SPACs: What You Need to Know

Summary.

SPACs are publicly traded corporations formed with the sole purpose of effecting a merger with a privately held business to enable it to go public. Compared with traditional IPOs, SPACs often offer targets higher valuations, greater speed to capital, lower fees, and fewer regulatory demands.

Despite the investor euphoria, however, not all SPACs will find high-performing targets, and some will fail. Many investors will lose money. As an investment option they have improved dramatically, especially over the past year, but the market remains volatile. More changes are sure to come, which means that sponsors, investors, and targets must keep informed and vigilant. This article is not a blanket endorsement of SPACs. It is simply a guide for businesspeople considering a move into this rapidly evolving (and for many, unfamiliar) territory.

Special Purpose Acquisition Companies, or SPACs, are garnering a lot of attention lately in corporate boardrooms, on Wall Street, and in the media. And for good reason: Although SPACs, which offer an alternative to traditional IPOs, have been around in various forms for decades, during the past two years they’ve taken off in the United States. In 2019, 59 were created, with $13 billion invested; in 2020, 247 were created, with $80 billion invested; and in the first quarter alone of 2021, 295 were created, with $96 billion invested. Then there’s this remarkable fact: In 2020, SPACs accounted for more than 50% of new publicly listed U.S. companies

A SPAC is a publicly traded corporation with a two-year life span formed with the sole purpose of effecting a merger, or “combination,” with a privately held business to enable it to go public. SPACs raise money largely from public-equity investors and have the potential to derisk and shorten the IPO process for their target companies, often offering them better terms than a traditional IPO would.

Investor euphoria naturally invites skepticism, and we’re now seeing plenty of it. When the researchers Michael Klausner, Michael Ohlrogge, and Emily Ruan analyzed the performance of SPACs from 2019 through the first half of 2020, they concluded that although the creators of SPACs were doing well, their investors were not. Another potential cause for concern is that all sorts of celebrities and public figures—from the singer Ciara to the former U.S. speaker of the house Paul Ryan—are jumping on the bandwagon, a development that led the New York Times to suggest in February 2021 that SPACs represent “a new way for the rich and recognized to flex their status and wealth.” Perhaps the most pessimistic take we’ve seen so far this year has come from Ivana Naumovska, an INSEAD professor who argued in an HBR.org article that SPACs have not changed much from their previous incarnation—the much-maligned blank-check corporations of the 1990s—and are simply not sustainable. Her article’s title? “The SPAC Bubble Is About to Burst.”

We agree with critics that not all SPACs will find high-performing targets, and some will fail completely. Many investors will lose money. Nevertheless, we believe that SPACs are here to stay and may well be a net positive for the capital markets. Why? Because they offer investors and targets a new set of financing opportunities that compete with later-stage venture capital, private equity, direct listings, and the traditional IPO process. They provide an infusion of capital to a broader universe of start-ups and other companies, fueling innovation and growth.

SPACs have allowed many companies to raise more funds than alternative options do, propelling innovation in a range of industries.

We write as practitioners. Paresh is the CEO and a cofounder, along with Sebastiano Cossia Castiglioni, of Natural Order Acquisition Corporation, a SPAC created in 2020, focused on the plant-based-food economy. Max serves on its board. In this article we’ll share much of what we’ve learned about the limits and virtues of SPACs, drawing on our recent experience and our deep expertise in the investment world (Paresh) and in negotiation and decision-making (Max). In particular, we’ll spell out why some companies are seeking capital from SPACs instead of traditional IPOs and what sophisticated investors and entrepreneurs stand to gain.

The evidence is clear: SPACs are revolutionizing private and public capital markets. Thus, it’s increasingly important that leaders and managers know how the game is played. We need to emphatically state, however, that this article is not a blanket endorsement of SPACs. It is simply a guide for businesspeople considering a move into this rapidly evolving (and for many, unfamiliar) territory.

A Questionable Start

When SPACs first appeared as blank-check corporations, in the 1980s, they were not well regulated, and as a result they were plagued by penny-stock fraud, costing investors more than $2 billion a year by the early 1990s. Congress stepped in to provide much-needed regulation, requiring, for example, that the proceeds of blank-check IPOs be held in regulated escrow accounts and barring their use until the mergers were complete. With a new regulatory framework in place, blank-check corporations were rebranded as SPACs.

In the decades that followed, SPACs became a cottage industry in which boutique legal firms, auditors, and investment banks supported sponsor groups that largely lacked blue-chip public- and private-investment training. They tended to focus on distressed companies or niche industries, reflecting the investment opportunities of the period. But that changed in 2020, when many more serious investors began launching SPACs in significant numbers. Established hedge funds, private-equity and venture firms, and senior operating executives were all drawn to SPACs by a convergence of factors: an excess of available cash, a proliferation of start-ups seeking liquidity or growth capital, and regulatory changes that had standardized SPAC products.

