Special purpose acquisition companies (SPACs) are shell companies formed for the purpose of raising capital through an initial public offering (IPO). The proceeds are used to acquire or merge with an existing private operating company, which becomes a public company. Because a target typically hasn’t yet been identified at the time of an IPO, these vehicles are often referred to as “blank-check companies.”
SPACs are increasingly popular, and competition for target companies is intensifying. Given this, it’s critical for sponsors — which may include hedge fund or private equity fund advisors or other sophisticated investment professionals — to differentiate themselves from the competition.
Special purpose acquisition companies offer a variety of potential benefits for sponsors, investors, and target companies alike. Although they’ve been around for decades, they exploded in popularity last year, thanks in part to headline-grabbing SPACs formed by celebrities, including Shaquille O’Neal, Serena Williams, and former House Speaker Paul Ryan.
According to SPAC Analytics, in 2020, a record 248 SPAC IPOs raised more than $83 billion, up from 59 ($13.6 billion) in 2019 and 46 ($10.75 billion) in 2018. So far in 2021, SPAC IPOs are outpacing traditional IPOs on their way to another record-breaking year. To compete in such an environment, sponsors need to develop a strategy that focuses on industries, sectors, or geographical locations that complement their teams’ expertise.
Walk Through the Process
Once a SPAC completes an IPO, the proceeds are held in an interest-bearing trust account while its management team seeks a privately held company to acquire — subject to approval by a majority of the SPAC’s investors — in what’s commonly referred to as a “de-SPAC transaction.” If management fails to complete a de-SPAC transaction within a specified time period (usually 18 to 24 months) and the investors decline to approve an extension, then the funds in the trust account (including accrued interest) are returned to the investors.
In a typical SPAC structure, IPO investors receive units that consist of one share of Class A common stock and a fractional warrant to purchase additional stock. After the IPO, these units begin trading on the applicable stock exchange and within a specified period the stock and warrants are uncoupled and may be traded separately.
Once the de-SPAC transaction is completed, the Class A shareholders have the right to redeem their shares in exchange for their pro-rata share of the amount held in trust — regardless of whether they voted to approve the transaction. The warrants provide an attractive additional incentive for investors. Typically, the exercise price is higher (for example, by 15%) than the per-unit price offered in the IPO. The warrants become exercisable 30 days after the de-SPAC transaction is completed. If the transaction is successful, investors enjoy the warrants’ upside potential, even if they previously exercised their right to redeem their shares.
The SPAC sponsors purchase “founder shares,” usually in the form of restricted Class B shares, for a nominal price. After the IPO, these shares represent around 20% of the SPAC’s outstanding shares. The sponsors also purchase warrants in an amount sufficient to cover the IPO’s underwriting fees and certain other IPO and operating expenses. This investment in warrants represents “at-risk capital,” because it will be lost in the event the SPAC fails to complete a de-SPAC transaction.
It’s not unusual for a SPAC to have insufficient funds to complete a de-SPAC transaction, especially if a significant number of investors elect to redeem their shares. In that case, the sponsors may contribute additional capital or seek additional investors, often in the form of a private investment in public equity (PIPE) transaction.
Benefits for Sponsors and Targets
From a sponsor’s perspective, acquiring founder shares (also known as the “promote”) for a modest investment can potentially generate substantial returns. Sponsors also gain access to a larger pool of prospective investors — including retail investors who wouldn’t be eligible to invest in a private fund — free from the advertising restrictions imposed on private placements.
For the de-SPAC target, merging with a SPAC offers:
- A streamlined path to becoming a public company, avoiding much of the expense, time and distractions associated with a traditional IPO,
- Greater certainty, since the offering price is determined through negotiations with the SPAC, and
- Access to investments that otherwise might be beyond its reach.
There is limited downside exposure because de-SPAC investors have the right to recover their investment if the transaction isn’t completed — or to redeem their shares if it is.
For SPAC sponsors, perhaps the biggest disadvantage is uncertainty over the tax treatment of founder shares. Many believe that these shares are entitled to capital gains treatment. Others take the position that any increase in their value represents compensation subject to ordinary income taxes. There’s also the potential for a capital shortfall as a result of investor redemptions and possible loss of at-risk capital should the SPAC fail to complete a de-SPAC transaction. And, because it’s often advantageous to form SPACs offshore, international taxation issues and complexities could come into play.
Disadvantages for target companies include shareholder dilution (due to the size of the sponsor’s equity share) and a limited timeframe to achieve “public company readiness.” From the investor’s perspective, two disadvantages may limit their potential returns:
- There could be a conflict of interest between a SPAC’s investors (who are looking to maximize their returns) and its sponsors (who have an incentive to consummate a deal within the applicable timeframe at almost any price).
- The popularity of SPACs means that an increasing number of them are competing for the same pool of potential merger targets, which may drive up prices.
Achieving Your Objectives
Special purpose acquisition companies offer significant benefits, but they also present a variety of risks, challenges and complexities.
If you’re thinking about participating in a SPAC — as sponsor, target, or investor — your Untracht Early advisor can help you weigh the pros and cons and structure a solution designed to achieve your objectives.