Why I don’t like Cash Shells

A cash shell is a company formed to make an unspecified acquisition. It raises money by listing on a stock market, with the stated intention of making an acquisition once it has achieved that listing. The eventual acquisition is then financed using the cash raised and, often, newly-issued shares.

I’d known about cash shells for years – I got interested when the ill-fated Knutsford Group plc[1] came and went in 1999 – and I’d never understood why people would put their money into such a vague proposition. When The Today Programme asked me to speak about Bumi, I started to research it further.

The original prospectus for Bumi (or rather, Vallar plc, the name of the company before it made its acquisition) referred to incentives for the Founders, Nat Rothschild and James Campbell. Now, executive incentives is my research subject, so I got interested and followed this up. It said – once you cut through the legalese - that the Founders would get Founder Shares and Founder Securities in order to, “incentivise them to achieve the Company’s objectives. The Founder Shares reward such members of the Vallar Team for their initial capital commitment to the Company and for completing the Acquisition… The Founder Securities encourage the Vallar Team to grow the Company following the Acquisition and to maximise value for holders of Ordinary Shares by entitling the Vallar Team to a share of the upside in the Company’s value once the Performance Condition is satisfied …”


Hmm – I’m sorry, but why exactly do they need this incentive? Surely growth and value are what they are founding the company to do? And as they are putting their own money into it, isn’t the prospect of that capital growth incentive enough? Apparently not.

Now, Founder Shares are a very commonly-used device in venture capital deals, where the founder of a business puts in a lot of effort to develop an idea/product before the financiers invest. In order to compensate them for this, they receive ‘sweat equity’ in the form of Founder shares that will convert into Ordinary shares on favourable terms if the enterprise is successful. This is a very useful device in structuring the finance for a venture capital-backed business. But in this listed shell company, I’m at a loss to see how much ‘sweat’ has been put into the enterprise at this stage.

I mean, it’s not as if they are doing the work for free. As well as being directors of the company, for which they, quite properly, receive a fee, they are also its Adviser. Well, technically they are not the Adviser, the Adviser is a newly-formed Jersey-based Limited Partnership. But the Founders appear to be the main owners of that partnership. And the partnership is going to do quite nicely out of the company. The prospectus says:

“…the Adviser will receive an annual fee of £5,000,000 or 0.5 per cent. of the average Monthly Market Capitalisation of the Company for the year in question (whichever is higher), subject to a maximum of £10,000,000”

So, £5m a year. Plus, the Adviser will be reimbursed all reasonable transaction-related costs when an acquisition is being considered. They are not doing too badly so far.

Now, back to those Founder Shares and Securities. Founder Shares always imply that the founders are getting a sweet deal – as I said earlier, that is the reason for them. How sweet is this deal?

Well, it’s not too easy to understand. So let me translate it as I see it, and explain a bit about venture capital deals as we go along.

In venture capital, you aim to make your money on an eventual sale of the business. So, the aim is to grow the enterprise, and sell out for a high share price. Let’s say that a company is started with £100,000, of which the Founders put in £10,000 and external investors £90,000. What might happen is that the Founders receive 10,000 Founder shares and the other investors receive 90,000 Ordinary shares. A few years later, the company is about to be sold, for say £1m. Just before sale, the Founder shares will convert into Ordinary shares. If they converted at par, i.e. one Founder share became one Ordinary share, then there would at the point of sale be 100,000 shares in issue, and the Founders would get £100,000 of the £1m proceeds.

Still with me? Okay, let’s make it a bit more complicated. We want to give the Founders an incentive to work really, really hard, and we want to reward them for what they brought to the business before the investors came in. So instead of converting the shares at par, we’ll convert such that for every one Founder share you get two Ordinary shares. That means 110,000 shares in issue on sale, with the Founders getting £181,818 of the £1m proceeds. A conversion of 3:1 would give the Founders £250,000. And so on. The Founders get more as the conversion ratio increases; and the investors agree to this because they know that without the Founders there wouldn’t be a business.

Right, now that we’ve had a venture capital lesson, back to the Vallar prospectus. There are Founder Shares and Founder Securities, so let’s deal with each in turn.

