A New Shell
Shell companies, along with junk bonds, penny stocks, and shoulder pads, are usually dismissed as an unfortunate trend of the 1980s. Back then, shells--that is, companies with ticker symbols but no operations--became synonymous with so-called pump-and-dump schemes in which stockbrokers artificially inflated share prices after a shell merged with a private company, without making financial statements on the acquisition available to investors.
Now shells are making a comeback in the form of specified purpose acquisition companies, or SPACs. Unlike the 1980s vintage, these shells are created by experienced management teams that hope to acquire a private company and take it public using a process called a reverse merger. The strategy, which gives shells two years from formation to sign a merger agreement, has become increasingly popular thanks to the tepid IPO market, which is prompting companies to look for creative financing alternatives. Meanwhile, investors, including many hedge funds, see a potential for big returns. In the first half of 2006, 23 SPACs raised money in public markets, compared with 27 in all of 2005 and none in 2002, according to The Reverse Merger Report. "There's been a sea change in the perception of SPACs," says David Feldman, a New York City attorney who specializes in small-business finance.
For private companies, SPACs offer a key advantage over IPOs: more certainty. Companies have no way of knowing exactly how much cash they will raise in an initial public offering. By merging with a SPAC, on the other hand, businesses are guaranteed a specific sum from the SPAC's investors.
That appealed to John Cline, founder of eTrials Worldwide (NASDAQ:ETWC), a company in Morrisville, North Carolina, that sells software used by pharmaceutical companies to manage clinical trials. Founded in 1999, the business grew quickly, landing a spot on the 2005 Inc. 500 list with $12.7 million in sales. But eTrials had only $1 million in the bank, which made it difficult to convince customers such as Pfizer (NYSE:PFE) and Merck (NASDAQ:MRK) that it could handle more work. What eTrials needed, Cline decided, was the credibility--and cash--that come with a public listing.
Several investment bankers informed Cline that eTrials was far too small for an IPO. Then one of Cline's board members--a venture capitalist who also ran a SPAC--told him about CEA Acquisition, a public shell company based in Tampa that was trading on the OTC Bulletin Board. CEA had no operations and no full-time employees. But it did have $21 million to invest.
In July 2005, after a reassuring meeting with CEA's four-person management team, including chairman and CEO J. Patrick Michaels, Cline began negotiating a deal. To determine an asking price, he looked at revenue multiples of other companies in the medical services industry and researched the terms of similar SPAC deals in Securities and Exchange Commission filings. Cline spent the next couple of weeks in heated negotiations with CEA, a process he compares to an arm wrestling match. The two parties came to a compromise that August. If the deal were approved by CEA's shareholders, mostly hedge funds and institutional investors, Cline and eTrials' other original shareholders would receive a 56 percent stake in a new public company valued at approximately $76 million. CEA's shareholders would receive 44 percent of the company, with about 9 percent going to the firm's management team.
Merger agreement in hand (and the money in escrow), Cline spent the next five months on the road trying to win over CEA's investors, who were looking for a growth company that was well-positioned to go public, preferably with a strong management team and a few years of audited financials. Unless 80 percent of the shareholders gave a thumbs up to eTrials, the deal would be called off and the SPAC would be liquidated. "I was going from train to plane to automobile nonstop to get these yes votes," he recalls. "It was nerve-racking." He also racked up hundreds of thousands of dollars in accounting and legal fees related to the deal, including submissions to the SEC.
The deal was approved last February and eTrials began trading on the Nasdaq exchange under the ticker symbol ETWC. The company now has close to $20 million in cash and could reap another $61 million if outstanding warrants are exercised by shareholders. Cline expects the improved balance sheet to help eTrials land new contracts and generate $20 million in revenue in 2007. That, he hopes, will help lift the company's stock, which traded recently at $3.70 per share. Over the next few years, Cline plans to use some of the cash and stock to acquire software companies that will allow eTrials to oversee the entire clinical trial process. Merging with a SPAC, he says, "was a hand-in-glove fit."
Despite the new image, shells still draw criticism from some financial advisers who argue that the deals are overly generous to investment banks and SPAC management teams, which typically walk away with a 10 percent stake in the newly merged company, along with bonuses and board seats. In 2005, the SEC adopted new rules designed to prevent pump-and-dump schemes by requiring shells to release financial records of acquired companies immediately after a merger. Before, shells had 75 days to provide records to investors. Meanwhile, the NASD, which regulates brokers, has begun investigating the marketing practices of a number of underwriters.
What's more, there are signs that the SPAC market could be slowing. The heated activity over the past two years has created a glut of shells searching for acquisitions. "A number of them are beginning to run out of time," Feldman says. This has caused some share prices to drop amid fears that some SPACs may not reach a merger agreement before their two-year deadlines. In addition, several SPAC deals have been voted down recently by shareholders. Deborah Quazzo, president of Think Equity Partners, a New York City investment bank that underwrites SPACs, chalks up the pullback to normal supply-and-demand cycles.
That notion offers little solace to Mike Traina, founder of ClearPoint Business Resources, an HR outsourcing company in Chalfont, Pennsylvania, that posted $84 million in sales in 2005. Last summer, Traina signed a merger agreement with Terra Nova Acquisition, a Canadian SPAC. He saw the deal as a relatively painless way to raise money for acquisitions and offer stock options to his employees. It has been anything but easy. The SPAC was trading slightly below its offering price when Traina signed the merger agreement, which has made it difficult for him to round up enough yes votes from Terra Nova shareholders, who may be better off voting down the deal and getting back their original investments in the SPAC.
Despite the hassles, Traina says that he will still be happy with his decision to pursue a SPAC, as long as the merger wins approval during a proxy vote slated to take place early this year. "There are no pure solutions," he says. "If the deal goes through, we'll still be a profitable company, except with $40 million in the bank. I try to keep that in context."