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Honest Shell Games?

Despite the stigma of past trading abuses, small companies still go public by merging with existing shells.
Tim Reason, CFO Magazine
April 1, 2005

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.


Funding the Next Step
While venture capital and other forms of private equity are pouring into companies at high levels lately, little of that funding has been directed to relatively successful small companies that need, say, less than $30 million for their growth plans. And, of course, because of their small size, they find the traditional IPO route all but closed to them.

"Companies at an inflection point can't really wait six months to go through painstaking due diligence with venture capital firms," says investment banker Randy Rock, a partner at New York­ based G.C. Andersen Partners LLC. Ironically, the very fact that these companies are generating returns may turn off VCs who desire the bigger payoffs associated with brand-new start-ups.

Traditionally, next-step capital for such companies has come from small institutional investors in Europe or the United States. But the costly and complex valuations required in both places have all but wiped out this avenue of funding. In Europe, self-imposed requirements for pre-investment valuations went largely ignored for years, but European boards are no longer so cavalier about their potential liability if investors challenge a redemption price. In the United States, meanwhile, investment fund managers say regulatory audits and subsequent negotiations with the SEC have resulted in investment firms being required to mark-to-market such investments at least quarterly.

"If a small company needs less than $20 million, it's in no-man's land," says Anthony Loumidis, CFO of privately held American Distributed Generation Inc. The Waltham, Massachusetts-based company provides electricity, heating, and cooling systems, and has $13 million in annual revenues. The company ran into this funding block several times in seeking $3 million to $10 million from institutional investors representing mutual funds and hedge funds. "Investors didn't want to bother hiring an independent firm to value our company on a quarterly or monthly basis," he says.

"I think you are going to see more and more companies going through a nontraditional process, because the IPO process is so expensive," predicts Surgenor of Cyberkinetics. The company's vice president of finance, Kimi Iguchi, who joined at the time of the merger, is now applying to switch the company's stock to the American Stock Exchange from Nasdaq's over-the-counter bulletin board. Going public through a reverse merger, says Feldman, can cost as little as $250,000 in expenses (not including the cost of acquiring the shell), and usually is accompanied by a PIPE that covers the costs. Most small companies taking that route end up on the OTC Bulletin Board, which has fewer exchange-driven regulations than the New York Stock Exchange, Nasdaq, or Amex.

Such companies also are so small that Sarbanes-Oxley regulatory burdens don't pose the same disincentives that they pose for larger companies. "Assuredly, there are incremental costs," says Anderson's Rock, "but they are outweighed by the ability to get capital." As for the stigma associated with shells, recent SEC regulation has reduced it significantly. In the past, "whenever anybody walked in talking about reverse mergers, I'd throw them out of my office," says Rock. "Now it may be the best source of funding."

Perhaps. But one SEC official, noting the limitations of the recent rule-making, cautions companies considering a reverse merger: "Be very careful who you deal with, because there is still a lot of fraud going on in this space."

Tim Reason is a senior writer at CFO.




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