Not all SPAC investors seek high-flying returns, nor are they necessarily interested in the merger itself. The structure allows for a variety of return and risk profiles and timelines.

As these experienced players brought credibility and expertise to the industry, less-sophisticated investors took notice, triggering the current gold rush. On the whole, however, SPAC sponsors today are more reputable than they have ever been, and as a result, the quality of their targets has improved, as has their investment performance.

Today, most SPACs focus on companies that are disrupting consumer, technology, or biotech markets. Some of these firms are speculative, have enormous capital requirements, and can provide only limited assurances on near-term revenue and viability. (Electric-vehicle companies often fall into this category.) SPACs have allowed many such companies to raise more funds than alternative options would, propelling innovation in a range of industries. Risk-taking and speculation at this level can be unwise for unsophisticated investors, of course, but we believe that seasoned analysts can find great investment opportunities.

Some observers aren’t so sure, including the researchers we cited above. Their study, published in the Yale Journal on Regulation, focused on an important feature of modern SPACs: the option for investors to withdraw from a deal after the sponsor identifies a target and announces a proposed merger. If investors don’t like the deal, they can choose to pull out, redeeming their shares for cash invested plus interest. The researchers found that among the SPACs in their study, the average rate of redemption per deal was 58%, with a median redemption rate of 73%. Not only that, in more than a third of the SPACs, over 90% of investors pulled out.

At a glance, those numbers don’t inspire confidence, because they suggest that most SPAC investors are backing out after targets are identified. But when we took a closer look at the study, we discovered that many of the SPACs had raised relatively small amounts of capital and offered higher-than-average warrants as an incentive to entice investors—both indications of lower-quality sponsor teams. Market conditions have changed over the past nine months, and sponsor teams have improved markedly. As a result, far fewer investors are now backing out. That’s what we found when we analyzed redemption history since the study ended. For the 70 SPACs that found a target from July 2020 through March 2021, the average redemption rate was just 24%, amounting to 20% of total capital invested. And over 80% of the SPACs experienced redemptions of less than 5%.

What this suggests is that today’s SPAC ecosystem is fundamentally distinct from the one that existed as recently as 2019, characterized by different risks, stakeholders, structures, and performance. In this new ecosystem, corporate boards, investors, and entrepreneurs are all putting time and effort into demystifying the SPAC process and making it as flexible as possible so that the economic proposition for target companies optimizes current valuation, long-term opportunity, and risk.

The SPAC Process at a Glance

1. Announce the creation of the SPAC. Prior to identifying a target, sponsors develop a SPAC business plan, invest ...

The recent results are encouraging. For all deals closed from January 2019 through the first quarter of 2021, the average stock price for SPACs postmerger is up 31%—a figure that trails the S&P 500, which is up 36%, on average, over the same time period. But a more recent snapshot—January 2020 through the first quarter of 2021—shows that postmerger SPACs are outperforming the S&P 500 by a wide margin, up 47% versus 20%. And for SPACs with an announced deal but no merger as of March 2021, stocks are up 15% since IPO, on average, compared with 5% for the S&P 500 over the same time period. Our point is not that our analyses are correct and the earlier ones were wrong. Rather, we mean to highlight the volatility of the SPAC market and the need to pay attention to the timing and limitations of market analyses.

Who Are the Stakeholders?

SPACs have three main stakeholder groups: sponsors, investors, and targets. Each has a unique set of concerns, needs, and perspectives.

Sponsors.

The SPAC process is initiated by the sponsors. They invest risk capital in the form of nonrefundable payments to bankers, lawyers, and accountants to cover operating expenses. If sponsors fail to create a combination within two years, the SPAC must be dissolved and all funds returned to the original investors. The sponsors lose not only their risk capital but also the not-insignificant investment of their own time. But if they succeed, they earn sponsors’ shares in the combined corporation, often worth as much as 20% of the equity raised from original investors.

Let’s do some math. A sponsor creates a SPAC with a goal of $250 million in capital, investing roughly $6 million to $8 million to cover administrative costs that include underwriting, attorney, and due diligence fees. With the structure and concept in place, the SPAC sells 25 million shares to investors at $10 per share. The sponsor also buys, for a nominal price, 6.25 million shares, which amount to 20% of the total outstanding shares. If the sponsors succeed in executing a merger within two years, their founders’ shares become vested at the $10-per-share price, making the stake worth $62.5 million.

