There was no road show, no banker, and no underwriter when Cyberkinetics Neurotechnology Systems Inc. went public last October. And no initial public offering, for that matter. Instead, the Foxborough, Massachusetts, medical-device company merged with an existing shell company: Vancouver, Canada-based Trafalgar Ventures Inc., registered in Nevada in 2002 for the purpose of mining copper, nickel, and platinum.

Cyberkinetics, which develops interfaces between computers and the human brain, is widely regarded as a well-run, respected young company, even if its combination with Trafalgar could have given some investors pause—or shivers. (Trafalgar's original Securities and Exchange Commission filing noted that "to date, we have not conducted any exploration activities.") But Cyberkinetics is far from alone in choosing a "reverse merger" into a shell as its way of taking itself public. In January, Worcester, Massachusetts, biotech firm Advanced Cell Technology Inc. merged with Two Moon Kachinas Corp., a four-year-old Utah firm created to sell wooden Hopi Indian statues over the Internet. (Like Cyberkinetics, ACT kept its old name after the merger.)

And some investment bankers think that reverse merging into a shell, whose main asset is its preexisting SEC registration, may well be on the upswing.

Companies engaging in this special type of merger, however, must look beyond the taint of boiler-room scams once associated with shells—still hardly free of scandalous connections today. And they must proceed cautiously. Fraudulent or suspect shells "come up on a weekly basis," says one official at the SEC, which just last April proposed rules to further crack down on the use of shell companies in "pump-and-dump" stock schemes. (In one common scam, penny-stock promoters may pump up shell stock values by touting a merger with a private company, then dump their own shares before the merged company's low value becomes obvious.)

At the same time that the SEC proposed restrictions on shells, however, the agency also indirectly acknowledged that such mergers are and can be used as legitimate tools. "If people can legally do these deals by reverse mergers and not defraud anybody, we don't have any objection," says the commission official.

The New Small-cap IPO
"A shell is a vehicle. It can be used properly, it can be used improperly," says Cyberkinetics CEO Tim Surgenor, who believes that whatever stigma is still associated with past abuses hasn't been a detriment to his company. "IPOs were also abused," he notes.

Basically, there are two kinds of shells: those truly designed to be operating companies, and the so-called blank-check variety, created expressly to take a private company public via merger. However, the line between the two types can be thin. It often seems impossible to tell whether a shell's stated business plan is simply a front—in other words, a blank check in disguise. (While investors in a newly merged onetime shell may not care how serious its original business plan was, disguised blank checks often have been used by promoters to lure unsophisticated early investors into shady business schemes.)

For Cyberkinetics, the main concern was finding a "clean" shell, without preexisting liabilities, shell-company officials with an unsavory past, or shareholders who might be upset by a change in direction of the firm. An outside investor found the Trafalgar shell, Surgenor says, and investors with an interest in Cyberkinetics then put up $700,000 to buy control of Trafalgar. "The horror stories about investors who don't know what they own do not apply here," he says, estimating that "95 percent" of the new Cyberkinetics shareholders "already knew who we were."

Mark Carthy, whose Oxford Bioscience Partners is Cyberkinetics's main venture investor, says Cyberkinetics benefited from Trafalgar's having little or no operating history of its own. "Sometimes it is better to be totally clean and not have any operations than worry about what liabilities the company had incurred before." He adds that going public in this manner "was more work than I expected."

Still, such "back-door registrations" can reward companies like Cyberkinetics, which is conducting a clinical trial in which quadriplegics are implanted with devices that help them manipulate computers. Says Surgenor: "We got lots of press and won lots of awards—none of which can benefit you if you're private."

But such recognition can be invaluable to public companies, with their access to the larger universe of investors. Just one month after its merger, Cyberkinetics raised $6 million in capital through a private investment in public equity (PIPE). One week before it became a public company, ACT closed on a placement of Series A preferred stock and warrants that generated some $8 million, and converted the shares to common in the merger. (ACT is involved in applying human embryonic stem-cell research to the study of regenerative medicine.) Further, hedge funds—another fast-growing source of private equity—are more likely to provide financing to companies with listed securities.

"It's the new small-cap IPO—a reverse merger and a PIPE," says David Feldman, managing partner of New York­based Feldman Weinstein LLP, which has represented many companies in such transactions. He prefers blank-check shells, a preference that sends a message that "we are doing it the honest way." Specifically, he adds, he avoids shells designed with "creative" business plans.

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