A Special Purpose Acquisition Company or SPAC is a corporation that acquires or merges a private company and takes it public within 2 years. Instead of the traditional IPO process that can prolong a timeline, SPACs raise capital for their target companies.
A SPAC is also referred to as a blank check company as it does not offer any services of its own. Rather, they exist to buy private companies and effectively take them public. Take a closer look at several distinct advantages of a SPAC stock over a traditional IPO and learn its risks in the stock market.
Special Purpose Acquisition Companies have captured the attention of investors and financial media. SPACs have existed for decades in various forms–recently gaining prominence in the public investment market.
When a company decides to go public, it must go through the IPO process. To speed up the IPO process, SPACs have emerged as a cheaper alternative. After becoming a public company, the SPAC merges with a private target company. The SPAC raises the required funds through an IPO and holds it till the desired acquisition is made.
This means that the only asset a shell company possesses is its IPO. There is a team of institutional investors that buys into the IPO without knowing the acquisition target company of the SPAC stock. The capital is raised through the IPO, and the SPAC’s founders or management team looks for a target company and prepares for an acquisition.
A History Of SPACs
When SPACs first emerged as blank-check corporations in the 1980s, the SPAC framework was flawed. Penny-stock fraud was common in the blank check companies, costing investors more than $2 billion a year.
These firms were notorious for absconding with investors’ money or engaging in deals that left investors with almost no returns. After the intervention of the U.S. Securities and Exchange Commission, SPAC stocks were thoroughly regulated. For example, blank check IPOs were now held in regulated escrow accounts and could not be used before the merger.
With a new regulatory framework, the blank check corporations rebranded as SPAC. Until the target company is announced, the investors now have the option to recover their funds from the SPAC stock.
How Does A SPAC Stock Work?
SPACs provide endless financial opportunities for boards of companies and investors. The traditional process of going public through the IPO is rather tricky for a private company.
Compared to an IPO, the SPAC is less risky for the target company. The costs associated with a traditional IPO are eliminated when a company chooses a merger. Going public with SPAC invites a board of potential investors and high levels of financial statements for the target company.
According to the Wall Street Journal, 2020 witnessed the record-breaking of SPAC acquisitions. Many private companies bypassed the IPO process and chose to go public with SPAC.
A SPAC Lifecycle
In the world of investing, SPAC is a rising trend. Large institutional investors like entrepreneur and VC Peter Thiel and baseball executive Billy Beane got involved. When learning about investing in stocks, it is imperative to know the different facets.
If you’re still confused about SPAC stocks, here’s everything you need to know about a SPAC lifecycle.
SPAC Formation
The initial stage of a Special Purpose Acquisition Company involves a group of sponsors, well-known investors, and private equity firms. Since the SPAC is a shell company, the reputation of its founders is the selling point for acquiring investors.
The SPAC is founded by a management team using capital from the founding members. In the pre-acquisition stage, the blank check company goes through an initial public offering (IPO) process where 80% of the SPAC’s shares are bought by investors while the remaining is distributed among the founders. To attract reputable investors, founders often hold an interest in a specific field that vouches for their credibility. These sponsors invest in risk capital or nonrefundable payments for the operating expenses of the management team.
If the sponsors or founders fail to acquire a target company, the SPAC is dissolved, and the money is returned to the SPAC investors. Most investments often come from institutional investors who buy shares before identifying the target company. The combination of the SPAC founders and investors forms the backbone of the shell company.
SPAC IPO
Unlike target companies, SPACs are required to go through the traditional IPO process. During the IPO process, the sponsors often withhold the name of the target company to avoid the complicated process with the U.S. Securities and Exchange Commission (SEC).
When issuing the IPO, the SPAC management team contacts an investment bank to administer the IPO. The investment bank charges 10% of the IPO as the fee charged for their services. The securities sold during an IPO are offered at the unit price (including common stock and warrants).
Investors receive two kinds of securities: common stock ( $10 per share) and warrants that allow them to buy stocks in the future (at $11.50 per share). Following the IPO, proceeds from the IPO are held in a trust account until the private company is identified as the target acquisition.
Acquisition Search
A Special Purpose Acquisition Company typically has 18 to 24 months to find the target company. The management team searches for a private company that is ready to go public within 2 years.
The imposed deadline requires the SPAC management team to work diligently to find and acquire a target company. If they cannot acquire the target company, the SPAC is liquidated, and the investors get their money back. During this period, the SPAC stock is traded near its IPO price as the proceeds are held in the escrow account.
The research process for acquiring a target company involves reviewing the company’s financial statements and corporate structure. After the SPAC acquires a potential target firm, they make a formal announcement. If everything checks out, the SPAC and the target company discuss the terms of the merger.
Acquiring A Target Company
After the SPAC announces the target company, the proxy vote is enforced. At this point, the SPAC shareholders can vote on the target acquisition. The fair market value of the target company needs to have at least 80% or more of the SPAC’s trust assets.
The SPAC may need to raise more money (issuing more shares) to acquire the private company. Shareholders also decide whether to liquidate their shares in the SPAC or continue with warrants. If most shareholders approve of the acquisition, the target company is listed on the stock exchange.
There is a certain percentage fixed for the number of shareholders who choose to liquidate their shares. Historically, the percentage is fixed at 20%, but it can be as high as 30%. If the percentage of the shareholders exceeds 50%, the escrow account is closed, and the deal is terminated.
Merger
When a Special Purpose Acquisition Company merges with a private company, the process is called a de-SPAC. After soliciting shareholder approval, the SPAC acquires the target company.
