What is a Special Purpose Acquisition Company (SPAC)?

A special purpose acquisition company (SPAC) is kind of like a blank check...

When you write a blank check, you sign over your money, but you’re not sure exactly who it’s going to, or what it’ll be used for. Similarly, a SPAC is pretty much a shell company when it goes public. It has no underlying operating business nor assets other than cash and maybe some limited investments. The proceeds from the SPAC’s IPO are placed “in trust.”

If you invest in a SPAC at the IPO stage, you’re relying on its managers to acquire or combine with an operating company. A SPAC may identify in its IPO prospectus a specific industry or business it will target for a merger, but it’s not obligated to follow through.

SPACs investors should be aware of the potential risks to which they're exposed. They may have access to less information about the structure and aims of a SPAC. Investing in a SPAC may also include fees. Investors should take care, as SPACs can be speculative, there may exist conflicts of interest, and SPAC investments may experience significant price fluctuations, among other risks.

Creating and deploying a special purpose acquisition company (SPAC) involves several stages:

1. Founding the SPAC

The first step is creating a SPAC. The people who form SPACs may be recognizable industry veterans — Since investors don’t know which company (or companies) the SPAC will acquire, if any, they place their trust in the expertise of the SPAC’s founders. The founders typically put up the initial capital to start the SPAC and they usually own a significant chunk of any companies the SPAC acquires.

2. Going public

Just as with a traditional company, a SPAC’s managers work with an investment bank to go through an initial public offering (IPO). But unlike in a traditional IPO, the SPAC’s initial share price is not based on a valuation of an existing business. Instead, “units” in the SPAC — which generally consist of a common stock and “warrants” to buy more stock in the future — are usually priced at a nominal $10 each. When units begin trading, their market prices may fluctuate. These price movements may have little to do with the ultimate economic success of the SPAC.

Since a SPAC doesn’t have much history to report, the IPO documents it files focus mostly on the experience of the SPAC’s founders or the type of investments they plan to pursue. You should carefully read the SPAC’s prospectus to understand how much of the company its sponsors own and whether they acquired their equity on better terms than the public will. You may also want to closely review the business backgrounds of the SPAC’s managers and sponsors, since you’re placing your trust in them.

All funds raised in the SPAC’s IPO go into a trust account until the managers find a company to acquire. Usually, managers don’t receive a salary or commission until a merger takes place. SPACs generally invest the IPO proceeds in relatively stable, interest-bearing instruments. But there’s no rule requiring them to do so, so you should carefully review the specific terms.

3. Acquiring a company

Managers of a SPAC usually have 18 months to two years to find and acquire a private company. Based on stock exchange rules, the fair market value of the company has to be at least 80% of the SPAC’s net assets. Sometimes, the SPAC and the target company need to find additional financing to close the deal.

Shareholders in the SPAC may vote against the decision and redeem their shares for cash. If they approve the deal, they receive stock in the target company based on how much they invested in the SPAC. Once shareholders approve the merger and regulatory boxes are checked, the target company becomes public and must meet all the requirements that the Securities and Exchange Commission sets for public companies. If the SPAC fails to acquire or merge with an operating company in time , the SPAC is liquidated. Shareholders at the time of the liquidation get back a pro rata share of the total amount then on deposit in the trust account.

Private companies face some risks when going public through a special purpose acquisition company (SPAC):

• Shareholders may not approve the deal. Shareholders in a SPAC must typically approve a merger — It’s not up to the managers alone. If shareholders don’t approve, the deal could fall through.
• Shareholders can redeem too many units. SPAC shareholders can choose to redeem their units for cash instead of stock in the target company. If too many do so, this can put into question how much money the SPAC will actually have to close the deal. It can also mean that the final company no longer meets regulatory requirements for the number of shareholders required.
• SPAC founders may want a seat at the table. Those who launched the SPAC will probably own a significant chunk of the company that comes out of the merger. They may want positions on the board of directors or other rights. If any other financing is part of the deal, those investors may want similar perks. In addition, the target company needs to negotiate whether its original management team will stay in place or whether the SPAC’s managers will take over, which isn’t usually an issue with a normal IPO.