Some critics consider that percentage to be too high. But remember, those rewards are available to sponsors only if they develop a strong concept and successfully attract investors, identify a promising target, and convince the target of the financial and strategic benefits of a business combination. They must also negotiate competitive transaction terms and shepherd the target and the SPAC through the complex merger process—without losing investors along the way. That’s a tall order. And with the proliferation of SPACs, the competition among sponsors for targets and investors has intensified, heightening the chance that a sponsor will lose both its risk capital and investment of time.

Investors.

The vast majority of investments in SPACs to date have come from institutional investors, often highly specialized hedge funds. Original investors in a SPAC buy shares prior to the identification of the target company, and they have to trust sponsors who are not obligated to limit their targets to the size, valuation, industry, or geographic criteria that they outlined in their IPO materials. Investors receive two classes of securities: common stock (typically at $10 per share) and warrants that allow them to buy shares in the future at a specified price (typically $11.50 per share). Warrants are a critical ingredient in the risk-alignment compact between SPAC sponsors and investors. Some SPACs issue one warrant for every common share purchased; some issue fractions (often one-half or one-third) of a warrant per share; others issue zero. Given that warrants, which provide additional upside to early investors, are incentives to subscribe, the greater the number of warrants issued, the higher the perceived risk of the SPAC.

After the sponsor announces an agreement with a target, the original investors choose to move forward with the deal or withdraw and receive their investment back with interest. Even if they decide to pull out, they can keep their warrants. In this sense, the SPAC provides them with a risk-free opportunity to evaluate an investment in a private company.

L-Dopa

Not all SPAC investors seek high-flying returns, nor are they necessarily interested in the business combination itself. Some have no intention of keeping capital in the merger and use the structure on a levered basis to obtain a guaranteed return—often at a higher yield than Treasury and AAA corporate bonds offer—in the form of interest on invested income and the sale of warrants, while getting a look at the combination. The complexity of the structure allows for a variety of return profiles, risk profiles, and timelines, depending on investors’ goals.

Targets.

Most SPAC targets are start-up firms that have been through the venture capital process. Firms at this stage commonly consider several options: pursuing a traditional IPO, conducting a direct IPO listing, selling the business to another company or a private equity firm, or raising additional capital, typically from private equity firms, hedge funds, or other institutional investors. SPACs can be an attractive alternative to these late-round options. They are highly customizable and can address a variety of combination types. Although targets are commonly a single private company, sponsors may also use the structure to roll up multiple targets. SPACs can also take companies public in the United States that are already public overseas and even combine multiple SPACs to take one company public.

How to Play the Game

Successful SPACs create value for all parties: profit opportunities for sponsors, appropriate risk-adjusted returns for investors, and a comparatively attractive process for raising capital for targets. The greater the value that can be created, the more likely it is that a SPAC will negotiate satisfactory terms for all parties and reach a successful combination.

In the early days, sponsors created value by investing risk capital and convincing public-equity shareholders of the investment opportunity. Sponsors are now providing more certainty to those stakeholders by tapping various types of institutional investors (mutual funds, family offices, private equity firms, pension funds, strategic investors) to invest alongside the SPAC in a PIPE, or private investment in public equity. This additional source of funding allows investors to buy shares in the company at the time of the merger. Sponsors use PIPEs to validate their investment analysis (PIPE interest represents a vote of confidence), increase the overall funding available, and reduce the dilution impact of sponsor equity and warrants. They also serve as a means to guarantee a minimum amount of cash invested in the event that original investors choose to pull out of the deal. PIPE investors commit capital and agree to be locked up for six months. They take on this risk because they’re confident in the investment opportunity, they assume the merged entity will be thinly traded after the merger, and they’re offered subscription prices that are expected be at a discount to market prices.

To steer a SPAC through the entire process, from conception to merger, the sponsor needs a strong team. Not unlike private equity firms, many sponsors today recruit operating executives who have the domain expertise to evaluate targets and the ability to convince them of the benefits of combinations. They also seek out board members with valuable relationships and demonstrated experience in governance and strategy.

SPAC deals are complex and must be executed on tight timelines. SPAC teams must have experience with operational and legal due diligence, securities regulations, executive compensation, recruiting, negotiation, and investor relations. Although some of these roles can be outsourced, sponsors typically hire dedicated staff to quarterback these parallel processes. If a SPAC can assemble a strong team, it will be more likely to attract sophisticated long-term investors on good terms, and more-attractive target companies will invite it into merger conversations. Indeed, when SPACs have these sorts of observable advantages, they often declare them in their IPOs. (High-quality targets are as concerned about the deal execution process as they are about price.)

