The Effect of Corporate Governance on Post-Reverse Merger Survival

Transcription

1 The Effect of Corporate Governance on Post-Reverse Merger Survival Hyun-Dong Kim Korea Advanced Institute of Science and Technology Bong-Soo Lee Florida State University Sang-Whi Lee Kyung Hee University Kwangwoo Park* Korea Advanced Institute of Science and Technology Abstract: This paper investigates how firm financial conditions and governance characteristics affect reverse mergers survival. Using a sample of reverse mergers that took place in the U.S. during the period, we find that firms with better corporate governance are more likely to survive after the reverse merger. In particular, CEO ownership, staggered board dummy, and venture owner dummy have positive association with reverse merger survival. We also show a concave relation between the average board tenure and the probability of reverse merger survival. In contrast, most of the firm characteristic variables have insignificant relationship with reverse merger survival. Our results suggest that the survivability of reverse mergers relies more on their presumed value-enhancing governance characteristics than on the financial conditions of the merging firms. Keywords: Reverse Merger; Corporate Governance; Firm Survivability: Going Public; Going Private JEL Classification: G2, G3, G34 * Corresponding author; Professor of Finance, College of Business, KAIST; 85 Heogiro, Dongdaemoon-gu, Seoul 3-722, South Korea; Tel: ; kpark3@kaist.ac.kr

2 І. ITRODUCTIO A reverse merger is an alternative way of going public. Unlike initial public offerings (IPOs), reverse mergers are less costly in terms of processing time and regulatory 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. 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 public 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 conditions can deteriorate, making the completion of an IPO unfavorable. By contrast, a reverse merger can be completed in as little as thirty days. Thus, reverse mergers can be quicker and cheaper than an IPO. 2 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 two 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 consultants to the new entity. 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 discount and undervaluation. In general, lowquality companies tend to undertake reverse mergers 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

3 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 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 separate. A company can go public without raising additional capital. Separating these two functions 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 controlling the public and private companies, market conditions have little bearing on the situation. 3 Gleason, Rosenthal, and Wiggins (25) confirm that there is a high mortality rate for firms engaging in reverse mergers. They suggest that the performance of reverse merger is driven by the pre-merger financial conditions of the public shell. Gleason et al. (25) further argue that the most common reason for a public shell to agree to the reverse merger is the solid financial position of the private firm. Recently, Sudarsanam, Wright, and Huang (2) find that firms going private have a significantly higher default probability using the U.K. data. They argue that price will trade at a discount to reflect these factors 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 public. 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 gatekeepers to the public markets. 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 common 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. 2

4 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, Shleifer, and Vishny, 988; McConnell and Servaes, 99). Therefore, the success of reverse merger can be explained not only by financial conditions but also by the characteristics of firm management and governance. Dong, Hirshleifer, Richardson, and Teoh (26) 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 should be performing at their best in reverse mergers. Information asymmetry in a private firm is likely to be higher and so the likelihood of the private acquirer being overvalued is greater. However, the public shell might be undervalued because the shareholders are ready to accept relatively lower bids so that they can recover at least some of their investments. A natural question arises: if the private firm was performing at its best prior to the merger, why then does the merged entity fail so often? Is it because the new company has inherited problems other than financial distress from the public shell, or are there problems with the private firm? Since the control is transferred from the public shell to the private firm management, the latter may have some problems such as too much management ownership (even if it is diluted), large boards, or management s lack of experience in public firms, etc. Therefore, 3

5 one might want to examine not only the firm financial characteristics but also the governance effects on reverse merger survival. This paper investigates how firm financial characteristics and the terms of governance characteristics affect reverse mergers survival. Although a few papers have examined the characteristics and wealth effects of reverse mergers, there are no studies on the relation between the governance of the new public firm through reverse merger and its performance after going public. This is the first paper, to our knowledge, that examines the influence of governance characteristics on the reverse merger performance. We find that firms with better corporate governance are more likely to survive after the reverse merger. In particular, CEO ownership, staggered board dummy, and venture owner dummy have positive association with reverse merger survival. In contrast, most of the firm characteristic variables have insignificant relationship with reverse merger survival. We also find a concave relation between the average board tenure and the probability of reverse merger survival. Overall, our findings suggest that the survivability of reverse mergers relies more on their presumed value-enhancing governance characteristics than on the financial conditions of the merging firms. Conventionally, firms try to improve the financial conditions of the merging firms to survive in the reverse merger. Our empirical results further stress that firms should also practice good corporate governance in order to be successful in reverse merger. The remainder of the paper is organized as follows. In the next section, we discuss related literature and develop hypotheses. Then, we present our data and sample selection, followed by our discussion of the empirical results. Finally, we provide concluding remarks. Ⅱ. THE LITERATURE AD HPOTHESES DEVELOPMET 4

