In brief - Reverse takeover may be better option than an IPO in certain circumstances
Back-door listings are seen as a quicker, cheaper and easier way to list on the Australian Securities Exchange (ASX) and are more popular for small transactions. While there are a number of advantages to this method compared to an Initial Public Offering (IPO), companies that wish to use this method should weigh up the pros and cons. In addition, recent proposed amendments to the ASX's Listing Rules, such as changes to the spread test, may make it more difficult for entities seeking admission of the ASX.
A summary of main points to consider about back-door listings
- It is important to choose the right shell - some shells offer more value to proponents than others
- Back-door listings offer the best value when proponents can avoid compliance with Chapter 1 and Chapter 2 of the ASX Listing Rules
- The right shell can offer relief from shareholder spread requirements
- Back-door listings have limited application for larger transactions and are more popular for small transactions
- Giving value to legacy shareholders in the shell is an important issue of back-door listings that does not apply to traditional IPOs
- There are downside risks, but these can be managed and balanced against upside opportunities
- ASX proposals for change - proposed amendments to the Listing Rules will make it more difficult for entities seeking admission of the ASX
Reverse takeover involves acquiring a shell company and using its listing status
A back-door listing, or a reverse takeover as it is often referred, is an alternative method for a company to list on the ASX to the conventional IPO.
For a back-door listing, a successful privately owned entity will seek a "shell" company (a company that has been listed on the ASX but no longer has a viable business model) to acquire and utilise its listed status. The shareholders of the unlisted entity will sell their shares to the shell company in exchange for shares in that company. The unlisted entity will then become a wholly owned subsidiary of the shell company and shareholders of the unlisted entity will generally obtain control of the shell.
Front-door IPO listing criteria
The traditional method for listing on the ASX is via an IPO.
An IPO requires an unlisted entity seeking admission onto the ASX to comply with Chapter 1 and Chapter 2 of the ASX Listing Rules. In particular, the unlisted entity must:
- issue a prospectus or product disclosure document and lodge it with the Australian Securities and Investments Commission (ASIC) and the ASX
- meet the minimum shareholder spread requirements
- satisfy either the profit test or asset test
- offer securities at, at least, $0.20 per share pursuant to the listing
An IPO is a protracted, costly process that generally takes no less than 12 and more likely, 14 weeks.
Short form prospectus may save time and money for transactions that do not result in significant change to the shell's activities
There is a view that a back-door listing is an easier, quicker, simpler and cheaper way to list on the ASX.
This is correct if the transaction does not involve what the ASX characterises as a "significant change in activities" by the shell. If so, the main steps in undertaking the back-door listing are entering into the transaction documents and calling a meeting of the shell's shareholders to approve the transaction, often involving approval of a change of scale under Listing Rule 11.1.2
and the issue of shares to the vendors under Listing Rule 7.1
. Almost invariably, shareholder approval is also required under section 711
Item 7 of the Corporations Act 2001
on the back of an independent expert's report on fairness and reasonableness of the transction.
Often, cases such as these still involve the raising of funds under a prospectus, but the shell can take advantage of short form "transaction specific" prospectus disclosure under section 713
of the Corporations Act
, rather than a full prospectus under section 710
of the Act. The shorter form prospectus is significantly less complex and costly, saving both money and time to completion.
These advantages operate to make some back-door listings significantly quicker, cheaper and simpler than a traditional front-door IPO. Having said that, even such a short form prospectus may need to contain many elements common with a full prospectus.
Re-listing at 2 cents a significant advantage of back-door listings
Listing Rule 2.1, Condition 2, requires an entity seeking to quote securities on the ASX to have an issue price or sale price of 20 cents in cash per security (20 cent rule). Often, the shell company will be trading below this 20 cent threshold.
Previously, where an entity sought requotation on the ASX, this condition required the consolidation of the shares in the shell company to increase the value of its securities, although this arithmetical exercise often simply failed when shares re-commenced trading.
