Tip of the Week: How are Shell Companies Valued?

A shell company is a company with no or nominal operations, and with no or nominal assets or assets consisting solely of cash and cash equivalents. To identify and value an appropriate shell for a specific company’s purpose, it is necessary to understand six important characteristics of the shell. These give the prospective buyer a way to gauge the shell’s value and utility for the purpose at hand.


1. How was the shell created?

Shells are created in one of two ways. A shell is created from scratch when a founder or group takes public an empty company whose business plan is to acquire a private company. A shell can also be created after the termination of operations of a “real” public company.

2. Does it have assets and liabilities?

Assets of shells can be significant amounts of cash, an old claim the company is asserting against a third party from its operations, or potentially valuable intellectual property.
In some cases shells also carry liabilities. These liabilities have to be included in the value of the shell, so often management tries to eliminate these liabilities or convert them to equity prior to or upon closing a merger.

3. Is the shell trading or non-trading?

Shells formed from scratch (other than SPACs) generally do not and cannot have their stock trading prior to a merger. Public shells resulting from a former public operating business typically do continue trading. The marketplace for shells deems trading to be positive, and generally values a trading shell higher than one that is not trading.

4. Is the shell reporting or non-reporting?

Some public shells “report” under SEC rules; others do not. A reporting company is obligated to file quarterly, annual, and other regular reports with the SEC and is subject to other rules. Companies that trade on the Pink Sheets often do so without being required to report. A company can also be a “voluntarily reporting” company. These companies are not subject to the reporting requirements but continue to file quarterly and annual reports with the SEC and have their financials audited. The marketplace generally assigns a higher value to a shell that is required to report and is current in those reports.

5. What is the size of its shareholder base?

One major asset a shell has to offer is a shareholder base. The only way meaningful trading in a stock can build is through the addition of a good number of shareholders. Simply put, a public company with 2,000 to 3,000 shareholders is more valuable than one with twenty to thirty. However, the identities of the shareholders, the percentage of the company’s float which they will represent, and the manner in which they became holders all may affect their value to the shell.

6. Is it clean or unclean?

Problems in a shell’s past history or management can adversely affect its current value. The cleaner a shell is the more valuable it is.

Tip of the Week: Need a Reverse Split? Avoid a Merger Proxy

When a public shell is in the process of completing a reverse merger it often finds itself with too many issued and outstanding shares or not enough authorized shares. One solution is a reverse stock split. A reverse stock split is a pro rata reduction in the number of shares of capital stock of a company that are outstanding. It is often used to increase per-share price, or to make more authorized shares available in order to complete a reverse merger. At the time of the split, each shareholder still owns the same overall percentage interest in the company. Most states’ laws require a reverse stock split to be approved by shareholders, and this requires a proxy or information statement under SEC rules, if the shell is subject to the SEC’s reporting requirements. If the reverse split is a condition of the reverse merger, the SEC requires a much more complex merger proxy.

There are three lawful ways to avoid an involved merger proxy:

• If sufficient shares are available for issuance in order to consummate the transaction, the reverse merger is closed with the number of shares already existing. After the merger is completed, the combined company could then seek a reverse split that is not a condition to the merger and only a reverse split proxy is necessary.


• Even if insufficient shares are available, the shell might be able to issue pre-authorized shares of preferred stock that converts into common stock when a reverse split or increase in authorized shares is approved after the reverse merger. Other strategies are possible even if the shell does not have so-called "blank check" preferred stock.


• The SEC requires a full merger proxy when the reverse spilt is a condition to the merger. To address this provide in the merger agreement that the parties request a reverse split, contemplate it, but do not make it a condition to the transaction. Again, in this case only the much simpler reverse split proxy is necessary.

Tip of the Week: When does a self-filing make sense?

The following definition is taken from my book: a self-filing is the process by which a private company may seek a public trading market for its securities without an IPO or a reverse merger, by completing its own filings with the SEC either to resell securities held by shareholders or to voluntarily become a reporting company. The company assumes the obligation of filing quarterly and annual reports and becomes subject to proxy and other rules.

Self-filings can be attractive because they do not require a shell or need to wait on the IPO market; there are no problems associated with due diligence; and the company does not give up any of the company’s equity. When deciding to do a self-filing take a look at the following 3 questions.

