When a company decides to go public, traditionally, it would go through the initial public offering (IPO) process. However, another way has emerged in the last few years as a popular method. Although they are not new, special purpose acquisition companies (SPACs), also referred to as blank check companies, have had a resurgence in popularity.
What are SPACs? How do they work (risks + benefits) – Public.com
Table of Contents
What is a SPAC?
A SPAC is a shell company that goes public solely for the purpose of taking another company public. SPACs, aka blank-check companies, merge with a target company within two years of going public. They then change their ticker symbol to represent the combined company.
Key Takeaways
The purpose of a SPAC is to raise money through an IPO to acquire and merge with another company.
A special purpose acquisition company (SPAC) doesn’t have any existing business operations at the time of its IPO.
SPACs have seen a surge in popularity since 2020 and are backed by private equity funds, celebrities, business leaders, and the general public.
SPACs often don’t have a target company in mind to acquire at the time of their IPO.
The time limit is 2 years for a SPAC to acquire an acquisition, or they have to return funds to investors.
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SPAC meaning
When youre learning about investing in stocks and researching companies to invest in, youll undoubtedly come across financial data obtained from the companys IPO. But not every public company decides to go through a traditional IPO and instead chooses to go public with a SPAC.
In fact, according to The Wall Street Journal, 2020 was a record year for SPACs, as more companies chose to bypass the IPO process and go public with a SPAC acquisition.
You may be wondering why a company would turn to a SPAC acquisition to go public?
The honest answer is that traditional IPOs are time-consuming and complicated at best, with a lot of hoops to jump through.
The IPO process consists of several steps, which include everything from getting investors interested and negotiating terms to dealing with the scrutiny over the valuation of the company until the very end. And a lot can go wrong at the last minute and cancel the whole thing.
When going public with a SPAC, the IPO is done, and all you need to do is negotiate the terms with the SPAC company youre merging with. Since the process cuts out all the complicated and timely tasks, it tends to be much faster.
The rise of SPAC investing
Despite the fact that SPACs have been around for quite some time and used as an alternative way to find financing and go public, the last few years have shown an upward trend with more private companies choosing to merge with SPACs to go public.
According to Nasdaq.com, 59 SPACs were formed in 2019; in 2020, that number spiked to 248, and in 2021, 613 SPACs were formed. Those figures would convince anyone the surge was impressive.
For example, in 2021, a few high-profile companies you may have heard of went public with SPACs, including SoFi, Grab, and WeWork, the company made popular by the Apple series We Crashed that offers workplace spaces.
WeWork had initially started out pursuing an IPO with intentions to focus on target businesses in the technology and media sectors but ended up bailing out of the IPO process due to intense scrutiny over providing the proper business documentation. Instead, a few years later, it went with a SPAC company and ended up in real estate.
So why the jump in SPACs? First, the interest of these groups has influenced the SPACs popularity.
- SPAC management teams
Benefit from getting a blank check and limitless upsides in the deal. They contribute a minimum of capital with few risks and receive a large stake that can equal 20% or more for the promotion phase. Since its their deal, there are no downsides.
- Private companies
The time and work that goes into a traditional IPO and the time it takes to go public is a big deterrent for many growing companies. With a SPAC, the process is less time-consuming, less volatile, and has the benefits of a quick and simple process where the SPAC does most of the work.
How SPACs work
As discussed, SPACs go through an IPO as a shell company with no active business model or assets. A SPAC is formed to raise funds, acquire and merge with another company, and then go public. They work differently than IPOs and generally have a 3-step process from start to finish.
Step 1 formation and incorporation 2 months
This is where the shell company incorporates and issues shares to its founders and prepares their S-1, which is a required by the Securities and Exchange Commission (SEC) before a companys IPO.
Step 2 research and due diligence 1 year or more
After the IPO, the shell company or SPAC finds target companies to acquire or merge with and performs due diligence into the companys background and financials. Once it decides on the target company, the SPAC begins negotiating the terms and starts working on getting the financing in place. Funds are put into a trust account, and periodic SEC filings are also made during this time.
Step 3 merger or acquisition 3 5 months
The acquisition or merger is finalized, and a public announcement of the transaction is made, informing investors. The SPAC files the Super 8-K within 4 days, informing interested parties about the acquisition or merger.
After the transaction closes, SPAC investors can become shareholders or redeem their shares, which is determined by the amount in the trust account.
For example, if an investor purchased their SPAC stock share for $15 before the acquisition, but the IPO share was only $10 per share, they are only entitled to $10, not the original share price of $15.