6 As discussed above, the reason for a private firm to go public is usually discussed in terms of the benefits of being a public firm such as having better access to public capital markets, increased valuation, and liquidity for the firm s shares, etc. Zingales (995) and Brau, Francis, and Kohers (23) examine the decision of a private firm owner to go public. The decision is based on the owner s choice of retaining ownership or adopting an exit strategy and is determined by cash flow rights and control rights. If the owner decides to maximize his wealth, he would sell cash flow rights and retain the control rights. If he chooses to withdraw from the business, he would sell both cash flow and control rights. The owner who wants to sell shares while retaining some control may prefer using IPO (Zingales, 995; Brau, Francis and Kohers, 23). In reverse mergers, the private management usually takes over the control of the new firm. So, it implies that the private management is not pursuing an exit strategy, but pursuing growth. For the public shells, Gleason et al. (25) suggest that the most significant reason for the public shell management to be involved in a reverse merger is the solid financial position of the private firm. Therefore, it implies that the public shell management is trying to salvage the shareholders investment even at the cost of losing control of the firm. There are several studies on governance characteristics and firm performance after IPOs. Carter, Dark, and Singh (998) argue that firms with more reputable underwriters are associated with less short-run underpricing. Brav and Gompers (997) report that IPO issues, backed by venture capitalists, show a strong performance. Howton, Howton, and Olson (2) find that the ownership of inside directors on an IPO firm s board is positively related to long-term performance. Crutchley, Garner, and Marshall (22) argue that the stability of the board of directors is associated with better performance after an IPO. Frye (24) examines how different governance structure can ameliorate the agency problem associated with going public. Jain and 5

7 Kini (999) find that riskier firms and smaller firms are more likely to fail and firms with strong pre-ipo operating performance are more likely to survive after an IPO. Howton (26) extensively examines the effects of governance characteristics on the state of the firm after an IPO. She finds that firms after an IPO are more likely to survive when they are venture-backed, the CEO is the original founder, and an outside blockholder is present. These studies all refer to the traditional way of going public, that is, IPO; however, in some respects, these findings may also be valid for reverse mergers, since IPOs and reverse mergers differ mainly in terms of processing times and costs, not in terms of firm-specific characteristics. In other words, in both cases, an initially private firm goes public. Only the consequences of these differences may matter for the firm-specific characteristics. Some recent studies refer to the reverse merger performance in association with operational characteristics, motivations, and wealth effects. Gleason, Rosenthal, and Wiggins (25) report that the public shells acceptance of reverse mergers is conditional on the financial strength of the acquiring private firms. Gleason et al. (25) also find that the public shell shareholders receive significant wealth gains upon announcement of the reverse merger, but they fail to generate longterm wealth for the shareholders of the post-event firm. Gleason et al. (25), however, mainly focus on firms financial characteristics and mention briefly the institutional ownership effect. Gleason, Jain, and Rosenthal (26) further examine the relation between firm performance and the characteristics of firms that go public through a reverse merger. They find that reverse merger firms are characterized by significantly lower institutional ownership than their matches, while IPO firms experience significant increases in institutional support. Interestingly, reverse merger involves not only the process of going public but also taking over another firm. Therefore, we need to examine the effects of public listing through reverse 6