1. Does the private company already have a large shareholder base?

• A company with a strong shareholder base reduces the need of a shell that already has shareholders and can be a good candidate for a self-filing.
• Self-filings can be easier than reverse mergers when the company has more than 35 shareholders who do not meet the “accredited investors” test.
  

2. Can the private company take care of its own financial needs during the lengthy self-filing process?

• Self-filings make sense for companies that can defer new financing until the process is complete. This could take anywhere from 5 to 8 months or in some cases even longer. This compared to an average of 3 months to complete a reverse merger with a shell.
  
• Whatever amount of time one thinks it will take to complete a self-filing, multiply that by 150 percent.

3. Does the private company have on tap a capable investment bank or Wall Street advisor to help “build” a public company from the private one?

• Members of senior management should have significant Wall Street experience, or the company should engage a capable investment bank or financial consultant to walk it through the process because of the “do-it-yourself” nature of self-filings.
  

No company should attempt a self-filing without a group on board that can build a team that is competent and works well together.

Tip of the Week: Due Diligence

Most people look for “clean” shells, companies with well-kept, organized records and no history of unsavory activity, but what they get more often are “messy” or even “dirty” shells. Due diligence is extremely important in reverse merger deals to weed out the good shells versus the bad shells. Taking shortcuts in the due diligence process is a very risky idea.

Messy shells are shells with bad housekeeping. Often times, agreements were made but there are no copies of such agreements or the agreements were never signed. Shell owners give information a little bit at a time and nothing is organized. Here is a list of practice tips for dealing with messy shells.
· Review every document carefully and more than once.
· Be cautious if SEC filings are not current.
· Be sure the board and officers of the shell were properly elected.
· Check everything and check it twice!

Dirty shells are shells in which possible abuses have taken place and bad guys may be involved. Most of the time shady practices are easy to spot. Run as fast and as far away from these shells as possible!

Here is a shortened list, taken from my book, of the major areas to investigate when performing due diligence on a public shell.

• Corporate structure and history, including certificate of incorporation, by laws, stock, records, and stock issuances
• SEC filing history of the shell, whether the shell is a reporting company or is only claiming to be, whether there are any SEC investigations past or present, and the whole story of how the shell went public
• Any litigation or threat of litigation by or against the shell
• Any contracts the company had entered into for any reason which might still be technically in force
• Review of the list of shareholders to attempt to garner information about who they are and what long term interest they may have in the company post merger
  

Bottom line, insist on proper due diligence because a bad deal can be much worse than no deal at all!

Tip of the Week: Building Post-Merger Support

You’ve done it all—found a shell, completed the long and daunting due diligence process, closed the deal—now what? The following tips, as described in my book, will guide you through the next step, gaining market support. Going public was just the beginning, it’s what you do next that counts!


Get a new attitude.

Going public is the 1st step of the process to becoming a public company. The first day trading is not important; the big picture lies in the trading activity 1 year to 18 months after the reverse merger.
Look at the long-term benefits of being a public company; raising money, using the stock as currency for acquisitions, and having stock options to provide incentives to management.
Big picture: the company should focus on long-term goals.

The importance of investor relations.

Investor relations (IR) firms attract attention from Wall Street firms and research analysts to improve trading and stock price. The better IR firms take a long-term approach to building market support. There are many shady IR firms that promise quick results. Even if their practices are not technically illegal they generally conduct bad business. They will often create temporary fixes and then disappear leaving the company with a mess.
Big picture: A strong, reliable, and legitimate investor relations firm can make all the difference.

Earn your support.

Support is earned when a company achieves the things it promises to achieve, and when it does the things that investors and Wall Street want or expect from it. Focusing on running the business to generate profit and long-term value to shareholders will achieve the best results.
Big picture: Support from Wall Street should be built the old-fashioned way – by earning it.

Movin’ on up.

Smaller companies start out on the OTC Bulletin Board or Pink Sheets, hoping to move up to Nasdaq, the American Stock Exchange, or the New York Stock Exchange. The move up will generate attention that will result in higher stock prices and market capitalization, easier financing, more acquisitions available, and even attracting senior executives.
In order to move up the company needs to qualify for the higher exchanges. Each exchange has qualitative and quantitative criteria it uses to allow a company to list its securities.
Big picture: All the benefits of being public come into focus on the larger exchanges.