The ASX recognised that when combined with a capital raising, compliance with the 20 cent rule could result in excessive dilution of the shell company holder's securities and increase in the time and cost for completing the transaction. Consequently, the ASX has provided guidance that it will consider waiving the 20 cent rule if the shares in the shell company are offered pursuant to the transaction at 2 cents or higher, allowing the issue of new shares at the prevailing share price or at least at a more attractive price. This relieves strain on capital structures in these transactions and offers a significant advantage over IPOs.
Shell companies with right shareholder base may help to overcome difficulty of spread test compliance
Listing Rule 1.1, Condition 7, requires an entity seeking admission onto the ASX to have:
(a) 400 security holders who hold a parcel of securities with a value of at least $2,000
(b) 350 security holders who hold a parcel of securities with a value of at least $2,000, where there is a free float of at least 25%, or
(c) 300 security holders who hold a parcel of securities with a value of at least $2,000, where there is a free float of at least 50%
At times when the market is flat or where the unlisted entity engages in higher risk business activity, for example technology or biochemical start-ups, the unlisted entity often experiences difficulty satisfying the "spread test" at listing. Instead, the unlisted entity may seek a shell company that offers some relief from spread through a large shareholder base.
If a shell has sufficient numbers of shareholders whose parcels of shares, when valued at the price the shell raises capital pursuant to the back-door listing meet the minimum parcel size prescribed in the rules ($2,000 since 1992), the transaction proponent may be relieved to that extent from complying with the spread test through its own capital raising activities. Again, a shell with the right shareholder base can therefore offer significant value in overcoming this perennial difficulty in small and midcap IPOs.
That said, ASX has a discretion to require that, despite parcels emerging from the shell's shareholder base, a specified number of "new" shareholders with the minimum parcel be obtained, to ensure that there is a viable market in the re-listed company's shares. The author has experience of that requirement being set at 100, for example.
Shell companies may offer access to contracts, networks and sources of capital
Another advantage of using a shell is that the incoming management team may gain access to networks established by previous management or to networks of significant shareholders of the shell that they would not otherwise have.
In particular, in the author's recent experience, access to sources of capital through legacy management or significant shareholders has been a driver in recent reverse takeover transactions. Moreover, if there is sufficient parity between the legacy and incoming business, obvious synergies and savings can be achieved.
Downside risks include re-compliance with ASX Listing Rules
Back-door listings are perceived as a smallcap exercise and therefore for larger transactions they are considered inappropriate. We often hear that a transaction "is not big enough for an IPO" and hence the choice to proceed with a back-door listing, instead.
If the ASX forms the view that the proposed transaction will result in a "significant change in activities" of the shell company, it may require not only shareholder approval but re-compliance by the shell with Chapters 1 and 2 of the ASX Listing Rules.
Usually, a back-door listing involves a shell company that has a relatively small-scale operation (either because its main operation has been unsuccessful or it did not achieve the growth it anticipated). By engaging in a reverse takeover with an unlisted entity there is often a significant change in the scale of the shell company's operations or the type of activities undertaken. The ASX takes the position that as shareholders generally base their decision to invest in a listed entity on that business's main undertaking, any change to the scale or nature of the entity must be approved by the shareholders.
That's not a problem, as almost all back-door listings require shareholder approval. But if the ASX considers the change is sufficiently significant, having regard to its published guidance and exercise of its discretion in a given case, it will require the shell company to re-comply with chapters 1 and 2 of the ASX Listing Rules.
This requires the shell company to re-apply for admission to the official list of the ASX and comply with substantially the same requirements as an IPO (please refer to Table 1 below for the advantages and disadvantages of back-door listings as opposed to IPOs). In these circumstances, a back-door listing is not really a simpler or easier method for gaining admission onto the ASX than a traditional IPO. Having said that, some of the benefits mentioned above may still apply.
