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Publicly traded
shell corporations are often touted (usually by the organizers and
promoters of the shell) as a cost-effective means of "going
public." While shell corporations may appear to be an attractive
alternative to a conventional registered initial public offering
("IPO"), the true cost of going public through a shell
corporation is usually much greater than a conventional IPO. This
article evaluates the purported benefits of shell corporations and
discusses the true costs "going public" in this fashion.
It is important
to understand the process of taking your company public using a
shell corporation. There are two types of shells: (i) those with
common stock registered with the Securities and Exchange Commission
("SEC") and traded on Nasdaq or on the NASD's OTC Bulletin
Board ("OTCBB") and (ii) those with common stock that
is not registered with the SEC and traded in the "pink sheets"
at www.pinksheets.com. In order for securities to trade on Nasdaq
or on the OTCBB, the common stock must be registered with the SEC.
Regardless of
the type of shell, typically, the first step in going public with
a shell is a "reverse merger" of your company into the
shell corporation: your company is acquired by the shell corporation,
which issues newly issued shares to the stockholders of your company,
in exchange for your company's stock. The shell corporation is the
surviving corporation in the merger, and you and your shareholders
end up owning 80-90% of the outstanding shares of the shell after
the merger. Conversely, the existing "public" shareholders
of the shell end up with the remaining 10-20% of the shares.
Assuming that
the shell's securities are registered with the SEC, immediately
upon consummation of the merger, the shell (i.e., you) must file
a current report with the SEC on Form 8-K. This Form 8-K report
is considered by the SEC to be like a registration statement, which
must provide a full description of the merger and the business of
your company. The requisite disclosures are essentially identical
to those required in a conventional IPO prospectus. Audited financial
statements are also required but may be filed on a delayed basis.
Once the merger
takes place, your company becomes "public." The consummation
of the reverse merger can occur in a matter of weeks within locating
the shell. The short time in which it takes to become a public company
is one of the benefits touted by shell promoters. To be sure, upon
the effective date of the merger, you and your company become subject
to all of the reporting obligations and liabilities under the federal
securities laws. But the process of going "public" really
just begins at this point.
The following
are a few of the purported benefits of going public through a shell
and the true costs associated with it:
- "Save
Time" - using a public shell to 'go public' saves time,
taking as little as 45 days to complete." In a conventional
underwritten IPO, after locating an underwriter and working with
them to carefully craft a disclosure document or prospectus, the
prospectus is filed with the SEC in a registration statement that
is subject to SEC review and clearance before the public offering
can commence. This SEC review typically takes between 45-60 days.
In the case
of shells with common stock already registered with the SEC,
there is no registration to be filed. The Form 8-K current report
of the merger, however, is considered by the SEC staff to be
a registration statement, and, most importantly, is subject
to the same SEC review procedures applicable to a registration
statement. Unlike a registration statement for a conventional
IPO, SEC review of the Form 8-K filed in a shell transactions
can take several months, because the SEC staff scrutinizes any
filing by a public shell. The staff typically issues several
comment letters on these filings and likely will require substantial
information about the shell's prior history in an effort to
ascertain whether the shell and its promoters have ever violated
federal or state securities laws. Moreover, because your company's
stock continues to trade during this period of review, if the
SEC finds material deficiencies in you Form 8-K disclosure document
(and they likely will), the SEC review could give rise to claims
by shareholders against you and your company for damages.
- "Saves
Money" - using a public shell is less costly than an
underwritten IPO, and there are no underwriter commissions or
fees when using a shell." Shell corporation promoters charge
between $50,000 to $150,000 for shells. In a conventional underwritten
offering, investment banking fees and commissions to the underwriter
may exceed 10% of the total offering proceeds. These fees, however,
are to compensate the underwriter for raising funds from investors.
Becoming public through a shell transaction, in and of itself,
will not generate any financing for the company…if the shell
transaction also contemplates an offering to investors following
the reverse merger, there likely will be similar costs and fees
associated with such financing.
The real
cost of going public using a shell is the 10-20% equity you
give up to the existing shareholders of the shell, who do not
contribute anything - other than being public shareholders -
to the shell merger transaction.
The real
cost of going public using a shell is the risk you assume by
inheriting unforeseen problems with the 10-20% of the shares
that are in the hands of the "public." Many promoters
of shells or their affiliates, profit not from the fees they
charge for the shell, but, rather, by selling their shares into
a market that may be artificially supported following the shell
merger. Using a variety of schemes and artifices, it is not
uncommon for shell promoters or their affiliates to cause the
trading price of your company's stock to rise dramatically after
the announcement of your merger with the shell. In the worst
case, the promoters sell into the artificial market to unsuspecting
investors, and, when the promoters are no longer supporting
the price of the stock, its trading price plummets. It is not
uncommon for this spike in price and trading activity to occur
during the period that the SEC is reviewing and commenting on
the Form 8-K disclosures. As a result, the unsuspecting investors
who purchased your company's shares during this time may have
a claim against the company, and possibly against you personally,
for damages if they purchased your company's securities while
the public disclosures in the Form 8-K were inadequate.
Conducting
due diligence on a public shell in an attempt to determine whether
it is a "clean" shell is costly. It is difficult,
and in many cases impossible, for you to ascertain whether the
shell's public shareholders ("public float") are bona
fide stockholders or are nominees controlled by the shell promoters.
- "Liquidity
and Exit Strategy
- Investors can readily buy and sell your stock and original investors
and founders have an "exit" strategy for their investment."
The shares you receive in the shell corporation will be "restricted
stock," that is, they may not be transferred without registration
or without an exemption from registration. As part of the shell
transaction, however, shell promoters may attempt to transfer
unrestricted stock to the new owners and their affiliates. The
SEC and NASD view promoters of shells, as well as their transferees,
as "underwriters" of the securities issued to them.
Therefore, the re-sale of shares transferred by such promoters,
affiliates and their transferees without SEC registration will
be restricted. Although the stock certificates evidencing such
shares may not bear restrictive legends, the transfer of those
shares is in fact restricted by law.
In summary,
although the traditional IPO in the current financial market environment
is difficult, at best, to accomplish, sometimes its best to do things
the old fashion way.
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