Investment Banker Tip - Put Some Shells on the Shelf

If you are an investment banker active, or seeking to be active, in the reverse merger and IPO alternative space, you may start by raising money for a PIPE or other financing to take place contemporaneous with the going public event. But did you realize that there is no prohibition on you, or your affiliates, owning the shell that is contributed to the transaction in addition to earning fees for raising money in the transaction? This allows the banker and its affiliates the opportunity to benefit even more from their involvement in the transaction, and avoids the all too common challenge of running around "finding a clean shell" for a current transaction. Let me answer a few of the questions you'd probably have about this topic.

Isn't this a conflict of interest? Yes, but. Technically if you are raising money for the combined entity and own a substantial piece of equity on one or both sides of a transaction, the key issue is disclosure, and possibly the need for a reasonably priced fairness opinion. In a public offering (which this is not), underwriter ownership of the company is extremely difficult, since the NASD regulates underwriter's compensation. Their analysis would include the value of that ownership in deciding whether the total compensation exceeded NASD guidelines, and that is almost always problematic. Note that in SPACs this is a problem, because the SPAC goes public through an IPO. Thus the underwriter of the SPAC generally cannot obtain an ownership interest in the SPAC other than customary warrant type compensation. Of course the underwriter takes substantial fees for raising the IPO money. A PIPE, however, is not a public offering, and placement agent compensation in private placements is not subject to the underwriter's compensation analysis, except possibly as noted in the answer to the next question.

Won't I have a problem registering my shell shares after the merger because of the NASD Rule 2710 underwriter's compensation rules? Possibly, but. If you own the shell shares in the name of your broker-dealer, and they were acquired within six months of the date of registration, the NASD will seek to apply a Rule 2710 analysis to the shares and other compensation received even though the PIPE was not a public offering. However, under current NASD advice, if you own the shell shares in names of people other than the broker-dealer, even affiliates, the same analysis should not be triggered. This may change down the road but that appears to be the case currently. Thus my practice tip is: when you get shares in a shell, age them a bit before doing a deal with the shell, even if the shares are not in the name of the broker-dealer, just to eliminate the issue.

Won't my company client complain that I am getting too much out of the deal? Hopefully your client will appreciate that you are bringing them a turn-key solution to going public, raising the money as well as supplying a clean shell that you have prepared in advance. After all, someone had to get the percentage of the company to be reserved for the shell's owners, why should your client care who receives it? The client also gets additional comfort in knowing who controls the 5-10% of their company reserved for the shell. Make sure, of course, that the percentage of the deal left to you and other shell owners is comparable to the market. In addition, the more you earn from gains in selling shares in the shell down the road, the better, because these sales are more likely to receive long term capital gains tax treatment. This can be more valuable than gains from exercising warrants earned as compensation for raising money.

Can I acquire the shell just before doing the deal? As I have blogged recently regarding the "shell tax trap," be careful to ensure that there is a good time lag from acquisition until a deal. If you buy shares in a shell one day before closing a reverse merger where your shares go from a value of, let's say, $250,000, to a value of several million the next day, there is a risk that the difference in value is treated as compensation and possibly taxed as well.

What's the best way to acquire a shell and hold it before a deal? If you are looking to acquire a shell that has already been set up either as a "virgin" clean but non-trading and fully reporting shell, or a shell that is trading, in general you should look to acquire it without a specific deal in mind, with the hope that a number of months later you will enter into a deal for that shell. In other words, look to put a few shells "on the shelf" in anticipation of future deals, rather than acquiring one for a specific deal. This maximizes the likelihood that you can get the best tax treatment for your interest in the shell.

What are the advantages and disadvantages of building vs. acquiring a shell? Building a shell takes some time, about 3-1/2 months to set up a virgin shell and get it to being public, assuming all parties cooperate. Then you generally should wait a bit before putting a deal in, because you represent to the SEC when you file for the shell to go public that you have had no substantive discussions with any company about merging with that shell. If you enter into a deal 3 days after the shell is public, they will (probably rightfully) assume that you were talking to that company about this shell before you were permitted. But building a shell in almost all circumstances will be much less expensive than acquiring one, whether virgin or trading. Plus building a shell allows you to determine who the shareholders are and have a bit more control over the post-merger process as a result. On the other hand, trading shells you acquire may have more shareholders which can be helpful, and the market also perceives that trading in a shell is a positive. See prior blog entries for some of the pluses and minuses of trading vs. virgin shells. In general though, if you have time, building seems the most efficient way to go. If you need something for a deal sooner, acquiring a shell may be more logical. But in any event, you will always have deals down the road (hopefully!), so building or acquiring some shells for the future probably makes sense in any event.

Can I buy a shell without a lawyer? Of course you can, but of course as an attorney I don't recommend it. Some people think it's a simple transaction, two page agreement, to purchase shares in a shell. As I discuss in detail in my book, there are too many traps to fall into in structuring the purchase of a controlling interest in a shell. In addition, whether you are buying a virgin shell or one with a long history of prior operations, a full due diligence examination should be undertaken before paying cash for a shell. But the lawyer's time should not be significant (we do this work on a flat fee basis).

What about the Worm/Wulff restrictions? Can I buy stock in a shell? In general you cannot buy shares from an existing shareholder of a shell if that shareholder acquired those shares while the shell was a shell. However, you can buy newly issued shares that the company sells to you directly.

How do I find shells to buy? This is an art, not a science, and a number of major players in the industry have learned how to find shells and purchase them for a reasonable price. I have several clients looking to sell virgin shells, though they did not set them up for this purpose (you can email me if interested). If you are interested in trading shells, in the Reverse Merger Report there is a list of basically all publicly trading shells. You can simply get in touch with the principal and see if he or she is interested in selling. Investment bankers certainly know how to cold call!

To sum up, it makes sense for investment bankers interested in reverse mergers to build or buy their own shells for use in their transactions. It may not be appropriate in every deal, but it will be very helpful in many situations to have a shell ready to go, and it provides extra financial reward to the banker as well.