Companies and investors are head over heels about Special Purpose Acquisition Companies (SPACs). What exactly are they and why are they popular? Find out here

If you are dialed into the financial world, chances are you have heard some buzz about SPACs in recent years. Venture capitalist Chamath Palihapitiya acquired a 49% stake in Virgin Galactic in 2019 through a SPAC and Bill Ackman raised $4 billion through a SPAC last year. Fantasy sports company DraftKings (NASDAQ: DKNG) completed a $3.3 billion merger with Diamond Eagle Acquisition Corp., a SPAC, in 2020.

What is a SPAC anyhow and why is it so popular all of a sudden? Read on to learn more about the SPAC trend, how it works and why it may be a good thing to consider.

A special purpose acquisition company, or SPAC, also known as a “blank check company”, is a shell company that never performs any commercial operations. It is listed on a stock exchange with the sole purpose of acquiring a private company, thus taking it public without going through the traditional initial public offering, or IPO, process.

A SPAC is a vehicle to raise money for a business acquisition through an IPO. SPACs have been around on Wall Street since the 1990s, but have garnered significant attention and popularity in recent years. In 2020, for instance, there were close to 250 SPAC IPOs completed in the U.S., raising over $80 billion. Although 2020 was a record-breaking year for SPACs, as of April 2021, the U.S. has already seen over 300 SPAC IPOs completed, with close to $100 billion raised.

SPACs afford investors the opportunity to co-invest alongside successful founders. A SPAC generally offers units, typically selling for $10 per unit, each comprising of one share of common stock and a portion of a warrant (i.e., 1/4th of a warrant to a full warrant) to purchase common stock. Investors thus receive units that are typically broken down into one share of common stock and warrants. Importantly, once a SPAC announces a merger target, investors have the ability to redeem their shares for cash, but they can keep their warrants for free, which makes SPACs particularly appealing for arbitragers.

The warrant is intended to compensate investors for agreeing to have their capital held in the trust account until the SPAC consummates a business combination or liquidates. The shares of common stock that an investor may receive from purchasing these units will act as normal shares, but the warrants offer an additional benefit to shareholders to purchase shares of the company at a predetermined strike price in the future, typically 15% above the IPO price. When a warrant is exercised, the shareholder will provide capital to, and purchase shares directly from, the company. The terms of SPAC units may differ slightly depending on the sponsor, with each employing its own structure.

SPACs raise money through an IPO process by SPAC management teams, also known as sponsors. Sponsors are required to complete an acquisition with the proceeds from the SPAC IPO, typically within 18 – 24 months of the issue date. If the sponsor does not find a target company to acquire within this time period, then the SPAC is usually liquidated and the IPO proceeds are returned to shareholders. In the early stages of a SPAC, shareholders are unaware of which ultimate company they are going to purchase, which is where the terminology “blank check” comes from.

SPACs are typically formed by experienced investors and / or business operators, the SPAC sponsors. Generally, a sponsor will have a 20% ownership interest in a SPAC in return for a nominal investment and is responsible for managing the SPAC. The sponsor’s goal is to raise capital and find a suitable acquisition candidate for the SPAC vehicle. These investments are time bound, with the sponsor typically having 18 – 24 months to complete the transaction.

Once the SPAC sponsor finds a suitable target to acquire, the investors are notified and approval for the transaction is required.

The general SPAC IPO process is outlined below:

1. The sponsor forms the SPAC based on its investment thesis, driven by the sponsor’s acquisition criteria, experience and background.
2. The sponsor issues the new SPAC units through an IPO, at which point the capital has been raised and the sponsor will begin evaluating potential targets for acquisition.
3. The capital raised from the IPO is immediately placed into escrow and remains in escrow until a suitable target has been identified and the deal approved by shareholders.
4. Once the target company has been identified, a public announcement of the potential transaction is made, at which point shareholders may vote against the transaction and / or elect to redeem their shares.
5. After shareholders approve the transaction, the merger closes and the target company officially becomes a public entity.

There are a number of benefits of working with a SPAC, both for the sponsor and potential seller. From the sponsor’s perspective, it provides for a broad base of potential investors and greater ease in raising capital. Raising capital through a SPAC structure is a secure and regulated process and can give independent entrepreneurs a path to break into an already-established industry. The SPAC structure also provides sponsors a platform to monetize proprietary deal flow.

Sponsors receive SPAC founder shares in return for sponsoring the SPAC in its pre-IPO stage. The sponsor will usually receive 20% of the SPAC’s founder shares in return for a minimal investment, which can provide the sponsor with a significant opportunity for capital appreciation. In addition, SPAC sponsors also receive warrants for sponsor capital provided. From the seller’s perspective, working with a SPAC can give it more security during a buyout. Since the SPAC manager is handling the IPO process, the seller can gain the benefits of access to public markets and public ownership without as many of the risks.

First and foremost, taking a company public through a SPAC is a quicker and cheaper process than a traditional IPO. The IPO market tends to be cyclical, following trends in the equity capital markets, and therefore timing becomes crucial, as the window to go public may close if market sentiment is not amenable. This timing dynamic is not nearly as important when going public by merging with a SPAC, as companies can go public even during times of public market instability through the SPAC structure.

