The Effect of Corporate Governance on Post Reverse Merger Survival

• Author: Khishigjargal Jambal,Hyun‐Dong Kim,Kwangwoo Park,Sang Whi Lee,Bong‐Soo Lee
• DOI: http://doi.org/10.1111/ajfs.12114
• Date: 01 December 2015
• Published date: 01 December 2015

The Effect of Corporate Governance on Post

Reverse Merger Survival*

Hyun-Dong Kim

College of Business, Korea Advanced Institute of Science and Technology

Bong-Soo Lee

College of Business, Florida State University

Sang Whi Lee

College of Politics and Economics, Kyung Hee University

Kwangwoo Park**

College of Business, Korea Advanced Institute of Science and Technology

Khishigjargal Jambal

Saunders College of Business, Rochester Institute of Technology

Received 17 June 2015; Accepted 30 September 2015

Abstract

In this paper, we examine how firm financial conditions and governance characteristics affect

reverse mergers’ survival. Using a sample of reverse mergers that took place in the United States

during the 1997–2009 period, we find that firms with better corporate governance are more likely

to survive after a reverse merger. In particular, CEO ownership, staggered board dummy, and ven-

ture dummy havea positive association with reversemerger survival. We alsoshow a concave rela-

tion between the average board tenure and the probability of reverse merger survival. In contrast,

most of the firm characteristic variables have an insignificant relationship with reverse merger sur-

vival. Our results suggest that the survivability of reverse mergers relies more on the presumed

value-enhancing governance characteristicsthan on the financial conditions of themerging firms.

Keywords Reverse merger; Corporate governance; Firm survivability: Going public; Going

private

JEL Classification: G21, G31, G34

*An earlier version of this paper was circulated under “Reverse Takeover and Firm Surviv-

ability”. This paper is dedicated to the memory of our co-author Bong-Soo Lee, who passed

away on 6 March 2015 while he was the Patty Hill Smith Eminent Scholar in Finance at the

Florida State University.

**Corresponding author: Kwangwoo Park, College of Business, Korea Advanced Institute of

Science and Technology (KAIST), 85 Heogiro, Seoul 02455, Korea. Tel: +82-2-958-3540, Fax:

+82-2-958-3620, email: kpark3@kaist.ac.kr.

Asia-Pacific Journal of Financial Studies (2015) 44, 811–848 doi:10.1111/ajfs.12114

©2016 Korean Securities Association 811

1. Introduction

A reverse merger is an alternative way of going public. Unlike initial public offer-

ings (IPOs), reverse mergers are less costly in terms of processing time and regula-

tory requirements, and there is little risk associated with withdrawing from the

process. The reverse merger is a mechanism in which a private company acquires a

public company to obtain its public listing status and control. The public firm

acquired by the private company is called the “shell”, because these firms usually

have no significant assets or operations but do have legitimate business labels. The

private company shareholders receive a substantial majority of the shares of the

public company and control of its board of directors.

1

One of the advantages of the reverse merger is that the transaction can be

accomplished within weeks. If the shell is an SEC-registered company, the private

company does not go through an expensive and time-consuming review with state

and federal regulators because this process was completed beforehand with the pub-

lic company. The process for a conventional IPO can last for a year or more. In

addition, during the many months it takes to put an IPO together, market condi-

tions can deteriorate, making the completion of an IPO unfavorable. By contrast, a

reverse merger can be completed in as little as 30 days. Thus, reverse mergers can

be quicker and cheaper than an IPO.

2

Going public through a reverse merger allows a privately held company to

become publicly held at a lesser cost, and with less stock dilution than through an

1

In a reverse merger process, a private firm typically finds a public firm, which is called the

shell company, then negotiates the merger terms (bidding) and files the relevant paperwork

with the SEC within 2 weeks. The private firm then obtains public listing through the merger

with the shell, and usually takes over the control of the newly formed public entity. The

managers of the shell company are usually retained on the board of directors or as “consul-

tants” to the new entity. A special-purpose acquisition company (SPAC) can be used as a

shell to acquire a private company. In our study, SPACs are not considered as they are shells

without operations but going public to acquire private firms.

