There have never been more way to take a company public.
IPOs are a mainstay, while direct listings were all the rage in 2019 after Spotify and Slack went public with great success through the latter model. But then talk of direct listings gave way to talk — a lot of talk — about SPACs once 2020 rolled around. The chatter is still going today. And that’s because SPACs have ushered in newfound flexibility and speed for those ambitious to enter the public market, whether founders themselves or the institutions and people who invested in their ventures.
SPACs — an acronym for “special purpose acquisition companies,” which are also known as “blank check” or “empty shell” companies — gained attention last year because of a number of high-profile names behind a handful of SPAC deals — from Virgin Galactic to former Speaker of the House Paul Ryan.
But SPACs are not new. In fact, they’ve been around for decades. And their appeal to investors of different stripes has ebbed and flowed over the years. Recently, however, venture capitalists have taken a shine to SPACs, following a years-long evolution of the financial maneuver and the success prominent figures and companies have recently enjoyed with SPACs.
How does a SPAC work?
A traditional IPO is a company looking for money, while a SPAC is money looking for a company.
SPACs are shell companies with no commercial operations or assets created by a sponsor, who has a background in M&A, private equity, or is a successful entrepreneur. SPAC sponsors seek to raise capital through an IPO for the sole purpose of acquiring a target operating company and take it public without going through the traditional IPO process.
At the IPO, the SPAC issues investors units, which are priced at $10 and typically consist of a share and a warrant. Each warrant customarily gives investors the right, but not the obligation, to buy an additional ⅓ to a full share at a specific price, typically at $11.50, for a term of five years.
The capital raised from the IPO is placed directly in a trust account, and the SPAC’s sponsors have 18–24 months after the IPO to identify and complete a merger with a target company, sometimes referred to as de-SPACing. Investors play a key role in the de-SPACing process since they can vote to approve the deal and/or demand redemption of their capital in trust if they decline to participate in the proposed transaction.
SPACs often target companies that are, on average, three to five times larger (on an enterprise-value basis) than the capital initially raised by the SPAC itself. It is common to raise a private offering of public equity (PIPE) financing once a target is identified to increase the capacity to fuel growth for a larger and more mature private company.
The history of SPACs — What has changed?
While SPACs have existed for years, they have cycled in and out of favor with investors. In the 1980s and ’90s, SPACs were criticized by some, occasionally drawing comparisons to fraudulent shell companies.
In the early 2000s, SPACs became popular again for a short period, which ended around the financial crisis in 2008.
Today, following an evolution, from structural and reputational standpoints,SPACs are generally viewed as more legitimate.
Regulations around SPACs shifted over time to become more investor-friendly and sponsors adjusted the terms to become more aligned with investors instead of getting rich quickly at the expense of investors as before.
SPACs’ growing association with high-caliber institutions and people is another factor that led to a rebranding of the financial vehicle. Companies like Virgin Galactic and DraftKings, which went public via SPACs, have raised the profile of SPACs, previously associated with small-cap affairs.
Other prominent names behind SPACs include Pershing Square Management founder Bill Ackman; Chamath Palihapitiya of Social Capita; and LinkedIn co-founder Reid Hoffman, to name a few.
Because investors are buying blindly into an operating company that is yet to be determined, they make their investment based on the composition of the sponsor team and whether the sponsor team can source a compelling deal, and then actively manage the future operating company. The better the reputation and track record of the sponsors, the more confidence the investors have in the SPAC offering — and the bigger amount of capital raised to fund more mature companies.
In addition, investors view sponsors’ experience and knowledge as a selling point to attract hot-ticket companies that are not only fundraising, but also looking for strategic partners that can help with post-IPO strategy.
The rise of SPACs. Why now?
SPAC issuance in 2020 has broken all previous records.
More than $83 billion were raised across 248 SPACs in 2020, compared to $13.6 billion raised through 59 deals in 2019 — a more than 6.1x increase, in terms of dollars, and 4.2x increase in the number of deals. The average SPAC in 2020 was also much larger than its 2019 counterpart — $334 million versus $230.5 million. Going into 2021, the SPAC boom has shown no sign of slowing down; in contrast, new ones are born daily, with 170 blank-check companies having raised $53 billion in the U.S. already in 2021.
