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What Are SPACs?

By Inyoung Hwang · December 28, 2020 · 5 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What Are SPACs?

Special purpose acquisition companies (SPACs) are shell companies that go public with the intent of buying a private business. Also known as “blank check companies,” SPACs have increasingly become a popular alternative to the traditional initial public offering (IPO).

It’s important to know that SPACs go public before they have any actual business operations and before they have a target company to buy. SPACs typically have a two-year horizon to find a private company to merge with. If a deal isn’t found, the SPAC is dissolved and the proceeds are returned to investors.

SPACs have boomed in 2020 as many private companies, particularly ones that have reached “unicorn company” status, look to debut in public markets. Some 247 SPACs were introduced in 2020, compared with 59 in 2019 and 46 in 2018, according to data from SPACInsider.

SPACs have a checkered track record, having historically underperformed the broader market. They can also offer more favorable terms to bigger, institutional investors versus retail ones, making it crucial that the latter do their research. Backers behind the latest batch of SPACs however argue that they now offer better incentives and target more quality businesses.

Here’s a rundown of what investors should know about SPACs before investing in one.

How Do SPACs Work?

Here’s a step-by-step guide to how a SPAC merger typically occurs:

1. A “sponsor” sets up a SPAC. Sponsors are typically industry experts or executives. They can pay $25,000 for a 20% stake–what’s known as the “promote” or “founder’s shares.”
2. The SPAC goes public, promising to buy one or more private companies with the proceeds from the IPO listing.
3. The newly public entity hunts for a private business to merge with.
4. When a target is found, stockholders vote on the proposed merger. They have the option to vote against the deal.
5. If more funding is needed for the merger, stockholders who are institutional investors or private equity firms can provide the additional capital in what’s known as a “private investment in public equity” or PIPE.
6. The target company then merges with the SPAC in a “reverse merger.” The SPAC’s name and ticker symbol on the stock exchange is replaced with that of the target company.

When SPACs go public, institutional investors are offered shares that are called “units.” Each “unit” includes a share priced at $10 and warrant that can be exercised when the shares reach $11.50.

So let’s say a SPAC’s shares rise to $15 each after the deal is announced, the institutional investor can exercise their warrants and net a profit from the difference between the $15 shares and $11.50 warrants that can be converted into shares.

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SPACs vs. IPOs

The flurry of SPAC activity in 2020 comes after years of dissatisfaction with the traditional IPO process. Businesses in the U.S. have held off on going public for longer, even after experiencing tremendous growth. This trend is particularly notable in the technology sector, where stakeholders in many private companies are now eyeing exits via SPACs.

With SPACs, companies are less at the mercy of the stock market’s mood. The price for the private company is negotiated behind closed doors, similar to deal making for a merger. This process allows for more stability in determining the value of the stock, which is especially attractive when the stock market is volatile. In an IPO, the price is set the day before the listing and often relies on the judgment of investment bankers.

SPACs also offer a much speedier way for companies to enter public markets. A merger between a SPAC and target company can take between four to six months. In contrast, the conventional IPO model can take 12 to 18 months.

The Securities and Exchange Commission (SEC) reviews merger terms between the SPAC and the target company, similar to how it reviews IPO prospectuses. However, because the SPAC is a merger, it’s more likely the deal can be marketed using forward-looking projections, which can be helpful for fast-growing companies that aren’t yet profitable. For IPOs, regulatory rules require that only historical financial statements can be shared.

Examples of SPACs

SPACs invaded the M&A and IPO markets in 2020. The deal structure has drawn a mix of famous figures as sponsors, including hedge-fund manager Bill Ackman, sports executive Billy Beane of Moneyball fame, former Speaker of the House Paul Ryan, former Trump administration economic advisor Gary Cohn, and even rapper Jay-Z, who partnered with a cannabis business.

Here’s a list of companies that went public recently through SPAC deals:

1. Truck maker Nikola Corp. (NKLA)
2. Sports-betting operator DraftKings Inc. (DKNG)
3. Space-flight company Virgin Galactic Holdings Inc. (SPCE)
4. Online real-estate marketplace Opendoor Technologies Inc. (OPEN)
5. Information analytics company Clarivate Plc (CCC)

SPAC Pros & Cons

Pros of SPACs

1. Seasoned Sponsors: Some recent SPACs have had sponsors who are more prominent figures. In essence, betting on a SPAC is trusting an experienced executive to suss out an underappreciated business in private markets and bring them to public markets.
2. IPO Alternative: Startups have increasingly shunned the traditional IPO model, calling it expensive, time-consuming and onerous. SPACs have become an alternative for some to go public in an often cheaper, faster way.
3. Navigating Stock Volatility: SPACs are one way that private companies can manage choppy trading in the stock market, since valuations and deal terms are negotiated privately.
4. SPAC 2.0: SPACs were once considered the “backwater of the stock market” and associated with penny-stock schemes. However, some of the more recent ones have featured seasoned executives, investor protections such as time-restricted warrants, and sponsors with more skin in the game.
5. Retail Participation: Retail investors can potentially get in on a deal at $10 a share. In a traditional IPO, they have to wait until the shares hit the public market after getting priced.

Cons of SPACs

1. No Deal: With SPACs, there’s always the risk that no target company is found. While in such cases investors do get their money back, plus interest, those dollars could’ve been invested elsewhere for those two years. And because so many SPACs went public in 2020, there’s now much greater competition for companies to buy, increasing the risk that they’ll overpay for targets.
2. Historic Underperformance: Business publications have noted that a majority of SPACs have a poor track record versus the broader stock market and that a number trade below their IPO price of $10 a share. Short sellers–investors in the market who bet that a stock’s price will fall–have already started targeting SPACs.
3. Sponsor Payout: The 20% stake paid to sponsor has been deemed by some observers as too lucrative.
4. Risk of Dilution: The warrants given to institutional investors who buy into SPACs can potentially dilute others when the warrants are exercised.
5. Potential Retail Disadvantage: When institutional investors participate in PIPE deals, they’re typically told the potential acquisition company. While this is legal, it’s potentially one way SPACs can favor bigger investors versus smaller ones, who are often left in the dark.
6. More Regulation? SEC Chairman Jay Clayton has said the regulator is looking into SPACs, particularly areas like ownership transparency and sponsor compensation.

The Takeaway

SPACs have surged in 2020, attracting many prominent figures to become sponsors as well as private companies looking for an alternative route to listing shares publicly. Even exchange-traded funds (ETFs)–tradable baskets of stocks–that invest exclusively in SPACs have cropped up.

While often described as a simple reverse merger, SPACs can be more complex than they seem at first glance. Investors can benefit from doing their due diligence, researching the sponsor’s incentives, what the terms for the warrants are, and the potential for more regulatory oversight.

With SoFi Invest, investors can set up an Active or Auto investment account and put money into a diverse array of stocks, buy pre-IPO stock or ETFs.

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