The Shell Trap
By
William Cate
[http://home.earthlink.net/~beowulfinvestments/]
[http://home.earthlink.net/~beowulfinvestments/globalvillageinvestmentclubwelcome/]
Publicly traded shells overcome two of the three primary obstacles to becoming a U.S. public company. The private company avoids the U.S. Securities Exchange Commission (SEC) initial registration review process. By buying a shell, the private company reduces the time it takes to go public from over one year to several weeks. The odds of a registration effort getting a SEC "Effective Letter" are better than even. Because the shell is publicly trading, the odds that the shell will continue to trade are almost certain. Shells win on time and certainty issues.
THE PROBLEMS
However, buying a trading shell means dealing with a different set of problems. The Industry Axiom that there is no such thing as a clean shell is true.
1. Shells aren't clean because the shell sellers usually hide shares or access to shares that will be sold after the buyer takes possession of the public company. The shell buyer tries to strengthen the public company's share price. The past insiders sell undisclosed shares into this effort.
2. If the shell has an operating history, there is always the risk of litigation by the SEC or by third parties.
3. Actions taken to clean up the shell, such as reverse splits of the stock are certain to antagonize existing public shareholders and their brokers, who are often the company's market makers.
While professionals can help a shell buyer reduce these and related risks, they can't be eliminated.
REVERSE MERGERS
In an effort to overcome the third primary obstacle to doing a SEC registration, most shells are sold as reverse mergers. The shell insiders and public retain their shares. The publicly traded Shell Company issues stock for the private company that gives the shell buyer over fifty percent control of the trading shell. The shell insiders expect to make their money by selling their shares.
Without a doubt, a reverse merger is the most costly way of going public in the United States. It ensures that no knowledgeable investor will do a private placement financing of the resulting public company. He knows that the shell buyers will dump their stock into any rising price, thus depressing the share price. He also knows that the added investor relations’ costs of supporting all those extra shares will kill off the company quickly. And failure to spend those funds will do the killing just as effectively.
FALSE PERCEIVED SAVINGS.
In April 2005, you can buy a public shell with 90% control that trades on the Over-the-Counter Bulletin Board (OTCBB) for about US$1.7 million. The costs of doing a reverse merger are about $200,000. The buyer appears to save US$1,500,000. However, the insiders have their shares and will sell them. The buyer must pay the investor relations costs to find the investors for these insider shares.
Let's assume that the shell insiders have 3 million shares and the buyer pays to take down these shares at an average price of US$4/share. The investor relations costs to create the buying will be about US$750,000. At this point, the reverse merger is still a good deal for the buyer because they have spent a total of about US$950,000 against a registration cost of at least $1.7 million. They have saved US$750,000.
MANAGING THE FLOAT
The stock held by the public is called "the float." As a general rule, the float trades every quarter. If the public can't sell their shares in any quarter, the share price drops. If buying exceeds the float, in any quarter, the share price moves up. The three million shares of shell insider shares are now part of the float. To hold the US$4/share price, the buyers must spend US$750,000 per quarter in investor relations' costs. In one year, their publicly traded shell will cost them US$3 million to buy the shell insiders' shares and repeatedly find share buyers each quarter for the resulting float. Almost always, the investor relations' costs will eventually bankrupt the public company. It's a downward spiral of high overhead, without offsetting income.
The reverse merger shell buyer seeking a fund or angel to do a Private Placement almost always fails. The potential investor should realize that the public company will be spending more money on investor relations in the year they must hold their shares than they will usually receive from their investment in the public shell company. Logic and past experience correctly tells the investor not to risk their money in the Private Placement. The fact is less than 10% of the investors in reverse merger private placements ever recover their risk capital.
A WISER PATH
If you are seeking a backdoor to becoming public in the United States, it isn't buying a trading shell. Doing so is a trap that will leave your company with few options in two to three years. There is a far wiser path for the CFO who understands the dangers of the Shell Trap. Learn it.
If you need help finding your way through the backroads of the public company process, you can email William Cate at: Beowulfinvestments@Earthlink.net
To contact the author visit:
[http://home.earthlink.net/~beowulfinvestments/]
[http://home.earthlink.net/~beowulfinvestments/globalvillageinvestmentclubwelcome/]
About the Author
He has been the Managing Director of Beowulf Investments [http://home.earthlink.net/~beowulfinvestments/] since 1981 and is the Executive Director of the Global Village Investment Club [http://home.earthlink.net/~beowulfinvestments/globalvillageinvestmentclubwelcome/]