Special purpose acquisition companies (SPACs) are not new investment options. But their popularity has grown dramatically in recent years.
Here are answers to frequently asked questions about SPACs.
What is a SPAC?
Essentially, a SPAC—which can also be known as a "blank check company"—is a publicly listed company designed solely to acquire one or more privately held companies. The SPAC is a shell company when it goes public (i.e., it has no existing operations or assets other than cash and any investments).
As defined by the US Securities and Exchange Commission, a SPAC is a company with no operations that offers securities for cash and places substantially all the offering proceeds into a trust or escrow account for future use in the acquisition of one or more private operating companies. Following its initial public offering (IPO), the SPAC will seek to identify acquisition candidates and attempt to complete one or more business combination transactions, after which the company will continue the operations of the acquired company or companies as a public company.
How is a SPAC managed?
The management team of a SPAC (which includes sponsors, directors, officers, and affiliates) decides which companies to potentially acquire. A minimum of 85% of the SPAC IPO proceeds must be held in an escrow account (typically, more than that percentage is held in escrow) for potential acquisitions. These funds are usually invested in government bonds while the SPAC sponsor seeks acquisition targets.
Typically, SPAC sponsors receive roughly 20% of the common equity in the SPAC and 3% to 5% of IPO proceeds.1 A SPAC can purchase one or more companies, and the managers of a SPAC typically earn a percentage of the value of a potential deal (commonly around 5%).1
While investors have the right to vote on potential deals brought forth by SPAC managers, a risk for SPAC investors is that they may not like acquisition targets. Consequently, the SEC notes that "the economic interest of the entity that forms the SPAC … often differs from the economic interest of public shareholders, which may lead to conflicts of interest."
SPAC investors vote in a proxy to approve or disapprove a proposed acquisition. If more than 50% of shareholders approve and less than 20% vote for liquidation, then the transaction is approved and the acquired company is listed on an exchange. If more than 50% approve but more than 20% want to liquidate their shares, the escrow account is closed and funds are returned to public shareholders via a pro rata distribution of the net offering proceeds (less any fees for early redemption).
How does a SPAC raise funds?
A SPAC raises funds via an IPO. If the SPAC does not make an acquisition (deals made by SPACs are known as a reverse merger) within a specified period of time after the IPO, those funds are returned to investors. Subsequent to the IPO, a SPAC may raise additional capital via a PIPE (private investment in public equity) and/or debt financing. For their investment, investors usually receive SPAC shares plus warrants. A warrant provides an investor with the right to buy additional shares at a later date at a fixed price.
What has changed with SPACs?
A SPAC used to combine the right to vote (i.e., accept or reject a potential acquisition) with the ability to redeem shares. That is, if you voted to reject a deal, you would redeem your shares. In recent years, regulators decoupled those rights (i.e., investors could vote yes or no against a deal and still redeem their shares). In effect, this change has led to most proposed deals going through as planned by the SPAC management.
Why might private companies choose a SPAC over an IPO?
Due in part to the SPAC voting rule change, and other market forces, SPACs have become an increasingly popular alternative to IPOs. According to a recent Investor Bulletin from the SEC on SPACs, "Certain market participants believe that, through a SPAC transaction, a private company can become a publicly traded company with more certainty as to pricing and control over deal terms as compared to traditional IPOs."
More specifically, some of the reasons a private company might choose to go public via a SPAC versus an IPO include:
- Circumventing the IPO process. An IPO can be time intensive and carry significant costs. A SPAC is already public and, consequently, it can allow a company to quickly access public markets.
- Flexibility of SPACs. Instead of raising funds through an IPO as a private company, a SPAC can be an alternative for those companies that are highly leveraged (i.e., the company has a relatively significant amount of debt as a percentage of its total financing). A highly leveraged company may have difficulty raising funds in an IPO.
- Private company shareholder benefits. Founders and other major shareholders who want to sell some of their ownership position upon going public can sell a higher percentage in a reverse merger than they might be able to with an initial public offering. Also, these founders and shareholders can avoid lock-up periods (a predetermined amount of time that a shareholder cannot sell their shares) that can be associated with an IPO.
An important distinction to note here is the different valuation approaches with SPACs and IPOs. According to the SEC, "Unlike the traditional IPO process, where a private operating company sells its securities in a manner in which the company and its offered securities are valued through market-based price discovery, [SPAC managers] are solely responsible for deciding how to value the private operating company and how much the SPAC will pay for it."
What is the bottom line for SPAC investors?
Reasons why investors may find SPACs attractive include the ability to invest in a private company that will go public via the SPAC, coupled with the ability to buy more shares once the reverse merger is completed. SPAC returns are based on the appreciation or depreciation of the SPAC shares.
Of course, there are unique and significant risks associated with investment in SPACs. While SPACs offer the benefit to the private owners of more limited financial reporting requirements, the flip side is that investors may have access to less information.
Also, an investor's percentage ownership may be diluted by subsequent fund-raising efforts as well as if other investors exercise their warrants. Both groups of investors—those who hold their shares and those who redeem their shares—have to accept the opportunity cost of invested cash being locked up for quite some time (e.g., up to 24 months). Many original investors do so for the warrants, which the investor retains even if they redeem their share interest. Some studies have found that, for a large majority of SPACs, post-merger share prices decrease. These, and other factors, may imply that SPAC investors could be bearing the cost of the dilution embedded in the SPAC structure. Another thing to consider is that, as a SPAC nears the end of its time frame to acquire a company, acquisition targets may have enhanced negotiating leverage (compared with, say, a SPAC at the beginning of its deal-making window) in the terms of the deal due to the SPAC possibly needing to return funds to shareholders if a deal isn't closed.
Investors should recognize that when a SPAC issues securities to its sponsors, the terms of those securities often differ from securities it issues to public shareholders. The SEC stresses that this "typically results in sponsors having substantial control over the SPAC," and that "a SPAC also may increase its capital by selling securities in private offerings, resulting in negotiated terms for those securities that may differ from the shares sold in the IPO."
Most importantly, investors should understand what the objectives of the SPAC are before considering a SPAC opportunity. As stated by the SEC: "Whether you are investing in a SPAC by participating in its IPO or by purchasing its securities on the open market following an IPO, you should carefully read the SPAC's IPO prospectus as well as its periodic and current reports filed with the SEC pursuant to its ongoing reporting obligations."
And as always, any investment should align with your objectives, risk constraints, time horizon, liquidity needs, and other factors relevant to your specific situation.