The target company also benefits from a knowledgeable, experienced management team, which will help preserve investors’ objectives. Another advantage of going public through a SPAC is that SPACs have cash on hand, which aids in creating immediate capital appreciation and value for the company in the transaction. Knowing that an acquirer has cash readily available in an account and having a currency for acquisitions are both significant benefits, in addition to having access to public capital to fund operations or growth. The SPAC structure also affords sellers the ability to structure the transaction to include cash-outs and earn-outs that are not normally available in an IPO process. Moreover, from an operational standpoint, the reputational improvement of being a public company is positive for customer interactions. The SPAC process also allows the inclusion of financial projections in the proxy statement for approval of business combination, which is not available through the traditional IPO route.

Another advantage of investing into a SPAC is that the capital raised from a SPAC IPO is immediately placed into escrow. This capital remains in escrow until the sponsor has either consummated a transaction, or in the event a target company is not found within the two-year window, the capital will be returned to investors with accumulated interest. This dynamic significantly reduces downside risk to investors as they still receive a return and also affords downside protection until an acquisition is consummated. In addition, investors also receive tradable stocks and warrants from the SPAC investment. Investors can trade their SPAC shares at any stage while waiting for the target company acquisition to be announced. For example, if the SPAC is trading at a high price in the market, then investors can sell their shares while maintaining their warrants, which can potentially be exercised at a later date. SPACs also provide investors with known time limits and offers them greater input into the investment itself.

While there are many meaningful advantages of employing the SPAC structure, working with a SPAC can also have its disadvantages, both for sellers and investors. From the seller’s perspective, while the IPO process is easier, it may not draw as many long-term investors as the traditional IPO process, as some SPAC investors have different motivations than traditional IPO investors and are more likely to sell their stock quickly to turn a profit.

Some investors also tend to be wary of SPACs due to their “blank check” nature. Investors do not have any details about what they are putting capital towards, so it is harder to justify the initial investment. There is also less oversight throughout the IPO and merger process, which is concerning to some.

From an economic perspective, SPAC IPOs can result in a more costly loss of equity (dilution) for the target company compared to a traditional IPO since the sponsor acquires shares at a nominal rate. For a minimal investment, the SPAC sponsor can acquire a 20% equity stake in the company, which

is dilutive to the aggregate equity stake of investors. In addition, the time constraint associated with SPACs only allows the sponsor up to two years to find a suitable acquisition target. The success of investors relies heavily on the quality of both the sponsor and target company. Lastly, SPAC IPOs are less regulated than conventional IPOs, which makes the process inherently more risky as a result.

However, just because SPACs are under fewer regulations during the IPO process does not mean that they are entirely unregulated. After the initial IPO period is over, the SPAC sponsor will eventually announce which company it intends to buy. Investors can then decide if they want to keep the shares they acquired in the company or if they would rather trade them and cash out.

One potential danger of the SPAC process is that the companies acquired by SPACs can potentially be acquired at high valuations. Due to the large sums of capital raised by SPACs in the last few years, there is significant competition for deals amidst an already frothy market backdrop. When combined with a two-year window in which to transact, this may lead to significant overvaluations for target companies that may not necessarily be justified by their business prospects or any conventional valuation methodologies.

Once capital has been raised through the SPAC IPO, the sponsor will then typically have up to two years to complete an acquisition. This gives it time to thoroughly evaluate potential acquisition targets, complete due diligence on the target company it plans to buy and manage deal negotiations.

If a SPAC fails to complete an acquisition within the designated two-year period, the money it accrued is returned to investors, less fees and expenses.

While SPACs have been a transaction option for decades, they have gained significant attention and momentum within the last few years. In 2020, $83 billion of capital had been raised through SPACs, and in YTD April 2021, there has already been $100 billion of capital raised in the SPAC market.

The figure below (Source: SPACInsider) represents recent transaction volume within the SPAC market since 2009.

Part of the reason for this recent upswing is the number of startups, particularly in the technology sector. Many of these startups, known as unicorns, are valued at over $1 billion and are considered ripe for public ownership. SPAC managers have taken advantage of the large number of these opportunities by helping these companies go public through the SPAC process.

Of course, SPACs have not remained static over the years. One of the biggest changes has been to the process after a SPAC announces the company it intends to acquire and investors decide whether they want to keep or sell their shares. In the old days, some investors would team together and threaten to vote no on the transaction, if they were not given certain special privileges. At the time, the right to sell shares and the right to vote yes or no on an acquisition were tied together. These days, those are two separate processes, and the investors do not have a say in which company a SPAC ultimately acquires. They can elect to trade in their shares to redeem their capital, but they are far more limited from impeding a successful transaction than they were previously.

Investing in a SPAC can be a great way to grow capital with limited risk. If the SPAC does not close its merger within the specified two-year period, investors can simply get their money back. If the SPAC sponsor buys a company that seems unlikely to achieve capital appreciation, investors can opt-out, get their capital back and move on to other investment opportunities.

Investors can invest in a SPAC through one of two options: 1) selecting individual securities; or 2) investing in a SPAC exchange-traded fund, or ETF, which are similar to mutual funds and offer the benefit of diversification. Selecting individual securities affords the opportunity to maintain closer control over investments, which the ETFs lack.

A SPAC can be a great way for investors to acquire private, pre-IPO companies without access to a large capital outlay. They can also be a relatively safe way for private investors to invest capital into an IPO. Thanks to the abundance of successful startups in recent years, there has been a significant increase in SPAC activity that may continue indefinitely.

We provide investment banking services for emerging and mid-market technology companies. Check out our SPAC advisory services if you would be interested in seeing if your company is a good candidate to go public via a merger with a SPAC.