You can’t read TechCrunch, the WSJ, or sit through a boring tech webinar without someone name-dropping SPACs. We decided to look into SPACs to evolve our own understanding and yours! We sat down with Will Cass, Managing Director at Needham & Company to help us answer the following questions. Note that we are not lawyers or bankers, so we endeavor here to describe what we learned in normal people speak.
A SPAC is a shell company that issues units in a public offering with a stated purpose to acquire “target” companie(s) aligned with some sort of strategy. The issued units are a combination of stock and attached warrants, and the strategy can be quite specific or quite vague. The primary rule is that the targets cannot be pre-defined. A typical SPAC size (meaning the $ raised in the initial IPO) is between $200 to $300M though some are ranging higher in 2020 (the 2020 average is $370M). SPACinsider has more stats. Typically the enterprise value of the target that a SPAC seeks is 3–5x times the size of the initial SPAC IPO, so call it $600M to $1.5B. There are a few reasons for this ratio, which we won’t get into now, but this helps minimize the effect of the dilution from the sponsor promote.
Once the SPAC is listed, the search process begins, and targets are identified. More on that below. This may also include the coincident raising of a PIPE financing commitment to increase capitalization and signal legitimacy of the deal.
Then the SPAC enters the de-SPAC phase by announcing the target and merger and filing an 8-K. At this point, initial SPAC investors have the choice to stay in the deal or redeem (pull out of the deal). They may redeem if they don’t like the target or feel that it is overpriced. Finally, the merger is completed with original shareholders in the target receiving some cash (perhaps 15 to 20% of the valuation) and the rest in stock of the combined entity. Thus original investors are still mostly illiquid, subject to a ~180-day lockup and the motions of the public market, often subject to a lock-up that can be similar to an IPO. More here:
SPAC sponsors — the person/people who put the SPAC together — like SPACs because they end up with approximately 20% of the final public entity through founder shares and purchase of warrants as their “carry”/”promote”/”fee”. The 20% sponsor ownership for SPACs is the post-IPO entity but not the post de-SPAC entity. Even if the final combined public company trades poorly, they can still make a 3–4x multiple on a relatively small upfront investment of a few million dollars. They can make a 10–20x multiple if the stock trades well! This is why we see a gold rush of people starting SPACs. Barring extremely poor trading results (the SPAC never finds a target and has to liquidate), the only cost to a sponsor of an unsuccessful SPAC is reputational damage. They will likely still make money even if they buy a bad target or overprice the deal. Needham has a great illustration of this here if you like details:
So how about the economics for SPAC and target investors?
Many SPAC investors are credit funds who invest for sure treasury-like returns during the search phase when the initial capital pool is in escrow…. with the option of redeeming if they don’t want to risk their money on the target. So they have a period of risk-free returns plus option value. Target company founders and investors don’t have such optionality. They are accepting mostly stock and will be locked up for a while.
This highlights the divergence of incentives to which shareholders of target companies must be very attuned. Sponsors have all the incentive in the world to get a deal done because they make money in most states of the world. Targets on the other hand may see a shiny valuation deteriorate post-merger, meaning a SPAC exit is not nearly as sure a bet as an exit at the same valuation to a large strategic acquirer for cash or highly liquid strategic acquirer stock (that is not locked up).
SPACs are becoming more popular for a few reasons. First, there is simply a lot of money out there seeking yield. The cynical view is that when this happens, hawkers and investors get “creative.” More on that later.
On the other hand, there are two rational openings in the market where SPACs have a role. The first is in getting companies with $50M to $100M in revenue to IPO. These companies have a much harder time going public directly these days. The implied enterprise value of $500M to $2B attracts less attention from underwriters and major pre and post-IPO funders who prefer the scale of larger IPOs.
The second rational reason for SPACs is that the SPAC process allows companies with more complicated stories to include pro formas in their filings, helping to clarify the path of what might be, for example, a highly uncertain biotech or battery technology commercialization process. Such long-term pro forma forecasting is not allowed in a traditional IPO process. That’s fine for software and services companies with established histories and relatively clear trajectories but makes IPOing hard for binary risk companies. SPACs can help these companies.
While startups of every type are talking about SPACs, SPACs are really only an option for good companies with at least $50M in revenue, who are roughly following the rule of 40 or better. Anything smaller doesn’t fit the enterprise value ranges discussed above. Moreover, SPACs are not a get-out-of-jail-free card for a stalled late-stage company. If you know it’s not a good asset, others will too!
As discussed above, SPACs are also a good option for highly technical companies with more complex pro forma stories.
There have been hopeful discussions of SPAC “rollups” among VCs and founders — something like SPACing 3–5 companies with $5M to $15M each in revenue to get one big enough asset. The limited cases of these have not gone well. For anyone who has seen the sausage-making of rollups and layered mergers, would you want to do that in public? Just not a clean story. However, becoming a tack-on acquisition for a large foundational SPAC target is certainly possible.
SPACs should be seen as just one of many funding, liquidity, and capital options a mid to late-stage startup considers. Will Cass at Needham points out that SPACs are essentially a growth equity round + IPO + liquidity all in one. Some cash goes to shareholders, some cash remains for growth, and the rest of the stock can ultimately float publicly. If that combination of capitalization strategies makes sense, go for it. Any good tech company banker would include this potential path as one option amidst conversations with strategic acquirers, PE acquirers, and growth funders in a typical late-stage financing/exit process. Beware anyone trying to sell you a SPAC only.
Likewise, as SPACs proliferate, the ones most likely to be successful are those with very strong sponsors — people/firms who have a specific strategy, understand the targets that fit that strategy, and have the credibility and weight to tell a strong public story. The target itself will also have to tell a strong public story once the merger is announced. That means that regardless of the quality of the target and its financials, its management team must have the characteristics that public markets seek.
SPACs are certainly more common today than they were ten years ago, and they do represent a unique solution for “smaller” late-stage companies that want to go public. However, research suggests that while returns are very good for SPAC sponsors, they aren’t so good for investors. One possible explanation is that SPACs represent a “peak cycle” phenomenon. When asset values are already really high, capital desperately seeks yield via alternative structures and creativity. In other words, perhaps SPACs popularity coincides with time periods when returns after-the-fact are generally low. We shall see!
You can view a recording of the full conversation here: