Honest Shell Games?

Despite the stigma of past trading abuses, small companies still go public by merging with existing shells.

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.


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