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You have probably come across the term SPAC and wondered, “what is a SPAC”?
SPACs, or special purpose acquisition companies, have been championed as a way to “democratize access to high-growth companies” while “dismantling the traditional capital market.”
In other words, they allow companies to raise money more easily, while at the same time giving investors a way to invest in these companies. However, it also comes with higher risk.
In this post, I’m going to talk about what a SPAC is, the difference between a SPAC and an IPO, and the benefits and risks of investing in SPACs.
What Does ‘Going Public’ or “IPO” Mean?
Before we can answer the question of “what is a SPAC”, we first need to understand the traditional IPO way of listing a company.
No matter how big or small, every company needs one thing to thrive in the market: capital.
Yes, every organization requires funds to sustain operations, pay staff, repay loans, etc.
But what happens when a company’s profits fall short of expectations, or it needs more capital?
They raise money. For many private companies, going public has become the most attractive way to raise capital.
When a formerly private company decides to go public, it opens the door for new investors to invest in the company. In other words, it is selling its shares.
The investors obtain ownership of a tiny slice or share of the company by paying a specified sum. This is beneficial to both the company and the investors—while the company raises capital from investors, the investors receive a portion of the company’s profits in the form of dividends.
Going public is a win-win situation for both sides.
What we are calling “going public” is actually known as an Initial Public Offering (“IPO”). So, when a private company offers its shares to the public for the first time, that is called an IPO.
What’s the Downside?
While going public can work wonders for private companies, the process of filing for an IPO is exceedingly time-consuming.
So, if you need to raise capital urgently (say, to pay off debts), using the traditional route of IPO filing can be incredibly inconvenient.
Furthermore, there is a laundry list of disclosures that you must consider. You will be required to reveal your prospects, finances, and the whole shebang.
Before you get to pitch to your future investors, you will need to work with investment banks, risk assessors, and underwriters.
In other words, you must pass multiple checkpoints before you can list your company on the stock market.
Because there are checkpoints (and so many of them), the risks of rejection are higher. Not to mention the significant cost that companies must incur to become fully functional private enterprises.
How would you bear the costs if you are already cash-strapped?
Overall, there are many drawbacks to going public the old-fashioned way.
Isn’t there a more efficient way to go public? There is, of course.
This is where SPACs come into the picture.
What are SPACs?
So, what is a SPAC?
SPACs, Special Purpose Acquisition Companies, are an efficient and quick alternative for private companies to go public.
A SPAC is formed by a group of investors, business owners, industry experts, financial market experts, and high-network individuals. These individuals of high value help private companies become public without going through the traditional IPO process.
SPACs are also called “blank check companies” or “shell companies.” This means that these companies do not sell or produce any product or service; they have no commercial operations.
How do they make money then?
Well, SPACs raise capital through IPO, and the money they make is further invested in ‘acquiring’ a private company.
The funds raised by SPACs are collected in a trusted account until the SPAC finds a suitable company to acquire and invest in. This trusted account is called an interest-bearing account as all the members of the SPAC receive a certain amount of interest from the money collected in the bank account until they find a suitable company to acquire.
Another thing to keep in mind is that a SPAC cannot look for an ideal company to acquire forever. Every SPAC has to find a suitable firm within 24 months.
What if the SPAC does not find an ideal company to acquire in this period?
In this case, the money collected in the account is returned, and the SPAC is considered non-existent.
However, if the SPAC acquires a company within 24 months, there are two options that its founders have: they can either:
- Redeem their SPAC shares and book a profit or
- They can convert their SPAC shares into the shares of the newly acquired company.
Going public through SPAC benefits both the SPAC’s founders and the firm acquired.
The firm goes public and is listed, gaining access to liquidity. The SPAC members, on the other hand, become shareholders in the acquired company.
Now that we answered the question of “what is a SPAC”, let us look at the pros and cons of SPACs.
