We get it. Acronyms can be scary. FBI, YOLO, SEC (both the commission and conference) NASDAQ – it's not just a matter of understanding what the letters stand for but the underlying meaning as well. From a distance, a special purpose acquisition company (SPAC) probably falls under that category, but, as we're about to demonstrate, SPAC is an acronym that's all bark and no bite. Or maybe just a little gnawing but nothing major.
So give us a few minutes as we explain what a SPAC is, when and why they're used, and dispense a few hands-on insights for good measure. Given the recent volatility in the IPO market, as well as a renewed openness towards the concept, SPACs are once again throwing around some serious weight around Wall Street. So bookmark this page and get comfortable because here we go.
What is a SPAC?
Distilling the concept to its roots, think of a SPAC as a type of blank check company that raises capital from investors through a specialized IPO. Sponsors form SPACs for to-be-determined (TBD – acronym madness) purposes, usually a future merger or acquisition target.
Of course, not just anyone can or should establish a SPAC since, like any other type of investment, trust is an absolute requisite. Therefore, only experienced sponsors – both firms and individuals – with sterling reputations and demonstrated success in the space use SPACs to raise capital.
A Brief History and Why SPACs are Back
SPACs have a bit of a rocky history, through no fault of their own. They've been bouncing around the financial markets in some shape or form since the economic Wild West days of the 1980s. In those earliest iterations, they were a relatively unregulated group of open-ended, ill-defined offerings – at least compared to today's SPACs – often with extremely vague business plans and no particular investment targets in mind. Naturally, without today's regulatory environment to keep them in check, fraud was rampant.
Thankfully, the SEC stepped in to provide some much needed boundaries for these shell companies, laying the groundwork for the modern SPAC. Since the 90s, their popularity has ebbed and flowed according to the health of the IPO market and economic environment. They surged in the years preceding the Great Recession, then virtually disappeared for a short time frame, only to reemerge like a financial Phoenix since 2015 or so.
Between regulations and the warm embrace of investment banks and stock exchanges, – even the Big Board itself, the New York Stock Exchange (NYSE) –, SPACs have become an increasingly vital component of the capital markets in recent years. Today, despite those inauspicious beginnings, there seems to be a high-profile SPAC around every corner.
Long story short, the modern version of the SPAC is nothing like its earliest ancestors, with a record-setting 248 SPAC IPOs hitting the stock market last year (2020), an over 300% increase from 2019. Nikola, Virgin Galactic, several healthcare companies, DraftKings, Bill Ackman's massive Pershing Square, and many, many more – they've all dominated financial headlines in the last couple of years. And this, as they say, is just the tip of the SPAC iceberg
Advantages of SPACs
For the most part, companies and investors use SPACs as an alternative route to a traditional IPO. In fact, SPAC sponsors, investors, and target business owners all enjoy specific benefits from SPACs.
- Sponsors – For raising capital, SPACs provide access to a much broader base of potential investors, especially in comparison to private placements. Also, their lucrative potential upside doesn't hurt much, either.Hedge funds, private equity, and other institutional investors have all prioritized SPACs in recent months.
- Investors – SPACs provide the opportunity to co-invest with successful sponsor firms and individuals. Also, they provide certain liquidity provisions and protection measures against potential downsides, at least until closing on target business combinations.
- Target businesses – SPACs give privately held companies easier access to public markets, particularly during market instability. That access to capital can fund their operations and growth strategies, while still allowing existing owners to share in that growth through stock rollovers.
Disadvantages of SPACs
Is it even necessary to say that no financial instrument, entity, or vehicle is perfect? Probably not. So as you might imagine, there are some disadvantages to SPACs as well.
- Sponsors – Like any initial public offering, SPACs are susceptible to execution risk if the market isn't as receptive as expected. Likewise, investors can reject any proposed business combination, adding another source of risk that a standard IPO doesn't have to worry about. Also, depending on the particulars of the deal, governance and management issues could arise if the agreement integrates the target company's management with the SPAC's management team.
- Investors – Time is money, and when the invested capital is inaccessible while sitting in the SPAC trust waiting for a suitable target, it could be making a higher return elsewhere. If the sponsor never finds such a target and the SPAC liquidates, well, at least investors more or less get their money back, but that’s certainly not what they were looking for in an investment. Of course, investors are also subject to standard investment risks after shareholders approve a target business and an acquisition closes, but that’s obviously not unique to SPACs.
- Target businesses – Once the sponsor identifies a potential business combination and strikes a deal, it's up to the investors to decide if they support or reject that deal through a proxy vote. Granted, that's a significant benefit for investors but also represents a definite risk for the target companies. Don’t uncork that champagne until those votes are counted.