8 merger on the firm-specific characteristics as well as the effects of the merger itself. Gleason et al. (25) conclude that the public shells are usually poor performers and rely on the financial strength of the acquiring private firms. In this sense, the public shells are underperforming and undervalued, whereas private firms could be overvalued due to potential information asymmetry. According to Shleifer and Vishny (23), overvalued firms might be able to make acquisitions, survive, and grow, while undervalued firms or relatively less overvalued firms become targets. Dong et al. (26) claim that high quality bidders improve bad targets more than bad bidders improve good targets. 4 In reverse mergers, private firms are acquiring public shells, which implies high quality bidders on average are acquiring bad targets. Another motivation for mergers is diversification. Berger and Ofek (995) find that unrelated diversification between different industries reduces value. Therefore, if the public shell and private firm are from unrelated industries, there may be little possibility to create a positive synergy. However, unlike normal takeovers, a reverse merger is more likely to be a strategic merger than a synergistic merger. Therefore, we consider the impact of segment relatedness on survivability. In addition, firms are likely to survive when they have a stable board (e.g., Crutchley et al., 22), tend to be older firms, and operate in more concentrated industries. Furthermore, existing studies such as ermack (996) and Eisenberg, Sundgren, and Wells (998) argue that firm value deteriorates with an increase in the board size. On the basis of extant theoretical and empirical literatures, we develop two hypotheses and consider the time window of survival and failure within three (and five) years after a reverse merger. Our hypotheses focus on how firm financial characteristics and the terms of governance characteristics affect reverse mergers survival. We define survival as the new public firm s 4 In a recent merger study by Lee and Chung (23), target firms with poorer stock market liquidity are more likely to obtain liquidity improvement after a merger or tender offer. 7

9 continuing existence as a public entity or as its acquisition and retention of control over another firm, while we define failure as the merger by a new firm, its bankruptcy, or delisting. In view of the studies by Zingales (995), Brau, Francis, and Kohers (23), and Gleason et al. (25), we assume that the private management is pursuing growth through a reverse merger since it takes over the control of a new firm. 5 To represent firm financial characteristics, we consider a number of factors. The public shell companies are usually poor performers which agree to a reverse merger transaction, relying on the private firms financial strength or new management. Gleason et al. (25) divide the public shell into two groups, distressed and functional, and they find that the driving force behind post-takeover success is the public firm s pre-event financial condition. In line with the arguments by Gleason et al. (25), we assume that financially distressed shells are more likely to fail than survive. Financial distress will be measured by the interest coverage ratio of the public firm, which is defined as the ratio of the sum of EBIT and depreciation to interest expenses (Shell Interest Coverage Ratio). This ratio is obtained from the accounting data of the public shells. If this ratio is below one for two or more fiscal years immediately prior to the reverse merger (we assume quarters for short-lived firms), the firm is said to be financially distressed. If the ratio is not below one, we assume the firm is functional or not financially distressed. If the shell is distressed, it is assumed that there is less probability of survival. We also include cash liquidity and profitability of the public shell. The ratio of cash to total asset is used as a proxy for cash liquidity of the pubic shell (Shell Cash Liquidity). Since the 5 On the other hand, in their recent study Goergen, O Sullivan, and Wood (2) show that there is a significant decrease in employment in acquired firms after a private equity acquisition. They argue that the corporate downsizing appears not to be accompanied by the improvement in profitability. 8

10 public shell s distress is a threat to the new company success, we also consider the new company cash liquidity (ew Corp. Cash Liquidity) as a proxy for the strength of the private acquirer s and the public shell s combined cash potential. The return on assets (ROA) of the public shell is used as a proxy for the public shell s profitability measure. In addition, we use the leverage ratio of the public shell as a proxy for equity deficits. Since the test is based on the merger date, relevant information is available only for the public shell at that time. Hence, we refer to the public shell data for these variables. We also include the return volatility of the public shell (Shell Return Volatility), which is defined as the standard deviation of quarterly ROA over three years prior to reverse merger. This risk factor is assumed to be negatively associated with the success of reverse merger in line with the view of extant studies such as Anderson and Reeb (23). Jain and Kini (999) propose that firm size is positively related to the probability of survival. Gleason et al. (25) also use firm size as one of the explanatory variables. We consider both the public shell size and the private acquirer size. It is not easy to find information about private firm accounting data; therefore, we use the new company firm size after the merger as a proxy for both firms combined size. Thus, we take the logarithm of the total assets of the newly combined firm (ln(ew Corp. TA)) as a proxy for firm size and expect greater new firm will have better chance for survival. We also define a variable Size Multiple as the ratio of new firm size to public shell size as the proxy for private firm size. If this ratio is large, the size difference between the private acquirer and the public shell is widening and we expect less synergistic gains from reverse merger. We now have our first hypothesis for the relation between financial characteristics and the survival of reverse merger. Hypothesis I: Reverse merger survivals mostly depend on the financial conditions of the public 9

