials of a Reverse Merger

The requirements for an arrangement to be termed a Reverse Merger are as follows:

1. The asset value of the bigger company must exceed the value of the assets of the small company,
2. The net profits (after deducting all charges except taxation and excluding extraordinary items) arising out of the assets of the large company must exceed those of the small company,
3. The equity capital to be issued as a considerable amount for the acquisition must exceed the amount of the equity share capital of a small company before the acquisition,
4. After the Reverse Merger, the small company shall continue the operations of the large company and the large company will cease to exist,
5. The merger must be in the interest of the public,
6. The transaction should result in obtaining the tax benefits under the Income Tax Act,1961.

Advantages of Reverse Merger:

1. A Simplified Process: Reverse mergers allow a private company to become public without raising capital, which considerably simplifies the process. While conventional IPOs can take months to materialize, reverse mergers take only a few weeks to complete. This saves a lot of time and energy for management.
2. Minimizes Risk: Undergoing the conventional IPO process does not guarantee that the company will ultimately go public. Managers can spend hundreds of hours planning for a traditional IPO but if the Stock market conditions become unfavorable to the proposed offering, the IPO may have to be called off. Pursuing a reverse merger minimizes the risk.
3. Less Dependent on Market Conditions: As the Reverse merger is solely a mechanism to merge a private company into a public entity or vice-versa, the process is less dependent on market conditions.

Disadvantages of a Reverse Merger:

1. Due Diligence Required: Reasonable due diligence will have to be conducted on the acquiring company, its management, investors, operations, financials, and possible pending liabilities (i.e., litigation, environmental problems, safety hazards, and labor issues.)
2. Regulatory and Compliance Burden: The reverse merger may impose additional regulatory and compliance requirements on managers of the acquired entity who may be inexperienced and this burden can prove significant and the initial effort to comply with additional regulations can result in an underperforming company if managers devote much more time for administrative concerns rather than for running the business.

Recent Trends:

There are numerous reverse mergers taking place in India and abroad. However, a reverse merger only comes to the limelight when the interest of the general public or a listed entity is involved.

1. Effective 1st April 1994, Godrej Soaps, a profitable company with a turnover of ₹437 Cr underwent a reverse merger with a loss-making entity, Gujarat Godrej Innovative Chemical Limited with a turnover of ₹ 60 Cr. The resulting company was named Godrej Soaps Limited.
2. In 2002, ICICI Group merged with its arm ICICI bank to create a universal bank that would lend to both industry and retail borrowers and the new entity post-merger was named ICICI bank.
3. In April 2003, the Sajjan Jindal-controlled Jindal Iron and Steel company and its subsidiary, Jindal Vijayanagar steel merged their business through a reverse merger to create a ₹ 4000 Cr+ entity. They merged in an Effective Share Swap Ratio of 1:1 after the reorganization of Jindal Vijayanagar steel’s capital.
4. On 2nd May 2007, IBP Co. Limited, the standalone petroleum marketing subsidiary of Indian Oil Corporation Limited with exclusive business groups for Explosives and Cryogenics, was merged with the parent company. This was a step towards achieving the smooth and seamless integration of business to integrate the various business segments of erstwhile IBP with similar business segments of the respective divisions of Indian oil at the earliest.
5. In April 2012, India Bulls completed the reverse merger of India Bulls’ Financial Services with India Bulls Housing Finance. The Share Swap Ratio among the stakeholders in the two companies was fixed at 1:1. This move enabled efficient utilization of India bulls Financials’ capital, consolidating it into the Housing Finance company, which accounts for most of the incremental mortgage business.
6. Hardcastle Restaurants Private Limited (“HRPL”), a master franchisee that operates McDonald’s branded restaurants in western and southern India and which also became the direct subsidiary of Westlife Development Limited (“WESTLIFE”), a BSE- listed company, by way of a Composite Scheme of Arrangement and Amalgamation under a reverse merger in the year 2013.
7. On December 19th, 2016, Yatra Online Inc. a prominent Indian online travel company announced a merger with US-based Terrapin Acquisition Corporation, a Special Purpose Acquisition Company (SPAC) formed for this purpose.
8. In 2018, Videocon d2h Limited, which runs the direct-to-home (DTH) business for Videocon Group, sold 33.5% of its equity shares to an American ‘blank cheque’ company by former MGM chief, Silver Eagle Acquisition Corporation for up to $375 million (Rs 2,378 crore). This effectively means the firm has opted out of a proposed Initial Public Offer (IPO) in India.