Tip of the Week: So Many Issues in Buying a Shell

One topic we simply didn't have much room for in the book was the mechanics of "purchasing" a shell. Many shell players find shells and acquire a controlling interest prior to identifying a transaction to put in. This is true for both trading and non-trading virgin shells, as both types are flipped, typically for a cash payment in what is often called a "cash and carry" transaction.


Here are just a few issues to be careful about in buying a shell.


1. Are you starting a tender offer? If you are not careful your offer to acquire shares from shareholders to obtain control might constitute a tender offer under SEC rules, which could trigger the requirement to put together a time-consuming and costly SEC filing which obviously should be avoided. There is no bright line test of what constitutes a tender offer, only a number of factors to be considered on a case by case basis. Make sure you consult with counsel to analyze whether your offer might inadvertently cross the line.


2. Watch out for Worm/Wulff. If the people you are buying shares from acquired them at a time when the company was a shell company, they may be subject to the so-called "Worm/Wulff letters." Among other things, these letters between the SEC and the NASD make clear that an affiliate or promoter of a shell cannot transfer his shares to a third party in a private transaction. Period. Further, the SEC staff expands that and has the view that all shell shareholders are subject to this, not just affiliates and promoters. Make sure to look for ways to avoid purchasing shares from current shareholders if possible (for example purchasing shares directly from the company), and if not possible, conduct an analysis as to whether the shares are or are not subject to Worm/Wulff.


3. Don't forget due diligence! Do thorough due diligence on the shell the same as if you were a private company merging in. If that takes weeks of review, so be it. If there are undisclosed problems in the shell, your entire purchase could become worthless. In particular, try to trace all stock issuances since inception to ensure that they match the company's claimed capitalization.


4. Watch timing of deals. It is generally recommended that shells be purchased and put on the shelf for a period of time before entering into a deal. There are a number of reasons for this that should be discussed with your counsel.


5. Can you get indemnities? What if the person controlling the shell misrepresents something, for example about how many shares or warrants are outstanding? Can you go after him afterward? Usually not. Sometimes sellers are willing to put some shares in escrow for a period to be used to help compensate for any misrepresentations or breaches of the purchase agreement. It depends on the transaction and the leverage of the parties.


6. Watch out for footnote 32! I think I've said this enough times, and you can go back to prior posts and my book to see the telltale signs of a tainted shell pretending to be or have been a real company. Make sure counsel experienced in this issue looks at it on every shell.

7. Watch out for short swing profits. If the seller purchased any shares (or anyone whose shares he beneficially owns did so) less than six months prior to the intended sale, the profit the seller earns in the sale may have to be disgorged back to the company. This is only true if the seller is an officer, director or 10% shareholder.


8. Surprise - filings required!


(a) Schedule 14f-1. If the purchase of shares of more than 5% of a public reporting company includes a requirement that a majority of the Board change hands, a Schedule 14f-1 has to be prepared, filed with the SEC and mailed to all shareholders of the shell at least 10 days prior to the purchase.


(b) Super 8-K. Wait, don't we only have to file the "super 8-K" imposed by the SEC since 2005 when the company ceases to be a shell? That filing includes all the information that would be in a Form 10 for the company, essentially the equivalent of a public offering prospectus, including audited financials and so on. A little known part of the changes the SEC adopted to Form 8-K included a requirement to file a super 8-K upon any change in control of a shell company.

(c) Insider Filings. If the seller is an officer, director or 5% shareholder, he will have to file Schedule 13D and possibly Form 4. If the buyer is going to become an officer, director or 5% shareholder, he also may have to file Schedule 13D and possibly Form 3.

Enjoy Indian summer!

Tip of the Week: Is the House in Order? Getting Ready to go Public

You're excited. You have met an investment banking or law firm. They have suggested that going public might be a logical strategy to help your company grow, raise capital, make acquisitions, etc. But are you really ready? Even assuming going public makes sense, are there any barriers that might make it difficult or a slower process?

In this tip of the week, I outline a few things to do early on in the process, ideally before the due diligence review begins, to ensure that barriers, some of which could be insurmountable, do not get in the way or, at the very least, are found out as soon as possible.