11 shell and the private firm. Specifically, among the financial condition variables we consider, Shell Interest Coverage Ratio, Shell Cash Liquidity, ew Corp. Cash Liquidity, and ln(ew Corp. TA) are expected to be positively related to the survival of reverse mergers, while Shell Return Volatility, Size Multiple are expected to be negatively related to the survival of reverse mergers. In addition to firm financial characteristics, corporate governance characteristics can affect the reverse merger survival, a proposition similar to one documented in a recent work by Sudarsanam, Wright, and Huang (2). We measure corporate governance characteristics using several factors. We include dummy variables for governance characteristics that may influence the success of the new firm cited in previous studies. We mainly consider the governance variables for the new public firm. A CEO-founder is likely to have a large stake in the firm in terms of enthusiasm, stock, and salary. One might, however, expect that a CEOfounder remaining in the office after reverser merger might be entrenched, leading to a chance of failure after reverse merger. We define a CEO-founder dummy variable (CEO-Founder Dummy) that is equal to if the current CEO is the original founder of either of the firms, and otherwise. Hence, we expect a negative relation between this dummy and the probability of reverse merger success. Another variable we consider is the CEO-shell dummy variable (CEO-Shell Dummy). If the former public shell s CEO is appointed to the same position in the new public firm, this dummy is equal to one. The reasoning is that the public shell s CEO may have more experience in managing a public firm than the private firm s CEO. If the public shell was functional and the CEO of the shell is appointed again for the new company, the survival of the new company is more likely. CEO Ownership variable (CEO Ownership) is also used in our investigation. This is the percentage of shares owned by the CEO of a new corporation after reverse merger. Following a well-established literature in corporate finance, we expect a non-linear concave relation

12 between CEO ownership and reverse merger success. 6 Our major corporate governance measures also come from board of directors. If there is an optimal number of board members, it can positively affect the survival of the firm. However, if there are too many board members, it may lead to a loose control; therefore, we expect a concave (i.e., inverse U-shaped) non-linear relation between the board size and the reverse merger survival probability. We use a quadratic equation to examine this relation. Consistent with the predictions from the existing studies such as ermack (996) and Eisenberg, Sundgren, and Wells (998), we expect that larger board will not be value-enhancing and hence lead to a greater chance of delisting after reverse merger. We use the log of board size, ln(board Size), to measure the importance of percentage increase of board members rather than a simple increase in the number of board. 7 Members of the Board of Directors (BOD) can be classified as inside, outside, and gray directors. Inside directors are current or former employees of the firm. Outside directors are completely independent of the firm and its operations. Jensen and Meckling (976) argue that outsiders can better monitor managers to ensure that decisions are aligned with the shareholders interests. Baysinger and Butler (985) report a positive relation between outsiders on the board and firm performance. However, Howton (26) finds that having an outside board is not important in determining the ultimate survival of the firm after an IPO. In reverse mergers, the 6 As early as the classical discussion of modern corporations by Berle and Means (932), the potential conflicts of interests arising from dispersed ownership structure are often unraveled in favor of incumbent management with substantial amount of agency costs. Thus, Jensen and Meckling (976) and Demsetz (983) argue that managerial equity ownership will provide managers with incentives to maximize firm value. Stulz (988), however, has proposed a model of entrenchment effects, where concentrated managerial ownership will allow managers to pursue non-value maximizing agenda. These theoretical predictions have been supported by a number of empirical studies including Morck, Shleifer, and Vishny (988), McConnell and Servaes (99), Hermalin and Weisbach (99), and Kole (995), among others. 7 For example, even when there is just a one board member increase, the impact will be much greater when it happens from a company with a smaller board (say, a board size of 4 lead to a 25 percent increase) as compared to a larger board (say, a board size of 2 leading to only a 8.3% increase).

13 public firm managers are usually retained as the board of directors. We thus believe it is less probable that the new firm s BOD will have a large portion of outside directors, but we will endeavor to use our data for further investigation. On the strength of extant board study (e.g., Hermalin and Weisbach, 99), we predict a positive relation between the percentage of outsiders on the board (Outside Director Percentage) and the firm survival after reverse merger. Gray directors are not directly employed by the firm but have ties to the firm beyond their directorship. We assume gray directors to be inside directors; therefore, we do not count them as a separate variable. Longer tenure enables stable boards and these are more likely to drive subsequent improved performance (e.g., Crutchley, Garner, and Marshall, 22; Howton, 26). Therefore, we follow previous studies and assume that the longer tenure of the BOD (stable BOD) implies the existence of continued success in performance. A variable of average tenure (Avg Tenure) can also be a proxy for the age of the firm and the stability of the firm (e.g., Howton, 26). However, as the average tenure of the new public firm s BOD becomes too long, the board members and the firm management may be entrenched and may not work for the best interests of shareholders. Hence, we expect a non-linear relation between average board tenure and the probability of reverse merger survival. We also introduce a staggered board dummy variable (Staggered Board Dummy). This variable will be equal to if a new corporation after merger has a board where directors are placed in different classes; otherwise it is. Bates, Becher, and Lemmon (28) show that staggered board reduces the likelihood of receiving a takeover bid, and they argue that the economic effect of bid deterrence on the value of the firm is relatively small. This suggests that at the minimum the staggered board dummy will have a positive effect on the success of reverse merger. 2