Legacy shareholder considerations include rewards for support and effect of overhang
One of the quid pro quos in a back-door listing is the need to give legacy shareholders in the shell a reward for their support of the deal. There is no rule of thumb as to what this number is, but obviously, it's a factor not present in an IPO. This reward is inevitably a share in the new, re-listed entity, which comes off the table for seed and retail shareholders. In the right cases, this price is justified.
A re-listed shell can face a shareholder "overhang" if its legacy shareholders do not believe in the new business model or if they wish to cut their losses and invest elsewhere. This can result in selling pressure on the newly re-listed company's shares, amplified if it re-listed at 20 cents without asset backing for that value, which has often been the case.
There are strategies for managing this risk.
ASX's proposed amendment to spread test may adversely affect back-door listings
In its consultation paper released on 12 May 2016, the ASX is proposing to increase the spread test to:
(a) 200 security holders if the entity has a free float* of less than A$50 million, or 100 security holders if the entity has a free float of A$50 million or more, and
(b) each security holder counted towards spread must hold a parcel of securities with a value of at least A$5,000
(*"Free float" refers to the amount of securities not classified as restricted securities or subject to voluntary escrow requirements at the time of admission. The consultation paper proposed to implement a 20% free float requirement on admission).
If this proposed amendment to the ASX Listing Rules is implemented, it will significantly increase the value of the parcel of securities to be held by each security holder from $2,000 to $5,000. The intention of the amendment is to ensure that there is sufficient investor interest in the listing entity, as investors will have to make a significant financial commitment to participate in the IPO. This poses a particular threat to future back-door listings, as it is unlikely the majority of the current shell companies in the market will satisfy this requirement, removing one of the key advantages of undertaking a back-door listing.
ASX proposes amending Listing Rule on audited accounts
The ASX is considering amending Listing Rule 1.3 to require production of audited accounts for the last three full financial years. This may impact on back-door listings involving acquisition of entities that do not have audited accounts, materially increasing the costs of the transaction. However, this is not unique to back-door listings.
Emerging market entities may face more uncertainty when trying to list on the ASX
Back-door listings are popular with entities in emerging or developing markets that may not have the scale to list via an IPO. This is an issue that will need to be managed early in back-door listing transactions. A recent example of the ASX utilising this discretionary power can be seen in the Guvera listing, which the ASX refused without giving any reason. Guvera is a music application that was seeking to raise $50 million through a listing on the ASX.
Possible outcomes from ASX's consultation paper
The author has attended a consultation with the ASX concerning these proposals, from which some interesting issues emerged. The outcomes are likely to differ from what is currently contained in the paper.
Factors to take into account when considering a back-door listing
As an alternative method for gaining admission onto the ASX, a back-door listing is only really advantageous where:
- the proposed reverse takeover will not trigger a "significant change in the activities" of the shell company, thus avoiding the requirement to re-comply with Chapters 1 and 2 of the ASX Listing Rules
- it may be undertaken at a share price of 2 cents (or more) rather than the usual 20 cent minimum (avoiding the dilutionary consequence of a consolidation of the securities in the shell company) and offering more flexibility for capital structures more closely approximating underlying value
- a struggling shell company is allowed to avoid de-listing or liquidation, enabling its shareholders to preserve some of the value and liquidity of their shares, and/or
- the unlisted entity is able to obtain relief from standard shareholder spread requirements by utilising the shell's share register (provided the shell company could meet the new spread test proposed by the consultation paper, as it is ultimately implemented).
TABLE 1: Comparison of IPO process to back-door listing
|Faster way to be listed
|Access to shareholder base
|Full control of destiny
|Easier to price
|Skeletons in the closet
|Ready reference point for brokers to price capital raisings
|Opportunity for uplift
|Yes, but arguably to a lesser extent
|Selling pressure from legacy shareholders
|Yes, but arguably to a lesser extent (from seed shareholders)
|Independent expert's report on fairness and reasonableness
|Short form prospectus