Amidst a global pandemic, why are so many companies rushing to go public via the SPAC, despite producing lower returns for investors?
By Louis Lehot, business lawyer and partner at Foley & Lardner LLP in Silicon Valley, and formerly the founder of L2 Counsel, P.C. and the video blog series #askasiliconvalleylawyer
In recent years, the world has seen a gold rush of private companies rushing to go-public via a reverse merger with a special purpose acquisition corporation, or “SPAC.” This article will attempt to answer why. We will also clarify what it means for entrepreneurs, what it costs, why it matters, and who will be disrupted. Finally, we will look for some market indicators to watch out for.
The market for SPACs vs. traditional IPOs in the last decade
To demonstrate the phenomenon that we are seeing the markets, following is a comparison of the volume of SPACs vs. traditional IPOs in 2014 to the present:
Why are so many private companies rushing to merge with a SPAC to go public?
In two words: time and money. Private companies have found the process of going public via a reverse merger with a SPAC can happen in much less time at a much lower cost than a traditional IPO or direct listing. A traditional IPO can take 6 months or more of extremely time-intensive management attention, while a SPAC IPO can get done in less than half the time with minimal effort. The cost involved in a traditional IPO typically reaches 10% or more of the amount of capital raised, while a SPAC IPO can be done for a fraction of that amount. The process of a traditional S-1 filing for a private company has become so time-intensive and so expensive that fewer and fewer companies have been willing to go through this process since 2000. According to Statistica, while over 400 companies went public via IPO in an election year in 2000, fewer than 160 were willing to do this in one of the greatest economic booms in history in 2019.
Today, many private companies would rather merge with a publicly traded SPAC than go through the time-consuming and expensive process of raising money through a more traditional initial public offering. That’s especially the case during the coronavirus pandemic.
What does it mean for entrepreneurs?
For entrepreneurs, particularly for operating businesses with healthy operating metrics, but where an IPO or M&A exit were not achieveable, particularly because access to capital was constrained, the SPAC is a pot of cash combined with listed acquisition currency with which to grow and give liquidity to stakeholders.
What does it mean for investors?
According to Rennaissance Capital, a provider of IPO ETFs and institutional research, however, the data between 2015 and mid-2020 shows that SPACs offer lower returns on average than conventional deals. Indeed, the sample set of 89 SPACs that had completed reverse mergers during the period had delivered an average loss of 18.8% and a median return of minus 36.1%, compared with an average after-market return from traditional IPOs of +37.2% in the same period. During the period, only 26 of the SPACs in the cohort had registered positive returns, according to this same study.
DraftKings CEO Jason Robins told Business Insider that while SPACs work for some companies, they’re not a good fit for everyone.
Palihapitiya cites two factors for the popularity of SPACs with investors: a scarcity of places where public investors can get big returns, and the inefficiency and cost of doing traditional IPOs. Another factor in the surge in SPACs is this year’s choppy stock market response to COVID-19.
What is a SPAC, and what attributes make it attractive for the market?
At inception, a SPAC is a blank-check company that raises capital to become publicly-traded. The capital raised is often called a “blind pool,” because it is for the purposes of acquiring a single, public-market ready operating business not yet identified. SPACs were first invented in the 1980’s, and have evolved extensively over the past 4 decades through market convention and SEC regulation.
In the initial SPAC IPO, investors effectively park their capital for up to two years in exchange for downside protection (redemption rights) and additional upside (warrants).
In return for sourcing an acquisition of an operating company, negotiating that deal, and bringing the target public in a reverse merger, and potentially providing ongoing support, the SPAC sponsor earns some portion of the company’s stock, which is referred to in the jargon as “promote” stock. The sponsor promote can amount to approximately 20% of the total capital raised at IPO.
To fund the IPO expenses and working capital, the SPAC sponsor purchases additional private placement warrants for proceeds representing 2.5% to 6% of the SPAC IPO, depending on the size of the IPO.
A successful SPAC IPO can be a lucrative opportunity for a sponsor who gains equity in the combined company (via the promote), additional upside (private placement warrants) and potential governance rights in the post-merger combined company.
With opportunity comes risk. The SPAC sponsors may not be able to locate an acceptable target, and stockholders may choose to vote against a target and redeem their shares for cash. In addition, the significant market overhang of the warrants can dampen the post-closing common stock price per share. There is reputational risk. The target may not perform post-closing.
Three evolutions in the market for SPACs have contributed to its recent surge. First, shareholders in the initial SPAC IPO are no longer required to vote against the subsequent “de-SPAC” reverse merger in order to redeem their shares, thereby improving the probability of the SPAC obtaining the requisite shareholder vote to the deal. Second, as we will discuss below, the SPAC instrument has been embraced by celebrity investors, increasing the product’s credibility and profile, allowing them to raise greater pools of money. Lastly, SPACs have come to the lucrative technology and life science markets, where higher betas unlock the potential for greater returns.