14 Outside blockholders (large shareholders) are the investors with a strong interest in the firm s success, because they have a large stake in the firm. Therefore, they are good monitors of management. Jensen and Meckling (976) claim that when the ownership is spread over many small shareholders, there will be less monitoring and the managers will have a tendency to use perquisites at the expense of the shareholders. Mitra and Pattanayak (22) examine the Indian corporate governance system and find that, among the major block holders, domestic financial institutions are found to be playing an insignificant role in comparison with the domestic and foreign institutional investors. Outside blockholders can affect potential agency costs. If there is such a shareholder who owns at least 5% or more in total outstanding shares and is not involved in management, the outside blockholder dummy is equal to one. Venture capitalists invest in a significant part of a firm s total assets. Therefore, they usually influence the firm to make sure that their investment is profitable. Jain and Kini (999) and Brav and Gompers (997) find that venture-backed firms usually have better performance after an IPO. Brav and Gompers (997) emphasize that a better performance is probable if the venture capitalist s representatives remain on the board. We anticipate that if there is a venture-owner in the new public firm, the firm will perform well and be more likely to survive. The venture dummy variable (Venture Dummy) is equal to one if there is a venture owner in the new company. Since unrelated diversification tends to reduce value (e.g., Berger and Ofek, 995), we also consider the segment relatedness. A dummy variable for the segment relatedness (Segment Relatedness Dummy) is if the business lines of both the acquirer and the target are from the same two digit SIC codes, or are different but with vertical alliances; otherwise it is. Using two-digit SIC codes, we assume that firms with the same code are related. Mergers in which both firms are of the same segment (scale) or of complementary segments are classified as related. For 3

15 unrelated segment mergers, further attention is given to vertical integration. If the different segments are vertical, performance will be positive and these cases are therefore considered related segment mergers. Thus, we expect more synergistic gains from unrelated reverser merger. In summary, we propose the following second hypothesis on the relation between governance characteristics and the survival of reverse merger. Hypothesis II: Reverse merger survivals mostly depend on the governance characteristics of the newly combined public firm. Specifically, among the governance characteristics variables we consider, CEO-Shell Dummy, Staggered Board Dummy, Outside Director Percentage, and Venture Dummy are expected to be positively related to the survival of reverse mergers, while CEO-Founder Dummy and Segment Relatedness Dummy is expected to be negatively related to the survival of reverse mergers. In addition, CEO Ownership, ln(board Size), and Avg Tenure are expected to have a non-linear (i.e., concave) relation with the survival of reverse mergers. III. DATA SOURCE AD SAMPLE SELECTIO Our sample of mergers in the U.S. is obtained from the Securities Data Corporation (SDC) Mergers and Acquisitions database for the years 997 through 29. This is because electronic filings in U.S. Securities and Exchange Commission (SEC) are available from 994 and our data require financial and governance information for three years before and after reverse merger. We have included the data of most up to dated available 3 years when there are significant declines in IPO markets and firms seek an alternative way of going public. An earlier reverse merger study by Gleason et al. (25) covers the period with 2 observations when IPO markets were active. On the other hand, our sample period of is categorized as a 4

