Beware of Risks When Playing 'Shell' Merger Game.

FOR many companies entertaining the idea of going public, there may be an alternative to the traditional IPO.

Reverse mergers have once again become the method of choice for many technology firms pursuing their dreams of going public -- even though the SEC takes a very negative look at such mergers and some funding sources shun them.

This type of acquisition generally occurs when a publicly traded company with essentially no assets (a "shell") issues stock to acquire a privately held operating company. The shell issues enough stock to the owners of the private company so they effectively control the public shell after the merger.

In some cases, the reverse merger is coupled with a private placement of stock shortly after or concurrent with the transaction in order to gain operating capital. This new stock may then be registered along with those shares issued in the merger in order to give the new investors and owners liquidity.

Among other advantages, the shell merger lets companies become public without the complicated filing requirements and expense of the traditional IPO. This can be extremely valuable to those technology companies that are sensitive to these factors.

There are other advantages to shell mergers as well. However, these advantages do not come without some serious concerns. Entrepreneurs must understand that whatever method they use to take their companies public, the ongoing expenses and reporting requirements for public companies are the same.

Still, there are many advantages in going public through a reverse merger. The process generally requires much less time, and is much less complex than an IPO.

Management time required to shepherd the process is significantly less than during an IPO, allowing executives to stay focused on company operations. In addition, the shell may have significant "tax loss carry forwards" that under some circumstances can be used by the company to shield future income from taxes.

But one of the most valuable benefits of a shell merger is the availability of stock for rollup activities for firms seeking rapid acquisitions.

These features make the shell merger an attractive alternative to many companies not interested in dealing with the time- and cash-consuming process of filing for an IPO. However, as with all things, there is no reward without risk, and shell mergers come with more than their fair share of potential problems.

Avoiding the pitfalls

Before taking a company public through a shell merger, a business owner should consider the many issues and disadvantages usually connected to it. The first question to ask is whether the company should be public in the first place, and if being public would actually provide benefits to the firm.

If the answer is no, then going forward with a reverse merger or even an IPO is probably not a good idea. After carefully considering that question, the owners should evaluate the risks of a shell merger in relation to its benefits.

Though shells are essentially empty companies with no assets, there may be liabilities -- sometimes unrecorded and even hidden. They often involve companies that have been taken public and then failed. Due to their previous operations, they may have incurred substantial liabilities, or have pending legal problems or other contingencies that have not yet surfaced.

Perhaps the most troubling scenario is when stockholders or promoters involved with the shell know of these contingencies but are not forthcoming with the new shareholders as they move to divest themselves of both the company and its liabilities. As a result, it's critical that any firm considering a reverse merger perform extensive due diligence on the acquiring shell.

Due to the nature of the transaction and the typically small number of broker-dealers involved with public shells, there may be a limited ability to market the company's stock subsequent to the merger. Initially, the stock will most likely be traded at less than the bulletin board price or what's in the pink sheets, limiting the ability of the new stockholders to move their shares as compared to more familiar and more liquid exchanges.

In addition, due to the rather poor repute of shell mergers in general, it may be more difficult to find investors who will fund a company that has become public in this manner.

Pump and dump 

When it comes to tech firms, unscrupulous promoters may use the shell merger to take advantage of the public's voracious appetite for technology companies. Using the opportunity to promote a company's stock through the Internet or other direct marketing media, the promoter might use the merger to hype the stock and sell off their shares, which can flood the markets and kill the post-merger stock price. This is the classic pump-and-dump scheme, another reason why the SEC takes a hard look at shell mergers.

The benefits of a shell merger may be significant to a company, but the risks associated with it can lead to disaster if not explored prior to undertaking the transaction. When considering this method of going public, entrepreneurs should consult trusted professionals, such as securities accountants and attorneys, early in the process to research any issues related to the shell while directing the business owners to reputable shell promoters.

Diligence on the front end may save much heartache once the deal is done.

Jim Pitrat is a manager at Singer Lewak Greenbaum & Goldstein LLP, a firm of certified public accountants & management consultants in Westwood.