1. Are you auditable? To go public you will need to have your financial statements audited going back two years (three for larger companies). One of the first questions you need to ask is whether your financial records are in good enough shape to be audited. For example, a client in the distribution business, with very clean financial statements, recently discovered he could not go public because 25% of his customers were retailers that he owned or controlled, and that IRS rules appeared to require consolidating the financial statements of the distributor and the "controlled" customers. Unfortunately, the retailers' records were extremely disorganized and unable to be audited, ending the quest to go public. If you are not auditable, you may want to clean up your records going forward and postpone going public until you have two years of good clean financials.

2. Did you issue all shares? In many early stage companies, "corporate formalities" like issuing stock tend to get overlooked in favor of more important things, like survival! It is more difficult to go back and do this as part of the shell's or investment bank's due diligence review of your company. Get a good corporate lawyer to make sure the company's stock records fully reflect what you have always known is the arrangement between the owners but may not have been written down.

3. Is your intellectual property owned by the company? Patents can only be issued in the name of the individual inventor, then he or she has to assign the patent upon issuance to the company. This last step is sometimes overlooked or, frankly, sometimes the inventor waits to see how things are going before giving up his or her rights. Often trademarks were issued in a prior company, or in the CEO's name, and the same need to assign applies. If you are ready to go public, the IP has to be assigned to the company, or some kind of license arrangement giving the company the right to use the technology, is arranged. Again, it's usually better to do this before due diligence by the shell and investment banker begins.

4. Are all affiliated relationships memorialized? It is important to be up front in the due diligence process about any arrangements, understandings or contracts between the company and its shareholders, officers, directors, affiliates and their relatives. This needs to be disclosed once public, there is nothing unlawful about doing this, but some investment banks prefer to avoid conflicts of interest, for example, when the business rents a facility that is owned by the CEO. If these arrangements exist, and you want to retain them, and they are not in writing, you should memorialize them so there is no dispute as to the nature of the relationship.

5. Is there litigation? If you are in any litigation, there may be times that it is better to make it go away rather than have to explain it to an investment bank and shell owners; even if you promise that the case will settle soon, or at a certain price, or that you have a winning case, the existence of the case could spook an investor and they usually prefer to go public with no material outstanding litigation.

6. Are there any issues in management's background? If a member of management, or the board, or even a large shareholder, has civil or criminal legal problems in their background, particularly if it relates to securities matters, examine the issue carefully and very early on. How serious were the problems? How important is this person to keep around and possibly have the embarrassment of disclosing their background? Can counsel advise that the matter may not need to be disclosed? Could it prevent the company obtaining an exchange listing?

7. Have you run the financials as if you were public? Many private companies are run loosely with regard to financial decisions. Maybe the CEO thought it was right to pay for a colleague's vacation because he worked extra hard. Maybe other perks might seem embarrassing if they were publicly disclosed. You should examine whether these types of things should come out, and try to avoid them in the two years before going public.

8. Are your investors on board? Sometimes prior investors in your company have a right to veto transactions such as IPOs and reverse mergers. Check your investment documents to see if that is true before you start the process, and determine the right time to reach out to investors who have the veto power, but generally the earlier the better.

9. Got a good law firm? As early as possible, engage a law firm with experience representing companies going public, to help with all these issues and more. Disclaimer: your humble blogger runs just such a law firm!

Tip of the Week - Which Lawyer Do You Need When?

I find that many actual and prospective law clients have different views of when and how lawyers should get involved in possible reverse merger and self-filing transactions, whether on behalf of a company going public or the public shell company. Allow me to humbly offer my thoughts following the near completion of 21 years of law practice:

A. Representing a Private Company

1. The "do the closing" mentality: Some private companies think they can structure a transaction, complete a term sheet or letter of intent with a shell and source of financing, then when the first drafts of the deal documents show up, ask the lawyer to come in then and "do the closing." They think completing a reverse merger is like buying a house, where you negotiate the price and leave the lawyers out of it until contract time.

