Reorganisations with negative equity: what are the possibilities?

Is a merger or demerger possible if one of the companies involved in the reorganisation has negative BE GAAP equity? Such a scenario can occur in the acquisition or demerger of a start-up or scale-up that is not yet profitable. The legislative framework for this matter is not very clear and in the legal doctrine this subject has already led to much debate.

Contribution versus transfer of assets

Since the introduction of a legal concept for a merger and a demerger, both no longer qualify as a ‘contribution in kind’ of a certain asset, but as a ‘transfer of assets’. The assets to be transferred in the case of mergers and demergers (including partial ones) do not therefore necessarily need to have a positive equity value.

No negative contribution

A contribution transaction with a negative equity value is not possible. The application of the going concern principle implies that each contribution transaction results in a capital increase for the acquiring company to the amount of the BE GAAP equity value of the contributed assets. A contribution is therefore only possible if the equity value of the assets to be contributed is positive. One possible solution is to revalue the asset to be contributed to the extent that this technique is workable or appropriate.

Position of Information Centre for the Auditing Profession (ICCI)

Sister merger

A sister merger with a company with negative BE GAAP equity is possible. The condition is that it is proven that the negative net assets of the company were underestimated as a result of non-expressed capital gains on assets or on an intangible ‘goodwill value’.

In any case, the ICCI's message is that the outcome should always be a positive asset transfer. You can't have a negative transfer. Specifically for this case: In determining the number of new shares to be allocated as a result of the asset transfer on the occasion of the sister company merger, the non-expressed part of the aforementioned capital gains may be taken into account.

Partial demerger

The ICCI issued a similar opinion on the possibility of a partial demerger if one of the companies involved has negative BE GAAP equity. This is possible if the economic value of the items to be transferred is positive, despite a negative equity. The demerger must take place between existing companies. The acquiring company should be able to absorb the losses of the demerged company without applying the alert procedure. If, on the other hand, the demerger is carried out with a newly created company, the undervalued assets of the company to be demerged must first be revalued in order to take its negative equity out of the red.

In other words, it must be shown that the net assets of the company with the negative equity have been underestimated and that a revaluation must therefore be recognised. The company must, however, be able to demonstrate that this revaluation is justified with proper application of accounting law.

CBN draft opinion of 2 June 2021

According to the Commission on Accounting Standards (CBN), a merger or demerger can be performed if the carrying amount of the net assets of one of the participating companies is negative, on condition that the economic value (i.e. fair value) of the net assets is strictly positive. In this way, the transaction meets the definition of a merger or demerger. If the economic value of the acquired or demerged company is negative or zero, the transaction cannot be regarded as a merger or demerger.

What does the ruling commission say?

Former position

According to the ruling commission, the equity value of the equity to be transferred of the acquiring company had to be brought to a positive level before the restructuring. It was not convinced that a demerger or merger was legally correct if it involved the transfer of equity with a negative carrying amount or if the acquiring company had a negative carrying amount.

This approach was probably prompted by the fear that the classification of such a transaction as a merger or (partial) demerger is disputable in company law. This obviously has a great impact on the applicable accounting and tax regime.

Updated position

Today, the ruling commission believes that the transfer of negative equity or the transfer to a company with negative equity in the case of a (partial) demerger or merger is feasible if the value of the transferred equity or of the acquiring company is positive from an economic perspective.

It clarifies this position by emphasising that in such case an exchange ratio can be determined. This allows the transaction to take place in accordance with the provisions of company law.

Special case of silent merger

The vast majority of the legal doctrine agrees that a parent-subsidiary merger, also known as a silent merger, is always possible, even if the economic value of the company to be acquired or the acquiring company is negative. In that case, an exchange ratio of shares does not need to be determined, since no new shares need to be issued. The acquiring parent company already owns all the shares of the acquired subsidiary.

Nevertheless, the legal doctrine is not blind to the fact that the accounting treatment of a parent-subsidiary merger with negative equity raises specific questions for which there are no ready-made answers yet. That is why it is important to discuss such a reorganisation thoroughly and in a timely manner with the relevant statutory auditor.

If you have any questions on this subject or on reorganisations in general, do not hesitate to contact our experts.