What is a reverse triangular merger, and why would a buyer propose one?

A reverse triangular merger is a way to buy a company in which the buyer creates a new company, the merger sub, and merges it into the target. The target survives, owned entirely by the buyer, and keeps its contracts and permits, while its shareholders receive the cash, buyer stock, or mix the merger agreement sets.

The letter of intent, or the first draft of the merger agreement, says the buyer's merger sub will merge with and into your company, and your company will survive. If you own the company with partners, family members, or employees who hold shares, the buyer is proposing a way to buy all of it at once.

How does a reverse triangular merger work?

The buyer creates a new company for the deal and merges it into yours. Three companies take part (the buyer, its merger sub, and yours), which gives the structure its name, and "reverse" means the target is the one that survives.

1. The buyer forms a new company, usually called the merger sub, and owns all of its stock.
2. Your company's board and shareholders approve a merger agreement with the buyer and the merger sub.
3. At closing, the merger sub merges into your company and stops existing.
4. Your shareholders' shares are converted into the agreed cash, buyer stock, or both, and the buyer's shares in the merger sub become your company's stock.
5. Your company carries on, owned entirely by the buyer.

Why would a buyer propose a reverse triangular merger?

It buys every share with one approval and leaves your company, with its contracts, in place.

One vote binds every shareholder. In a stock purchase, each shareholder has to agree to sell. In a merger, the shareholder vote the law requires binds them all: under Delaware's corporation law, for example, a majority of the outstanding stock entitled to vote (§251(c)), unless the certificate of incorporation requires more (§102(b)(4)). Each state sets its own rule, so read the statute of the state where your company is incorporated.

The company that signed your contracts survives. Under Delaware's statute, when a merger takes effect the merged company's property and rights vest in the surviving corporation, and its debts and liabilities attach to it (§259). In a reverse triangular merger the survivor is your company, so its contracts, licenses, and permits stay in its name. A contract with a change-of-control clause can still give the other party a right to consent or to end it, so list those contracts early.

Your company's liabilities also stay with your company, which the buyer then owns as a separate company. And when at least 80% of your company's stock is exchanged for the buyer's voting stock, the merger can be tax-deferred for your shareholders, as the section on taxes explains.

How does it compare with other ways to sell a company?

The difference is which company survives and who has to sign or vote.

Asset sale vs stock sale compares the first two in detail, including what each means for your taxes.

How is a reverse triangular merger taxed?

It is a taxable sale for your shareholders unless it qualifies as a reorganization under section 368(a)(2)(E) of the Internal Revenue Code. The statute sets two tests.

• Your shareholders exchange, for the buyer's voting stock, shares that amount to control of your company: at least 80% of the voting power and at least 80% of each other class of stock (section 368(c)).
• After the merger, your company holds substantially all of its own assets and those of the merger sub.

The regulations add more, including continuity of the business and of the owners' interest (Treasury Regulation 1.368-1). The reorganization rules apply to corporations, S corporations included, so an LLC taxed as a partnership falls outside them (Treasury Regulation 1.368-2).

When the merger qualifies, a shareholder recognizes no gain on the buyer stock received (section 354), recognizes gain up to the cash and other property received (section 356), and carries the basis of the old shares over to the new stock (section 358). That is why people call it tax-free, though the tax on the stock is deferred until the stock is sold.

When it does not qualify, the exchange is taxable like any sale (section 1001), and a deal paid mostly in cash cannot meet the 80% test. A forward triangular merger works under different tests: in the regulations' own example, a merger paid 40% in stock and 60% in cash keeps the continuity of interest it needs (Treasury Regulation 1.368-1(e)(2)(v)). Work out what you would keep after tax under the structure proposed and under its alternatives, for your entity type, before you agree.

What should you check before you agree to a reverse triangular merger?

The structure decides how each shareholder is bought out and taxed, so read these points in the draft.

• The mix of cash and stock. If you take the buyer's stock, part of your price depends on what that stock is worth after closing, and on whether and when you can sell it.
• Shareholders who may vote no. Know where each holder stands before you sign, and ask your attorney what a holder who votes no can do in your state.
• Contracts with change-of-control or consent clauses, and which ones need the other party's approval.
• Options, warrants, and shareholder agreements. The merger agreement has to say what happens to each.
• Escrow, indemnities, and any earn-out, which work as in any other sale. How to structure an earn-out agreement covers the last.

The letter of intent settles the main terms, the structure among them, so raise these points before you sign it, as what happens after you accept a letter of intent explains. If you own every share and the price is all cash, a plain stock purchase does most of the same work.

What to do next

1. Ask the buyer why it chose this structure and what mix of cash and stock it has in mind.
2. List every shareholder, option holder, and warrant holder, with what each would receive.
3. List the contracts, licenses, and permits with change-of-control or consent clauses.
4. Calculate your after-tax proceeds under the proposed structure and its alternatives, for your entity type.

Our M&A advisory work builds the valuation, models your proceeds under each deal structure, and prepares the materials a buyer asks for.

Questions owners ask

Can a buyer use a reverse triangular merger and pay all cash?

Yes. The structure works with any mix of cash and stock, and only the tax result changes. An all-cash reverse triangular merger is taxable to your shareholders like a sale of their shares, and the buyer still acquires every share through one shareholder vote.

Does a reverse triangular merger work if my company is an LLC?

The merger itself can. Delaware's LLC law, for example, lets an LLC merge with a corporation or another business entity (§18-209). The tax rules in this article apply to corporations, so an LLC taxed as a partnership follows the partnership tax rules instead, and the after-tax math has to start there.