The de-SPAC process involves heavy oversight from the SEC team that evaluates the financial information of the target company. A form 8-K must be filled with the U.S. Securities and Exchange Commission within four business days of closing the transaction.
A SPAC may go through several rounds of negotiation with potential investors (like large funds or private equity firms) to raise additional capital. The initial IPO raised only covers about 25%-35% of the purchase price. To raise capital, SPAC sponsors may also resort to new outside investors using a Private Investment In Private Equity (PIPE) transaction.
Is SPAC Better Than Traditional IPO?
Regarding funding and liquidity, SPACs offer specific advantages to target companies. Compared with traditional IPO, the process is less complicated and faster with fewer regulatory demands.
In a traditional IPO, a private company uses an underwriter to go public on the stock exchange market. When it comes to valuation, traditional IPOs take nine to 12 months with little certainty about the capital raised till the end of the process. Target companies directly cede the valuation process to underwriters who solicit and manage potential investors. Refer to the table below for the main differences between the two groups.
| Difference | Traditional IPO | SPACs |
|---|---|---|
| Valuation time | 9-12 months | Within the first month |
| Pricing | Depends upon market conditions | Target companies can negotiate the pricing |
| Liquidity | No access to liquidity | Security in liquidity through the cash raised in IPO |
| Cost | It is costlier than SPAC | The total costs are comparatively cheaper |
| 5. Valuation yield | Conflict of interest between private companies and underwriters which results in lower valuation yield | Higher valuation yield as the SPAC sponsors directly communicate with investors |
SPACs are required to go through the IPO process first which allows other private companies to avoid the traditional IPO. It benefits both parties–target companies and investors to choose the easier route.
Advantages of a SPAC
Successful SPACs create benefits for all the parties involved. The sponsors gain profits, the institutional investors acquire risk-adjusted returns and target companies go public without the traditional IPO process. Some of the advantages of SPACs are listed below:
- SPACs are faster: As we’ve already discussed, SPACs have a swift valuation process. The merger with a SPAC takes 3-5 months while the IPO process takes around 12 to 18 months.
- SPACs are cheap: Most SPACs are priced at $10 a share–making them accessible to all investors. According to Jay Ritter, IPOs, on average, don’t jump on the first day of trading.
- They invest in trending industries: The new breed of SPACs primarily focuses on the tech and consumer sectors. Promising startups like Nicola, Clover Health and Opendoor have all gone public via SPACs.
- SPACs are open to individual investors: For SPAC offerings, institutional investors are important as they go to the front of the line. This allows smaller investors to buy shares in SPACs too.
- The target company can negotiate a premium price: Due to the limited time of closing a deal, the target company can negotiate the merger price.
SPACs have recently gained popularity in 2020. Many private companies have opted out of the conventional IPO as SPACs offer more security and certainty than the traditional process.
Risks Of A SPAC
SPACs are garnering a lot of attention since high-profile companies like SoFi, WeWork and Grab have been associated with its operations. At first, the SPAC process appears faultless to potential investors and target companies. There are a few risks of investing in SPACs that cannot be ignored.
An investor in a SPAC IPO buys shares without knowing about the target company. Some of the risks of investing in SPACs are listed below.
Ambiguous Returns
Sometimes returns from SPACs may not meet expectations during the promotion stage. Shareholders often don’t benefit from investing in SPACs due to the lack of regulatory requirements. According to a renaissance capital strategist, 70% of SPACs that held their IPO in 2021 were trading below their $10 share price.
For example, Digital World Acquisition Corp (DWAC) brought Donald Trump’s Truth Social app to the public space fairly poorly after closing the deal. The initial share price of $100 per share has fallen sharply lower to $18 at the end of 2022. The underwhelming performance of shares after the deal is a risk that potential investors should be aware of.
Scam Alerts
Since a SPAC does not announce the target company after the research process, there are a lot of scams where money is emptied from the escrow account without the shareholders' permission.
With the U.S. Securities and Exchange Commission introducing new accounting regulations, SPACs have decreased due to their underwhelming performance.
Minimum Regulatory Requirements
Within an IPO, every aspect of a company is thoroughly regulated before the company goes public. Investors can put their trust in a specific company and have confidence in what they’re investing in.
For a SPAC, requirements are not stringent, so investors do not know if the company they’re investing in has what it takes to survive.
Unfulfilled Deals
One risk investors usually face with SPAC acquisitions is the surety of the deal. Even if the sponsors identify the target company, there are risks of the real deal not going through due to insufficient funds or the proxy vote of the shareholders.
According to industry reports, 55 SPACs worth tens of billions of dollars were terminated in 2022. This means that many investors received their money back without any valuable returns. Investors usually get back the par value of the shares ($10) however if they have invested more in hopes of closing the deal, they could suffer a significant loss.
Since investors are only entitled to the pro rata share of the escrow account, they could suffer a significant setback when deals are terminated.
SPAC Poor Performance
As SPACs compete with each other for target companies, they could be potentially overpaying. An analysis of the SPACs that went public between 2013 and 2015 shows that most traded below their IPO prices.
SPACs are also responsible for underperforming the overall stock market as they traded below the IPO prices. As a whole, SPAC stocks still underperform the broader market by 24%.
Conclusion
SPACs continue to gain popularity among many companies even if the risks are increasing on the playing field. Just like other modes of investments, there are risks to every kind of stock.
Some SPACs will, of course, fail, so it’s important to choose the right SPAC for your investments. As more changes are yet to come, staying updated and vigilant is key to making a breakthrough in the SPAC world.
