SPACs – An Alternate Way to Go Public

2020 and 2021 are the years that SPACs (special purpose acquisition companies) skyrocketed in popularity and became a promising alternative to IPOs (initial public offerings (IPOs). As a result, going public through a SPAC has become the new trend in the startup world. A special purpose acquisition company makes it possible for certain privately held companies to become publicly traded in a less complicated and much faster process than going through a traditional IPO.

A SPAC is an entity that is created for the sole purpose of raising money to merge with or acquire an existing privately-held operating company. Once the merger or acquisition is completed, the newly-formed company’s shares will be listed on the selected stock exchange.

This article will discuss what SPACs are, how they work, their structure, advantages and disadvantages, reasons for their popularity, regulations, and how to invest in them. 

An infographic that explains what a Special Purpose Acquisition Company is, the SPAC process a company has to go through to become publicly traded, SPAC benefits, and the risks of investing in a SPAC.

What Is A SPAC?

A special purpose acquisition company is an entity that is formed to raise capital through an IPO for the sole purpose of merging with or acquiring a private operating company. A SPAC is a non-operating company that does not have commercial operations. In other words, it does not produce or sell anything. That is why they are also known as shell companies.

Its ‘special purpose’ is to find a promising private company and take it public in a much quicker and more efficient way than the traditional IPO route. 

SPACs are generally created by a group of incorporators, also called sponsors or promoters. These sponsors are typically well-known institutional investors, private equity firms, or hedge funds. In addition, they are often backed by CEOs and celebrities with expertise in a particular industry or sector to attract potential investors. Because these sponsors provide the starting capital for the “new” company, they will get a stake in the newly-formed company when the acquisition or merger is completed. 

Management does not publicly identify the acquisition target until after the SPAC IPO has been completed to avoid various SEC disclosure regulations. The special purpose acquisition structure allows the SPAC IPO to raise money solely based on the sponsors’ previous track records, and retail investors buying into the IPO have no idea which company is targeted for acquisition. In other words, investors in the IPO are essentially placing their trust in the incorporators of the special purpose acquisition company. This is why a SPAC is also called a ‘blank check company.’

The funds raised for the IPO are placed in an escrow account and come with a “satisfaction or your money back” guarantee called redemption right. This redemption right guarantees that investors who are not fully satisfied with the business combination can sell their shares back to the SPAC. As a result, they will get the money they invested back plus interest accrued. Generally, redemption rights are offered to all public shareholders but not to sponsors and management. 

Typically, sponsors have 18 to 24 months to make the business combination a reality. After a formal agreement between the SPAC and the target company has been reached, the De-SPAC process starts. The most important part of this process is shareholder approval. The merger or acquisition requires approval by a majority of the SPAC shareholders. The business combination will not occur without majority approval, and the special purpose acquisition company will be liquidated.

There are many more reasons why the merger might not get completed in the allotted time. Luckily, no matter what reason stands in the way of the deal closing, public shareholders will always get their money back when the SPAC is liquidated. But unfortunately, the target company’s plans are shattered, and it will have to start searching for another buyer or company to merge with all over again.

How Does It Work?

An infographic the steps required in a SPAC for a company to go public; from SPAC formation. to SPAC IPO, to the search for a target company and fianlly the completion of the acquisition or merger.

Although special purpose acquisition companies are a faster and less complicated way to go public, multiple steps still need to be completed before a merger or acquisition can be finalized. Here is a detailed overview of the lifecycle of a special purpose acquisition company:

1. Formation of SPAC by Founders

A special purpose acquisition company is generally formed by one or more sponsors with impressive track records, such as institutional investors, venture capitalists, or private equity firms. These professionals are confident they can leverage their experience and reputation to raise enough capital to acquire a profitable target company through a SPAC IPO.

SPACs are only created to combine with a private operating company. Sponsors provide the starting capital for the sole purpose of acquiring or merging with a promising target company. The plan is that once the newly-formed company goes public, it will increase in value and make them significant profits. Public investors put their money in the IPO because they trust the SPAC sponsors’ impressive financial track records and expertise.

