The Benefits and Challenges of Trading in a Shell

Many comments I have received on the RM blog have suggested that I push the benefits of the non-trading fully reporting “virgin” shells to the exclusion of all other types of shells and methods of going public. While I clearly tout the advantages of the virgins, I acknowledge and strongly support the use of other types of shells and going public methods, depending on the circumstances. In this week’s post, I’d like to focus on the direct debate between a fully reporting OTCBB trading shell and a virgin shell, and welcome all comments, thoughts and suggestions. Disclaimer: I am a principal in six virgin shells in addition to having represented dozens of clients in creating over 110 virgins in the last two years.

1. What are the comparable costs? As we know it costs about $700-$800,000 to acquire a controlling interest in a trading shell on the OTCBB, including a slug of equity to the shareholders of the shell as well. If there is no cash to be paid, the shell holders generally look for about $2.5-3.0 million in equity value as part of the merger. Virgin shells cost about $200,000 to acquire 100% of the stock, or about $1.0-1.5 million in equity value if no cash is being paid.

2. Doesn’t trading in a shell right after a deal make a difference? As I describe in my book, imagine a trading shell with 1 million shares in its public float. Upon a merger, the private company’s shareholders obtain 90%, or 9 million shares out of a new total of 10 million shares outstanding. The new 9 million shares are initially restricted under SEC rules and cannot trade until registered (or an exemption becomes available). Thus upon closing only the 1 million may trade until a registration is completed. Of that 1 million, typically one promoter controls about 2/3, and he or she is not likely to sell anytime soon. Thus in our example about 300,000 shares, or barely 3% of the total stock, is hoped to be trading until a registration of more shares is completed, about 3-4 months after closing the merger. In most cases very little trading actually occurs during this time, as there are so few shareholders actually interested in trading and able to do so. Plus, who are the shareholders in an OTCBB shell? They all invested in some other business and predicting how they will react to the merger is a guessing game at best. In a virgin shell, no shares can trade prior to a merger. After the closing, a registration must be completed for some shares to trade. In that same 3-4 month period that 3% of a trading shell’s shares are sort of trading, the holders in a post-merger virgin shell must wait. But at the end of the 3-4 months, both shells are essentially in the same place, with tradeable shares and a ticker symbol. So the first question is, what is it worth to have 3-4 months of sporadic trading of about 3% of the stock? Is it worth the difference between $200,000 and $750,000? In some cases yes, as I will mention below.

3. What other risks exist in a trading shell merger?

* In way too many mergers with trading shells, illegal insider trading occurs before or sometimes after an announcement of a transaction. Under certain circumstances the company can be liable for this trading, not just the insider traders and tippers themselves.
* Due diligence can be challenging, and at best is burdensome. A trading shell had some other business in it before that either closed down, got sold or went bust. You must “scrub” the past and be certain that no liabilities from prior operations will come back to haunt you. In the end you can never be certain, and shell principals these days generally are not willing to personally guarantee anything, leaving no one to sue if there is a problem after closing. In a recent transaction, after all our due diligence, a year later an individual arrived announcing he had 1,000,000 warrants to buy stock of the former shell. He had proper paperwork that simply was never disclosed to us as private company counsel. The company ended up settling with this individual for $1 million and had no recourse against the shell principals because there was no evidence of fraud. True story. Due diligence with a virgin shell takes about five minutes.
* The supposed “thousands” of shareholders in a shell may be illusory, as in many cases where shareholder addresses had not been updated in a number of years, mailings get returned and shareholders are “lost.” In a recent transaction a shell touted its 400 shareholders, but when the post-merged company sent out a proxy statement for a reverse split, one half of the mailings came back. So there were only 200 shareholders. Thus you may have many less shareholders than you think.
* If you can work with an experienced and respected RM professional who has acquired the shell, scrubbed it and feels comfortable, hopefully a number of these concerns can be ameliorated.

4. But doesn’t trading get going faster with a trading shell since it has so many shareholders to start? The answer is generally yes. But again, you have the uncertainty of not being able to predict exactly how the shareholders of the shell, who invested in some other company, will react to the transaction. But that said, if there is urgency in developing trading in the very short term, there may be a benefit to a trading shell merger.

5. Can a virgin shell be used if a company wants to go right on Nasdaq or Amex? Generally not, because most higher exchanges require 300-400 shareholders and virgins often do not have that. Thus, one true benefit of merging with a trading shell is for a company with a very imminent intention to apply to a higher stock exchange. If that plan is a year or two away, however, the shareholder base can be built over time, working with a strong investor relations firm, even if it is not in place at the time of the merger.

6. Don’t some investors require a trading stock before putting money into a PIPE? Absolutely. There is a small cadre of PIPE investors who are either obligated in their funds or simply have a policy to be able to mark their investment to market every day. If there is no trading stock they are not able to do this. Thus, for this group of investors, a trading shell seems necessary.

7. But how is a merger with a virgin better than a self-filing by a private company? Some say, what’s the point of merging with a virgin that has only a few shareholders and give up 5-10% of the company to the shell principals vs. having the private company complete a self-filing of its own SB-2 or 10-SB? The answer is, simply, timing of financing. The virgin does not have great utility, frankly, if a company (a) has sufficient shareholders to be able to trade on the OTCBB (generally 35-40 holders with at least 100 tradeable shares), (b) has patience to wait, and possibly not be able to obtain financing, during the 5-8 months (sometimes more) while its registration winds its way through the SEC to approval vs. the three months or so it takes to complete a merger with a shell and (c) has on its management or advisory team a strong Wall Street hand who can help “build a public company,” something usually brought along with shell principals.

8. Some say Chinese companies only will merge with OTCBB shells. False. A number of Chinese reverse mergers have now been completed with virgin shells.

9. Some say virgins have fallen out of favor because fewer new shells are being formed. False. There was a pause last fall because of the brouhaha over Rule 415. That pause has ended. Also, there was an initial buildup of inventory in the year leading up to last summer, and players are simply using up the inventory before adding more shells. In fact, we are already gearing up for the next batches for several larger players.

10. Does the Rule 415 mess help or hurt trading shells? As mentioned in a previous post, senior SEC staffers have indicated to me that their concern in the whole 415 problem was the situation where holders with tradeable shares are very suddenly and dramatically, almost without notice, diluted very substantially through the registration for resale of a very large number of shares. This is indeed a real problem in the case of a trading shell. However, in a virgin shell, there are no holders with tradeable shares prior to a merger and subsequent registration, and before a single share is tradeable all shareholders know who will be registered. When I pointed this out to staffers, they confirmed the logic that there is less concern in the case of the virgin scenario. Thus, I believe there is a greater likelihood that you can convince the staff to register a greater percentage of your stock following a merger with a virgin shell than a trading shell.

11. Don’t investors just not “get” the non-trading thing and have to see a ticker to feel comfortable? In some cases yes. Despite our efforts at education and making investors understand the relative benefits of virgins, some simply feel it is much harder to attract investment to the reverse merger transaction without a trading stock. We are slowly changing these perceptions, but old habits certainly die hard.

Conclusion: There is a place for all kinds of options. Trading shells make sense in certain situations, virgins in others, self-filing in others, merging with a SPAC in other situations. In general when a client presents to me, I discuss all options candidly and objectively.

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