A public shell company is used by a private entity to go public. This arrangement is used to go public quickly and at minimal cost. When a private company gains control of a public shell company, the shell is structured to be the parent company and the buyer’s company becomes its subsidiary. The owners of the private company exchange their shares in the private company for shares in the public company. They have now gained control over a majority of the stock of the shell, and are running a public company.
The legal structure used for this merger is called a reverse triangular merger. The process flow for a reverse triangular merger is:
- The shell company creates a subsidiary entity.
- The newly-formed subsidiary merges into the private company that is buying the shell.
- The newly-formed subsidiary has now disappeared, so the private company becomes a subsidiary of the shell company.
The reverse triangular merger is used to avoid the cumbersome shareholder approval process that is normally required for an acquisition. Though the shareholders of the private company must still approve the deal, it is only the shareholder of the new subsidiary that must approve the deal on behalf of the shell company – and the only shareholder of the new subsidiary is its parent company.
The reverse triangular concept is particularly useful, because it allows a private company to continue operating as a going concern and without a change in control of the entity. Otherwise, the business might suffer from the loss of any contracts that would automatically expire if either of those events were to occur.
A reverse merger into a shell requires the filing of a Form 8-K with the Securities and Exchange Commission within four business days of the reverse merger. This filing contains many of the items found in a full-scale prospectus for an initial public offering, and so is a major production.
Reasons to Buy a Public Shell
There are a number of advantages associated with the reverse merger concept, which are:
- Speed. A reverse merger can be completed in just a few months.
- Time commitment. If a company were to follow the tortuous path of an initial public offering, the management team would be so distracted that there would be little time left to run the business. Conversely, a reverse merger can be accomplished with such minimal effort that management barely notices the change.
- Timing. If the buyer is not immediately intending to use the shell to raise money from the public, it can take the reverse merger path even in weak stock market conditions.
- Tradable currency. Being public means that the stock issued by the combined entity is a more tradable form of currency than the stock of a private company, which makes it easier for an acquirer to engage in stock-for-stock transactions. Also, the shares of a public company are frequently valued higher than those of a private one (because the stock is more tradable), so the public company that engages in stock-for-stock purchases can do so with fewer shares.
- Liquidity. The reverse merger path is sometimes pushed by the current shareholders of a business, because they want to have an avenue for selling their shares. This is a particular concern for those shareholders who have been unable to liquidate their shares by other means, such as selling them back to the company or selling the entire business.
- Stock options. Being public makes the issuance of stock options much more attractive to the recipients. If they elect to exercise their options, they can then sell the shares to the general public, while also obtaining enough cash to pay for taxes on any gains generated from the options.
Problems With a Public Shell
Against these advantages are arrayed a considerable number of disadvantages, which are:
- Cash. A company may not achieve an immediate cash inflow from the sale of its stock, as would be the case if it had taken the path of an initial public offering. Instead, a stock offering may be delayed until a later date.
- Cost. Even the lower-cost reverse merger approach still requires a large ongoing expenditure to meet the requirements of being public. It is difficult for an active business to spend less than $500,000 per year for the auditors, attorneys, controls, filing fees, investor relations, and other costs needed to be a public entity.
- Liabilities. There is a risk associated with buying the liabilities that still attach to the old public company shell. This risk can be ameliorated by acquiring only a shell that has been inactive for a number of years.
- Stock price. When a company goes public through a reverse merger, the sudden rush of selling shareholders puts immediate downward pressure on the price of the stock, since there are more sellers than buyers. When the stock price drops, this makes any stock options issued to employees less effective, since they will not profit from exercising the options. Also, if the company intends to use its stock to make acquisitions, it will now have to issue more shares to do so.
- Thinly traded. There is usually only a minimal amount of trading volume in the stock of a public shell company – after all, it has been sitting quietly for several years with no operational activity, so why should anyone trade its stock? Also, immediately following the purchase of the shell, the only stock that is trading is the original stock of the business, since no other shares have yet been registered with the SEC. It takes time to build trading volume, which may require an active public relations and investor relations campaign, as well as the ongoing registration of additional stock.
This lengthy list of problems with public shell companies keeps many companies from buying them. In particular, take note of the annual cost of being public, and the issue with thinly-traded stock. The cost should completely block smaller companies from taking this path, while the lack of a market for the stock offsets the main reason for begin public, which is having tradable stock.