What you need to know about SPACs

SPACs have been around for decades, but they’ve rapidly grown in popularity as of late. Why is this and what do you need to know?

In brief

• SPACs are investment vehicles that raise capital from investors through a traditional initial public offering (IPO) to be used later to acquire one or more target companies.
• No matter your role in the SPAC life cycle, your success depends on understanding the SPAC market landscape, opportunities and risks.

There is certainly a lot of public discussion about Special Purpose Acquisition Companies (SPACs), including a considerable amount of speculation. Are SPACs a nefarious “backdoor” path to the public markets run by sponsors focused solely on quick profits? Or are they a legitimate path to the public markets, offering early-stage private companies an expeditious journey to access growth capital and liquidity? As a private company founder or a potential SPAC sponsor or board member, what do you need to know?

How SPACs work

SPACs, often referred to as publicly traded shell companies or “blank-check companies,” are investment vehicles that raise capital from investors through a traditional initial public offering (IPO) — the SPAC IPO — to be used later to acquire one or more target companies. Funds raised via the SPAC IPO and any additional investment secured are held in trust until SPAC management finds a suitable target. At that point, investors can vote to either accept or reject the SPAC’s merger with the private target(s).

The targets’ valuation is agreed between the SPAC and target(s) and is then “validated” through equity funding commitments from investors in the form of PIPEs (private investments in public equity). SPACs generally have two years to find a target; if they don’t, then the money raised is returned to investors. Shareholders can also redeem their shares if they’re not interested in participating in the proposed merger. Finally, if approved by shareholders, the merger is executed — often called the de-SPAC transaction — and the target private company or companies become public entities. The SPAC target is usually publicly announced once a formal merger agreement has been executed.

Fad or permanent fixture?

SPACs have been around for decades, but they’ve rapidly grown in popularity over the past year or so as higher-profile sponsors, larger deals and strong returns have propelled the SPAC market into the mainstream. The expeditious SPAC life cycle can also offer significant return-on-investment (ROI) potential for sponsors and investors.

In 2010, just two SPACs came to market. In 2020, SPACs netted record-breaking IPO proceeds of $83.4 billion, and approximately 115 SPACs completed or announced mergers. This dwarfed the 21 and 22 mergers in 2018 and 2019, respectively. 2021 has been off to a rapid start: as of March 24, 2021, 294 new SPACs have already priced their IPOs (generating $95.7b in proceeds), 21 have completed SPAC mergers, and 116 have announced deals, according to SPACresearch.com.

Among the drivers are high-growth, entrepreneurial companies searching for growth capital by seizing opportunities in the SPAC market. While there will always be ebbs and flows impacting access to the capital markets, it’s likely that the SPAC vehicle will persist and continue to evolve. 

Risks and rewards for SPAC sponsors and targets

As with any investment or corporate transformation, there are always opportunities and risk considerations to evaluate. While potential returns can be attractive for SPAC sponsors and investors, yields depend on finding the right target company or companies and successfully negotiating mutually beneficial transaction terms. For targets, SPACs can offer an attractive public market on-ramp, albeit one that requires the target to become public company-ready under a condensed timeline, often with limited resources.

Who sponsors SPACs and why?

SPACs are formed by sponsors with specialized financial, operational or other capabilities — usually former industry executives, institutional investors or private equity firms. Because SPACs have a straightforward, easy-to-understand business purpose and a simpler financial reporting (i.e., shell company financial statements), most of them can complete the SPAC IPO process within three months, with fewer comments from Securities and Exchange Commission (SEC) staff. For many SPAC sponsors, the potential to generate returns over short periods seems to outweigh the costs of creating a SPAC, which has limited setup costs in the scope of the broader deal size.

With many established SPAC sponsors — including political figures, celebrities and larger private equity firms — entering the arena, SPACs are generating considerable media attention. Target companies brought public via a SPAC are also seeing a healthy aftermarket performance, which is, in turn, fueling the creation of new SPACs and the willingness of higher-quality private companies to merge with SPACs.

What’s in it for corporate SPAC sponsors?

For larger corporates looking for strategic growth, SPACs can be an attractive additional instrument in their toolboxes. They can provide unique opportunities to shield the larger corporation from financial risk and offer potential for sizable ROI.