In July 2021, getting RBI’s nod to the application of Small Finance Banks (SFBs) for a reverse merger with their holding companies, the reverse merger of Ujjivan Small Finance Bank (SFB) and Equitas SFB with their respective holding companies will bring down promoter shareholding to zero, thereby helping the entities comply with the Reserve Bank of India (RBI) guidelines and reap rich rewards for the shareholders of the holding entities. This is beneficial for the shareholders of the holding company because they will now get shares of the bank on a particular share swap ratio, which is yet to be decided.

In the case of small finance banks, the holding company is expected to be merged into the subsidiary bank. This type of reverse merger is also referred to as a Downstream Merger.

Benefits of a Reverse Merger from a Tax Perspective

The Income Tax Act, of 1961 seeks to encourage reverse mergers by granting tax incentives. The objective of Section 72A of the Income Tax Act, 1961 is to ‘facilitate the revival of sick industries by merging them with healthier industries by providing incentives in the form of tax savings.’ This may ensure increased employment and the generation of revenue in the interest of the public.

Section 72A uses the term ‘amalgamation’ and not a merger. Hence, the merger between the healthy company and sick company must fall within the definition of amalgamation given under the Act. This would require the merger to be one where:

1. All the Assets and Liabilities of the amalgamating company become the assets and liabilities of the amalgamated company under the amalgamation
2. Shareholders holding not less than 90% in value of the shares in the amalgamating company under this amalgamation become shareholders of the amalgamated company.

Reverse Mergers Impact on the Shareholders

Shareholders of public firms engaged in Reverse Merger gain from such transactions. The consideration shares may be supplemented by other forms of consideration, which include cash, stock options, convertible notes, and earn-outs (e.g., performance shares). The decision to opt for a Reverse Merger as opposed to traditional methods of going public with an initial public offering offer different benefits and costs to a different class of stakeholders such as the management of the private entity, the private shareholders, and the shareholders of the combined, post-transaction corporation.

These shareholders include both the “promoters” who hold the vast majority of shares as well as the “bystanders” who control only a tiny slice of the entity in Reverse Merger transactions. Promoters and bystanders would not be implicated in an IPO, since the private company would issue shares directly to the public in such a transaction, rendering a shell unnecessary.

PE Perspective of Reverse Mergers

From a PE fund’s perspective, a reverse merger remains an attractive option though. It provides instant liquidity, and it’s not easy to take a ₹ 40–50 Cr turnover company public. The cost of the issue, and the pricing commanded, could both make it unattractive. If the issue devolves, it is a serious loss of face.

If the promoter, PE, or the merchant banker has to bail the issue out, then instead of providing liquidity, the issue could do exactly the reverse.

Conclusion

A reverse merger is one of the best ways of going public without making an initial public offer (IPO) and going through burdensome requirements of a public issue, thereby paving a way for unlisted entities (by a merger with the listed entity) to obtain access to capital markets.

India having a good corporate governance structure helps companies to go public by way of reverse mergers while at the same time it keeps a check that no fraud is committed.

Reverse mergers are good for the acquiring company the shareholders will have to bear a lot of risks. As a precautionary measure, companies are advised that before entering into a reverse merger, thorough research must be conducted on the acquiring company and to go through all the pros and cons that may be associated with such a reverse merger, to avoid any difficulties issues and contingent liabilities that may arise in future.