During the formation of the special purpose acquisition company, the founders/sponsors buy shares equal to about a 20 percent stake after the IPO is completed. These founder shares are purchased at a discounted price. They are intended to compensate the founders because they do not get a salary or any other form of compensation until the acquisition is completed.

2. Issuing of the SPAC IPO

SPACs have to follow the normal IPO process. This means that management hires an underwriter, typically a large investment bank, to manage the IPO. However, there is a difference. Because the founders do not publicly disclose the target company’s identity, they avoid some of the complexities associated with disclosures and disclaimers typically required by the SEC. 

Special purpose acquisition companies start the IPO process by raising capital on a stock exchange. The money raised comes from retail and institutional investors in return for SPAC units. Each unit consists of a share of common stock and a warrant to buy more stock in the future to provide investors with additional compensation for their investment. Typically, the IPO price for a unit is $10. This initial sale of stock is the SPAC IPO. Depending on the SPAC size and investment bank, a warrant may correspond to a fraction of a share or a full share of the common stock.

The funds raised must be held in an interest-bearing escrow trust account and can only be used to fund a shareholder-approved business combination.

After the required capital has been raised and the SPAC IPO completed, the SPAC gets assigned a ticker symbol and gets listed.

3. Searching for Target Acquisition Company

After successfully raising enough capital through the IPO, the special purpose acquisition company must identify the target company and complete the acquisition within 18-24 months. Though this timeline varies depending on the industry, most management teams get a maximum of 2 years to search for a private company to acquire or merge with.

Such a time limit is often easily met as sponsors usually already have an industry or company in mind before forming the special purpose acquisition company. If the special purpose acquisition company fails to complete the acquisition within the specified time, it dissolves, and the IPO proceeds are returned to the shareholders.

4. Completion of Acquisition or Merger

Once the sponsors identify the target company for acquisition, it is formally announced. The deal will only go through if approved by a majority of the SPAC shareholders.

After the announcement, due diligence will be done, including a third party’s business valuation. Then the De-SPAC transition begins. This process involves filing financial statements, a prospectus with the SEC, and a proxy statement to the shareholders. In addition, many other matters have to be taken care of, such as accounting and tax matters and required legal documentation.

If needed, the company can raise additional funds to complete the acquisition. After the target is identified, the SPAC may bring in additional equity investors in what is known as Private Investment in Public Equity (PIPE), particularly if it needs more money to close a deal.

After the business combination is completed, investors have a choice to make. They can either swap their shares for shares of the new company or redeem their SPAC shares and get back the capital they invested, plus interest accrued while that money was in the trust account. The sponsors typically profit and get about 20 percent of the common stock of the newly acquired/merged company.

The “new” company typically gets listed on one of the major stock exchanges such as the Nasdaq or the New York Stock Exchange.

In essence, a special purpose acquisition merger combines the benefits of an IPO with the flexibility of an M&A (Mergers and Acquisitions).

History

Special purpose acquisition companies have been around since the 1990s in different industries such as technology, healthcare, and telecommunications. David Nussbaum created them in 1993 as a way to get around the illegality of blank check companies in the U.S. However, it was not until 2003 when it saw a resurgence as public offerings started popping up in various industries in the public sector and in developing economies like China and India.

In the 2000s, entrepreneurs started looking for alternative ways of securing capital and growth financing. Companies that wished to go public but could not do so otherwise due to lack of funding or other reasons jumped on the SPAC bandwagon. Even investors started to favor SPACS because of the increase in popularity of hedge funds and disappointing returns from traditional asset classes. Furthermore, due to the increasing interest in special purpose acquisition companies, the SEC increased its involvement which helped legitimize this alternative way of going public.

Between 2014 and 2019, their popularity increased even further. According to SPAC Analytics, there were 12 SPAC IPOs with a value of $1.8B during this time. Then, in 2019, their popularity grew exponentially, with 59 new SPAC IPOs valued at $13.6B!

Some special purpose acquisition companies were very successful in creating equity value for their shareholders. This success not only attracted more investors but sponsors such as Bill Ackman and Bill Gates as well.

