The Old Shell Game

Joseph W. Bartlett, Founder of VC

Whenever the IPO market dries up, early stage companies in search of capital often turn to "reverse" or "backdoor" IPOs, meaning a merger of the emerging growth company with a public shell. A public shell is typically a company without significant operating assets, but with some cash and a roster of 500 or more shareholders, which is enough to require public registration under the Securities Exchange Act of 1934. The stock ordinarily is not listed on any national stock exchange and does not trade, but the outstanding securities are registered and the company is therefore "public" in a technical sense. The idea of a shell registration is to merge an early stage company with a real business into the shell. Presto! You have an instant IPO of sorts.

Assuming the shell has acquired a genuine business, potential investors will hopefully take an interest in the stock. Perhaps more shares can be offered in the secondary registration, which is a good deal easier than an IPO from a regulatory standpoint. And the company, when all is said and done, is off and running as a genuine public vehicle, meaning real trading activity, genuine interest in the stock, a form of currency for subsequent acquisitions. Thus, an early-stage company can get all the benefits of public registration without the enormous time, expense and risk entailed in a conventional IPO.

Over the years my experience has been negative as far as shell games are concerned. The reasons are relatively obvious when you think of them: First, although a merger with public shell is considerably cheaper and faster than a conventional IPO, ordinarily that transaction does not get you where you want to go. An IPO entails people buying the stock because they want to buy the stock. The shell transaction entails people winding up with stock in a company they have never heard of. Further, as one commentator has put it: "These shells have the potential for unknown liabilities, law-suits, dissatisfied shareholders and other skeletons in the closet." Moreover, there is a taint to companies created by the shell game. If the company could not qualify for an IPO, why is it public in the first place? And, finally, on the other side of the ledger, the transaction entails all the burdens of public ownership, including quarterly and annual reporting under some quite specific (and sometimes expensive-to-comply-with) SEC rules. To be sure, there are successes from time to time. Rare Medium, for example, started out as a public company by virtue of the reverse IPO methodology. Turner Broadcasting is often cited, as is Occidental Petroleum. And it is a much cheaper and faster to "go public" via the shell game, depending on how one defines the phrase 'go public.'

Given that history, in 1997, Paul Kunz and I performed a study [1] to test the shell game. Based on real data, we analyzed whether the few successes were, in effect, the exceptions that proved the rule. I do not claim that our empirical evidence is conclusive, but it is persuasive, in part because it supports my initial hypothesis. Below is the conclusion from our analysis, plus a reference to the original materials so that interested parties can review the study in detail.


The final statistics for the identified 102 companies indicate that only 17 companies produced positive investor returns, with 12 outpacing our conservative benchmark. Only two companies in the survey paid dividends. If the paper returns are discounted for the applicable bid/ask spreads, 14 companies would have posted positive returns, with only 9 companies besting the benchmark. Stated conversely, 86% of after market investors would have lost money by investing in the aftermath of reverse mergers and over 91% would have failed to keep pace with the comparable small company market.


The foregoing summary should be viewed, of course, as a work in progress and not a definitive last word on the issue. Certainly, there are occasions on which reverse mergers into a public shell have worked out to the satisfaction of all interested parties including the post-merger investors. Moreover, none of the material should be construed as casting aspersions on reverse mergers in which the acquired and acquiring companies are operating entities with significant assets and the mergers make business sense; such business combinations stand apart, and succeed or fail depending on the underlying business imperatives and subsequent events, including on occasion the luck of the draw.

The sum of the matter is that the Shell Game does not appear, from the investing public's standpoint, an attractive proposition. If the burden of public registration is too great for worthy private firms, the answers lay elsewhere...the subject of a subsequent paper."

Venture capital is built on hope and optimism. Absent those qualities, no one would start a business. However, optimism can shade over into foolishness in the appropriate context. Given this empirical research, it might be foolish for investors to attempt to choose which shell contains a viable company.

1: "Reverse Mergers and Shells: A Preliminary Analysis", Bartlett, Joseph W.; Kunz, Paul E., The Journal of Private Equity, Winter 1997, Volume 1, Number 2, Pages 45 - 52

These numbers are consistent with the findings by the authors cited in footnote 1:

  • "Over the past two years the S&P Small Cap index increased in value approximately 15%.
  • "However, the average value of the stocks of 46 companies that we researched that went public through a reverse merger over that period declined approximately 67%.
  • "A consolidated view of the data reveals the same picture. Only four of the 46 firms we researched were able to increase their stock price over the past two years after going public in a reverse merger - and all four of them remain penny stocks.
  • "And there is a significant survivorship bias in the data, as we have excluded from the averages the 18 companies for which we could not find any current share price date."