Of course nothing could be further from the truth. These transactions are complex and sophisticated, and we can provide significant value add right from the moment you are even considering when to go public. In fact, often the best advice I provide in a deal is right at the beginning. Helping a company analyze whether to be public, and if so which is the right way to do so (self-filing, merger with a trading shell, merger with a virgin shell, etc.) involves quite a bit of self-analysis of a company's goals, stage of development and cost-benefit review.

2. Do you need a "local" attorney? Many CEOs think they need a lawyer admitted in their state of incorporation or state of their headquarters, that lawyers cannot give advice on the laws of other states. This is not true. In some states, a locally admitted lawyer is required for real estate transactions or estate work, but no state that I'm aware of requires you to be admitted locally in order to advise on corporate law. The very fact that virtually every corporate lawyer I know is willing to not only give advice, but give a legal opinion, on issues of Delaware law, even though almost none of us is admitted there, proves the point. The key ethical analysis for the lawyer is this: if you feel you have enough knowledge about the state law in question, you can give advice concerning it. Thus, because of our heavy involvement in reverse mergers, for example, for good or bad we have become knowledgeable about many aspects of the corporate law of Colorado and Nevada.

Depending on what is required in the deal, however, sometimes your "non-local" attorney can bring in a local lawyer to deal with very narrow aspects of a transaction. But we have represented clients based throughout the US and the world.

All that said, however, if work involves a foreign company, then you almost always do need local counsel in the foreign country to complement the work of your US counsel.

3. How many specialists and why? Some law firms (especially larger ones) replete with various experts in environmental law, labor law, tax and the like, feel it is essential for these various experts to weigh in on the various aspects of every transaction. Of course this helps them charge higher fees. Almost every reverse merger or self-filing has very limited tax issues which can generally be dealt with by the parties' capable accountants and auditors. If a company is in the software business, chances are its environmental liability risks do not need to be looked at. However, we do generally recommend that issues of stock option plans and executive compensation be reviewed by an expert (this is not only because we happen to have a great such expert in our firm!). And of course there are situations, particularly with technology companies, where review of a company's intellectual property (patents, trademarks and the like) is appropriate.

4. A reverse merger is no different than any other M&A transaction, right? Many private companies use their existing corporate or securities counsel to go forward with a reverse merger or self-filing. If that counsel has not done these transactions, or has only done a few, as I point out many times in my book, there are many tricks and traps to fall into. If you are happy with your current counsel and want to keep them going forward and keep them involved with the going public process, the best way to go is to find a firm expert in these transactions and willing to step in solely to complete the transaction then leave.

My colleagues in the legal profession are aware that my firm, for example, for various reasons is not interested in retaining the company as a client once it is public. Thus they are comfortable recommending us to come in as special counsel while they remain as general counsel, then after the deal they remain and represent the now public company going forward.

B. Representing a Shell

1. The "do the closing" mentality. Same issue as before but a little different. Here chances are the shell founders or promoters are experienced deal professionals who may have even done a number of reverse mergers. Thus they may, even appropriately, feel they have the expertise to structure the deal and get to the point of drafting documents before bringing in counsel. They hate spending money on lawyers to look at letters of intent that end up not happening, then paying the lawyers thousands of dollars for a deal that didn't even get signed up.

Here, where a shell founder feels this way, I still recommend having counsel review the LOI or term sheet right before it is finalized or signed, and make clear through the process that everything is subject to final review by counsel. Not always, but often we can make some suggestions that are easier to implement at this stage than in the document stage.

2. Do you need a "local" attorney? Again, same issue as above but with a twist. Some shell founders or promoters believe that they can rely on work done by a placement agent's lawyer or, believe it or not, the lawyer for the private company, whether for due diligence, local law in a foreign country or the like. As in all things, it's simply determining the risk of not having the proper counsel as against the things that can happen if counsel is not on board. If you are a shell and this is a Chinese deal, we always recommend having your own Chinese counsel.

3. Do you really need to do due diligence? Clients do come to me suggesting they rely on the due diligence of an unaffiliated placement agent, or the brief review of documents by an experienced shell promoter who is not an attorney, as sufficient due diligence review of a private company. Here it may depend on what type of shell you have. In a publicly trading shell with hundreds or thousands of shareholders, the officers and directors of that shell have fiduciary duties to those holders. If something significant and bad could have been found out with customary due diligence procedures and is not, these affiliates could be personally liable for negligence or the like. If, however, the shell is a virgin shell with one shareholder, and that shareholder chooses not to do due diligence, the potential liability is somewhat less. However, even there, future shareholders may have the right to come after the original shell promoter who missed something.