16 time when raising capital through IPO is worst among any decades. 8 Ritter (23) points out two reasons for firms seeking an alternative way of going public. First, Sarbanes-Oxley Act of 22 (SOX) has imposed substantial costs on publicly traded firms, especially small firms, discouraging these firms from going for IPO. Second, the investment banking fees for IPOs are still quite high in the U.S., making small firms too costly to raise funds in the IPO market. 9 So, reverse merger has become popular for private firms as an alternative way of going public. The data for each case are investigated through SEC filings and Factiva. The EDGAR system in the SEC web site ( offers free file transfer service of proxy statements from 994. Since we examine survival of three years after reverse merger, our sample period is the period. The information used in our paper is verified from their proxy statements, - Ks, and other SEC filings such as -Qs, 8-Ks, and press releases. If both firms are already public, or the merger is an ordinary acquisition (i.e., a public firm acquires a private firm), these cases are excluded from the sample. All utilities and financial firms are excluded because of their highly regulated nature. We provide a list of our sample of completed reverse mergers for the period in the Appendix. In the Appendix, the information on public shells, target firms, the announcement dates, the completion dates, actual survival, and predicted survival probability are provided. To determine if the merger is ordinary or reverse, the cases for mergers of one public and one private firm are considered, and the change of control and the public status of the newly combined firm are the mandatory conditions. If the change in control happened to the private firms, these cases are excluded. Some cases are simply firms going private, while others are 8 According to Gao, Ritter, and Zhu (22), during the 98-2 period, an annual average of 3 firms went public in the U.S., while an annual average of only 99 firms went public during the 2-2 period. 9 As shown by a recent study by Abrahamson, Jenkinson, and Jones (2), until lately most moderate-size IPOs in the U.S. pay investment banking fees of 7%, whereas the fees in Europe would typically in the vicinity of 4%. 5

17 cases of the private firm management selling their company to a public firm. Therefore, these cases are excluded and the control transfer is investigated carefully. The motivation for the mergers, the information on new officers and directors, the listing status, and the financial condition are checked from the SEC filings (-K, -Q, and 8-K) and proxy statements. We use two approaches to obtain the initial sample pool. The first approach is that of selecting all U.S. merger cases with public-target and private-acquirer. We impose such restrictions as excluding asset acquisitions and including all stock swaps and tender mergers. The second approach considers the reverse merger cases with private-target and public-acquirer. This is a typical case of reverse mergers that on the surface it appears to have a public firm acquiring a private firm, while in fact the reverse is at work internally. Using the Securities Data Corporation (SDC) Mergers and Acquisitions (M&A) database, reverse merger criteria are set for the cases in which the acquirer (the public shell) internally transfers its control to the private-target. The initial sample pool for this type of reverse merger in the U.S. between 997 and 29 consists of 47 cases. Applying the mandatory conditions and the data availability as filters, this approach yields 37 reverse merger cases where the private firm became public. Out of 37 total sample firms, one firm is listed on the SE, one firm on the AMEX, and 3 firms on the ASDAQ, while as many as 4 firms (75.9 percent) are traded on the OTC Bulletin Board. In Table, the distribution of reverse mergers completed in the U.S. for the period is provided. A total of 37 reverse merger sample firms are obtained from the SDC M&A. All utilities and financial firms are excluded because of their highly regulated nature. Each sample is manually investigated through SEC filings (proxy statements, 8-K, and -K) and Factiva to collect such information as the survival data, financial statement, and governance characteristics. The announcement and completion dates of reverse mergers are verified from SEC filings and 6

18 Factiva. Among the 37 reverse merger sample firms, 95 reverse mergers are completed in the same year as their announcement year, while 39 reverse mergers are completed in one year after its announcement year, and 2 and sample firm are completed in two years and in three years, respectively. We find that 93 (8) of the 37 cases survived at least three (five) years after the reverse merger, while 44 (56) cases of the sample failed within three (five) years after the reverse merger. Table also shows the annual distribution of failures after reverse mergers. It shows that as many as 39 firms (69.64%) of failed firms fall in the range of one to three years after reverse mergers. [Insert Table here] Since our sample covers from 997 to 29, some of the Internet bubble period of the mid to late 99s, which is also known as the hot IPO wave, is included in the sample. Therefore, we examine whether firms in the technology sector have varying performance at work by introducing a technology sector dummy variable. This variable will represent firm s business being related to internet technology and information technology and control for the time-trend effect with this dummy. We also include year and industry dummies in our multivariate analysis. During our sample period, there was a passage of the Sarbanes-Oxley (SOX) Act of 22. We have conducted the pre-sox and post-sox panel studies, but found no statistically significant difference in the results between the two sub-sample periods.. Descriptive Statistics IV. EMPIRICAL RESULTS 7