What kinds of operating companies should consider a SPAC?
Businesses that have healthy operating metrics, have the internal controls in place to provide audited financial statements that can withstand the scrutiny of auditors, the SEC and Wall Street analysts, and are not otherwise able to access a traditional IPO or private equity exit, should consider a SPAC.
But even the best-laid plans can land in the rough. DraftKing and Nikola had massive run ups after initially completing their SPAC mergers. DraftKings dipped as low as $10 a share and is now trading near a high of $50 a share. On the other hand, while Nikola initially traded up as high as $79 a share, it has since dropped back to earth at $24 a share, and is now under investigation by multiple government agencies about the accuracy of its disclosures. Virgin Galactic, initially founded by Richard Branson, merged with Silicon Valley venture capitalist Chamath Palihapitiya’s SPAC called Social Capital Hedosophia, and traded as high as $33 a share before dropping down to $18 a share.
What kinds of operating companies should avoid the SPAC vehicle?
If you can get to a traditional IPO or private equity or other exit, this is imminently preferable to a SPAC. Furthermore, real estate investment trusts or other vehicles that trade on some derivative of net asset value are not suitable. Single investments subject to restrictions under the Investment Company Act of 1940 are also not appropriate. Finally, companies that could get a complete exit (albeit with some management rollover) for their investors are better served by a sale to a strategic or financial investor than a SPAC.
Why is that? Because the SPAC has significant market overhang, limited liquidity, and typically a lot of financial investors (think hedge and arbitrage funds) looking to get out of the stock, as opposed to fundamental investors (think pension and 401k type funds) looking to build a long-term position in the stock. Indeed, post-closing of a reverse-merger, the SPAC faces immense pressure from existing stockholders who seek to run for the exits, as opposed to the traditional IPO, where only 10–20% of the company has been sold, there is limited liquidity for fundamental investors to build positions, and where there is a better correlation of supply and demand for the stock.
Key considerations for entrepreneurs to consider in selecting a SPAC vehicle
If the pros outweigh the cons, or if the stars are aligning for your business to merge with a publicly traded SPAC, following are some key items to think about before pressing “go”:
- Are the SPAC sponsors going to be good long-term partners for your business? Not all SPAC sponsor teams are created equal. While having a great basketball player like LeBron James is worth millions on the court for your sports franchise, do we know if this celebrity will translate into financial success in a non-sports related public company?
- Will there be sufficient post-closing capital to enable growth on a go-forward basis? As noted, shareholders in the SPAC IPO have the right of redemption. If they redeem in too high a percentage, the business will not have sufficient capital to grow. Sometimes, this is solved by a concurrent private placement of capital into the combined company.
- Is your business predictable 3–4 quarters out, such that you will not shock and disappoint Wall Street once public?
- Is your business ready to build out the internal controls over financial reporting and other governance requirements for a company to withstand public scrutiny and the plaintiffs’ bar?
- Will the combined company post closing provide sufficiently active and large enough trading volume to provide liquidity to stakeholders?
Are SPACs here to stay, or is this a flash in the proverbial pan?
This is the 64 million dollar question. After previous surges and flame-outs, is the SPAC IPO market here to stay? How will we know? The answer is whether or not the recent co-hort of SPAC IPOs, from Virgin Galactica to DraftKings, to Nikola, to Pershing Square, can outperform the market. If valuations continue to surge, and maintain the surge over time, expect more SPACs.
Finally, with more capital in the market, more deals will become available, and terms may evolve. If the terms become more favorable to SPAC promoters and target entrepreneurs, expect the vehicle to continue to gain popularity and traction as an alternative to the traditional IPO or M&A exit.
Every Wall Street investment bank and law firm is promoting a SPAC conference and making hay with the sun is shining. Long-term performance and continued availability of capital will be required to prove out whether these efforts are a flash fad or a sustainable trend.
Louis Lehot is a partner and business lawyer with Foley & Lardner LLP, based in the firm’s Silicon Valley, San Francisco and Los Angeles offices, where he is a member of the Private Equity & Venture Capital, M&A and Transactions Practices and the Technology, Health Care, and Energy Industry Teams. Louis focuses his practice on advising entrepreneurs and their management teams, investors and financial advisors at all stages of growth, from garage to global. Louis especially enjoys being able to help his clients achieve hyper-growth, go public and to successfully obtain optimal liquidity events. Louis was the founder of a Silicon Valley boutique law firm called L2 Counsel. He previously served as both the co-managing partner and co-chair of the emerging growth and venture capital practice of a global law firm in Silicon Valley.