Reverse Triangular Merger

What is a reverse triangular merger?

Reverse triangular merger (in German umgekehrte Dreiecksverschmelzung) refers to an acquisition structure under US law in which a purpose-formed subsidiary of the acquirer (merger sub) merges into the target company. The target company continues to exist as a company and becomes a wholly owned subsidiary of the acquirer. Its former shareholders receive the agreed consideration in cash or in shares of the acquirer. “Triangular” refers to the three companies involved, “reverse” to the fact that it is not the target company but the acquirer's subsidiary that ceases to exist.

The structure is common in the acquisition of US corporations, above all those under the law of the state of Delaware. These issue shares even without a stock exchange listing. German founders encounter the structure in two situations. Either their company has a US parent company that is sold as part of a trade sale, or a US acquirer transfers its familiar contract templates to the purchase of a German GmbH (limited liability company). It is not available for German target companies. German law has no comparable merger, and company sales here are very predominantly implemented as share purchases.

Process and structure under US law

In the US market the structure runs in three steps:

1. The acquirer forms a subsidiary without a business of its own, which exists only for the transaction.
2. Acquirer, subsidiary and target company conclude a merger agreement. The governing body of the target company and its shareholders approve. Under the statutory default in Delaware, a majority of all voting shares suffices, not only of those present. The charter or agreements may require higher majorities or separate votes of individual classes of shares, such as the investors' preferred shares.
3. When the merger takes effect, the subsidiary ceases to exist. The subsidiary's shares are converted into shares of the target company, which is then wholly owned by the acquirer. The shares of the former shareholders become a claim to the consideration.

Shareholders who did not approve are bound by the result. Under US law they can demand a court review of the value of their shares (appraisal rights) but generally cannot prevent closing. For listed target companies, a two-step procedure of tender offer and subsequent merger is often used. Anyone holding at least 90% of the shares in Delaware can carry out a simplified merger without a resolution of the remaining shareholders.

Reasons for the structure

• All shareholders in one step: The majority resolution also binds shareholders who do not want to sell or cannot be reached. With a broad group of founders, investors, business angels and employees holding shares, individual signatures are not needed.
• Continuity of the target company: Contracts, licences and permits remain with the same legal entity and in principle continue. Whether a contractual prohibition on assignment is affected depends under US law on its wording. Change of control clauses (change of control) apply regardless.
• Ring-fencing of the acquirer: The liabilities remain in the target company and do not pass to the acquirer's parent company.
• No resolution of the acquirer's shareholders: The sole shareholder of the subsidiary is the acquirer. Its own shareholders generally do not vote under company law, unless stock exchange rules require a resolution for the issue of many new shares.

Transfer to German target companies

A German GmbH cannot be acquired in this way. In a merger under the German Transformation Act (Umwandlungsgesetz, UmwG), the shareholders receive shares in the acquiring entity. Consideration predominantly in cash or in shares of a third company, such as the acquirer's group parent, is not provided for. Cash payments are limited to one tenth of the nominal amount of the shares granted. Merger resolutions require three quarters of the votes cast in a GmbH and three quarters of the share capital represented in an AG (German stock corporation). The UmwG permits cross-border mergers only with companies from the EU and the EEA.

Even the exclusion of minority shareholders against cash compensation (squeeze-out) is possible only to a limited extent. German law recognises it only for stock corporations and partnerships limited by shares, and only from a holding of 90% or 95%, depending on the procedure. For the GmbH there is no statutory procedure of this kind.

What is usual instead

• Share purchase: The acquirer or an acquisition vehicle buys the shares from the shareholders in a notarised agreement (share deal). The GmbH continues to exist as a legal entity, and its contracts continue, subject to change of control clauses.
• Drag-along obligation: The function of the majority resolution is taken over by the drag-along obligation (drag-along) in the shareholders' agreement. So that it can be implemented without the cooperation of individual shareholders, it is often secured by powers of attorney.
• Contribution in exchange for shares: If the consideration is to consist of shares of the acquirer, the shareholders contribute their shares in the company in exchange for new shares of the acquirer (share exchange). With a German acquisition vehicle, this is done by way of a capital increase in kind. The assignment of the shares must also be notarised here. The exchange is tax-neutral only under the conditions of the German Reorganisation Tax Act (Umwandlungssteuergesetz). These in principle require an acquiring company in the EU or the EEA, so an exchange for shares of a US company must be examined separately.
• Subsequent merger: If the acquirer wants to integrate the target company into another group company after the purchase, this is done in a second step under the UmwG.