4. Who pays shell counsel? This does vary, but in many cases the private company pays the shell's lawyer. This is especially true where the shell's founder is also involved with raising money for a PIPE, or where a much larger company (maybe $75 million in value or more) is taking over a shell. Usually shells are maintained with minimal cash, but lawyers may run up meaningful fees in a complex deal. Others take it indirectly as placement agent in "non-accountable" expense allowances or large reverse merger transaction fees. But in deal involving no cash to the shell and its affiliates, it is very common for the private company to cover these costs.

Remember my constant refrain. This is not legal advice, do not rely on it, consult with your attorney or advisor in all such matters!!

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.]

Tip of the Week- Don't Fall into the Shell Tax Trap!

Greetings blogees! I was on the Left Coast last week on business, so I apologize for not appearing for a few days. Just one joke from the Carrot Top show in Vegas: "Don't you hate airlines? We all know Delta stands for 'don't expect luggage to arrive.'" Might just use that in future appearances.

Anyway, I've noticed over and over again a trap that clients fall into and wanted to blog on it this Saturday morning.

As most of you know, many of my clients have created "virgin" shells through filing Form 10-SB, in fact we've been hired to create over 100 of these. Other clients acquire shells that are trading by purchasing a large percentage of the outstanding stock. Either way, in many proposed reverse mergers, investment banks or other intermediaries are seeking compensation for putting the deal together, raising money or general consulting.

Many of these intermediaries think: let me acquire an interest in the shell just before the deal closes because I can buy stock for a very low price and then have the value of my shares increase dramatically just moments or days or a week or two later when the deal closes. This way, the intermediary thinks, I have no tax currently (I made an investment before the deal closed), and when I sell my interest, if it's at least a year later, I have long term capital gains tax treatment on the sale, with a much lower tax than ordinary income. The shell guy is happy because he doesn't have to pay me in cash. If I had just taken cash or stock as compensation when the deal closed I would have had to pay ordinary income tax immediately, so this pre-deal purchase of stock seems better. Or is it?

In general, if it is reasonably close to the closing of the merger, almost certainly not. Here is the problem. Even though the deal hasn't closed when the intermediary acquires the stock for a very low price, the IRS could come back and say that the parties basically knew the deal was going to close. In fact, in many cases the principals are already out seeking new capital for the post-merged company, of course at a much higher price per share than the intermediary is paying pre-deal. This, the IRS would say, is evidence you knew the shares were worth more than you paid, and the difference between what you paid and the "real" value is taxable currently as compensation to you- ordinary income. In addition, that amount is a deduction, or charge to earnings, to the merged company, which in most cases is something a newly public company does not wish to have.

Here's a real life example from a client situation, with some numbers changed so as to mask the real players. My client, the private company, signed a merger agreement with a shell after which 90% of the stock of the combined company would be owned by former owners of my client. The combined company would be worth about $70 million upon closing.

Shortly after signing the merger agreement, an intermediary putting the deal together acquired 20% of the stock of the shell for $10,000 (remember the merger hasn't closed yet). My client said, why do I care, as long as I end up with the same 90% of the deal after all is said and done, how the shell promoter and banker choose to whack up their 10% (even if 20% of that 10%, or 2% after the deal, was going to the intermediary) is up to them.

The intermediary was happy because upon closing several weeks later, his $10,000 investment instantly became worth $1.4 million! That's his 2% of the $70 million post-merger value. When he sells in a year, he is taxed at the much lower long-term capital gains tax rate. If instead he received $1.4 million in cash upon closing, or got stock at closing worth $1.4 million, he'd pay tax immediately at the much higher ordinary income rate.

My client, the private company, was so worried about this issue they felt they had to disclose to investors the risk that the IRS might re-characterize the stock as compensation with a net value of $1,390,000 after his $10,000 investment, which could result in a big income hit to the intermediary and a charge to earnings for the combined company of that amount. This disclosure was included in their disclosure documents for investors even though some felt we were basically writing a road map for the IRS to come after these players.