To give a perspective on how big the SPAC market has become, we look at its market shares. Before 2020, SPAC never outnumbered traditional IPO and capital raised by SPACs never made up more than 20% of the total IPO proceeds. The 248 SPAC IPOs in 2020 account for 55% of the total IPOs and 46% of the total IPO proceeds. These records demonstrate that SPAC has entered the mainstream and are expected to continue to affect merger and acquisition dynamics, bridge the gap between private and public equity, and expand the opportunity set for public equity-oriented investors.
Macro factors have contributed to the surge in the popularity of SPACs in 2020. The last time SPACs represented such a large percentage of U.S. IPOs was during the other most volatile period in the markets. This relationship might explain the record level of SPAC issuance in 2020 as the global economy has continued to work through the economic impacts of the COVID-19 pandemic, the U.S. presidential election, and other factors.
Private companies have reduced their cash burn, while concerns about fundraising prospects have grown ever-more prevalent. Today, more companies are looking to the public market for liquidity and are moving quickly to capitalize on the current favorable public market conditions. As private market valuations have trended downward, public company valuations have continued to rise amid a pandemic-driven recession, reaching an all-time high and widening the public-private valuation gap. To ride that trend, many private companies use SPACs as the vehicle of choice to do the last financing round and the IPO, all in one.
SPACs offer a unique and wide array of benefits, which vary depending on the party involved. On the back of the remarkable volatility of the equity markets, those advantages pushed the SPAC into the spotlight and allowed it to attract more private companies, more sponsors, and more investors to join the game, thus unleashing a financial product that had otherwise been very much in the background.
For Private Companies
Price Certainty: From a private company standpoint, finding the right window to debut on Wall Street via traditional IPO can be tricky and costly, especially in unstable market conditions. The price of the stock may suffer simply because the market was down the day the company goes public. On the other hand, if a company is too conservative and prices its offering too low, the company risks leaving money at the table. SPAC solves those issues due to its ability to lock in a price and shields the company’s value from market volatility.
Speed: Private companies also find that SPACs serve as a smoother path to the public markets because of its shorter timeline. A traditional IPO can take more than a year from start to finish, while a SPAC transaction, from company identification to completion, takes about five to six months. That is because SPAC transactions function more like an acquisition. The private company has to negotiate with only one party — the SPAC’s sponsor — rather than a host of investors on a road show. There are also fewer upfront SEC reporting requirements for the company during a reverse merger because with a SPAC, the IPO is already done.
Flexibility and Customizability: These attributes are also a selling points of SPACs because companies can sell more of the business, raise more capital than they might have in an IPO, attach earn-outs, reduce insider lockups, and more, giving the private company more flexibility to tailor a transition to the public market around its wants and needs. For example, while a traditional IPO is typical for only a small portion of a company, a SPAC can have a wide range in the amount of total equity being transacted and can go out and raise additional funds through a private offering of public equity (PIPE). Coming to terms before even having to talk about all of these things very publicly, allows for creativity and innovation.
- Institutional Investors:
High-reward investment with limited risk: An added sweetener in the form of warrants allows the investors to buy more shares and benefit from any share price appreciation above $11.50 post-acquisition. On the other hand, investors can redeem shares and take their money back plus whatever interest accrued during the time it was held in the trust if they are dissatisfied with the acquisition decision or if the SPAC fails to find a target.
2. Retail Investors:
Early participation: The trend of staying private longer over the past years has limited the flow of new companies into the public markets. By the time those private companies get to the market, they have already become too big, thus having less room for growth and value creation to benefit public-market investors. SPACs allow retail investors to enter the private market early, gain exposure to emerging industries, and invest in young and quickly-growing companies to secure higher returns. The key selling point of a SPAC is that it allows the public to co-invest with what are perceived to be successful sponsors who have the skill sets to acquire and run a public company. In addition, with SPACs, retail investors can enjoy the “pop” in share prices once a target is announced in contrast to the traditional IPO which restricts retail investors from investing prior to the company’s debut on the public market and thus leaves retail investors out of the potential upside available from an IPO.
3. SPAC Sponsors:
Economic incentive: SPACs offer sponsors significant upside for relatively low upfront costs. Sponsors receive a special class of shares — founder shares, which equate to 20% of the shares in the SPAC, known as the promoter fee, for an investment of approximatedly 3%-4% of the IPO proceeds. Those founder shares give the sponsors an outright ownership position, which increases the potential upside in the post-business combination entity.