The Founder Shares convert into Ordinaries using a formula that is slightly different to the one I demonstrated above, and rather more complex. It means that if the Founders put in £20m and another £680m was raised from external investors, the Founders’ investment of 2.85% of the whole would give them 6.67% of the company. Using the terms from above, that is a conversion ratio of about 2.4:1.

Then there’s the Founder Securities. The terms again are quite complex, but broadly, these give the Founders 15% of the increase in the value of the company over and above its value at the flotation.

Okay, let’s summarise. If you put your money into this shell company you would be buying shares in an unidentified business, in the hope that its promoters (a) found a target to buy, (b) could buy it at a not-too-excessive price, and (c) could run it successfully in order to make it worth more than it was worth to its previous owners. (They need to create some sort of synergy – a grossly-misused word in corporate finance – in order for them to justify paying the vendor a premium over what it’s currently worth. Because presumably, the vendor is not going to sell out for less than it’s currently worth…) That’s quite a big ask. And in exchange for you giving them your investment funds on trust, they will take out salary, advisory fees and a rather significant share incentive.

Please don’t think I’m getting at Messrs. Rothschild and Campbell for this. I’m not. Well, not really. I happen to have looked at Bumi because I was on the Today Programme talking about it. But what they are doing, although very aggressive, is above-board. I pulled all of this information out of the prospectus, which is a public document. Any potential investor could read it.

Do other shell companies do similar things? Well, I had a quick look at a shell company that was floated about the same time as Vallar/Bumi – Horizon Acquisition Company. This company, led by entrepreneur Hugh Osborne, raised about £400m floating as a shell early in 2010 with the aim of buying over-leveraged businesses hit by the financial crisis. On a very quick look-through, its remuneration structure is less aggressive that Vallar’s. It doesn’t have Founder Shares but it does have Founder Securities, which convert to the same 15% of capital gain as did Vallar’s. What is interesting to me about Horizon is what it did with the money. Here is an extract from the RNS Announcement [2] (I couldn’t find the prospectus online):

“Horizon intends to acquire and restructure a single major business or company, significantly reducing its debt (the "Acquisition"). The business is likely to have significant operations in the UK, to have an enterprise value of between £1 billion and £3 billion ( although a business with a larger enterprise value may be considered ) and to be constrained by its capital or ownership structure. … Horizon intends to use the net proceeds of the Placing primarily to reduce the leverage of the acquired company or business.”

The RNS announcement  just gave a couple of line so information about the directors, but press comment at the time [3], presumably based on the prospectus, emphasised the skills and background of Hugh Osborne and Alan McIntosh, the executives behind the venture.

In June 2011 Horizon acquired APR Energy, a US energy company! Hugh Osmond and Alan McIntosh then stepped down from the Board – presumably because there was little that their experience could bring to a US energy business. I have not checked, so I have no idea if this acquisition brought value to the original shareholders in Horizon. I merely point out that a US energy company isn’t exactly what they signed up for.

So, what is being done about this? Well, it’s tricky to regulate. A few days ago the Financial Services Authority issued the catchily-titled Enhancing the effectiveness of the Listing Regime and feedback on CP12/2. In a short section on ‘externally managed companies’ (apparently the new technical name for cash shells) they introduce rules to stop such shells taking a premium listing, and they tighten some regulations for the companies’ advisors. This doesn’t do much, although it does prevent such companies from becoming a component of the FTSE 100, which will mean that your index-tracker pension fund is no longer exposed to them. The problem the FSA has is that this is a legitimate business activity, and difficult to regulate.

The new regulation will limit ‘accidental’ investment in cash shells. But one really would hope that common sense would limit deliberate investment: buying shares in an unknown quantity on the strength of its (probable) management will always be risky.

Around the time of the South Sea Bubble there was a company that raised money “for carrying on an undertaking of great advantage, but no-one to know what it is”. Nobody would fall for that these days. Would they?

[1]  Knutsford raised about £600m to buy a struggling retailer, partly on the strength of the track record of Archie Norman, who had been successful at Asda.  He then left, for a political career. As far as I’m aware, Knutsford never bought a retailer, but it did acquire a small internet company.

[2] Regulatory News Service.  A London Stock Exchange service to ensure market news is released in an orderly manner.

[3] See for example The Telegraph, 12^th December 2009, 20^th January 2010

Posted 11 Oct 2012.  Typos corrected & minor textual changes 12 Oct 2012