19 Table 2 presents the descriptive statistics of the variables for the whole sample. The interest coverage ratio of the shell firms ranges from -2,79 to with its mean (median) of (-4.34). This is because most of the shell firms face net losses, and some of them show a large amount of depreciation expenses. It seems reasonable to find that the profitability measure (ROA) of the shell is negative on average (for both mean and median) in the whole sample. Of the firms, 36% in the sample are associated with CEO-founders, and 4% are CEO-shells of the new firm s management. Table 2 also shows that a mean (median) of 2.4% (4.7%) of shares are owned by the CEO of a new corporation after reverse merger. The average (median) board size is 5.6 (5.), while the average (median) board member tenure is 3.3 (2.74) years, and 8% of new corporations after reverse mergers involve a board where only a fraction of the board members is elected each time (i.e., staggered board dummy). More than half of the sample firms involve outside blockholders (73%). [Insert Table 2 here] 2. Methodology The sample is grouped according to survivals and failures within three years after the firms go public. We examine the sample characteristics and the existence of significant difference in all variables in both groups pair-wise. Univariate tests are used to compare the variables between survivals and failures. To test the significance of mean differences between the two groups for each variable, a t-test is used. To test the significance of median differences, the Mann-Whitney U test is applied, since the groups do not have equal variances. In addition, multivariate tests are used to test the effects of financial and corporate 8

20 governance variables on the state of new firms after the reverse merger. The dependent variable in these models is the probability of survival. Since the dependent variable is given as a dummy variable that takes zero or one, we use binary logistic regressions. In other words, the probability of survival [p(s)] is described by a binary variable y, where y is one when a new firm survives, and zero when it fails. Therefore, our model is given by, p(s) = βo + Σi βixi + Σi γjdj +ε, where Xi = continuous and ordinal variables considered in the hypotheses, and Dj = dummy variables. 3. Univariate Test Results The test results of mean differences between the two groups are summarized in Table 3. Table 3 shows univariate test results for three years after reverse mergers. In comparison with the failure group, the survival group shows more distress cases (lower shell interest coverage ratio), higher shell profitability (Shell ROA) before the reverse merger, lower shell return volatility, higher chance of the current CEO as the founder of the firm, higher CEO ownership, larger board size, longer average tenure of the board, more venture involvements, and less involvement in internet or technology sector, on average. Among these variables, significant differences in means are found for the following variables: the total assets for the new company, CEO ownership, board size, staggered board dummy, and venture dummy. Regarding the total assets for the new company, CEO ownership, the board size, average tenure, staggered board dummy, and venture dummy, the survival and failure groups show significant difference in median values. 9

21 The results from Table 3 indicate that there are differences in firm characteristics of surviving firms and failed firms. Surviving firms tend to enjoy greater cash liquidity. However, the differences in mean and medians are not significant. Both the survival and failure groups show negative Shell ROA before the reverse merger, while the survival group shows relatively higher ROA for the shell. Surviving firms have much larger total assets for the new firms. The t-test for differences in means and the Mann-Whitney U test for differences in medians are significant. The greater expansion after mergers means private acquirers are relatively smaller than the shells (size multiple). The corporate governance variables in Table 3 also show significant differences between surviving firms and failed firms. Surviving firms have a higher percentage of retaining the founder as the current CEO. Also, CEO of surviving firms holds relatively higher ownership of a new firm after reverse merger. In addition, in comparison with the failed firms, surviving firms tend to show greater size of the board and longer tenure of boards. The mean (median) board size for survived firms is 5.42 (5.) while the mean (median) board size for failed firms is 4.3 (4.). This suggests that there may be a nonlinear relation between board size and firm value (or firm survival), which will be further examined later. In other words, firm value will increase with board size up to an optimal level and then will decrease. The board of surviving firms tends to show a higher proportion of directors being placed in different classes after merger. The differences in both mean and median are significant. Our results on board structure are broadly consistent with the findings from extant studies such as ermack (996) and Eisenberg, Sundgren, and Wells (998). We also find that the survival group is associated with a longer tenure of the BOD. Finally, our findings show that surviving firms are less associated with the technology sector, and involve more venture-owners in their deals, suggesting that the role of 2

22 value-maximizing corporate control is crucial for the post-reverse merger success. [Insert Table 3 here] 4. Multivariate Test Results To test for firm financial characteristics and corporate governance factors in affecting the probability of survival after reverse mergers, we employ a binary logistic regression analysis in our empirical study as discussed above. Table 4 shows logistic regression estimation results for the probability of survival of reverse mergers in three years. The dependent variable is a dummy variable which takes if the sample firm survives three years after the reverse merger; otherwise it is zero. There are 37 total sample firms with reverse mergers completed during the period in the U.S. Shell interest coverage ratio shows a negative relation with reverse merger success, but the effect is insignificant. We also find an insignificant relation between the shell profitability (ROA) and the firm survival. The return volatility variable for the new company is weakly negatively associated with the firm survival. Size multiple, defined as the new company s total assets divided by the shell company s total assets, shows insignificant relation to survival. Since we are also interested in examining the role of corporate governance variables in firm survival after reverse mergers, the estimation models in Table 4 have a number of corporate governance explanatory variables. While the coefficient for the CEO-founder dummy variable, which takes if the CEO after reverse merger is the founder of either of the shell or the private target and zero otherwise, turns out to be positive in all specifications, but it is insignificant. CEO ownership variable (the percentage of shares owned by the CEO of a new corporation after 2

