SPACs, shorthand for special purpose acquisition companies, have become this year’s most popular alternative option for private companies to access the public capital markets and become publicly traded. Earlier this year, capital market experts declared 2020 a banner year for SPACs. The latest numbers from DealPointData back the claim. As of November 30, 2020, SPACs raised more than $64.35 billion in 203 IPOs, more than five times the amount SPACs raised—$12 billion in 38 listings—in all of 2019, also a record year.
The growing deal volume and value of SPACs across industries, from technology to healthcare to space tourism, coupled with a list of high-profile transactions, such as the transactions completed by DraftKings and by Virgin Galactic Holdings, have spurred unprecedented interest among investors and targets alike. Although some signs are starting to point to a possible leveling in months to come, companies that want to create liquidity or go public continue to consider a SPAC transaction as a strategic alternative to a traditional IPO or a direct listing.
What do you need to know about SPACs in order to decide if it is the right fit for you as a private company seeking access to the public markets or as investors looking for an exit strategy or an investment opportunity? The Fenwick team worked up some FAQs to consider.
How do SPACs work?
SPACs are formed strictly to raise a blind pool of cash through an IPO with the objective of acquiring or merging with privately operating companies. These shell companies are initially formed by a group of investors or “sponsors.”
The following is the typical structure of a SPAC:
- Founder shares: Sponsors purchase initial equity, often referred to as Founder Shares or Promote, for nominal value and purchase additional warrants to help fund startup costs and commissions. Founder shares are usually structured with anti-dilution protections designed ensure that such shares convert into at least 20% of the post-IPO and pre-business combination companies.
- Units: IPO investors receive “units” typically consisting of one share of common stock and a portion of a warrant (e.g., 1/2 or 1/3 a warrant). Units, common stock and warrants are all publicly traded, and investors can unbundle their units to trade stock and warrants separately. Generally, units are priced at $10 in IPO and warrants have a strike price of $11.50. Common stock will typically trade within a narrow band around $10 during the period prior to announcing or completing an acquisition.
- Warrants: Sponsor warrants and public warrants (i.e., warrants from units) have largely the same terms and cannot be exercised until after the completion of the business combination transaction with an operating company. Sponsor warrants can generally be net-exercised (public warrants generally cannot) and may be redeemable for cash or shares on a formula basis. Public warrants, sponsor warrants or both, could be subject to formula redemption for cash or stock to clean up a public company cap table.
- Trust account: A significant portion of the capital (90% or more) raised through the IPO process is then placed in a trust account that earns interest during the SPAC searching/combination period. SPACs generally are required to negotiate for waivers against any claims against the trust in all contracts to protect the trust funds from being used for any purpose prior to completion of an acquisition. The sponsor has limited ability to draw against interest earned by trust to help fund working capital.
- Target size: The value of the eventual target business combination is generally required to represent at least 80% of the trust assets. As a result, most target values exceed the cash on hand (on average, by three to four times), and the form of deal consideration is both cash and SPAC stock.
- Searching period: Typically, SPACs are limited to 21 to 24 months after IPO to identify a target and submit it to stockholders for a vote. SPACs usually need to hold a stockholder vote on a proposed deal before the outside date or its governing documents will require an automatic unwinding of the SPAC and trust account, unless the SPAC stockholders approve an extension of that deadline. Note that this requires some lead time to get a Form S-4 or general proxy solicitation prepared and declared effective, so the effective deadline for signing a deal is a few months less. The sponsors lose their investment if no target is found within the searching period.
- Stockholder redemption: A key feature of SPACs is that stockholders have a right to redeem their stock when voting on any business combination or amendments to governing documents (e.g., to extend a searching period). Stockholders are generally required to approve the business combination at the stockholder meeting to effectively redeem their stock. Redeeming stockholders receive cash from the trust account equal to the IPO price plus accrued interest but get to keep their warrants. Certain SPACs include restrictions on individual stockholders redeeming large blocks of stock (e.g., 15% of outstanding stock).
What kind of company is an ideal candidate/target for going public with a SPAC?
The scope of SPAC targets in 2020 has been expanding with deals getting done across a variety of sectors. So far this year through November 30, there have been 14 technology transactions and seven deals in business services, a sector which only recorded one deal last year and had not seen a SPAC acquisition since 2013, according to DealPointData. There have also been nine industrial deals, 13 consumer acquisitions, nine financial services transactions, 14 healthcare deals and one energy deal. These figures include completed and pending transactions.
But even though it appears that SPACs are now common across almost all industries, the ideal targets for successful mergers generally have the following in common:
- Viable IPO candidates in their own right, usually in high-growth industries, with compelling long-term prospects that long-only investors would see as an attractive opportunity, and the infrastructure and management team to support the obligations that come with being a public company;
- Companies that seek fast-track access to the public markets with limited market or timing risk, flexibility to handle complicated structures and access to a sponsor team;
- Targets that are typically seeking a liquidity route and access to capital even in difficult debt and equity markets—the likelihood and length of which are both uncertain; and
- Companies that have succession issues or may be over-leveraged, or they may just want to keep majority interest and upside potential, which can be structured through an earn-out.