Practical example: reverse triangular merger via a Delaware parent

A software company with development in Berlin has a parent company in Delaware that holds all shares in the German GmbH. Founders, investors and some employees hold shares in the parent company, the investors mostly preferred shares (preferred stock). A US group acquires the group.

• The acquirer forms a merger sub in Delaware; acquirer, merger sub and parent company conclude the merger agreement.
• The parent company's board approves, as do shareholders with 68% of the votes, including the majority of the preferred shareholders required by the charter. The remaining 32% are bound by the result.
• When the merger takes effect, the merger sub ceases to exist, the parent company is wholly owned by the acquirer, and the former shareholders receive the purchase price under the distribution rule of the charter, including the liquidation preferences.
• The German GmbH is unaffected. Its shares are not transferred, and notarisation under Section 15 of the German Limited Liability Companies Act (GmbHG) is not required for the acquisition.

From a German perspective, a number of points nevertheless remain to be checked. Change of control clauses in the GmbH's contracts can also capture an indirect change of owner via the parent. The investment screening under the Foreign Trade and Payments Ordinance (Außenwirtschaftsverordnung, AWV) includes indirect acquisitions by acquirers outside the EU. Added to this are merger control, the settlement of virtual shares of the German employees and real estate transfer tax if the GmbH holds real estate. If the GmbH itself were the top company, all shareholders would have to sign a notarised share purchase agreement or be obliged to cooperate through the drag-along provision.

Distinction: merger under the UmwG, share deal and reverse merger

• Merger under the UmwG: universal succession with consideration in shares of the acquiring entity, resolved by a three-quarters majority and effective upon entry in the commercial register.
• Share purchase (share deal, in the US market stock purchase): The usual form of company purchase in Germany. Each shareholder sells its own shares unless bound by a drag-along obligation. US acquirers therefore choose the direct stock purchase mainly when there are few shareholders.
• Reverse merger: term for the stock exchange access of an unlisted company through a listed shell company. Apart from the name, it has little in common with the triangular acquisition structure.

Common mistakes

• Transferring US law to the GmbH. The assumption that a majority can oblige all shareholders to sell applies to the GmbH only if there is a contractual drag-along obligation.
• Overlooking an indirect change of control. Clauses in the German subsidiary's contracts and the investment screening often also attach to a change at the parent company level.
• Drag-along obligation without implementation mechanics. Without powers of attorney or clear procedural rules, the clause can be enforced against a reluctant shareholder only with loss of time.
• Tax consequences of a share exchange not examined. If German shareholders receive shares of a US acquirer, tax can arise without liquidity flowing in.
• Subsidiary's equity programmes forgotten. The merger agreement regulates options of the US parent. Virtual programmes of the German GmbH need their own settlement rule.

Frequently asked questions

Can a German GmbH be acquired through a reverse triangular merger?

No. The Transformation Act does not provide for a merger in which the shareholders of the target company receive predominantly cash or shares of a third company. The share purchase is usual, possibly supplemented by a contribution in exchange for shares.

What is the difference between a reverse and a forward triangular merger?

The direction of the merger. In a reverse triangular merger, the acquirer's subsidiary ceases to exist and the target company continues. In a forward triangular merger, the target company is merged into the acquirer's subsidiary and ceases to exist. Its contracts pass to another legal entity, which can trigger consents from counterparties.

How is a reverse triangular merger treated for tax purposes?

Under US tax law, the consideration decides. If shareholders receive cash, the transaction is taxable for them like a sale. It can be tax-neutral if shares amounting to at least 80% are exchanged for voting shares of the acquirer. In a forward triangular merger a lower share component suffices. For shareholders resident in Germany, German tax law applies. Whether a share exchange remains neutral here must be examined case by case.

Is a reverse triangular merger the same as a SPAC transaction?

No. A SPAC (special purpose acquisition company) is a listed shell company that acquires a business and thereby gives it access to the stock exchange. The reverse triangular merger, by contrast, is an acquisition technique used with and without a stock exchange connection.

Does the German subsidiary of an acquired US company need a notary?

For the acquisition itself, as a rule not, because its shares are not transferred. Follow-up measures such as a change of management are, however, filed with the commercial register through a notary as usual.

The Roemer Capital view

When Roemer Capital negotiates with US acquirers, their draft contracts often begin with the logic of the reverse triangular merger even though a German GmbH is being sold. It transfers the economic points into the structure of a share purchase, that is, purchase price, distribution, holdbacks and retention of the team. With the law firm, it clarifies early how all shareholders are bound through the drag-along obligation.

If the company already has a US parent company, Roemer Capital examines early what a sale at parent level means for the German company. This concerns above all change of control clauses, investment screening and the team's virtual shareholdings. The legal assessment under US and German law rests with the law firms.