The VC view of SPACs
With a creative and disruptive nature in its DNA, the venture capital industry continuously searches for alternative exit routes to achieve liquidity for long term investors. Given some of the challenges inherent in executing an IPO, VCs have been exploring other ways to ease the process of taking companies public and allow more public investors to be a part of the investment journey at an earlier stage.
As a result, VCs have welcomed the prevalence of SPACs, which have opened doors to certain companies that might otherwise not be marketable in a traditional IPO. That includes pre-revenue companies with a less established business model, young companies with moonshot goals, fast-growing companies with unprofitable operations or struggling older companies with a complicated business history.
IPO candidates normally have revenue above or approaching $100 million, with a growing customer or contract list, a determined business model with double-digit sales growth, and diminishing losses as a percent of revenue. SPAC candidates need only show potential to achieve those things.
To paint those pictures, the SPAC’s target companies can offer up their “forward looking” numbers — namely, how they think top and bottom lines will perform in the future. This is not a privilege of both traditional IPOs and direct listings which can only show historical financial statements. Being able to set forth projections is helpful for fast-growing but not yet profitable companies to tell their story, stoke enthusiasm, and attract capital.
But SPACs are not cheap. In order to do an IPO, a target company pays investment banks 7% of what you raise. In a SPAC, the company leaves equity for sponsors, which is 20% pre-merger and is diluted by an exchange ratio to 1%-5% post-merger, and 5.5% for underwriters. So SPAC fees are about a quarter of the money raised, three or four times as much as the company would pay for in an IPO, albeit better disguised.
The VC industry has gone through trends such as being a platform to provide a full support to startups. SPACs fit in the VC ecosystem naturally since it allows VCs to create exits for their portfolio companies after curating them. This ability also adds a new potential stage in which VCs can remain invested, extending the trend of VCs holding on to their winners for as long as possible, turning some VCs into crossover investors. When a VC firm forms a SPAC, it differentiates itself from an ever-growing venture capital field. Given the long term relationship, deep involvement, and great influence, the founders entrusted the venture capital firms to help the target company determine the right structure for the IPO and play an ongoing role in management post-closing to continue to provide significant added value to the newly public company. Many VCs have already set up SPACs, including Lux Capital, travel-focused venture fund Thayer Ventures, Tusk Ventures and FirstMark Capital.
What it can mean for a venture capital firm is that SPACs are a natural fit in an effective ecosystem built to support founders.
It’s important to keep in mind that merging with a SPAC is not a silver bullet for all private companies. There is a cost of going public and being public which involves a tremendous amount of time, management attention, and financial cost to meet higher reporting requirements and adhere to more stringent and complex accounting rules. Whether a company chooses to go public via a traditional IPO, a direct listing or a de-SPAC merger, we need to make sure that it is fundamentally ready to face the scrutiny of public market investors.
At the time of this writing on February 24th, the sheer number of SPACs currently seeking acquisitions is 336 and the amount of money ready to be deployed is $105MM, all with time limits of 18 to 24 months maximum. Since there are a finite number of attractive targets of interest to a large and growing number of SPACs, the monumental task of finding a good acquisition will get harder. The time constraints might force the sponsor to forgo appropriate due diligence and rush to acquire any willing company. The fear of running out of time is no substitute for sound judgment in evaluating a SPAC target.
The outlook on SPACs
The class of 2020 SPACs is under the gun to strike deals and the pace of SPAC formation shows no sign of ebbing. We are encouraged by the momentum driving innovation around public listings. We will be watching the evolution of SPACs with greater interest and expect the financial institutions entering the space will make mergers with SPACs a more attractive transaction option.
We expect deal terms and the structure of SPACs to continue to evolve to remain competitive. SPAC founders are now revamping SPAC terms to attract long-term investors and to induce shareholders to vote for a proposed business combination.
Although SPACs are having a moment in the current environment, our view is that they will not replace traditional IPOs or direct listings as a main avenue for companies to enter the public market. What is right for each company varies widely based on numerous circumstances, including whether founders’ need to raise primary capital, need large amounts of secondary liquidity, whether their story will be exciting to public market investors right out of the gate, and many other factors.
However, because SPACs provide more flexibility, efficiency and certainty, they have surely earned their place as an alternative path to the trading floor.
This post was authored by Fuel Venture Capital General Partner and Chief Investment Officer Maggie Vo, CFA®. Maggie manages investment activities, leads due diligence for prospective investments, and performs valuation analysis for existing portfolio companies. Follow Fuel Venture Capital on social media, via Instagram, Twitter and LinkedIn.
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