Cash shells which require a health warning

When it comes to cash shells the market price and the share price at which a deal is done are not always similar. In fact, they can be hugely different. This is something that any investors in the latest hyped-up shell, Gate Ventures (GATE), need to bear in mind.

Logic does not appear to come into the Gate share price as it continues to trade at around its high of 182p a share. That values Gate at £59.6 million.

On 10 March 2015, Gate raised £3.24 million at 10p a share. One good thing is that all of the shares were issued at the same price, which is not always the case. Sometimes the initial shareholders subscribe for shares prior to the flotation at a fraction of the AIM admission price.

Gate's nominated adviser and joint broker Beaumont Cornish has exercised warrants at 10p per share - these were issued when Gate joined AIM - raising a further £34,851. These warrants were originally exercisable one year after admission, but presumably the nominated adviser allowed them to be exercised early!

That leaves pro forma cash of £3.08 million after the expenses of the AIM admission. There are corporate costs, including the fact that the four directors have total annual remuneration of £145,000, plus potential bonuses, so this cash will reduce over time.

This means that Gate is trading on nearly 20 times its cash value. That is like paying £1 for a 5 pence piece.

To be fair, there are additional benefits of a shell on top of the cash. There is the quotation and the experience and skill of the directors - Gate has directors experienced in the media and entertainment sector including executive chairman Geoff Morrow who is a songwriter. That is not worth the premium, though.

The nearest thing to a business that Gate has is its option granting the sole and exclusive right to fund the UK theatre production called Being Woody Allen, where Morrow has written the music and lyrics. Theatre is a risky investment and this is not a base on which to build a quoted company.

When shares are tightly held it can lead to the kind of large share price rises, or even falls in some cases, such as that experienced by Gate. The main shareholders and directors own 88% of Gate so there is a limited number of shares to trade. During March, there were 619 bargains in a total of 8.3 million Gate shares and they had a total value of £8.5 million. That means that the equivalent of just over one-quarter of the total shares in issue were traded during the month.

Possible Gate chairman Jun Zhu has doubled his shareholding to 17.5% after acquiring Stephen Gold's shares at 145p a share. The deal does not seem to be included in market trading volumes. The rest of the stake was inherited when Zhu bought Black and White Investment Ltd from Keith Bennett so there is no indication of the effective share price paid.

Crazy times at celebrity shell Knutsford

It may comes as a surprise to some that Gate is not the most overhyped shell of all time. The most extreme example of an overvalued shell with cash - there are plenty of shells with barely a few pounds or even net debt at ridiculous valuations as well - is Knutsford, where "business celebrities" sparked investor hysteria.

Knutsford started out as another Michael Edelson shell floated on AIM on 27 September 1999. It had a small leather goods business called David Conrad International, but it was always intended as a shell. It was not until 2 November 1999 that the share price really started to take off and trading was suspended at 9.25p. This was when the acquisition of Maybeat, a company with £5 million in cash and nothing else, for 247.5 million shares at an issue price of 2p.

This deal brought investor Nigel Wray, property developer Nick Leslau, consumer electronics retailer Julian Richer and former Asda boss Archie Norman to Knutsford and they were on the lookout for retail, leisure or property assets. This led to unfounded rumours of a bid for Marks & Spencer, but the big retail deal never happened.

The four men owned 90% of the share capital after the Maybeat deal so the shares were very tightly held thereby fuelling the rocketing share price.

At one point the share price reached 270p, valuing the company at £742.5 million, and by the end of the year it was 250p, valuing Knutsford at £660 million. The shell had £5.4 million in cash and the David Conrad business that was subsequently sold for £1.4 million. In reality, by the end of 1999 people were paying one pound for less than one penny of cash and assets.

In November 1999, there were 2,695 trades in Knutsford shares, even though there was a period of suspension, valued at £10.2 million. This shows that a large number of small deals - the average size of trade is just below £3,800 - have pushed the share price up. Although the share price was much lower at the beginning of the period which is likely to have brought the average down. In the previous month there were 16 trades, valued at £13,350 in total.

In December, there were 350 trades valued at £1.33 million. In January 2000, there were 748 trades worth £2.39 million although the share price fell to 140p by the end of the month. Trading levels remained high in subsequent months but the share price continued to decline.

It took until 2001 for Knutsford to secure a deal and that was the acquisition of annual reports and investor relations services supplier WILink.com. On 18 July 2001, WILink completed its reversal into Knutsford for £55 million cash, shares and loan notes. At the 10p issue price, the company was valued at £60.6 million - and there were many more shares in issue by then because a further £11.35 million was raised at the time.

WILink was taken over for 300p a share in 2006 but that was after a 250-for-one share consolidation so it is the equivalent of 1.2p a share, which is even less than the Maybeat reversal price. The end-1999 share price was £625 post-consolidation.

Harder getting deals done

An overpriced shell makes it difficult to do a deal. It has to be assumed that someone seeking a shell to reverse their business into is not foolish. If a shell has £1 million in cash and is valued at £40 million then it will not be an attractive home to a business, worth say £10 million and making £1 million profit.

Why would owners give away 80% of a combined business just to get an AIM quotation and a small amount of cash? Even if it is difficult to secure a direct flotation rather than a reversal into a shell it is not worth doing a deal at an inflated share price. Any adviser worth its salt would tell their client not to do it.

Looking at it from the reverse angle, the high share price ultimately does not do the shell or its shareholders any favours because it can take longer to do a deal. If that deal is then done at a large discount to the market price then it causes shareholder disappointment.

It may seem perverse to say that a high share price is not a good thing but it not only prices a shell out of deals it also leads to doubts about the company’s credibility.

The shell and its advisers have to take at least a large proportion of the blame for this. One of the main reasons that shells go to ridiculous levels is because they are set up in a way where there is limited liquidity and the broker in particular will be well aware of what will happen if there is any interest from investors.

In my next article I will analyse some of the prices at which shell deals have been done in recent years and how they compare to the share price prior to the deal.