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 can be an alternative to the traditional initial public offering (IPO) route.
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.
While SPACs are less common today, interest in SPACs peaked during 2020 and 2021 as many private companies, particularly ones that had reached “unicorn company” status, looked to debut in public markets. In 2021, there were more than 600 SPACs, up from nearly 250 in 2020.
In 2022, by contrast, there were only 86 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.
The IPO process and trading IPO shares is a risky one for most investors. Understanding the route a company chooses when going public can help investors better assess whether the stock falls within their risk tolerance.
💡 Quick Tip: Keen to invest in an initial public offering, or IPO? Be sure to check with your brokerage about what’s required. Typically IPO stock is available only to eligible investors.
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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.
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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. Many SPACs that went public in 2021 have failed to find merger targets.
The number of SPAC deals since then has continued to dwindle, with traditional IPOs also decreasing.
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SPACs vs IPOs
The SPAC model emerged after years of dissatisfaction with the traditional IPO process. Some startups may believe that going the SPAC route will 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 may allow 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 may 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 as well as 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.
| SPAC | IPO |
|---|---|
| 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.
💡 Quick Tip: If you’re opening a brokerage account for the first time, consider starting with an amount of money you’re prepared to lose. Investing always includes the risk of loss, and until you’ve gained some experience, it’s probably wise to start small.
Pros of SPACs
There are several reasons that SPACs appeal to some investors and founders as a method of taking companies public.
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.
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.
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.
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.
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. Buying a company before it goes public does provide an opportunity for a potentially higher profit if the company eventually succeeds, but SPACs and IPOs are high-risk endeavors that offer no guarantees.
Cons of SPACs
While there are some potential advantages of investing in a SPAC, there are also important risks to understand.
No Deal
With SPACs, there’s always the risk that the SPAC cannot 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.
Underperformance
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.
Sponsor Payout
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.
More Regulation
SEC Chairman Gary Gensler proposed new rules that would increase the oversight and accountability for SPACs so that investors would receive the same protections as they would vis a vis IPOs.
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 |
| Some investor protections | Risk of dilution through warrant execution |
The Takeaway
While often described as a simple reverse merger, SPACs can be more complex than they seem at first glance. A SPAC is a shell company that attracts investors, raises capital, and then finds a target company to acquire. Although SPACs went through a heyday of sorts in 2020 and 2021, their numbers have dwindled owing to regulatory concerns and some high-profile failures.
As with any investment, individuals can benefit from doing their due diligence on these types of shares, researching the sponsor’s incentives and understanding the terms for the warrants.
Whether you’re curious about exploring IPOs, or interested in traditional stocks and exchange-traded funds (ETFs), you can get started by opening an account on the SoFi Invest® brokerage platform. On SoFi Invest, eligible SoFi members have the opportunity to trade IPO shares, and there are no account minimums for those with an Active Investing account. As with any investment, it's wise to consider your overall portfolio goals in order to assess whether IPO investing is right for you, given the risks of volatility and loss.
FAQ
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. Either way, SPACs and IPOs are considered high-risk investments.
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.
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