2

There are, however, some drawbacks associated with reverse mergers. Reverse mergers tend

to come with some bad history of shell companies so that they tend to come with a large dis-

count and undervaluation. In general, low-quality companies tend to undertake reverse merg-

ers because more attractive financing options are available to higher quality companies.

Hence, going public through a reverse merger signals to the market that the company has

likely been passed over by underwriters and is therefore of low quality. Because there is no

underwriter involved in a reverse merger, there is no implicit underwriter certification of the

company. As a result, the company’s stock price will trade at a discount to reflect these fac-

tors and the stock’s relative illiquidity. Therefore, companies that have gone public through

reverse mergers or self-underwritings were, on average, less profitable, had lower balance

sheet liquidity, and had more leverage than comparable IPO firms in the year they went pub-

lic. Thus, a prominent feature of reverse mergers is that they allow companies to go public

even though the companies cannot secure the support of underwriters, the primary gatekeep-

ers to the public markets.

H.-D. Kim et al.

812 ©2016 Korean Securities Association

IPO. With a reverse merger, a privately held company obtains public trading status,

which allows the possibility of commanding a higher price for a later offering of

the company’s securities. While the process of going public and raising capital is

combined in an IPO, in a reverse merger, these two functions are separated. A com-

pany can go public without raising additional capital. Separating these two func-

tions greatly simplifies the process. In addition, a reverse merger is less susceptible

to market conditions. Conventional IPOs are risky for companies to undertake

because the deal relies on market conditions, over which senior management has

little control. In a reverse merger, since the deal rests solely between those control-

ling the public and private companies, market conditions have little bearing on the

situation.

3

Gleason et al. (2005) confirm that there is a high mortality rate for firms eng ag-

ing in reverse mergers. They suggest that the performance of reverse merger is dri-

ven by the pre-merger financial conditions of the public shell. Gleason et al. (2005)

further argue that the most common reason for a public shell to agree to a reverse

merger is the solid financial position of the private firm. Recently, Sudarsanam

et al. (2011) find that firms going private have a significantly higher default proba-

bility using United Kingdom data. They argue that a good corporate governance

structure makes a positive contribution to bankruptcy avoidance after going private

transactions.

In reverse mergers, the control of the new entity is usually in the hands of the

former private firm’s management. Private firms are mostly owned by insiders.

Through reverse mergers, the private firms become public-owned, but the degree to

which the management ownership is reduced is debatable depending on their after-

merger performance. If there is a low level of insider ownership, when management

ownership increases firm performance will improve. However, if there is a high level

of insider ownership, when management ownership increases firm performance will

get worse (Morck et al., 1988; McConnell and Servaes, 1990). Therefore, the success

of a reverse merger can be explained not only by financial conditions but also by

the characteristics of firm management and governance. Dong et al. (2006) claim

that takeovers with overvalued acquirers and undervalued targets should perform at

their best. From the point of view of a takeover transaction, the new public firms

3

While the primary benefit a company enjoys from going public through an IPO is a large

infusion of additional equity capital and share liquidity, the typical reverse merger (RM)

company receives neither of these benefits. One of the reasons why companies nonetheless

pursue RMs is that RMs open up PIPE (Private Investment in Public Equity) financing as a

funding option, an option normally not available to private companies, with a small number

of sophisticated investors. In a typical PIPE, the company relies on an exemption from SEC

registration requirements to issue investors common stock or securities convertible into com-

mon stock for cash. The company then registers the resale of the common stock issued in

the private placement, or issued upon conversion of the convertible securities issued in the

private placement, with the SEC.

Corporate Governance and Reverse Merger

©2016 Korean Securities Association 813