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).
Despite their popularity, SPAC IPOs have drawn criticism from those who believe they benefit SPAC insiders over retail investors, and that the businesses that they ultimately take public lack solid business fundamentals.
Here’s a rundown of what investors should know about SPACs before investing in one.
Understanding What SPACs Are
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 with which they can merge. If they do not find a deal, the SPAC dissolves and returns any proceeds to investors.
Interest in SPACs shot up in 2020 as many private companies, particularly ones that have reached “unicorn company” status, looked to debut in public markets, and continued in 2021. In 2021, there were more than 600 SPACs hit the market, up from nearly 250 in 2020. In 2019, there were only 59 SPACs, according to data from SPACInsider.
Some SPACs have a checkered track record, having historically underperformed the broader market, a trend that has continued in the recent boom. SPACs may also offer more favorable terms to bigger, institutional investors versus retail ones, making it crucial that the latter do their research.
Nearly half of small companies that went public in 2021 via a SPAC have not met the earnings targets that they presented to investors, according to an analysis by The Wall Street Journal. That, in turn, has potentially dampened the market for future SPACs.
How 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 the SPAC finds a target, stockholders vote on the proposed merger. They have the option to vote against the deal.
5. If the SPAC needs more funding 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” known as a deSPAC. The target company’s name and ticker symbol on the stock exchange, replacing the SPAC.
7. When SPACs go public, institutional investors have access to shares called “units.” Each “unit” includes a share priced at $10 and a warrant the holder can exercise 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.
History of SPACs
Investment banker David Nussbaum launched the first SPAC in 1993 and went on to cofound the SPAC-focused investment bank EarlyBird Capital. At the time, SPACs represented a new take on the “blank check companies” that had become embroiled in fraud and penny stock schemes in the 1980s. Over the next 25 years, SPACs remained a relatively obscure avenue for private companies to go public.
In 2009, only one company went public via a SPAC, and in the decade that followed, the numbers of SPACs per year ranged from just a handful to a high of 59 in 2019. The market saw an unprecedented boom in SPACs in 2020 and 2021, but with mixed results, some believe that the market has already peaked. By late February 2022, there had only been 44 SPAC deals, putting the year at less than half of 2021’s pace. Many SPACs that went public in 2021 have failed to find merger targets.
SPACs were extremely popular in the last few years. The deal structure has drawn a mix of famous figures as sponsors, including former President Donald Trump, billionaire venture capitalist Peter Theil, actor Channing Tatum, basketball player Steph Curry, and race car driver Michael Andretti.
Here’s a list of high-profile companies that went public recently through SPAC deals:
• Coworking space WeWork (WE)
• Mobile banking platform Moneylion (ML)
• Satellite manufacturer Spire Global (SPIR)
• Sports-betting operator DraftKings Inc. (DKNG)
• Space-flight company Virgin Galactic Holdings Inc. (SPCE)
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SPACs vs IPOs
The flurry of SPAC activity that began in 2020 comes after years of dissatisfaction with the traditional IPO process. Businesses in the United States have held off on going public for longer, even after experiencing tremendous growth.
Some startups may believe that going the SPAC route would put them less at the mercy of the stock market’s mood when it comes to their valuation when listing. The SPAC negotiates the price for the private company behind closed doors, similar to deal making for a traditional 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 speedier way for companies to enter public markets. A merger between a SPAC and target company can take a few months, while the conventional IPO model can take 12 to 18 months, and requires extensive investment in the documentation for regulators and the roadshow for investors.
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.
|Valuation negotiated behind closed doors like a traditional acquisition||Valuation determined the day before launch by underwriters|
|Process takes three to four months||Process takes 12 to 18 months|
|Merger terms reviewed by SEC||IPO prospectus reviewed by SEC|
SPAC Pros & Cons
There are benefits and drawbacks to investing in SPACs. Here’s a look at some of them.
Pros of SPACs
There are several reasons that SPACs appeal to some investors and founders as a method of taking companies public.
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.
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.
Navigating Stock Volatility
SPACs are one way that private companies can manage choppy trading in the stock market, since they can privately negotiate valuations and deal terms.
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.
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. Buying a company before it goes public does provide an opportunity for a potentially higher profit if the company eventually succeeds.
Cons of SPACs
While there are some potential advantages of investing in a SPAC, there are also important risks to understand.
With SPACs, there’s always the risk that the SPAC can not find a company to acquire. While in such cases investors do get their money back, plus interest, they may have preferred to put their money elsewhere during that time period. And because so many SPACs went public in the last two years, there’s now much greater competition for companies to buy, increasing the risk that they’ll overpay for targets or be unable to find one.
Many of the SPACs that have recently gone public have failed to live up to their projections. Short sellers — investors in the market who bet that a stock’s price will fall — have already started targeting SPACs.
Some observers believe that the 20% stake paid to sponsor has been deemed by some observers as too lucrative.
Risk of Dilution
The warrants given to institutional investors who buy into SPACs can potentially dilute others when the warrants are exercised.
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.
New SEC Chairman Gary Gensler has hinted that the agency is interested in increased oversight over SPACs, potentially reviewing them in a manner similar to its IPO reviews.
SPAC Pros and Cons Summary
|SPAC pros||SPAC cons|
|Seasoned sponsors lend legitimacy||SPAC could fail to acquire a company|
|Alternative route to IPO||Despac companies have underperformed|
|Ability to negotiate deal terms in private||Terms favor institutional over retail investors|
|Some investor protections||Risk of dilution through warrant execution|
|Retail investors can participate||Potential for more regulation|
SPACs have surged in the past few years, 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 and understanding the terms for the warrants. Interested investors can purchase SPACs for as little as $10 per SPAC unit by opening an account on the SoFi Invest® brokerage platform.
Are SPACs good investments?
You’ll need to evaluate each SPAC based on its specific characteristics. While many SPACs have underperformed the market, others have performed in line with expectations.
How do SPACs work?
SPACs are shell companies, typically led by industry experts, that go public with the sole intention of acquiring a private company and listing it on an exchange. If investors in the SPAC approve the merger, the companies combine, taking the name and ticker symbol of the newly private company.
How can I buy SPACs?
You can buy SPACs through an online brokerage account like SoFi Invest®. One unit in a SPAC typically sells for $10.
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