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.

Leaps and Bounds

Thanks to you my faithful blogees, the Reverse Merger Blog has hit a record for visits this past week, thanks! It looks like about 50% of all visits are new people each week which is great. Thanks to those of you that have come back regularly to see what's up. I even get a sense of where folks are coming from, including law firms, investment banks, almost all continents (OK no one from Antartica yet!), even the SEC!

The world has certainly changed so dramatically since I started practicing law back in the mid-80s. The fax was a new machine and we weren't allowed to use it in our big firm except for international transmissions. The faxes came in on long thermal paper that had to be cut with scissors. Everything else went by courier, regular mail or messenger. Even FedEx was brand new then.

When we worked on corporate transactions, secretaries did not have computers. Shorter documents were typed on typewriters, and pages re-typed when changes were made or even, heaven forbid, changes were made by hand. If changes were too long we added page 2A in between 2 and 3.

For longer documents, we spent hours waiting for our word processing department to input our hand-written changes, then fix what they didn't do right. Then we spent hours "blacklining" by hand to show changes in a document, underlining with a ruler new material and putting a little carat where stuff had been taken out. Then we spent long hours preparing "distributions" of documents, standing at a copy machine that jammed at 3 in the morning making 10 versions of 10 documents that were each 50-60 pages. Then a cover letter to 10 people and 10 sets of mailings every single time documents were revised. Distribution of signature pages back and forth would take days, or require folks to gather in a large conference room to get it done. The manpower to get this done was mind-boggling.

These days of course, we revise documents ourselves on Word with almost no secretarial assistance. A great software program does the blacklining in a matter of seconds. The 10 documents get instantly emailed to the 10 people with no copies made or mailing. Closings are almost always done through distributions of pdf's. Even the fax is almost obsolete at this point.

Why talk about all this? I guess because I can and it's the beauty of having this unique outlet to discuss things. But what does it have to do with reverse mergers? It means for lawyers, investment bankers and others involved in these transactions, the process of doing deals has been vastly simplified because of these dramatic technological advances. It allows sophisticated players who might be in smaller shops to go toe to toe with the larger firms because it is now more about brainpower than manpower.

Sure, if I were doing a multi-billion dollar acquisition of a multinational corporation that had to be completed in 3 weeks, I would only go to a larger firm. But middle market and smallcap deals simply do not require it. It allows players both big and small to have a role in influencing the manner in which deals are completed, and allows us to focus on learning to avoid tricks and traps and constantly improving and evolving our form documents, instead of spending all our time getting distributions out.

As we head to finally enjoy some spring weather, I urge you all to visit my blog one less time this week and stick your head out the window and enjoy! Back to more substantive discussions next time, thanks for letting me muse a bit.

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.

2006 Year in Review: A Great One

Greetings blogees. According to DealFlowMedia's The Reverse Merger Report (my favorite periodical!), 2006 was a banner year for reverse mergers. Over 200 deals were done, eclipsing the number of IPOs for the year. About half the deals either were self-filings or mergers with "virgin" shells, showing the growing power of these relatively new trends. The average size deal for the year was a company with a market capitalization upon the merger of over $50 million.

SPACs continued to proliferate with over 100 specified purpose acquisition companies either public or in the process of getting there. The involvement of Citibank, Deutsche Bank and others in underwriting SPACs has helped strengthen their legitimacy and place in the market. High profile deals like the Jamba Juice merger with a SPAC also helped, as did the addition of major players like Steve Wozniak, founder of Apple, and Michael Gross, former partner of Apollo, on the management teams of SPACs.

Almost a quarter of last year's deals involved foreign companies merging with US shells. The vast majority of those were companies coming from China. Several major players in the RM space have set up permanent offices or personnel in the PRC and have committed substantial resources to sourcing and analyzing deals there. Others are taking 3-4 trips a year to China to cement relationships and look at companies.

The regulatory environment has improved since the difficulties over Rule 415 last fall. The SEC is poised to announce a group of proposals before the summer (as mentioned in a prior entry) that are expected to further improve things for smaller public companies, including, hopefully, reducing the holding period under Rule 144 for unregistered securities from one year to six months, and allowing companies to continue to utilize the "small business" lesser disclosure rules until they hit $75 million in revenues (currently it is $25 million).

The Reverse Merger Association was established last year as our industry's first trade assocation. Our RMA board has been busy reviewing applications for membership, conducting background checks and making sure all members are as committed as we are to the "high road" approach to dealmaking. A number of members have already been admitted (including several at the patron level) and we are looking to grow the group so that our industry can work to speak with one voice to the regulators, and share information and deals.

All in all, the growing popularity of IPO alternatives has enhanced opportunities for businesses throughout the world to find faster, cheaper, simpler ways to access the US capital markets and achieve their goals.

PS Happy birthday to me!