SPACs also enable corporates to compete to acquire high-potential, entrepreneurial companies as assets in their portfolios. As SPACS increase in popularity, many of these pioneering private companies are merging with SPACs versus pursuing a traditional M&A route, so a large corporate that ignores the SPAC market could miss opportunities to strengthen its corporate portfolio and capabilities.

Increasing demand for SPAC board members

As SPACs continue to grow in popularity and number, there is an increasing demand for directors to fill their boards. Directors who are approached about filling a board seat need to start by considering the overall reputation of the sponsor with which they would be associating.

Executives considering joining a SPAC board also need to gauge their expected level of involvement. Some sponsor groups will expect board members to contribute significantly in identifying, vetting and filtering potential targets. In other cases, directors are less directly active in deal making.

Potential board members should also assess the level of risk they would be taking on, including litigation risk related to alleged proxy statement deficiencies and underwhelming performance of the target company after the de-SPAC merger. They should also understand the directors and officers (D&O) insurance being carried by the SPAC sponsor and make sure they’re comfortable with that level of coverage. Focusing heavily on diligence, disclosures and forecasting can help mitigate these risks.

How SPAC targets can prepare

Private company executives and boards seeking growth capital or liquidity through a public listing should always consider all viable options for accessing the capital markets. Should a private company team deem the SPAC vehicle a fit for its financing needs, it must understand that this expedited path still requires the business to be prepared to operate as a public company post-merger – and often requires advanced preparation in a very compressed time frame prior to the completion of the merger.

If possible, to be a more attractive target in advance, private companies should focus on several functions – from strategy and structure to operations and reporting – prior to becoming a target. Top considerations include:

Defining deal goals

How much control do you want to give up? In an IPO, private company owners are teamed with largely passive, institutional investors, which generally enables pre-IPO owners to maintain control over the strategic direction of the company. Conversely, while private companies can benefit from the sponsor’s industry experience and connections, the sponsor will generally take a more active role post-merger, particularly through board representation, due to its more concentrated ownership and influence.

Setting a strategy for incoming capital

Outline how you will plan to deploy the funds raised via the SPAC merger and focus on the quality of pre-revenue forecasting. Will you use the capital infusion to expand your workforce, build breakthrough technologies or reinvent an existing product category? Investors will want to know your plan and your timelines for delivering against major milestones — then they’ll expect you to deliver against that plan.

Refining operations

Identify opportunities for organizational improvements you can undertake immediately that will help you operate as a public company post-merger. Could you enhance internal controls in advance of the merger? Could you use automation to close your books to deliver higher-quality reporting against a shortened timeline?

Focusing on human capital

Make sure you have the right talent deployed and that they’re prepared to help the company deliver against public company expectations. Like in a traditional IPO, proxy material will need to be developed, which typically includes two to three years of financial statements, management’s discussion and analysis, and pro forma statements for the latest fiscal year and year-to-date interim period. You’ll need to ask yourself: Do I have access to the right team members or advisors to deliver against these public company requirements (periodic reporting on short timelines, the ability to forecast, etc.)?

SPAC targets also need to be aware that a SPAC needs to have a minimum amount of cash on hand to complete the transaction. However, if pre-merger shareholder redemptions are greater than expected, that condition might not be met. While we aren’t seeing this happen often, it could jeopardize the transaction or reduce the amount of capital available to the company once it has gone public.

Looking ahead

Thirty years ago, amid skepticism and uncertainty, SPACs gradually entered the capital markets landscape as an option for accessing the public markets, and that activity has ebbed and flowed ever since. While much of the early concern around SPACs as a financing vehicle for private companies was rooted in the fear of manipulation and dilution based on how the vehicle functions and operates, this ambiguity has somewhat subsided as SPAC awareness has grown.

There is no question that the unprecedented rise of the SPAC market is transforming and reshaping our capital markets. Regardless of market conditions, success is dependent on understanding all of the risks and rewards involved in a SPAC merger, regardless of your role in the process. While it’s impossible to predict with certainty how the SPAC appetite will ultimately evolve, the vehicle can offer a viable and expedited path for private companies looking to access growth capital and liquidity via the public markets.