In structuring a transaction, parties consider a variety of forms of business combination depending on the specifics of the buyer’s goals, the target’s business, transferability of the target’s assets, and various tax considerations. A popular form of business combination often discussed among clients and their advisors is a reverse triangular merger.
A reverse triangular merger involves three entities – the buyer, the target, and a newly formed shell entity wholly owned the buyer, commonly referred to as the “merger sub.” At the closing of the transaction, the merger sub merges into the target, and the merger sub’s outstanding equity is converted into shares1 of the surviving company. The target’s outstanding shares are cancelled and converted into the right to receive cash, equity interests, or another kind of consideration in payment for the target’s shares. After consummation of the merger, the merger sub ceases to exist, and the target survives as the surviving company and wholly owned subsidiary of the buyer.
Because post-merger the target entity continues to exist as a wholly owned subsidiary of the buyer, a reverse triangular merger shares many advantages with a stock purchase transaction between the buyer and the target’s shareholders, including the following:
- Business Continuity of the Target. By structuring a transaction as a reverse triangular merger, the buyer can gain control of the target while maintaining business continuity and preserving the value of the target’s brand, public image, and goodwill with customers and vendors. Because the target entity remains intact following a reverse triangular merger, the target continues to own its brand, trademarks, and other intellectual property post-merger. This allows the buyer to continue operating the target’s business with the same public-facing image, which can help maintain goodwill and continuity with customers and vendors.
- Streamlined Third Party Consent Process. All assets remain with the target entity at the closing of a reverse triangular merger, which often minimizes the applicability of transfer restrictions in the target’s contracts, permits, and licenses. Many contracts, permits, and licenses contain restrictions on assignment that either prohibit or, more commonly, require the consent of the counterparty to transfer the contract, permit, or license to a different entity. These restrictions on assignment are triggered by an asset purchase because the assets are transferred to a different entity at closing. In a reverse triangular merger, the target continues to own its contracts, permits, and licenses, with no transfer to a different entity. As a result, reverse triangular mergers often avoid or minimize restrictions on the assignability of contracts, licenses, and permits.
Less commonly, the target’s contracts, licenses, or permits can contain restrictions on changes of control, which sometimes require consent of the counterparty prior to a change of ownership of the target even if the contract, license, or permit is not transferred to a different entity. These restrictions on changes of control can be triggered by a reverse triangular merger because of the change of ownership that occurs at closing.
Restrictions on assignment or changes of control generally provide that, absent consent, the transfer (or deemed transfer in connection with a change of control) of the contract is void or constitutes a breach of the agreement. Because of this, consents for at least the target’s more material contracts are generally required as a condition to closing. Given the involvement of third parties, obtaining consents required under the target’s contracts, permits, or licenses is largely outside the control of the parties to the transaction and occasionally delays closing. Because restrictions on change of control tend to be less common than restrictions on assignment, the consent process in connection with a reverse triangular merger tends to be less burdensome than would be expected with an asset purchase transaction.
- Streamlined Buyer Approval Process. Because the buyer is not a constituent party of the reverse triangular merger, the merger can be consummated without buyer shareholder approval (unless the buyer’s governing documents require shareholder approval). For corporations, by statute, mergers require board and shareholder approval of both the target and buyer entities. Because the buyer is not a constituent party of a reverse triangular merger, typically only the target and the merger sub are required to obtain shareholder approval to close the transaction. As the sole shareholder of the merger sub, the buyer can approve the transaction with only board approval and need not solicit consent from its shareholders (unless otherwise required by the buyer’s governing documents). This eliminates complication and potential delay caused by the buyer’s shareholder approval process, which may be important to buyers with large shareholder bases.
- Limited Liability for Buyers. A reverse triangular merger allows buyers to keep the target’s pre-closing liabilities in the target entity, protecting the buyer’s assets. In a direct merger, in which the target merges directly into the buyer, all assets and liabilities of the target are transferred directly to the buyer. This means that any pre-closing liabilities of the target become the buyer’s liabilities, which exposes the buyer’s assets to claims by the target’s creditors. With a reverse triangular merger, however, the target survives the transaction as a separate entity with the buyer as its sole shareholder. As a shareholder, the buyer has limited liability, meaning the buyer entity is not liable for any pre-closing debts, liabilities, and obligations of the target, and the buyer’s assets generally cannot be used as a source of recovery by the target’s creditors. Accordingly, following the transaction the buyer’s assets are shielded from the target’s creditors.
Given the necessity of forming a new subsidiary and required statutory filings in connection with a reverse triangular merger, a stock purchase is often administratively a simpler transaction structure. Despite the additional administrative burden, however, a reverse triangular merger has a lower threshold for approval that makes it an attractive alternative to a stock purchase in transactions in which the target has a large number of shareholders or anticipates hold outs from certain shareholders.
A stock purchase generally requires that every shareholder of the target agree individually to sell his, her, or its shares at the agreed-to price for the buyer to acquire all of the target’s shares and consummate the transaction. In addition, each shareholder typically must execute various documents in connection with a stock purchase. Consequently, stock purchases are susceptible to shareholder holdouts, as even a single shareholder who refuses to sell for the agreed-to price can stall the transaction. Stock purchases are also administratively cumbersome for targets with a large number of shareholders.
In contrast, merger approval is subject only to the approval thresholds set by statute (typically, a majority of the shareholders entitled to vote) and in the target’s organizational documents. Once the approval threshold is met, the merger can be consummated, and the buyer will acquire all of the target’s shares by operation of law. Individual target shareholders are not required to sign the merger agreement or any other transaction documents, although buyers might require the stockholders to sign other transaction documents. Dissenting target shareholders cannot hold up the transaction by refusing to sell for the agreed-to price. Instead, their rights are limited to any appraisal rights provided by statute.
Structuring an M&A transaction involves numerous considerations, many of which are deal-specific, and typically requires input from financial, tax, and legal advisors.
1The article assumes that the buyer, target, and merger sub are corporations, but the concepts discussed in this article also would apply to limited liability companies.
