Monday, August 3, 2020

SPACs: A Brief Overview

Just as every founder seems to have a side angel fund, every late stage investor now appears to have a SPAC (Special Purpose Acquisition Company). While SPACs have existed outside of tech for decades (largely to help slower growth profitable companies go public), SPACs are now entering the tech ecosystem. SPACs in tech were pioneered early by Chamath Palihapitaya, who used one to take Virgin Galactic public. More recent SPACs have been raised by funds like Dragoneer, Goldman Sachs, Pershing Square, as well as Barry Sternlicht's Jaws and Eventbrite's Kevin Hartz.

At its core, you can think of SPACs as decentralized investment banking - SPACs are roughly public search funds that allow individuals or funds to take private companies public.

Given all the capital raised by SPACs, it seems likely a number of technology companies will be acquired by SPACs as a mechanism to raise more capital and go public in the next 12-24 months.

This post reviews how SPACs work, where incentives lie, and how SPACs compare to Direct Listings (DLs) and IPOs. The emphasis of this post is tech-centric SPACs, versus the original usage.

What is a SPAC?
A SPAC is a shell company that raises money by going public via an IPO, with the goal of merging with a private company within 18-24 months as a way of taking the private company public (without an IPO). The SPAC raises money from public market investors which is then part of the merged entity. For example, a SPAC could raise $500 million in a public listing, and then 6 months later "acquire" a private tech unicorn. The unicorn now has an incremental $500 million (either in primary investment and/or existing shareholders could have sold stock), is a public company, and may keep a subset of the directors of the SPAC as its directors.

A SPAC is composed of:

  • The owners of the SPAC. Often the SPAC is associated with a venture fund, crossover fund, or other institutional capital platform. The owners of the SPAC put up a % of the SPAC capital to cover investment banking and other costs, as well as raise the money for the SPAC via the IPO. The owners of the SPAC are also putting their vote of confidence behind the target company acquired.
  • The operators of the SPAC. As a public shell company, the SPAC has a CEO and a board of directors. The task of the CEO, a small operating team, and the board is to find a company to acquire or merge with. In some cases the directors of the SPAC are deeply involved with the search and later operations of the target. In other cases, the SPAC directors are window dressing to legitimize the SPAC and make it easier to raise money or acquire targets. The owners of the SPAC and operators of the SPAC often overlap substantially.
  • The investors in the SPAC. Often public market investors, the SPAC investors have some say in who the SPAC merges with. In particular the SPAC investor can choose to redeem their capital (i.e. get it back) if they do not approve a merger. This means the SPAC owners need to get buy in from the SPAC investors to actually "acquire" the target company. This means many SPACs end up with a 3-way negotiation on valuation, governance, and other items between the owners & operators of the SPAC, the investors in the SPAC, and the target private company.

Timeline for SPACs

  • Setup. SPACs are quick to set up as (i) they are a shell company without an underlying operating business or projections and (ii) most people running SPACs have ties to crossover or public market investors and investment bankers so can raise SPAC money quickly. Most SPACs take a few months to set up.
  • Target acquisition. SPACs are usually required to find a private target company to acquire within 18-24 months. The people who own and operate the SPAC typically want a longer time to find a target, while the SPAC investors prefer their capital not be tied up indefinitely and want a shorter timeline.

Finding a target to acquire
SPACs tend to target companies whose valuation is roughly 3-5X the size of the SPAC. For example, a $500 million SPAC may seek targets that are worth $1.5 billion to $2.5 billion in size. This is not a hard and fast rule and there may be a larger range driven by the capital needs or secondary interest of a private company and its owners.

Once a SPAC is public, it has 18 to 24 months to find a private company to "acquire". This search is driven by a mix of investment banker ideas, relationships the SPAC owners and operators have, and a search done by the SPAC operators. Most SPACs are in the $300M to $1 billion range, which limits the types of companies that make sense for a SPAC to work with. In general a company needs to have at least $500M in market cap, and usually is quite larger, for a SPAC to make sense.

The negotiation
The negotiation will largely be between the private tech company and the SPAC.

The SPAC negotiation may include terms such as:
  • Valuation. What is the price of the target company?
  • Governance. What will the board look like post SPACing? Other terms?
  • Primary versus secondary. What portion of the SPAC will go to buy out existing shareholders versus is new capital into the company itself? Will there be a follow on investment such as a PIPE (see below)?
  • Liquidity. Under what terms can insiders in the private company sell stock? Is there a lockup or other constraints? Unlike an IPO (where bankers, not regulators, ask for the 6 months lockup, SPACs can acquire the tech company and immediately start trading the stock).
  • Warrant coverage. Early SPACs included the ability for the SPAC owners to buy shares cheaply from the target company, in parallel to the SPAC itself merging with it.
(As an aside: the SPAC may more rarely negotiate with its investors to prevent them from redeeming their capital if they do not like the deal. In most SPACs, the investors can ask for their money back if they do not approve of the acquisition. Some SPACs, like Bill Ackmans, have complex structures in place to deal with redemptions but that will not be covered here. There is also a negotiation between the SPAC and PIPE investors, if a PIPE is also done (see below))

Raising more money via a PIPE
In addition to the money raised by the SPAC via its own IPO, a SPAC can also raise more money as part of acquiring its target in what is known as a PIPE (Private Investment in Public Equity). This is a fancy way of saying they can raise more money with special terms for private investors. The follow on PIPE can be quite a bit larger then the original SPAC and allow for acquisitions of bigger private companies or better capitalization of a business if needed.

