n recent years, alternative mechanisms of entrepreneurial finance have emerged that are impacting the venture capital industry. One of the most salient tools is Special Purpose Acquisition Companies or SPACs. Although they have recently become very popular, SPACs have actually been around since the 1990s when they were used to take small, immature companies public for a large fee which led to company failures and poor stock performance to the detriment of investors.
However, their recent growth has been quite dramatic. Between 2019 and 2020, there was a 451% increase in the total deal value of SPACs as the total amount raised by 247 SPACs in 2020 amounted to $75 billion. These figures more than doubled to $172 billion in 2021. Incredibly, in 2020, SPACs accounted for more than 50% of the new US publicly listed companies. What is driving this boom? What are its characteristics? And what are its strategic implications for the entrepreneurial finance community? We shall explore these issues in this blog post!
WHAT ARE SPACS?
Essentially a SPAC is a publicly traded buyout company with no operating assets that was established for the specific purpose of acquiring other companies by either securing a controlling stake or outright purchasing them. The SPAC begins as a private shell company and then essentially undergoes an IPO itself in order raise funds for its operations.
A unique aspect of the SPAC is that when the team behind it, which is usually comprised of senior management that brings expertise from a specific industry, pursues funding it is does not tell investors what they are going to be investing in as according to regulations, they are not allowed to know. As such, SPACs are also called blank check companies because the target company is unknown to investors at the time of the IPO.
This vagueness in requirements is a part of the attraction of SPACs as it allows for an easier process to become listed and results in less regulation. After going public, the SPAC typically has two years to acquire one or more companies but when it does so, it goes public without paying the fees that are associated with an IPO as those fees and underwriting costs are covered before the target enterprise ever becomes involved. Within the allotted two-year time frame, the SPAC will have the opportunity to combine/merge with the private company with the resultant company going public and receiving a combination of the SPACs IPO proceeds and additional capital from private financing.
While SPACs are vague with investors, there are distinct trends regarding what firms they seek to acquire. At present, SPACs tend to focus on niche, highly disruptive companies in the consumer, biotechnology, and technology sectors which puts them firmly in the same domain as venture capitalists. These firms are often speculative and have huge capital requirements with scant certainty of revenue or viability which is the same risk profile as many venture capital investments. Since 2018, when the current SPAC boom began, the largest deals in terms of size by average enterprise value and number have been in healthcare, industrial manufacturing and energy:
Number of mergers and average enterprise value (2018–2020)
These target firms typically have modest revenue with most falling below $500 million. The exceptions are consumer, retail and travel; industrial manufacturing; and tech, media and telecom—each of whom has revenue in excess of $3 billion:
SPAC target companies usually have modest revenue (2018–2020)
This generally modest revenue size suggests investors value SPACs for their future financial and earnings potential.
SPAC ADVANTAGES VS DISADVANTAGES
If SPACs are so speculative, why are they so popular? The reasons for this have to do with the advantages that they offer to investors. The first advantage is reduced cost as participants can forego underwriting fees, which can cost over a million dollars as part of a traditional IPO. In addition, there are also reduced marketing costs as a SPAC merger does not need to generate interest from investors through public interactions via an extensive roadshow.
A second advantage is speed. The SPAC process can reduce the time to a public offering by as much as 75%. SPACs have two years to acquire an enterprise or return the funds to investors but the actual SPAC merger usually occurs in 3 to 6 months on average versus 12 to 18 months for a traditional IPO. The issue of speed correlates with reduced regulatory burden as there is generally much less paperwork intrinsic to the SPAC process than with IPOs.
An important SPAC advantage is valuation. With a SPAC, the valuation is set within the first month whereas it can take up to 18 months with a traditional IPO; and there is little certainty about the valuation and the amount of capital successfully raised until the end of the process.
Because the parties involved negotiate the capital commitment and binding valuation before the transaction closes and SPACs can’t be traded as much or to as many people as IPO shares, their price can be determined much sooner which provides greater predictability to investors—particularly in volatile markets—whereas the IPO price depends upon the market conditions at the time of listing.
There is also a control issue as in a traditional IPO, the targets cede the valuation process to the underwriters who directly solicit and manage potential investors. That control issue should not be underestimated as it points to a deeper problem in traditional IPOs: the inherent conflict of interest between underwriters and customers.
Oftentimes, underwriters have a one-off and transactional relationship with companies that are looking to go public but an ongoing relationship with their regular investors. Therefore, the underwriters are in a position to leverage their control over the allocation of shares to reward their most important clients by setting an initial price below the market’s actual valuation and thereby providing higher returns to their buying customers and themselves. This is detrimental to the companies and part of the reason for the growing appeal of SPACs as an alternative.
Like all investment mechanisms, SPACs are not without risks and disadvantages. Lack of transparency is a key consideration as with SPACs, the investor does not know what company they are investing and is therefore in the dark regarding the cash flows, opportunities and marketing potential of the business that they are investing in.
Shareholder dilution is also an important consideration. SPAC sponsors usually own a 20% stake in the SPAC through founder shares as well as warrants to purchase more shares. In addition, SPAC sponsors benefit from an earnout component that allows them to receive more shares when the stock prices achieve a specified target over a certain time frame which can lead to even more shareholder dilution.
The speed advantages of the SPAC process can also be detrimental as it also means there is a compressed timeline for public company readiness. The SPAC sponsor may offer assistance during the merger process but generally, the target company absorbs the bulk of the work involved in preparing the required SEC filing and other public company functions such as investor relations and internal controls within a much shorter deadline than is typically required under an IPO.
Another speed-related issue has to do with the fact that the imperative to acquire or merge with a company within 24 months or return the investors’ funds may lead managers to make shortsighted decisions that are more about using the money than doing that which is strategically and financially beneficial.
In addition, the reduced regulatory requirements of the SPAC process and lack of an underwriter mean that stakeholders do not reap the benefits of the rigorous due diligence of a traditional IPO, which can lead to the need to provide restatements or even incorrectly valued businesses and lawsuits.
While there are certainly conflicts of interest and cost issues intrinsic to leveraging an underwriter, there is also a potential opportunity cost of not doing so. Finally, SPACs also have conflicts of interest. A SPAC manager can acquire a company that a family member or associate owns; or overpay for a company that is line with their financial interests instead of those of the collective investor group.
Despite the increased interest in SPACs as a tool in entrepreneurial finance, they are not a panacea. Indeed, their actual market performance has lagged to date. For example, the price of one exchange-traded fund that tracks SPAC performance has sunk 37% between 2021 and March 2022 while the S&P 500 grew by approximately 18% during the same period. SPACs are no different from IPOs in that neither guarantee strong investor returns. They are simply a different modality of investing whose suitability is determined based upon the interests and strategic priorities of the investor. But the fundamentals are the fundamentals and they will always matter. In investing, particularly in the high-risk/high-reward arena of entrepreneurial finance, extensive due diligence will always be paramount.
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