Updated: Aug 19, 2021
Over the past year, Initial Public Offerings have climbed in popularity. As part of this wave, mid-sized corporations have attempted to make their own splash in the market, either by direct listing like Coinbase or through additional investor funding like Robinhood just a few weeks ago.
As a refresher, an IPO is the process of offering shares of a private company to the public in a new stock issuance. For further explanation into the IPO cycle, read our Robinhood article.
Rather than go into the IPO cycle, a company can also become publicly traded through a Special Purpose Acquisition Company (SPAC). A SPAC is commonly referred to as a “blank check” company, and with good reason. A SPAC is created by raising a large sum of money. This money is poured into a shell company that has no revenue or product at this stage. Eventually, the management team of the SPAC will use the funds generated to buy a private company. The merger of the SPAC with the private company will result in the private company going public without going through the IPO process.
What are the Benefits of a SPAC?
The major benefit of a SPAC lies in the management team. If led by industry professionals who know how to properly value a company, management can create a profitable merger with whatever private company is ultimately decided on. The key to these “blank check” companies lies with the competency of the management teams. Some of the most famous examples of SPAC mergers are DraftKings, SoFi Technology, Virgin Galactic, and most recently Lucid Group.
What Happens During a SPAC?
The initial step of a SPAC is the leadership team starts the black check company and describes the plans for any funds to be raised. At this stage, the SPAC will typically give an indication of what industry they are looking to acquire a company in (biopharma, finance, consumer electronics, etc.).
The next step is that the SPAC holds an IPO to raise the necessary funds. It is at this point that the SPAC is publicly traded by investors. After the funds have been received in the SPAC, the third step of the SPAC is to find a suitable target company and begin negotiations on a merger.
After an appropriate company has been identified, the SPAC can go one of two ways: 1) the SPAC can reach an agreement and merge with the private company to make it public, or 2) the SPAC will be unsuccessful in finding a private company. If this occurs, the search for a new private company may begin, or the funds are returned to investors. A SPAC has up to 24 months to officially acquire a company before the funds are automatically returned to investors. In scenario 2, the funds that are returned to IPO investors are after any fees incurred by the SPAC thus far, most likely resulting in losses for investors.
SPAC Merger – Future or Fad?
Over the past two years, SPACs have exploded in their use, rivaling IPOs in popularity.
With the rise in popularity in SPACs, one of the biggest questions that remains is whether they will be a longstanding force in the market.
An alarming concern is that the due diligence measures on these private companies often have not-and cannot-be properly conducted. With a traditional IPO, companies are required to provide their current and previous financial statements. From there, third parties will provide a valuation for the company to base their IPO price on. In a SPAC, companies are allowed to create valuations based off future cash flows and financials, resulting in loftier prices that may not be based in reality.
An additional risk posed by SPACs is the fees the management team will charge from the company. From the cash raised by the SPAC IPO, management can charge up to 25% of the cash raised. This hefty cost ultimately provides little value to the company outside of the management’s professional experience, and could result in instant losses for IPO investors.
What Is the Future of SPACs?
The future of SPACs is very much up in the air. They have no precedent for future market conditions, as their rise to fame has occurred only under positive market conditions. The true test will come during stagnant or bear markets, and whether their numbers will continue to rise at their current trajectory. One other item that could potentially impact SPAC use is federal legislation. Because it is relatively new, there have not been an abundance of legislation for or against SPACs. If new legislation were to come out against SPACs, they could easily crush their rise to popularity.
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