What’s the difference between a SPAC merger and a traditional IPO?
Both transactions have the same overall strategic goal: to go public and establish a currency and a public valuation. Additionally, as we see from most IPOs as well as SPACs, in most instances, the founding stockholder group or management team continues to have majority control of these entities after the IPO or SPAC merger. But SPACs and the traditional IPO differ in how valuation is determined: in the former, negotiation with a single counterparty (tested in the PIPE process), and in the latter, setting a valuation range with underwriters and a book building process with institutional investors through a roadshow.
What are some of the advantages of partnering with a SPAC?
From a target company perspective, here are some of the advantages:
- Public disclosure: In contrast to a traditional IPO, a SPAC transaction facilitates the public disclosure of forward-looking projections in a Form S-4 registration statement or proxy, and allows sponsors and management teams to engage in direct discussions with investors over a period of time, which may create an opportunity for companies to tell a more thorough story in terms of the investment thesis.
- Fixed valuation: Since SPACs have already raised necessary capital, there is less volatility in pricing compared to a traditional IPO process, where shifting investor sentiments and market conditions often influence pricing.
- Top-shelf talent: The SPAC structure gives the investors access to top-tier management that is highly incentivized to generate optimal return on investment.
- Flexible transactions: Sellers have flexibility to structure transactions to meet their needs and can potentially be more attractive than an IPO based on a SPAC’s ability to market and structure itself. For example, a private company may only be looking to go public to raise a small amount of capital and may not want to go through the expense of attracting investment banks to underwrite the process for them; or if an early-stage company cannot qualify for an IPO because it doesn’t have solid revenue or plans for near-term profitability yet but has a compelling growth potential story to tell. Both companies would benefit from the SPAC’s structure since they can avoid the valuation and investor story pitfalls of the IPO process while becoming public quickly and at a potentially lower cost.
- Access to seasoned SPAC sponsors: SPAC sponsors are often seasoned investors with a proven track record and deep industry insights and can attract stockholders of similar professional and reputational caliber.
What are some potential downsides, risks and liabilities of a SPAC?
Some of the potential downsides of partnering with a SPAC include the potential for higher costs of capital due to sponsor promote, warrant dilution and fees; headline valuation may not necessarily be indicative of true equity value due to dilution; deal and capital risk due to redemption potential; and significant stockholder overhang and churn in the months post-merger.
In addition, while the liability standards related to disclosure of company information that apply to a registration statement on Form S-4 or Form S-1 registration statement for a traditional IPO are somewhat different, liability still attaches with respect to those disclosures, including projections that are not accompanied by adequate cautionary statements. Further, the marketplace may hold issuers accountable to live up to the projections that are provided to investors by the SPAC.
What is the SEC process for a SPAC?
The requirements with respect to target disclosures in a Form S-4 registration statement or proxy are similar to an S-1 (though not identical), including disclosures regarding the target’s business, historical financial performance and other topics like executive compensation or risks related to the operating business.
Unlike in an S-1, SPAC targets have the discretion to disclose five-year financial projections and KPIs in the S-4. Financial requirements with respect to the target are largely the same as an IPO, so an independent registered public accounting firm under applicable PCAOB and SEC standards will need to audit financial statements of the target; and an extra year of audited financials may be required depending on the filing status of the SPAC and target. Generally, the target company will bear full liability for the completeness and accuracy of its disclosures. Directors at the close of the transaction consent to being named as such in the registration statement, assuming liability for its contents. With increasing numbers of companies going public through the SPAC process, however, such projections may become a greater area of focus for shareholder-driven securities litigation. See also Fenwick’s “Financial Projections in SPAC Transactions: Mitigating Class Action Litigation Risk.”
What is the role of a PIPE financing in SPAC transactions?
Private investments in public equity (PIPE) play a key role in the success of SPAC transactions. Attracting a marquee list of PIPE investors serves several purposes, including providing some risk mitigation against redemptions and helping validate valuation. By the nature of its structure, SPAC shares and warrants are separate and freely tradable. Stockholder churn can be significant during the deal process, and the risk of excess redemptions can leave the SPAC without expected cash balances in the absence of a PIPE financing. Securing established PIPE investors or other more stable financing sources can often influence public market sentiments.
What is the role of financial institutions and intermediaries?
In an IPO, financial institutions and intermediaries help market the story, create a prospectus for which they take responsibility, underwrite the offering and provide research coverage. In contrast, financial institutions in a de-SPAC transaction act as advisors who help structure the transaction and market the story through the PIPE transaction.
In the right circumstances, SPACs offer private companies a viable alternative exit strategy and a very attractive method of reaching public markets. As with any complex corporate transaction, successfully executing a SPAC transaction will require careful consideration and execution and close coordination with proper counsel and other advisors. For more information on SPACs, check out our recent joint webinar with KPMG and Bank of America, “SPACs: Unlocking a ‘Blank Check’” and reach out to the Fenwick authors of this article.
Originally published December 22, 2020, on Crunchbase.