SPAC Transaction Timelines
Now that we've discussed what SPACs are, some of their pros and cons, and why they're unique in the IPO market, let's roll up our sleeves a bit and get into some of the nitty-gritty. We're going to start with a typical SPAC transaction timeline, split into three main phases, each with specific key objectives.1. Initial IPO – The same general process as a standard IPO, just more streamlined and less complex
- Incorporate the SPAC and sell the founder shares
- Prepare and file the S-1 with the Securities and Exchange Commission
- Obtain underwriting agreements
- IPO roadshow, pricing, and closing
- The SPAC files any regularly required SEC filings during this search phase
- Identification of the target business or businesses
- Perform due diligence on those businesses
- Prepare the proxy filing
- Sign the SPAC acquisition and other financing/commitment agreements
- Finalize and announce the acquisition agreements
- File the preliminary proxy with the SEC
- Obtain SPAC shareholder approval of the transaction through a majority shareholder vote
- Redeem common shares for investors opting out and close the transaction
- File Super 8-K with the SEC
To tie a bow around that brief timeline, the IPO process itself is essentially the same for a SPAC as a traditional IPO. It still features underwriters, fair market value, public shareholders, a registration statement, and most of the other terminology you're already familiar with. With a SPAC however, the process is generally just a lot simpler and more straightforward, at least until the sponsor chooses a target company.
A Slightly Deeper Dive into the SPAC Pool
For the sake of both brevity and bandwidth, we're not going to take an extraordinarily deep dive into SPACs, but we certainly want to flesh things out a bit more for you. So let's take a look at some of the finer details to give you a better idea of how a SPAC works.
SPAC Structure and Capital Raising
- Equity sold in a SPAC IPO consists of units, usually one share of common stock and a warrant to buy a fractional share in the future.
- The warrant is to compensate investors for investing in the SPAC before the business combination.
- The sponsor places all IPO proceeds into a trust account, typically held in short-term US government securities or cash equivalents.
- Sponsors can access that trust account to fund an investor-approved business combination, satisfy redemption requests, or use the interest to cover operating expenses or working capital needs.
Identifying a Target Business & Completing a Transaction
- SPACs must complete a business combination or liquidate within a set time after their IPO, usually 24 months.
- A SPAC cannot identify a target business before closing its IPO, nor can it have any communication with a potential target prior to that point.
- Once a sponsor identifies a target business, the sponsor management team then prepares and files a proxy statement to solicit shareholder approval, as discussed in phase #3 of our timeline above. Once again, the identification process could take up to two years, sometimes longer in isolated cases.
- After approval, the combined entity is the publicly traded company, usually governed by a board of directors that includes both the SPAC's sponsors as well as directors chosen by the target business. The sponsors can choose to keep the target company's management or actively manage the combined business themselves.
Accounting & Reporting Considerations
Once again, we're not going to get too terribly deep on this topic, but still want to provide the broader brushstrokes that you should keep in mind, whether you're a sponsor or target business.
Identifying the Accounting Acquirer
This one is pretty murky – especially when the transaction is a mix of cash and equity – but oh-so critical for any related accounting and appropriate presentation & disclosure in the financial statements. Although ASC 805 is the business combinations gospel and you should absolutely use it as a guide, there could still be a significant amount of judgement required to determine the accounting acquirer.
To add a layer of complexity, in the case of a reverse merger or acquisition, while the SPAC is the legal acquirer and the target business the legal acquiree, for accounting purposes, these roles are reversed. This occurs when a public entity – the SPAC – acquires the equity interests in a target, private company in exchange for equity in the public company. Companies use reverse mergers or acquisitions to allow the combined entity to retain its public company status. As for the actual accounting, ASC 805 will tell you if the transaction creates a business combination or the acquisition of an asset or group of assets accompanied by a recapitalization.
Determining the Predecessor Entity
Likewise, the entities involved must decide who will be considered the predecessor entity. This is the one that presents historical financial statements for the combined entity before the transaction. In general, however, the target business is the predecessor entity. In the case of multiple target businesses, the predecessor entity is usually the one that makes up the most significant portion of the combined entity's operations.
Remember, determining the predecessor entity is an entirely separate process from identifying the accounting acquirer. You should perform each analysis independently from the other.
Form and Content of Financial Statements of Target Business
Since the target businesses are almost always private companies, their historical financial statements generally comply with US GAAP requirements for non-public entities. But post-SPAC IPO, those historical financials must now comply with Regulation S-X and the US GAAP requirements for a public company. What exactly does that mean? Don't be surprised if you have to revise those historical financials – while also including additional disclosures – before filing them with the SEC.
Target Business Historical Audits
If a target business is the predecessor entity in the combined entity's financial statements, then they must be audited by an independent auditor under PCAOB auditing standards. However, if a target business isn't the predecessor entity but must include its historical financials per other SEC rules, then those historical financial statements can be audited under AICPA standards.
Pro Forma Financials for the SEC
Pro formas are one area where a SPAC transaction usually has a bit more complexity, simply from the numerous accounting issues to evaluate. And you're typically evaluating all of those issues well before you finalize the transaction. Therefore, take a look at some of our previous insights on pro formas and start them early because time has a way of slipping through even clenched fingers.
So that's a SPAC IPO in a nutshell. Granted, there's plenty of other important details to consider but, for the purposes of an introduction and high-level explanation, this is a very good place to start. And needless to say, whether you're a target company or a sponsor, Embark is always available to dig in and help you wherever and whenever you need us. Kind of like a financial Batman, just far less brooding.