Investors in SPACs may also face risks of their own:

• Target companies may overstate growth potential. Because of some legal quirks, companies that go public through SPACs face less liability when it comes to projecting future results than do companies going through traditional IPOs. Those predictions can help companies reach higher valuations than they might have otherwise, even when they haven’t made any profits.
• A SPAC’s managers may not be up to par. Although some reputable and experienced businesspeople are starting SPACs, not every firm has a top-notch team. Since the SPAC itself has little history or financials to go on, investors put a lot of faith in managers, who may lack experience or qualifications.
• An acquisition may not pan out. A SPAC’s IPO prospectus may point to a specific industry or company it will target for acquisition, but it doesn’t have to follow through. A SPAC’s managers may choose to invest in something totally different or fail to acquire any company on time, an outcome that isn’t all that unusual. Investors are entitled to a pro rata share of the total amount then in the trust account (less fees), and they have the option to sell their SPAC units on the secondary market in the meantime. However, there’s an opportunity cost associated with waiting to see whether a merger will work out — The money isn’t earning a significant return in the interim.
• Share prices of SPACs may not have much to do with their success. When a company goes public the traditional way, its initial share price is usually based on an estimate of the business’s value. Not so for a SPAC — Since it’s really just a shell company, units (consisting of common stock and warrants) are usually priced at a nominal $10 each. Once units start trading, changes to their market price may have little to do with how the SPAC (and the company it acquires) ultimately performs.
• A SPAC’s sponsors may have different interests from public shareholders. Investors who contributed money to create a SPAC (its sponsors) generally purchase equity on more favorable terms than investors in the IPO or shareholders who buy units on the open market.That can create a conflict of interest, since sponsors may be motivated to close a deal on terms that are less optimal for public shareholders. A SPAC may also turn to sponsors for additional financing to close a merger, which can dilute ownership in the company.

Compared to an initial public offering (IPO), going public via a special purpose acquisition company (SPAC) can have some benefits for private companies:

• A faster timeline. A SPAC can sometimes merge with a private company in as little as three or four months. A traditional IPO usually takes at least five months. But that also means the private company has to get ready faster to meet all the regulatory requirements associated with being a public company. This includes accounting requirements, financial reporting, tax obligations, and more.
• More access to capital for small and mid-sized companies. Going public can help companies build their brands and access cash to invest in growth. But most companies that go public, or undertake an IPO, are on the larger side. Going the SPAC route can help smaller companies get their hands on capital.
• Fewer externalities up front. A traditional IPO comes with a lot of uncertainty. If a company happens to pick the wrong day to go public, or prices its stock too low, it could raise less money than it might otherwise. This is especially true at a time when the market is experiencing lots of ups and downs. In a SPAC merger, the private company just needs to negotiate a price with the SPAC versus relying on the market.
• Access to expertise. The managers behind SPACs often (though not always) have business experience and are looking for companies in sectors that they know well. By going public through a SPAC, a company can tap the knowledge of those veterans.
• Flexible terms. Besides price, the target company can also negotiate other aspects of the acquisition, such as access to more cash through debt financing or who will sit on the board of directors.

Anyone considering investing in a SPAC may want to closely review the forms it files with the Securities and Exchange Commission, including the IPO prospectus (Form S-1), annual (Form 10-K) and quarterly (Form 10-Q) reports, and current (Form 8-K) reports. Pay attention to the background of the company’s managers and sponsors, where money in the trust account is invested, your rights to getting your cash back, and any financial details about the company the SPAC plans to acquire.

Here are some high-profile SPAC mergers:

• In April 2020, DraftKings, a sports betting tech firm, merged with SBTech Global and a SPAC named Diamond Eagle Acquisition Corp. As of early January 2021, its stock price had increased by 169% since the deal closed.
• In June 2020, electric truck maker Nikola merged with a SPAC called VectolQ Acquisition. It’s stock price fell 47% between then and early January 2021.
• In October 2020, a SPAC named Churchill Capital Corp III merged with MultiPlan, a healthcare tech firm. It was the largest SPAC deal to date, worth around $11B. Its stock price has fallen 19% since then.

Reference

For more information, please visit the Securities and Exchange Commission’s Office of Investor Education and Advocacy (OIEA) bulletin on investing in SPACs available at https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/what-you. You may also consult FINRA's investor insights page on SPACs, available at https://www.finra.org/investors/insights/spacs

Disclosure

The securities mentioned are for illustrative purposes only and not a recommendation.