Playing the shell game: ISU finance professors study the value of shell companies

AMES, Iowa - Some companies that appear like nothing more than empty "shells" on small stock markets may yield a nice payoff for savvy investors, according to a new study by two Iowa State University finance professors. But the study also warns buyers to beware: these companies are on the clock in terms of a return on investment.

ISU authors Travis Sapp and Yianni Floros studied 585 "shell companies" from 2006-08. A shell company is a public company -- typically formed from a failed, small private firm -- that has no operations or assets, yet has investors. It maintains its stock reporting status and exists for the sole purpose of attracting a privately held larger "suitor" firm into a reverse merger (RM). That agreement would allow the private firm to quickly assume the public trading status of the shell company, complete with current reports and a stock ticker symbol.

The study found that shell firms that consummate a reverse merger deal earn an average three-month return of 48.1 percent -- largely as compensation to shareholders for shell stock illiquidity and the uncertainty of finding a reverse merger suitor.

But the researchers also report that an investor who puts a dollar in every shell company would still lose money, on average.

Decaying stock prices over time

And Sapp and Floros found that only about half of all trading shell firms find reverse merger suitors in a given year and the stock price of most shells decays over time. Since the shell firm consumes cash to maintain its current reporting status on the stock exchange, being able to conduct a reverse merger quickly is critical for its stockholders.

"The more time that passes from your incorporation date as a shell company without having consummated a deal [with a reverse merger suitor], the probability of you ever consummating a deal drops," said Floros, an assistant professor of finance. "Because obviously, there is something about the shell company that investors are dubious about. If a shell has a messy history, then private firms may steer clear of it."

Based on the average rate of shell stock price decay and the average return from a reverse merger, Floros and Sapp estimate that a typical shell would need to locate a reverse merger suitor within five months to be profitable to an outside investor.

Their study, titled "Shell games: On the value of shell companies," is publicly available online and will be published in the September 2011 edition of the Journal of Corporate Finance.

Out of 1,200 identified shell firms in DealFlow Media's PrivateRaise database, the ISU researchers focused on the 585 that actively trade in their study.

"We find those more interesting because they are investible," said Sapp, an associate professor of finance. "Most trading shells are the hollow remains of failed development-stage businesses, or firms that went through bankruptcy or liquidation."

"These [private firms that use shells to go public] are small R&D-intensive firms in the U.S. or abroad," Floros added. "They cannot bear the cost of an IPO [initial public offering]. And they cannot wait for the funding because the average duration of an IPO -- from the kickoff meeting to your investment buyers to the effective closing date of your IPO -- is about nine months. Whereas for the reverse merger, if it's done concurrently with PIPE [Private Investments in Public Equity] financing, it's about one month."

Reverse merger motivation

The authors found that a primary motivation for many private firms to quickly go public via a reverse merger is to acquire another firm. They want to have publicly traded stock that can be used for payment in the acquisition.

Yet most of the firms that use a shell merger to become publicly traded continue to struggle to grow, according to the study.

"A local commercial banker once told me, 'If you're not growing, you're dying' when it came to his commercial loan clients," Sapp said. "So in some sense, if these firms are languishing on the OTCBB [Over the Counter securities market in the U.S.] for a long time after being publicly traded, there's a problem."

Sapp says after completing a shell reverse merger, the stock price of 90 percent of those firms tends to decline over the following year.

The two ISU finance professors are working on a related study that focuses on why firms issue multiple PIPE offerings.