Why SPACs Have Been so Popular Recently

A graph that shows the growth in the number of SPAC IPOs and SPAC Dollars raised between 2012 and 2021.

Special purpose acquisition companies have been around for a long time and were often used as the last alternative when companies faced trouble raising money. However, in 2020 their popularity skyrocketed because of market volatility due to the Covid 19 pandemic, excess available capital, and SPAC’s deregulated nature.

SPAC’s popularity has attracted big-name underwriters such as Goldman Sachs and many celebrities who are happily endorsing them for a stake in the combined company. Examples of celebrities supporting SPACs are Jay Z, Shaquille O’Neil, and Martha Steward. 

The global pandemic also contributed to its rise. In 2020, SPAC IPOs were about four times higher than in 2019. According to SPAC Analytics, 248 SPAC IPOs got filed with over $83 billion raised. In 2021, this number more than doubled to 613 IPOs with over $163 billion raised. 

One of the largest special purpose acquisition companies in 2021 was Lucid Motors, the electric vehicle company. In July 2021, the Lucid Group merged with Churchill Capital Corp IV. It raised $4.5 billion in cash and started trading on the Nasdaq.

To protect investors, the SEC issued the following warning on March 10, 2021, regarding celebrity involvement with SPACs:

…….SPAC transactions differ from traditional IPOs and have distinct risks associated with them. For example, sponsors may have conflicts of interest, so their economic interests in the SPAC may differ from shareholders. Investors should carefully consider these risks. In addition, while SPACs often are structured similarly, each SPAC may have its own unique features, and it is important for investors to understand the specific features of any SPAC under consideration.

Why Do Private Companies Prefer SPAC over IPO?

Saves time – A company might prefer to go public through a special purpose acquisition company versus a standard IPO to save time and money. A traditional IPO typically takes between 12 to 18 months and is complicated. The IPO process consists of regulatory filings and extensive negotiations with regulators and sponsors. During times of uncertainty when risks are high such as during Covid 19, this can hamper a company’s goal of going public. In contrast, the SPAC structure provides a less complex and faster way for a private company to get listed on a stock exchange. A SPAC IPO typically gets completed within 3 to 6 months.

Upfront pricing and better deal –  A private company can go public within months through a merger or acquisition by a special purpose acquisition company. The two-year time limit for a deal to close ensures that the target company owners have more negotiating power. 

If a deal cannot be reached within this time limit, the acquisition will not go through, and the SPAC has to return the money raised to their investors. Management does not want this to happen, which sometimes results in a better deal and more money for the target company. In contrast, in a traditional IPO, there is no time limit which gives the private equity firms more bargaining power. Furthermore, the price gets negotiated before the deal closes in a SPAC deal. In contrast, market conditions set the price in a traditional IPO, which can be a considerable disadvantage in a volatile market.

Saves money – SPAC IPOs do not require expensive and time-consuming roadshows to get the attention of public investors. Furthermore, the special purpose acquisition company typically pays for most of the merger costs.

Democratize the process of stock buying – Another reason a company would opt for a SPAC over an IPO is to democratize the process of stock buying. As special purpose acquisition companies are public companies, anybody can invest them and, as a result, acquire an interest in the newly-formed company at a relatively low price of about $10 per share. Then, when the merger is completed, these investors can take advantage of the initial price surge when the newly listed stock starts trading.

In contrast, IPO shares are only offered to a select group of investors at the offering price that the underwriter sets. The prices of these traditional IPO shares typically rise substantially above the offering price during the first few hours or days of trading. This initial IPO price pop can result in significant profits for the select group of investors. However, prices do not typically remain that high later on, so individual investors who only have access to the shares on opening day will never see the enormous profits that the select group of investors will see.

As SPACs allow all interested investors to invest from the get-go, everybody will benefit equally from the potential initial stock price increase.

Access to expertise – Companies acquired by a SPAC sponsored by reputed and experienced finance professionals and business executives will have better market visibility and access to an expert management team.

