Shell Shock?

New rules are driving small firms into shells, where they could get a nasty surprise.
Magazine Contributor
4 min read

This story appears in the December 2004 issue of Entrepreneur. Subscribe »

In the wake of the Google IPO in August, private business owners are once again daring to dream of taking their companies public. And yet, just as the IPO window may be opening, lawmakers and regulators are working to slam it shut by implementing tough new rules for public companies.

Recently enacted accounting and auditing standards, such as those mandated by the Sarbanes-Oxley Act, are so onerous that they're driving a new interest in so-called nonreporting public companies. These companies offer a comparatively simple process of going public through the purchase of a publicly traded company "shell."

Acquiring the shell of an otherwise defunct public corporation gives a small company at least some publicly traded stock without making them subject to either the Sarbanes-Oxley Act or the most stringent SEC reporting requirements. At least that's the theory.

In practice, however, the road to acquiring and benefiting from these shells is fraught with risk. Undeniably, the opportunity exists: There are thousands of nonreporting public companies, perhaps hundreds of which are shells that can be purchased. Like any other shell, these companies look good on the outside (they have public stock and stockholders) but are empty on the inside, with no real business or operations.

Those shells that have limited SEC reporting obligations are listed on the Pink Sheets at The price of a Pink Sheet-listed shell has risen dramatically, from an average of just $50,000 a few years ago to more than $85,000 today. Particularly desirable shells are going for upward of $200,000, as entrepreneurs scramble for ways to raise equity capital.

It isn't so clear, however, whether acquiring a Pink Sheet shell is a real opportunity to raise capital or just a giant headache. "When somebody offers free trading stock along with the control of the shell, it's usually a prelude to an illegal transaction," says , an independent securities attorney in San Diego. The paradox: If you buy a shell to raise money, that generally happens by selling the stock; but if you own the stock, you can't sell it. Moskowitz explains that as soon as the stock goes back to your control, it becomes "deregistered," and loses its free trading status.

Like most professionals who observe the market for public shells, Moskowitz urges caution. "There's more to it than being a public entity," he says. "To raise capital by selling shares in the company, you'll need trading activity in the market."

Building that trading activity often necessitates the involvement of a stock promoter. And therein lies the danger. Stock promoters are notorious for so-called "pump and dump" strategies that enrich the promoter-not the company-and ultimately depress the value of the stock.

"If you do [a reverse merger] on the speculation that you'll get the cash, there's no assurance you'll receive it, and you could be left in the lurch," says Moskowitz. The lurch, he explains, is having a penny stock and no trading activity. In that situation, having public shares and shareholders ends up being more of a burden than a benefit.

The SEC must agree. In June, it suspended all trading activity of 26 shells in an effort to stem the tide of "pump and dump" schemes. Further, the SEC has made noise about prohibiting reverse mergers altogether.

It's not all doom and gloom, however-there are legitimate reasons to buy a Pink Sheet company. A Pink Sheet can be a road to liquidity for current shareholders and a source of growth capital for an emerging company. "It can also help you move up to another exchange," says , a securities attorney in Palo Alto, California. "Institutional investors may invest in a Pink Sheet stock, especially if you can't afford or qualify for the other exchanges."

Technically, Pink Sheet companies are traded OTC. This gives nonreporting companies a head start if they decide to become reporting and then to pursue listing on larger exchanges like Nasdaq.

To successfully manage a foray into publicly traded stock, remember to look at the market from the investor's point of view. Unlike the large exchanges, Pink Sheets doesn't require companies whose securities are quoted on its systems to meet any minimum size or volume. With the exception of a few foreign issuers, the companies quoted in the Pink Sheets tend to be closely held, extremely small and thinly traded. And of course, since nonreporting companies aren't required to provide extensive SEC filings, there may be very little public information available about the company. For all those reasons, investors will probably continue to view Pink Sheet companies as high-risk investments.

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