Hopefully you get it now. Here's a way to do this the right way, ready? Several of my clients who own shells and work pretty regularly with intermediaries and consultants who assist them have begun allowing those intermediaries to buy into one or two of their shells currently, long before there is any deal in place. The shell founder also gets the right to buy back the stock sold to the intermediary if no deal develops within a certain amount of time. Then, maybe 3-4 months later, a deal develops and is closed. In that situation, you have a much stronger argument that the stock purchase was not compensatory or connected to the deal completed much later.

My simple advice to intermediaries and shell founders: plan ahead!!

Tip of the Week- Watch Your Trading Patterns

If a private company is seeking to complete a reverse merger with a shell whose stock is trading, there are three different periods of time where questionable trading can occur. One hopes, as in most deals these days, that normal trading patterns develop and there is no reason for concern. But vigilance as the deal progresses is important, and you should watch the stock all throughout the process. The three time periods are as follows:

Before the Announcement. If a stock's volume picks up noticeably in the days and weeks before announcing even a letter of intent, be cautious and ask questions. Anyone trading on material nonpublic information is committing a crime. And don't always assume the person trading is connected with the shell, it could be someone on the private company side looking to cash in a bit. If the illegal trader is a control person of the shell, it may not be just their problem. The company could be held liable on an "alter ego" theory, and the private company inherits that liability upon the merger.

After Announcing an LOI or Agreement. If a stock's volume picks up dramatically immediately after announcing a deal (but before completing the deal), it may be a sign that the shell's control people and friends were teeing up their trades to hit the minute the announcement came. That could be illegal, because the shell's affiliates know much more about the possible deal than is typically included in a press release to announce a letter of intent or signed agreement. In most deals, because analysts do not cover shell stocks and broker-dealers do not follow them, it takes awhile for word to get out, and the stock picks up, if at all, over a period of a week or two after the deal, not the same day as the announcement. Truth is in most deals I'm involved in the stock barely moves on the announcement, which is a sign that insiders are appropriately not trading and keeping mum.

After Closing the Merger. If a pre-revenue biotechnology company is trading at a $300 million market cap after closing a revese merger, be cautious. It may indeed be worth that and not a concern, but rapid rises in stock following a merger to stratospheric levels may be a sign that someone is over-hyping the stock, possibly through questionable investor relations tactics. Why do we care? If the person orchestrating this activity is connected to the company, the company is responsible. Second, these meteroric rises almost always lead to SEC or NASD investigations, and who needs that?

Best Case Scenario. Ideally, the shell's stock does almost nothing before and after the announcement, and begins to move slowly after the deal is consummated. It can take a number of months after closing a reverse merger to put in place strong, legitimate investor relations and begin to have an impact on the trading market. Patience is a virtue in these situations, and when a stock rises too rapidly, well as Newton found out, everything that goes up...well you know the rest.

Here's to our Presidents and enjoy the holiday weekend!

Tip of the Week - Is a Self-Filing for You?

As described in detail in several chapters in my book, many have recently discovered the benefits of the so-called “self-filing” method of taking a company public. In this case, no IPO takes place, and no merger or combination with a shell is involved. Thus there is not even a reverse merger. The company is in control of the process and timing (subject to the SEC of course) and there are other benefits, but there are drawbacks as well.

In a self-filing, a private company files either a Form SB-2 or Form 10-SB registration statement with the SEC to go public. There are different implications of each which I will describe below. Either way the SEC reviews the document and provides comments, which can take several months. In fact, I generally advise clients that the process overall should be expected to take five to eight months, but it can be both quicker and longer depending.

I believe a self-filing can only make sense if three conditions are present: 1) the company has sufficient shareholders (or can put them in prior to the filing) to qualify for trading on the OTC Bulletin Board; 2) the company is either able to wait for financing until the filing is declared effective by the SEC or can finance itself either before or in some cases during the pendency of the registration process; and 3) an experienced Wall Street hand is on board either on the management team or engaged to assist in “building a public company.” If you need a larger financing sooner, and your financing source will not provide funding before being public, a reverse merger with a public shell will probably be preferred, since it can be completed much quicker.

