For private companies looking to go public, the process of doing so has always been a hot topic. There is no one size fits all solution, but the popularity of various listing vehicles has fluctuated with changes in the global economy and the exposure given to different options in the media. These range from traditional IPOs to direct listings to SPACs – the latter of which has been the recent flavour of the market for much of the past few years.
A SPAC – Special Purpose Acquisition Company – is a specific legal entity that is set up as a public shell company. The entire purpose of a SPAC is to identify, acquire and merge with a private company looking to go public. SPACs are often referred to as “blank cheque” companies as they have no commercial operations or business plans themselves. The main benefit of a SPAC is that they can take another private company public without that company going through the traditional, but onerous, Initial Public Offering (IPO) process.
SPACs have been around for decades, but until recently have mostly been discussed in niche financial circles. However, following the start of the COVID-19 pandemic, and amidst increased global market volatility, SPAC popularity has surged to record-breaking levels. Since the beginning of 2020, SPACs have accounted for over half of all new public listings in the US (and close to half of all money raised) each year. (It is worth noting that SPACs have mostly been popular in the US, but since 2013 the JSE has allowed for SPAC listings in South Africa, with a few successful ones having taken place.) With increased investor mania though, comes increased scrutiny, and this hasn’t fared so well for SPACs as evidenced by the significant drop off in SPAC activity in 2022. Investors, those being acquired (target companies), and regulators are combing through the SPAC process closer than ever before, and the risk / reward profile might not be what it seemed just a few years back.
How do SPACs work?
In order to understand the benefits of going public via a SPAC, as well as to grasp the associated risks and drawbacks, it is worth briefly exploring the full lifecycle of a SPAC.
A SPAC is created by a group of investors known as the sponsors, who are typically well-known investors, venture capitalists and/or experienced business executives. They complete the normal filing process to list their SPAC on a public stock exchange. As part of the listing process, the SPAC will raise external capital from public investors (often hedge funds, pension funds and other institutional investors), specifically by selling the expertise and experience of the sponsors themselves. Although the traditional IPO process is followed here, it is far simpler and quicker than usual as the SPAC is merely a shell company with no commercial business operations or complex financial statements.
The SPAC then goes public and lists on an exchange, with the capital raised stored away only to be used for the future acquisition of a target company. As a normal listed company at this point, anyone, including retail investors, can buy and sell the SPAC shares on the public exchange.
Following this listing, the SPAC sponsors have a maximum of two years to go and find their target company – a private company to purchase and take public by merging with the now-public SPAC. Once the target company is identified, the SPAC negotiates the acquisition terms with them and if agreed, the process of merging the two companies begins.
During this next phase, the SPAC will advocate the merger to shareholders, the majority of whom need to approve the acquisition in order for the process to move forward. A unique aspect of the process – and something that could be seen as an important contributor to the popularity of SPACs in recent years – is that unlike in the traditional IPO process, the SPAC and its target company have been allowed to present forward-looking reports to shareholders in the merger process. For many new companies (especially tech-focused ones in sectors such as software, electric vehicles, and biotechnology), this can be a major selling point as they can promote their potential future growth even if they have limited existing sales and revenue.
If the SPAC shareholders approve the acquisition, the merger can go ahead after regulatory approval is received, and the once private target company becomes a publicly listed one. Generally, the listed SPAC’s name will change to reflect the newly acquired company.
What are the key benefits?
There are many factors to consider for those involved, but some of the key benefits that SPACs provide to both investors and the target company include the following:
- The typical IPO process can take two to three years to complete. In contract, a SPAC merger can take as little as three to four months. With the recent market volatility, many VC-backed companies have either become uncertain as to where their next funding round will come from, have needed to raise capital fast for operational requirements, or have come under pressure from investors looking to exit. In these cases, a SPAC listing provides an efficient route to capital via the public market.
- During the merger process, a target company has certainty over their valuation and the amount of capital they will receive. In comparison, during the traditional IPO process, the capital raised is only known at the exact time of listing and is at the mercy of market forces.
- Many recent SPACs have been created by well-known investors and business executives with track records of success. Their experience and guidance are often selling points to the target company, who can leverage off these sponsors to their company’s benefit.
- If the SPAC fails to identify and acquire a target company, the SPAC is dissolved, and all investors receive their money back. Even if an acquisition moves ahead, those not in favour still have the option to redeem their shares and have their initial investment returned.
- Retail investors can participate by purchasing shares in a SPAC when it initially lists. This allows them to participate in potential early gains of a new publicly traded company – something that is often unavailable to them with a traditional IPO.
- Initial SPAC investors are often given the option to purchase additional shares in the SPAC at a predetermined price (through a financial instrument known as a warrant). If the acquired company performs well post-merger, this option can be exercised, and investors can profit further.
- For sponsors, as a shell company, a SPAC provides an easy way to raise capital from a regulatory point of view.
- Sponsors stand to make millions in profit. They acquire the initial SPAC shares when the company is created for a nominal fee and generally retain 20% of the shares post-merger – a sizeable chunk if the acquired company merges with a valuation of a few billion dollars!
What are some drawbacks?
Of course, SPACs are not perfect and with the recent surge in popularity, their downsides and risks have become more apparent and publicised.
- A SPAC merger is hugely expensive for the target company. At first glance SPACs might appear cheaper than traditional IPOs as they usually pay investment banks a lower fee, but as mentioned, the sponsor typically retains 20% of the merged shares, which the target company effectively gives away as a fee.
- Initial investors put their money on the team behind the SPAC, not the business they will seek to acquire. Although investors can technically redeem their SPAC shares before the merger, logistically this is often not feasible for retail investors who therefore take on additional risk.
- As SPACs have only two years to acquire a target company, they may rush an acquisition as the deadline approaches. Alternatively, a private company in desperate need of capital could seek a SPAC listing due to its speed and their ability to dress up the business with forward looking numbers. To the detriment of the end investors, both scenarios might lead to a mediocre company being acquired.
In recent years, the global economic climate appeared to align and create an environment that was ripe for SPAC listings. But as investors and companies dived into SPACs, the tide has seemingly turned. Whether it be the astronomical cost a company pays in the form of equity, or the historically poor performance of numerous SPAC-listed companies, regulators are starting to implement change and many private companies are hitting pause on their SPAC plans.