23 reverse merger) is generally positively related to survival. As the CEO of the new firm holds more shares, it is more likely to be successful in reverse mergers. We expect some non-linear relation between the board size (and average board tenure) and reverse merger survival. Therefore, we use a quadratic equation to examine this relation. Models (2), (4), and (6) of Table 4 show that there is no significant non-linear relation between board size and the probability of the reverse merger firm survival. The coefficient for the squared (logged) board size is insignificant and that for the (logged) level of board size is either insignificantly positive or insignificantly negative depending on models. We have conducted chi-square tests to see whether board size and board size squared are jointly statistically significant. Overall, we find insignificant test results. Specifically, for models of Table 4, we find: for model (2), χ 2 (2) =.6 (significance =.738); for model (4), χ 2 (2) =.77 (significance =.684); for model (6), χ 2 (2) =. (significance=.9943). However, the coefficient for average tenure is marginally positive while the coefficient for the squared average tenure is significantly negative in models (2), (4), and (6) of Table 4. This indicates that a concave relation is at work for the average board tenure and the probability of reverse merger survival. This finding suggests that if the average tenure of the new public firm s board becomes too long, the board members and the firm management may be entrenched and may not work for the best interests of shareholders. The average tenure maximizing the probability of success after reverse merger is 5.47 years for three year survivals. The percentage of the observations with average tenure close to the maximum average is.95 percent (i.e., 5 out of 37 sample firms). By solving the probability of success (e α+βx / + e α+βx ) for the actual average tenure and maximum average tenure, we find that the probability of success increase from.6576 to.733 for three years after reverse merger if a company has the board members with maximum average tenure from an actual average tenure. Regarding how much of the variation in survivability is due to the average tenure of board members and the elasticity at the mean, we find the following. In Table 4, the elasticity of dependent variable (Survivals in 3 years) with respect to average tenure at the mean for model (2) is əlny/əlnx =.6995 with its z-value of.99 (P> z :.47; for model (4), əlny/əlnx =.689 with its z-value of.57 (P> z :.6); for model (6), əlny/əlnx =.5226 with its z- 22

24 When a new corporation after merger has a board in which directors are placed in different classes (i.e., a staggered board), firms are more likely to survive after reverse merger. This result is consistent with the view by Bates, Becher, and Lemmon (28), who argue that staggered board reduces the likelihood of receiving a takeover bid, and that the economic effect of bid deterrence on the value of the firm is relatively small. The outside director percentage shows a weakly positive relation with survival, and outside blockholder dummy shows insignificant effect on survival. The findings of a significant positive relation between venture backing and the probability of reverse merger survival are consistent with the findings of Brav and Gompers (997), Jain and Kini (2), and Howton (26). In all models, the Chi-square statistics are very significant with their values ranging from to Therefore, we see that these interpretations of the variables, which are significant in the models, are valid for their related models. Pseudo R-squares of this study range from 2.3% to 35.24% in Table 4. [Insert Table 4 here] We further implement exclusion tests (untabulated) to examine whether we can exclude corporate governance variables as a group from the regression. This confirms that corporate governance variables are more important than firm financial characteristics as a group in explaining the probability of the reverse merger survival in three years. In order to investigate value of.83 (P> z :.67). The null hypothesis of the exclusion restriction test (untabulated) is such that the coefficient of pre- and postreverse merger firm financial characteristics variables as a group is zero is not rejected at the % significance level with χ2 (7) = 8.9 (significance level =.3245). However, the null hypothesis that the coefficient of eight corporate governance variables as a group is zero is rejected at the % significance level with χ2 (8) = 22. (significance level =.49). When we replace Outside Director Percentage with a squared term of Ln(board size) for corporate governance variables, we obtain a very similar result with χ 2 (8) = 2.27 (significance level =.5), which is statistically significant at the % significance level. 23