Tip of the Week: Derivatives in Shells

Sometimes a shell contains previously issued options, warrants or other securities that have the right to convert or exercise into common stock. These “derivative” securities have many valuable purposes in normal operating businesses. Typically these securities are exercisable or convertible at a price that is much higher than the stock is trading at on the day of issuance (these are called “out of the money” securities). In other cases warrants were given to insiders and may have very low exercise prices (these may be “in the money”).

If one is looking to acquire or merge with that shell, these derivatives should be examined. If they are out of the money, one can imagine them as a positive if cash is required to exercise or convert. Convertible preferred stock, for example, does not require a cash payment to convert to common stock. But if a shell’s stock is trading at, say $1.00 and the warrants are exercisable at $10.00, a company merging in might feel that if and when they get their stock trading above $10.00 the option or warrant holder will be encouraged to exercise to pocket the “spread” between their exercise price and the trading price. Upon paying the exercise price, the company achieves a financing. If derivatives are already in the money, an acquirer of the shell may simply consider the derivatives as if they were already exercised. For example, if the shell has 1 million shares and 1 million warrants, exercisable at a very low price, it might be reasonable to simply assume that the shell has 2 million shares, since it seems likely that the warrant holders will exercise.

Some feel there is an “overhang” represented by the derivatives. Whether this is an issue depends on the number of warrants and to the extent they are in or out of the money. If you control a shell, and prefer to eliminate any derivatives contained therein, there are a variety of tactics that can be employed depending on the company’s circumstances.

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