Reverse acquisitions are an alternative method for private companies to go public than an IPO. A private company acquires a public company (often a shell company) by buying the majority of its shares and becomes public.
The resulting new entity becomes a public company with a reverse acquisition. The new entity may continue to use the name of the previously private company. The accounting and legal restructuring of the new entity will differ.
Let us review at a glance what is a reverse acquisition and how we can consolidate the accounting treatment for the transaction.
What is a Reverse Acquisition?
A reverse acquisition happens when a small listed company acquires a large private company. In this transaction, the small listed company (often a shell company) exchanges its shares with the private company. Thus, the private company becomes a publicly listed company without an IPO.
In such transactions, the shell company issues the majority of new shares to the owner (s) of the previously private company. After the transaction, the legal and accounting terms will differ.
The legal acquirer (shell company) often adopts the private company’s name. For financial reporting, the legal acquiree (the private company) will be reported as an acquirer. Thus, disclosures to the financial statements should clearly describe these changes to inform the users.
Transaction Structure in a Reverse Acquisition
The transaction structure in a reverse acquisition involves a private company and a listed shell company. The objective of such a transaction is to convert the private company into a listed public company without going through the complexities of an IPO.
The process begins with locating a public shell company (listed and dormant company). The private company first acquires the shell company to become a legal owner of it. The shell company then issues new shares to the owners of the previously private company. The arrangement works on a stock-for-stock exchange basis.
The ASC 805-40-25-1 requires that in such transactions, the legal acquirer must meet the definition of a business. Thus, if a shell company is used, it will not increase the goodwill of the newly formed entity after the transaction.
The ASC rules also state that the transaction must end in a change of control after the transaction. That effectively happens with a stock-for-stock exchange by both companies.
Continuation Basis of Reverse Acquisition
In accordance with the business combination rules, the consolidated financial statements of the newly formed entity are prepared. Legally, the financial statements will represent the acquirer company (the shell company). However, in substance, the statements will continue to represent the acquiree (the previously private company).
For accounting purposes, the financial statements will represent the elements such as assets, liabilities, and equity of the legal acquiree. If there are any comparative financial statements, these must disclose sufficient information so that users can distinguish between the legal acquirer and acquiree.
In many cases, the legal acquirer (the shell company) adopts the name of the acquiree. That is the objective behind the move in the first place. However, the disclosures and the headings of the financial statements must provide sufficient information to the users to identify such transition.
Consolidation Structure with a Reverse Acquisition
For consolidated financial structure, the continuation basis will be based on the legal acquiree’s statements. However, the capital adjustments should be made in a way that reflects the change. The capital of the legal acquirer (shell) and the legal acquiree (private) company must be adjusted for consolidated financial statements.
Except for capital, the consolidated financial statements of the newly established entity would be a continuation of the legal subsidiary.
The ASC 805-40-45-2 provides guidelines on the post-combination financial statement structure of the newly established entity.
- The consolidated equity structure should be adjusted to reflect the legal equity structure of the new entity. It must include the changes such as the issuance of new stocks by the shell company to acquire the private for a stock exchange transaction.
- The assets and liabilities of the private company should be recognized and measured at the pre-combination carrying amounts.
- The assets and liabilities of the shell company should be recognized and measured according to the ASC 805 guidelines of the business combination.
- Retained earnings and other equity items should be measured and recognized at the carrying amounts on the pre-combination basis of the private company.
Special Considerations in the Case of Non-Sub Subsidiary
A special case in reverse acquisitions has been that of “special-purpose vehicles” or “variable interest entities”. A sponsor company funds a start-up such as an emerging tech company with convertible debt in these transactions.
The private company’s management or the entrepreneur offers the skills against a stake in the newly formed company. After a specified period, if the start-up becomes successful, the sponsor (or parent) entity exercises the convertible debt to own majority equity. However, if the start-up fails, the sponsor does not exercise the conversion, and hence the entity does not reflect in its consolidated financial statements.
Even in the absence of voting stocks, the sponsor company practically fulfills the role of an acquirer. Thus, it should reflect the ownership of such entities in its consolidated financial statements.