Cashing Out: Shells Offer Liquidity
If you own a small company in a fragmented industry, then you probably know all too well that your liquidity options are limited.
"There's very often no logical way for business owners in certain industries to exit their companies -- certainly not a way that rewards them for all the time and energy that's been put into the companies," says Michael Busch, a management consultant with the Wharton Capital Group, in Chicago. For example, owners of hardware stores or pharmacies who are ready to sell their businesses are often disappointed to find that their strong sales and cash flow don't automatically translate into gratifyingly lucrative checks. "These businesses are never sold on the basis of a cash-flow multiple," Busch says. "Somebody comes in and buys just the inventory and other assets."
Busch and his partner, Jim Greenfield, recommend what's known as a reverse merger, in which a smaller company winds up being part of a larger public shell that will eventually carry out a public stock offering.
A public shell is Wall Street's jargon for a corporate entity that is registered with the Securities and Exchange Commission though it conducts no business operations. A merger with a public shell permits a group of entrepreneurs with few financing options of their own to band together with a common goal: eventually to gain liquidity by selling stock.
Early this year Squire Drugs, a $12-million drugstore chain based in Philadelphia, undertook the first steps in the reverse-merger process. "We transferred 51% of our stock to a public shell in return for a $3-million note," says Robert Volpe, an executive vice-president. The rest of the stock transfer is due to take place in three years, at a price that will be pegged to the chain's cash flow for that year. "That gives us a strong incentive to leave cash in the business and build up our cash flow," Volpe emphasizes, "in order to maximize our payout."
Squire is just one of about a dozen pharmacies that will constitute the new entity. "After we acquire enough companies and build up three years of audited financial statements from them," Busch explains, "the public shell will sell stock, and we'll use the proceeds to pay off the original owners." Here's a nice touch: should participants grow dissatisfied with the arrangement, the reverse merger can be revoked by either the business owners or the investors at any time before the final stage.