Tip of the Week - Reincorporating a Shell? Be Careful

Happy April to all! The season of renewal is upon us. And for shells (ok not great segue), that can sometimes mean reincorporation. Many shells are incorporated in nontraditional states due to the prior business that was in the shell. Some are in California, Texas, Florida and other places. Some manufactured shells are in Colorado, Utah, Nevada and so on.

In some of these states (such as California) there are somewhat stringent shareholder protection laws that require formal shareholder approval (and an annoying proxy process with the SEC) for things that might not otherwise require approval in most other states, including in some cases the classic reverse triangular merger that I describe in my book. In other cases, merger candidates feel being in Utah or Nevada evokes reverse mergers' shady past. In others, it is simply the desire to be in Delaware, the most business friendly state where virtually every corporate lawyer in America knows how to do business.

Thus, in more and more deals that our firm is involved with, the parties desire to reincorporate the shell, typically into Delaware. Seems simple no? Well as with many legal issues in the reverse merger world, there are tricks and traps that are too easy to fall into.

First let's talk about the mechanics of reincorporating. It's not a simple wave of a magic wand. The process actually involves a merger. Let's say your public shell was incorporated in Nevada. You incorporate a new company, let's say in Delaware. The most common approach is to initially issue 100% of the stock of the Delaware company to the Nevada company, making the public Nevada company the parent of the Delaware company.

The next step is a merger between the two. The merger generally requires approval of the shareholders of the public parent (ie a proxy process requiring a document to be approved by the SEC). Upon completion of the merger, the public Nevada company merges into the Delaware company, with the Delaware company surviving the merger. Under SEC rules it becomes the "successor issuer" and is permitted, if done right, to simply take over the public SEC reporting status of the Nevada company. In the merger, every shareholder of the Nevada company swaps their shares for new shares of the Delaware surviving company.

Under SEC Rule 145, the issuance of the Delaware shares in the merger is exempt from SEC registration, and the shares are as freely tradeable as the shares they were exchanged for. And under that same rule, the issuance of the Delaware shares to the Nevada shareholders is not deemed a "sale," which means state securities or blue sky law generally should not be applicable. Voila, you are now a Delaware public company.

When to do this? Some merger candidates want the reincorporation completed prior to a merger. This can delay things but can be particularly helpful if you are moving out of a state where the merger itself may require shareholder approval but in Delaware would not. Others wait and reincorporate after the merger.

So here are some tips if you are reincorporating:

1. Make sure it's a "pure" Rule 145 transaction. All the beauty of the SEC's approach to permitting reincorporation might go away if other things are happening at the same time. For the exemption to be available, it has to be done solely for the purpose of changing the company's "domicile," and no other purpose. If, for example, the reincorporation were a condition to a merger transaction, you might lose the exemption. Thus, either complete it before signing any binding merger agreement or after consummating the deal. It is also tempting, while seeking shareholder approval for one thing, to get approval for other things, like maybe a new option plan, for example. It's generally not a good idea as the two might be seen as being together.

2. Can you split shares as part of reincorporating? Most states seem to permit, and the SEC rules permit, a change in capitalization that is pro rata to all shareholders as part of reincorporating. Thus if you want to issue every Nevada shareholder one share of the Delaware company for every 10 shares of Nevada, that appears to be permitted (I am not an expert on Nevada and this is illustrative only), though each state you are working with should be checked. However, some states, like California, could decide to be more restrictive in this situation. If possible, try to avoid using the reincorporation as a method to effect a split.

3. Can you increase the authorized shares in a reincorporation? Since your Delaware company can have as many authorized shares as you want, there appears to be no restriction on reincorporating through a Delaware company that has many more authorized shares than your Nevada company, even if the Nevada shares are just being swapped one for one. This can be a neat way to solve a common shell problem, where not enough authorized but unissued shares are available to complete a transaction. In lieu of a split (potentially problematic as above), by increasing the authorized number of shares in the successor Delaware company, there would be enough shares to complete a merger, and a reverse split, if desired to reduce the number of outstanding shares and increase share price, can be completed after the merger. Again, it depends on your state and you need to check.

4. Is the proxy process difficult? In general, if you provide the proper disclosure and avoid some of the concerns above (don't do a split, don't do anything else at the same time, do it before signing a binding merger document), the SEC is not likely to give much attention to a proxy statement relating to a "run of the mill" reincorporation. There is much disclosure required, however, including a detailed comparison of the applicable laws of the two states in question. But there are good models out there of proxies that have met SEC approval comparing virtually every state. You can use those plus do your own research to ensure the disclosure is complete.

5. Can other SEC filings for the merger take place at the same time? What if you are changing the Board as part of a proposed transaction and, even though the merger agreement is unsigned, you want to file a Schedule 14F and mail it to shareholders (this is a required document if the majority of the board will change upon a transaction) to start the 10-day clock before you can close? One can do this and it would seem not to implicate the reincorporation, but you are probably better off being cautious and waiting until the reincorporation is totally clear before making other filings.

As always, please do not consider anything in this blog entry as legal advice. Check with your lawyer on all these things! [Note: this entry was updated on April 11 to clarify certain things.]