Option of raising additional capital – The SPAC structure allows sponsors to raise additional capital through PIPE funding. Sometimes the SPAC IPO cannot raise enough money for the upcoming business merger or acquisition. To ensure the deal gets closed, the SPAC will offer select private investors stock at a below-market price. This will enable the SPAC to quickly raise enough money to close the deal.

SPAC Regulations

The Securities and Exchange Commission governs SPACs in the United States, and one of its goals is to protect the increasing number of SPAC investors. However, as SPACs have seen exponential growth, it is clear that regulations are lacking. Therefore, the SEC is currently on a mission to add and expand existing SPAC regulatory obligations to ensure that investing in special purpose acquisition companies becomes more transparent and safer.

As mentioned before, the SEC has warned about various investor risks and cautioned against securities law violations. For the last two years, it has not only issued guidance and public warnings, but its Chairman Gary Gensler has implied that in the spring of 2022, it will start discussing various new regulations concerning special purpose acquisition companies. 

One of the agenda items will most likely be to increase disclosures to retail investors to give them more insight into the financial incentives of sponsors and management. It also plans to increase regulations concerning increased transparency in how SPACs evaluate their targets. Right now institutional investors have access to this information but retail investors do not.

Another issue that will be addressed is the current use of misleading, incomplete, or fraudulent information in fancy marketing materials. These practices are illegal according to U.S. securities laws. For example, when SPACs publicly announce the target company, they often use high-profile celebrity endorsements and fancy press materials to convince investors to buy the stock. However, just because a celebrity is involved does not mean it is a smart investment.

As a result, the SEC plans to discuss regulations specifically targeting special purpose acquisition companies. These regulations will require SPACs to engage in more intense and stricter due diligence and related disclosure processes on potential target companies to improve the new companies’ success potential. The regulations will also require full disclosure to retail investors earlier in the process.

Investment Opportunities in SPACs

Special purpose acquisition companies offer three types of investment opportunities depending on investment level and risk tolerance.

Sponsors – This first investment opportunity is only open to a select group of investors. Sponsors are typically experienced investors or firms, who have a lot of capital to invest, are willing to take on significant risk, and have a long and successful track record.

SPAC IPO – Investing in a SPAC IPO is open to retail investors. Investing in a special purpose acquisition company means trusting the sponsors and relying on their skills and experience to pick a profitable target company. The SPAC IPO share price tends to be stable before the merger has been completed. The capital raised is held in a trust account to earn a interest. This limits the downsides during the search for the target company.

Though investing in special purpose acquisition companies involves a leap of faith because retail investors do not know which target company they are investing in, the returns can be substantial. Furthermore, investing at this stage is a great way to get in on the deal early at limited risk because investors can redeem their shares after the merger.

SPAC IPO shares are sold on major stock exchanges and can be bought through a regualr brokerage account. Selecting individual SPAC securities will allow investors to participate in promising companies while taking little risk because of redemption rights. Another way to limit risk is to take a more diversified approach by investing in SPAC-based ETFs.

PIPE (private investment through public equity) – This investment opportunity is only open to institutional investors like hedge funds. After the target company has been announced, sponsors often raise more money to ensure that they have enough capital available for the acquisition as there is a possibility that more investors redeem their shares than expected.

Risks of investing in a Special Purpose Acquisition Company

Lack of disclosure and proper due diligence – Lack of upfront information about the target company and less oversight of regulators means investors run a higher risk that investments turn out to be fraudulent or overhyped. Investors mostly rely on the SPAC sponsors’ track records to select a profitable target company. This is pretty risky.

An example of a SPAC that defrauded investors by misleading them is Nikola, the electric truck maker that entered the public market through a special purpose acquisition company on June 4, 2020. Its shares soared to almost $100 later in June, although it had never even produced a single truck for sale! As a result, the SEC started an investigation, and the company has agreed to pay $125 million to the SEC to settle civil fraud charges for misleading investors. On March 14, 2022, its stock closed at $6.87.

Shareholder dilution – One of the biggest problems of investing in special purpose acquisition companies is share dilution. The first source of dilution is through the sponsor promote. Sponsors typically receive a 20 percent stake in the SPAC for putting the deal together. Another, even larger source of dilution are the warrants issued. These warrants allow sponsors to purchase more shares leading to further dilution. 