What’s in It for Targets

SPACs offer target companies specific advantages over other forms of funding and liquidity. Compared with traditional IPOs, SPACs often provide higher valuations, less dilution, greater speed to capital, more certainty and transparency, lower fees, and fewer regulatory demands.

Take speed, for example. For targets, the entire SPAC process can take as little as three to five months, with the valuation set within the first month, whereas traditional IPOs often take nine to 12 months, with little certainty about the valuation and the amount of capital raised until the end of the process. When it comes to valuation, SPACs again often offer more than traditional IPOs do. Several months prior to a merger, the parties in a SPAC, including the target, negotiate a capital commitment and a binding valuation (although the valuation is subject to approval by PIPE investors). In traditional IPOs, by contrast, targets largely cede the valuation process to the underwriters, who directly solicit and manage potential investors.

Another important advantage is that SPACs often yield higher valuations than traditional IPOs do, for a variety of reasons. First and foremost, in the traditional process there’s a conflict of interest: Underwriters often have a one-off and transactional relationship with companies looking to go public but an ongoing one with their regular investors. To a large extent, the underwriters control the allocation of shares and use the process to reward their best and most important clients. They often set an initial price below the market’s actual valuation, providing higher returns to their buying customers and to themselves.

For targets, the entire SPAC process can take as little as three to five months, with the valuation set within the first month, whereas traditional IPOs often take nine to 12 months.

Consider what that means for the target. In 2020, the value of companies in the first 90 days after they went public in a traditional IPO rose 92%, on average. That might sound like a resounding success—but what the strong post-IPO performance actually suggests is that these companies raised too little capital at too low a price in the IPO process. In failing to optimize their balance sheets and overall dilution, the companies left money on the table, which was probably captured by IPO bankers and their clients.

As a target, you should be laser focused on the sponsor’s deal execution and capital-conversion capabilities. You should scrutinize the quality and expertise of the team’s legal advisers, bankers, and IPO-readiness advisers and their ability to complete the work in the dramatically condensed time frame. You should ask sponsors to explain their investment theses and the logic behind their proposed valuation. And you should evaluate the team’s ability to execute back-end activities, including raising the PIPE, managing the regulatory process, ensuring shareholder approvals, and crafting an effective public relations story—all of which are necessary for a smooth transition to a public listing. Bearing these things in mind, you may find you have plenty of reasons not to choose the SPAC that makes you the highest offer.

One last piece of advice for targets: Remember that sponsors don’t have much time to complete a combination. Because of that, if you can demonstrate that your financial records are in compliance with the Public Company Accounting Oversight Board’s regulations, you’ll save everyone time and provide more certainty, which will make your firm a notch more attractive and put you in a better negotiating position.

Negotiate for Success

Game theory emphasizes the importance of thinking about the likely decisions of the other party in developing a rational course of action in a negotiation. This is certainly true in the SPAC ecosystem, where you need to fully understand the motivations and goals of multiple parties.

Consider the sponsor-target negotiation. If you analyze it simply as a two-party process, you’ll find that the target has considerable leverage, particularly late in the 24-month cycle, because the sponsor stands to lose everything unless it is able to complete a deal. But when you factor original investors into the equation, the calculus changes, because they can reject deals after they’ve been announced. Unreasonable terms that favor targets will not survive the PIPE process or will trigger high investor redemptions and put the deal at risk.

Sponsors, therefore, need to negotiate an effective combination that creates more value for the target relative to its other options—and is also attractive to the investors. The negotiation is further complicated by the fact that targets may be talking with more than one SPAC, at least early in the negotiation process.

As with any other complex negotiation, a SPAC merger agreement presents almost unlimited options for customization. All players should come to the table with a solid understanding of what they need, want, and care about—and where they can find common ground. If you’re an investor or a target, be aware that sponsors are focused on not only their shares but also their reputation, which can affect their ability to create additional SPACs. And if you’re a sponsor or an investor, be aware that targets need to balance the various kinds of value they can gain—from the SPAC team, from dilution, from the execution of the deal, and even postmerger. Targets have to consider a host of other factors as well—cash available for operations, publicity upon going public, derisking, shareholder liquidity, and market conditions—which can further complicate the negotiation.

. . .

We believe that SPACs are here to stay, and that they offer the potential for significant benefit. Some SPACs will fail, of course, at times spectacularly, and some of the players will behave unethically, as can happen with any other method of raising capital. But SPACs have improved dramatically as an investment option since the 1990s, and even since just a year ago. More changes are sure to come—in regulation, in the markets—which means that anybody involved in the SPAC process should stay informed and vigilant. This is a rapidly evolving story.