Understanding the Mysterious Shell Company

Written by John Peterson
Posted October 4, 2018 at 8:00PM

Dear Reader,

You may have heard the term but, like so many of those on the fringes of the world of finance, decided that it was better left a mystery.

The shell company... What is it? How does it work? Why does it exist? And most importantly: What can it do for you?

The most basic way to describe a shell company is as a company without a business model.

"But how can this be?" you might ask.

It may seem that a company and a business are one and the same. But in the world of public markets, they are, in fact, two distinct concepts altogether.

A business is a mechanism by which labor and ideas are turned into revenue. To operate, a business needs to have a product in the form of a sellable object or service. It must have an avenue by which that product is delivered to its customers. It must have a method by which payment is accepted. And to survive, it must generate more revenue than liability (cost).

A business is everything from the lemonade stand you had outside your house as a kid to the huge, enormously varied organizations that have their hands in seemingly all aspects of the modern economy.

That's a business. And to exist, it must work. A business that doesn't fulfill these criteria, either on an immediate or prolonged timeline, is, quite appropriately, out of business...

If You Want to Make Money, Starting a Company Is the Last Step

But a company doesn't need to possess any of these attributes.

Companies are nothing more than stacks of legal documents that describe the structure of the organization that either does or might, at some point, run a business.

This collection of documents describes who's in charge of what, where the entity is based — and which tax and litigation laws it's subject to — and who owns the thing.

Companies fulfill one important need that almost all businesses have. And that's to deflect legal liability and also manage and minimize tax liability.

A business can exist without being a company. Although, it would create difficulties for the people involved. So, generally speaking, when legal — and sometimes illegal — revenue-creating organizations become big enough, they go through the long and convoluted process of becoming formal companies.

In the world of public markets, the company is the entity in which you buy fractional ownership when you choose to buy stock.

Along with specifying who in the company is responsible for which duties, the organizational documents also specify how many fractional units, or shares, the company is broken into. Public companies offer these shares for sale.

Notice that I'm not using the word "business" in any of these descriptions. That's because, in the world of public markets, a company doesn't need a business model to exist. 

Public companies can be, and sometimes are, nothing more than stacks of documents that state who is in charge and how many shares have been issued.

They can be left over from previous businesses that have gone out of business. Or they can be purpose-built companies that were supposed to go into business but for whatever reasons, like the market changed or the owners decided to walk away, never came to fruition...

An Empty Suit Still Has Value

That's what we call a shell company. It's essentially an empty suit with all the appearance of formality, but it lacks a body to occupy it.

Seems a bit bizarre, right? But considering the time, energy, and cost that it takes to organize a publicly traded company, there's an intrinsic value in that legal work alone.

But why? 

Well, let's say you own a company that you want to take to the public markets to raise money from retail investors...

Usually, this process would take months, even years. And it could cost hundreds of thousands, even millions, of dollars in legal fees.

But what if you could buy a ready-to-go package, slide your business model into it, and make whatever superficial modifications were necessary to suit your needs?

The time and money saved could be used to grow your business. And that's an appealing prospect for anybody who's already taking the financial risk of running an enterprise.

But this leads us to a rather bizarre phenomenon. These companies that are just sitting there, waiting for a group with a business model to come in and turn the stack of legal documents into a functioning organization, remain tradeable during this wait.

They're not doing business. And they're not making any products or providing any services. But because the documentation is in place, the number of shares has been specified — maybe when the company was hosting its previous business — and the shares are on the public markets, ready to be traded.

It's a suit awaiting a body to put it on and go to work.

Shell companies are regularly purchased and repurposed, from whatever their initial creators envisioned, to facilitate completely new and unrelated business models...

Canadians Love Them

These companies are especially common on the Canadian exchanges, like TSX and CSE. It's there that you can find dozens of companies, with stock symbols that can be identified with the .V or .CN suffix, that trade despite being inactive in all other aspects.

So, why would any investor consider risking their money on something that does nothing besides exist?

Well, remember the metaphor: A suit without a body.

Suits aren't cheap. But when they're worn, the complete package becomes far more valuable.

Investors who buy shell company stocks are waiting for one thing and one thing only: a group of businessmen to come around and fill that suit. And that group will bring a brand-new business, start producing a product, and start making press releases to alert new waves of investors that progress is being made.

The risk isn't small because, without concrete knowledge of any plans about this shell company, the wait could be long indeed. It could be months or even years.

The number of investors who are willing to take this risk is also understandably small. And that means if you take the chance, you might be stuck for a while with no way out.

And yet, if you get lucky, the payoff can be huge.

I've seen old mining companies devolve into shell companies only to be bought and reorganized into software or blockchain-oriented operations. And then their share prices explode seemingly overnight.

Lately, this trend has become popular with another sector: cannabis.

On the Canadian exchanges, there's no shortage of inactive shells. And with so many entrepreneurs who are looking to get into red-hot niches, the market for these shells itself is starting to heat up.

If you want an example of one, take a look at Seaway Energy Services (TSX: SEW.V)...

Needless to say, this company isn't in the energy business. It's not in any business at all. Not yet, anyway.

But it does trade, albeit trickles at a time, which makes me suspect that it might soon get the body it needs.

That's really it... Shell companies, in a nutshell.

Nothing mysterious. Nothing devious.

That's all for now.

Until next time,

John Peterson
Pro Trader Today

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