The PIPE can also offset redemptions - for example if half of a SPACs investors do not want to participate in a deal and they redeem their capital, more money can be raised to offset this via a PIPE.

Economics and incentives
The SPAC owners put up the "at risk" capital of the SPAC and in exchange reap an economic bounty if the SPAC works. While each SPAC is unique, the terms of the SPAC roughly include:

  • At-risk capital. The SPAC owners will put up on the order of $5M to $10M minimum to cover SPAC expenses and investment banking fees to take the SPAC public, perform the search, pay the operators and directors etc. If the SPAC never buys a target, this money is lost.
  • Upside. SPAC owners typically receive 20% of the equity of the SPAC. For example, if you raise a $500M SPAC, you may receive $100M of the value when the SPAC buys its target. In some cases hurdles are inserted - for example "you only receive 20% of the value over a 8% a year internal rate of return (IRR).
  • Warrants. In addition to the SPAC upside, the SPAC owners traditionally have negotiated additional warrant coverage with the target company they acquired. Early SPACs had 1:1 warrant coverage (i.e. they could buy one share at a steep discount for every share the SPAC bought in the private company). More recent SPACs have reduced this ratio to 1:5 and it will likely go away as higher quality companies use SPACs to effectively go public.

Differences from an IPO or Direct Listing
Because a SPAC buying a target is an acquisition versus an IPO, the regulatory rules and banking asks differ quite a bit. This includes:

  • Pricing. The price of the private company going public is set in negotiation between the SPAC and the target (and in some sense the SPAC and its own investors who can redeem a deal they do not like). This differs substantially from a typical IPO in which bankers set pricing, often with both the company and their own incentives in mind.
  • Liquidity. The 6-month lock up around an IPO is a contractual term put in by investment bankers when they take a company public, not regulators. In a SPAC acquisition, who can sell what shares when is completely open to negotiation between the SPAC and the target. For example, insiders could sell immediately, be locked up partially or fully for different periods of times, and you can even differentially lock up different people or investors. This provides enormous flexibility. In a direct listing, only existing shareholders can sell and a company is not allowed to raise money itself for some period after the direct listing. Often, a company doing a direct listing will raise money in advance of the listing, as well as organize a large secondary sale of existing employees and investors to soak up internal demand to sell its stock in advance of listing on an exchange. This serves to keep the stock price stable.
  • Capital raised. The capital injected into the private company by a SPAC is a mix of the amount of money the SPAC raised plus any PIPEs. The now public SPAC-target hybrid could also raise money directly after the merger. This is similar to an IPO where capital can be raised via IPO as well as via a follow on offering. Direct Listings, in contrast, do not allow primary capital to be raised immediately following listing.
  • Banker involvement. Bankers are involved with taking the SPAC public, as well as the merger with the private target company. However bankers do not set the terms of liquidity or the price of the IPO.
  • Roadshow. For a traditional IPO there is typically a 2 week roadshow where the company execs fly around the country pitching the company in 30 minute meetings to institutional investors. In a direct listing, a single "investor day" is often done instead, where potential investors can dial in. For a SPAC, the company executives may meet with major SPAC shareholders. However, no formal process is required.
  • Information and projections. In order to public via a SPAC, the target company needs to have audited financial information. Given that the SPAC-target tie up is a merger, rather than an initial public offering, there are fewer regulatory constraints on the ability to share projections or other information. In particular, unlike an IPO a SPAC can provide forward looking projections and guidance for the asset it merges with.
  • Brand. In the finance world, SPACs have traditionally had a second tier brand. The companies that used SPACs prior to the recent tech wave were often seen as the less interesting or weaker companies. This may change given the types of investors who have raised SPACs, and the technology companies likely to effectively go public via a merger with said SPACs.

Future of SPACs
SPACs have raised a bolus of capital recently. Will SPACs become a mainstream mechanism for the best technology startups to go public? Will SPACs become more attractive to companies by lowering sponsor cut (Pershing Square is taking a sponsor fee largely driven by performance and earn outs, likely yielding around 6% of the post-merger entity), lowering warrants, and getting a few high quality companies to buy in? Or will SPAC be the 2020 version of ICOs - lots of activity that will enrich a handful of sponsors but be a secondary use case? The coming 2 years will determine a lot of this outcome.

Thanks to Gokul Rajaram and Troy Steckenrider for feedback on this post.

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