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The Nature of a Public Shell Company

When a public company elects to become a shell, it files Form 15, which is a very brief notification to the SEC that the company is suspending its duty to file reports with the SEC. At this point, operational control of the entity is frequently placed with an attorney who specializes in shell companies. The attorney will generate the minimum number of required board meetings, authorize audits, and file tax returns for the shell – all this for a number of years, while the shell “lies fallow.” The attorney’s intent during this period is to wait for the statute of limitations to eliminate the risk that the shell can incur any liabilities, especially from lawsuits. Thus, the best shell companies have been sitting quietly for a number of years. The attorney may take additional steps to modify the shell’s articles of incorporation or bylaws, if those documents contain provisions that would be less likely to attract an eventual buyer for the shell. Also, if there are too many shares outstanding, the attorney can engineer a reverse split to shrink the number of shares.

There may still be a tiny market for the company’s shares, which may continue to trade on the over-the-counter market. Shares will typically trade at a few pennies on the dollar. The only reason why there is any value to the shares at all is the market’s perceived estimate of the price at which the shell can eventually be sold to a buyer.

The Price of a Public Shell

When a company wants to buy the shell, it will pay anywhere from $100,000 to $1,000,000 for the entity, with the price increasing if the shell is perceived to be an unusually clean one, with minimal likelihood of undocumented liabilities.

Initial SEC Filings

Once the acquiring company has bought the shell, the existing directors and CEO of the shell company will resign in favor of the new management team, and the shell will issue shares to the shareholders of the acquiring company in exchange for their old shares. The newly operational company will then file a Form 8-K with the SEC to document these events, and then proceeds to issue all standard SEC reports from that point onward. The initial Form 8-K will be a lengthy one, itemizing the acquisition agreement and following up with many of the same disclosures found in a Form 10-K, but now describing the operations of the buying company, rather than those of the shell. Also, the Form 8-K must include the separate audited and combined pro forma financial statements for both the shell and the buying company for the past two years, which requires some coordination between the auditors of both entities. The effort required to complete this initial Form 8-K is so significant that the buying company should begin its preparation of the Form 8K at least one month before the scheduled acquisition date, since the form must be filed within four business days following the acquisition event.

Stock Trading in a Public Shell

At this point, the only stock that can be traded is the stock of the shell company that was tradable prior to the acquisition transaction. If the new management team wants to have other shares trade, then it can either advise shareholders to wait for Rule 144 to take effect in either six or twelve months, or it can engage in the sometimes lengthy and always expensive stock registration process.

Reasons to Buy a Public Shell

There are several reasons why a company will buy a shell in order to go public. These reasons are most appealing to smaller firms with weaker balance sheets, and quite possibly with operational histories that would not allow them to bear up well under the public scrutiny of a traditional IPO. The reasons are:

Cost. Buying a shell can be quite inexpensive in comparison to the cost of an IPO, and is one of the main reasons why companies buy shells. If an entity simply does not have the cash to pay for an IPO, the initial cost of a shell can be quite attractive. Some shell sellers will even accept shares rather than cash in payment for their shell, thereby reducing the buyer’s out-of-pocket cost even further.
Timing. Buying a shell can be completed in a few weeks and requires minimal regulatory approval, whereas an IPO can drag on for many months, and involves the detailed review of filing documents by the SEC. For a company in a hurry to go public, buying a shell can be an excellent choice.
Acquisitions. The stock of a public company is considered to be more liquid than that of a private firm, which makes it a more viable currency for engaging in acquisitions. Thus, a company interested in multiple acquisitions may acquire a shell for this sole purpose.
IPO ineligibility. Many companies have such weak operating results, structural anomalies, or high risk levels that they cannot reasonably expect to have a traditional IPO succeed – the institutional investors that traditionally buy large blocks of stock through IPOs will have no interest in investing. For these companies, a shell acquisition is the only remaining path to going public.
Net operating loss carryforwards (NOLs). A shell may have built up a significant amount of NOLs that the buyer can use to offset its future taxable gains. However, upon a change of control such as the sale of the shell to the buyer, the amount of NOLs that can be used in each subsequent year is severely restricted; it is limited each year to a small percentage of the market value of the shell. Since a shell have a small market value (as evidenced by the purchase price paid for it by the buyer), the NOL available each year will be minimal.

Problems With a Public Shell

Against these positive reasons to acquire a shell are arrayed several problems that can cause serious operational issues for the newly active public company. They are:

Residual liabilities. Shell companies are famous for having undisclosed liabilities that will haunt the newly merged firm, quite possibly sapping its cash reserves. Many major law firms refuse to assist a company with buying a shell for this single reason. The risk can be mitigated through an extensive legal review of a shell, but there is always the possibility that some liability has been overlooked.
Questionable trading activity. When the buyer acquires a shell, trading in the shell’s stock will be thin, and so is subject to wide swings in price. It is unfortunately common for stock manipulators to cause wild gyrations in the price, which keeps legitimate investors from investing in the stock. Also, the share price will initially be in the penny stock range, which also keeps many potential investors from buying the stock.
Funding. One of the main reasons why a company wants to go public is to raise money, which is integral to the IPO process. However, it is not integral to buying a shell company; in fact, a company is poorer after buying a shell, since it presumably paid cash to the holder(s) of the shell. Thus, fund raising requires a separate transaction besides purchasing the shell.
Reputation. Shell companies have a sometimes-deserved reputation for being on the seedier side of the public securities markets. A company going public by this avenue may inherit that reputation, which keeps a large part of the investment community from investing in the company.
Stock registration. In the absence of any exemptions, the acquirer of a shell company will likely register stock through a Form S-1. Any entity that has been a shell company during the past three years is not allowed to incorporate information by reference into the Form S-1 from its other SEC filings, which represents a considerable additional filing burden (and expense) for the company.

The preceding pros and cons generally steer larger firms away from buying a shell company. However, this may still be an attractive option for a smaller company with a higher risk profile, as long as it engages in extensive due diligence before acquiring the shell.

Podcast

A discussion about buying a public shell company is available on Episode 33 of the Accounting Best Practices podcast. Listen Now.