Benefits of SPACs
There are numerous benefits to going public through SPACs. Let’s have a look at some of them:
Quick and streamlined IPOs
Securing capital through SPACs is extremely easy and quick.
While IPOs usually take anywhere from 12 to 18 months, a SPAC merger takes only 3 to 6 months. So, if a company is in urgent need of money, going public via SPACs is the way to go.
Furthermore, any company can raise funds through SPACs irrespective of its size and experience. Growing companies usually find it hard to access liquidity due to the lack of a proven track record, but this is not an issue when a company chooses the SPAC route.
The cost of going public through an IPO is quite high. Small companies struggle to pay this amount because they lack the capital.
As a result, going public remains a pipe dream for many.
However, if they go public in a non-traditional, SPAC way, they will easily attract a large pool of valuable public investors.
This is attributable to the fact that SPACs price their IPOs at only $10 per share. And this amount is set in stone.
As a result, many public investors can purchase the shares, and the company receives the money it needs.
SPACs are much more liberal when it comes to pricing the stocks.
They give a chance to the target company that they wish to acquire to negotiate and set the price of their stocks.
This is not possible in the traditional IPO process.
When a company goes public in the traditional manner, it is expected to set a price that is neither too high nor too low.
This means that there is a risk that the company will not receive the amount that it is worth. However, the valuation risk in SPAC IPOs is minimal.
Access to operational expertise
The founders of SPACs are highly skilled and experienced individuals, and they choose a target company from the industry they themselves belong to.
This means when a small, growing firm gets acquired, it receives access to its founders’ expertise.
Secondly, the professionalism of the SPAC founders boosts credibility and ensures returns and investor confidence.
Potential Risks for Investors
Though SPACs have been considered a risk-free route for companies to go public, there are a few risks for investors. Here are some of those:
Longer waiting period
As mentioned above, SPAC founders have up to 24 months to find the target company they will acquire. If you invest in a SPAC, you will have to wait that long before seeing any actual returns and earning your return on investment.
The unfortunate thing is that there is a possibility that a SPAC will not find its ideal to-be-acquired company within this time frame. For investors, it simply means a waste of two valuable years that they could have used to seize some profitable opportunities.
No guarantee of what your returns will look like
When a SPAC is formed, the founders have no knowledge of the company that they will acquire in the future. As a result, investors have no idea what their returns will be or whether they will obtain a higher return on investment.
Furthermore, SPAC founders are constantly under pressure to find their target company before the deadline, which is two years.
They often accept a terrible deal in the rush because they are afraid of not bagging any deal at all. This bad deal has a direct impact on the returns received by investors.
High chances of fraud
One of the primary reasons many private companies opt to go public through SPACs is fewer checkpoints and lenient screening.
The target company may not meet certain requirements due to a lack of stringent protocols and scrutiny.
This does not bode well for investors. If the target is of poor quality, the returns will be nothing to write home about.
Sole reliance on sponsors’ reputation
Investors must take a risk and invest based on the reputation and image of the sponsors in the market.
They become enthralled and eager to invest when they see the high-profile sponsors who launched the SPAC.
Aside from the sponsors’ reputation, there is no substantial document on which they can rely. As a result, they encounter a slew of roadblocks after investing.
SPACs are the biggest thing on Wall Street right now.
While it is an excellent opportunity for private companies to go public and raise much-needed funding, investors should weigh the pros and cons before investing to ensure that the deal is profitable for all parties involved.
Personally, I am not a big fan of SPACs, because I prefer to have more control over my investments, instead of giving a blank check to someone and hope that they pick a good investment on my behalf.
Now that I have shared all about SPACs and their pros and cons, what do you think of them? Do you think SPACs are a good investment? And if someone asks you “what is a SPAC”, will you be able to give them a quick summary?
Let me know in the comments below.
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Spencer is an avid globetrotter who achieved financial freedom in his 20s, while trading & teaching across 70+ countries. As a former professional trader in private equity and proprietary funds, he has over 15 years of market experience, and has been featured on more than 20 occasions in the media.