The short timeframe for the target company to get ready for going public – While the shorter timeframe of going public through a special purpose acquisition company is an advantage for a company that wants to go public during a volatile time, it can also be a disadvantage. The target company will not only have to prepare the required financial statements for the SEC filings but it also has to make sure that required public company functions such as investor relations and financial reporting are taken care of. This is not an easy task to complete in a few months.

Potential lack of capital due to redemptions – If more investors redeem their shares than expected, there might not be enough capital available for a successful business combination. This might require the SPAC to raise PIPE financing, further diluting existing shareholders.

The Future of SPACs

As mentioned before, in 2020 and 2021, the number of special purpose acquisition companies skyrocketed. Some have already completed their merger or acquisition, while others have picked their acquisition companies and are in the process of closing the deal. However, the majority of them still have to announce their targets. According to SPAC Analytics, as of January 31, 2022, there are 588 SPACs seeking acquisition.

During the latter part of 2021, a new trend emerged. More and more SPAC deals got canceled or failed. There are several reasons for this increase in failures and cancellations. 

First, recent history has shown that returns after the mergers have been significantly below-market. As of September 2021, about 70% of the 2021 IPO SPACs traded below their base price. These disappointing numbers have resulted in institutional investors being less interested in investing in SPACs and retail investors exercising their redemption rights resulting in some SPACs not getting enough capital to close the deal.

An example of a SPAC deal with returns way below market returns was the acquisition of Metromile, the pay-per-mile auto insurance provider by blank check company INSU Acquisition Corp. II. Since the SPAC deal closed in February of 2021, Metromile’s shares have performed poorly. They went from about $19 when the deal closed to $0.86 on March 14, 2022.

In addition, more scrutiny by the SEC has increased the wait times to get the acquisitions approved. Longer wait times have resulted in some SPAC deals getting canceled. For example, Fast Acquisition Corp, a blank check company, found their target company Fertitta Entertainment and negotiated a deal. However, the SEC took a very long time to approve the deal, which eventually resulted in Fertitta Entertainment walking away from the deal. 

Furthermore, the expected increase in new SEC regulations in the first half of 2022 has created more uncertainty, resulting in some special purpose acquisition companies deciding to dissolve and return the raised capital to their investors. 

So, with 588 SPACs still seeking target companies within the next year and a half, it is a crowded playing field. There might just be too many SPACs and not enough quality companies to acquire. During the first few months of 2023, the deadline for many of these SPACs will expire. It will be interesting to watch which ones are successful and complete their acquisition and which ones will have to cancel their plans, return the money to their investors and dissolve the special purpose acquisition company. 

Conclusion

Although the explosive growth in the number of SPACs is slowing down, it is unlikely that they will disappear in the near future. Special purpose acquisition companies are a very lucrative business for sponsors such as institutional investors and billionaires, so they keep launching new ones. Furthermore, considering the potential advantages associated with special purpose acquisition companies, there is no doubt that it is an appealing way for some companies to go public. Finally, SPACs are an attractive investment option for retail investors because they enable retail investors to get portfolio exposure to new evolving companies in lucrative sectors.

There are several factors that have contributed to the recent decline in SPAC popularity. First, recent SPAC history has shown that business combinations through special purpose acquisition companies are in practice more costly than expected. In addition, many of these new public companies seem to have a hard time reaching their profit goals. Lastly, the SEC announced that new SPAC regulations will be on the horizon in the spring of 2022.

So, should you add SPAC IPOs to your portfolio? Partially that will depend on your risk tolerance. For example, if you are risk-averse, you probably should not invest in a special purpose acquisition company as you do not know which target company you are actually investing in. Likewise, if you do not have a highly diversified portfolio of stocks, bonds, and cash yet, it may be wise to work on that first before ever considering investing in an individual SPAC.

However, suppose you want to diversify your portfolio further by investing in a SPAC IPO. In that case, you should do in-depth due diligence by researching the sponsors involved and their track records, as they are responsible for picking the target company.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.