The benefits: as mentioned you control the process, there is no shell to negotiate with. There is no dilution from stock given over to shell shareholders in a reverse merger. Some become frustrated with the process of finding a clean shell and simply file themselves. This process also solves a big problem that arises occasionally in reverse mergers: namely, if your private company has more than 35 “unaccredited” investors, the issuance of shares in a reverse merger cannot be completed without a complex SEC filing. In a self-filing, no new issuance of shares occurs, so the problem is avoided.

The drawbacks: primarily the time delay is the biggest frustration. Also, shell promoters often help in the area of market support and investor relations after a merger, and this relationship is not present when you “do it yourself,” thus buttressing my suggestion to have an experienced player on board.

Which way to file if you are going for it? If you use SB-2 it should be because you have at least some shareholders who have held their shares for less than two years and would not have the Rule 144 exemption from registration available for trading. Registering their shares directly solves that problem. However, no private financing can be raised for the company while the SB-2 is pending. If a Form 10-SB is used, no offering is taking place, so financing can be raised. And even if shareholders have not held long enough, after the effectiveness of the Form 10-SB an SB-2 resale registration can follow immediately, and that will receive little review because the Form 10-SB will have just been reviewed.

The new Rule 415 intepretations, in our view, help self-filings, especially if a PIPE investment is completed before the filing. The SEC is more likely to view these as “completed” sales and not suggest the investor is an underwriter, and therefore a larger percentage of the company’s stock may be able to be registered for resale.

In almost all cases where a company is contemplating a reverse merger, it makes sense at least to look at whether a self-filing also might make sense.

Tip of the Week - Beware Footnote 32

As mentioned in my book, a tiny footnote in the SEC's rulemaking on reverse mergers in July 2005 essentially invalidated, in my mind, a large number of publicly trading shells. Sometimes a "company" (sometimes an actual tiny business and other times an entity alleging it is a start-up) completes an IPO or other going public event with the plan to either shut down the business or transfer it back to the promoter upon a merger with a real operating business. If that intention is not disclosed, that company is deemed a shell company under SEC rules from day one. There are a number of implications of this, but in my view this is fraud, plain and simple and I urge clients to stay away from shells which might contain these characteristics.

Why do people do this? Because SEC Rule 419, passed in 1992, makes it extremely difficult to complete an IPO of a blank check or shell company, and never permits trading in the shell's stock prior to a merger. If you intend to be or are an operating business, even a start-up, Rule 419 does not apply to you and you can go public and start trading, which rather dramatically increases the market value of the shell. Thus savvy promoters sought an end-around this rule through this tactic.

Here are the telltale signs of a "footnote 32 shell:"

• A start-up or very early stage company is doing an IPO or other "going public" filing and allowing shareholders to resell their stock in the public market.
• The filing is completed less than one year after the company is started.
• The IPO is seeking to raise very few dollars (maybe $100,000), and may actually raise even less.
• Management of the "company" has little or no experience in the supposed business they are entering into or has experience in the securities or consulting business or other area of Wall Street.
• Sorry to say this, but the company claims to be based in Utah, Nevada or Canada.
• Sorry to say this, too, but the company intends to be engaged in a business relating to oil, gas, mineral rights, or to own rights in entertainment projects that are not yet developed.
• The officers, directors, large shareholders or consultants of the company have done it multiple times before.

Of course not every company with these characteristics is a sham. The SEC has told me they are stepping up enforcement efforts on these shells. The fact that the SEC let a footnote 32 shell go public should NOT be taken as an assumption that the shell is "bulletproof" after a reverse merger. In fact, we hear of comments being received after a merger in connection with a subsequent registration of shares, where the staff is questioning issuances and transfers of shares in the shell prior to the merger under so-called "Worm/Wulff" analysis. Here the staff, after the fact, is suggesting the entity was always a shell and did not declare itself as such.

Why do we care? There are two sets of victims of footnote 32 shells. First is anyone who trades the stock not knowing that the real intent is not to be in the oil and gas business but find a merger, reverse split everyone 1 for 100 and be part of a biotech company. Second are all the legitimate players in the industry who wish to create shells for their own use the proper way and are not permitted to have those shells trade prior to a merger. I applaud all efforts (1) for the SEC to go after these fraudsters and (2) for practitioners to stay away from these very risky vehicles.