SPAC vs. IPO
When a private company has become well established, it may decide to go public, which means it wants to be publicly traded on the stock exchange. A company may choose to go public for various reasons, but for most companies, its to raise capital to expand their business.
Going public is a big event for companies, but it comes with a lot of preparation, paperwork, and scrutiny, and once its done, it can be a beneficial business decision. So, how does a company go public? The 2 most common ways are through a traditional IPO or a SPAC.
The IPO process
An IPO is when a company goes from a private company to a public one for the first time, where shares of its stock are available to the public. An IPO is a long process and includes the following steps, most of which have a variety of additional sub-steps to complete:
Selecting an investment bank – the bank advises the company on its IPO and provides underwriting services.
Due diligence and filing regulatory requirements – the underwriter acts as a broker between the issuing company to sell initial shares of stock and files all documents required by the SEC.
Pricing – after the SEC approves the IPO, a price is set for the shares and the number of shares that will be sold is set.
Stabilization – the underwriter provides analyst recommendations on after-market stabilization on order imbalances.
Transition to market competition – investors transition from relying on mandatory disclosures to market forces regarding their shares.
The SPAC process
Its a different process when a SPAC company goes public. As stated above, the process includes:
Step 1 – formation and incorporation
Step 2 – research and due diligence
Step 3 – merger or acquisition
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Whats a SPAC merger?
When a SPAC begins, it is a shell company that goes through the IPO process. Then it started raising capital on the stock exchange, offering its common stock at $10 and extending warrants to purchase shares into a target company. The fund SPAC finance raised is put into a trust account until the target company is found and a merger or acquisition occurs.
Once the SPAC chooses and negotiates a merger or acquisition with a private company, it trades the cash raised during the IPO and its status as a publicly-traded company in return for a percentage of the business after the completion of the merger. Sometimes the SPAC brings in institutional investors, who are professional investors that invest money for their clients that receive shares of the target company, to help in the process.
Once investors get familiar with the target company and the terms of the deal, they can value the company more appropriately and adjust the share price to align with the value. After the target company is announced, the SPAC share prices typically jump, but they can also drop just as quickly if anything changes to dilute the value of the original shares.
Once the merger is announced, a process called the de-SPAC transition starts, and any business and legal matters are resolved. Generally, SPACs have 2 years to find a target company after initial capital is raised and put into the trust account. If, for any reason, they are unable to find a target company, they must return all funds to investors.
SPAC risks
Investing has both risks and rewards, and like any other type of investment, SPACs have certain risks associated with them that include:
- Minimum regulatory requirements
With an IPO, every aspect of a company is put under a microscope and evaluated so that when the company goes public, investors can have confidence in the company they are investing in. With a SPAC, requirements arent as stringent, and even as a company goes public, a lot of unknowns exist, making it difficult to know if the company has what it takes to survive.
- Investors may not be aware of what theyre investing in
Although a SPAC has usually identified and announced the target company when investors are brought in with the IPO, they arent required to, so investors have to trust that management will take the company in a positive direction but wont have any data to back it up.
- Ambiguous returns
Too often, shareholders dont benefit when investing in a SPAC, which isnt surprising due to the lack of regulatory requirements for SPACs.
SPAC benefits
A few of the reasons that SPACs are popular include:
- Faster and less complicated than a traditional IPO
To begin the IPO process, a business typically has been operating for several years and has a proven business model. As discussed, an IPO is a long process with some strict requirements attached to it, but with a SPAC, that time frame is cut down to 1 to 2 years, and the requirements arent as stringent since the company is merging with the SPAC.
- Less expensive shares
A common stock price for a SPAC is $10, whereas, for an IPO, it can be significantly higher, which makes the SPACs accessible to more investors.
How to buy SPAC stock
To add SPACs to your investment portfolio, you just go to your online brokerage account. SPAC IPOs can be sold in units, so when searching, youll want to find a U at the end of the ticker symbol to identify it as a SPAC. But you can look for SPAC exchange-traded funds (ETFs) as well.
When you buy a SPAC unit, youre purchasing a share of a stock warrant, which allows you to buy additional shares later. Of course, youll want to decide how many units youll want to buy, depending on the share price.
If you determine that a SPAC ETF is a better option for you, it works just like any type of ETF, so youll want to know what stocks are included and the costs associated with it.
Its crucial to know that SPACs have a 2-year time limit on moving on a merger, so your money could be in limbo. Your investment goals will help to determine if thats a positive move for you or not.
SPAC Q & A
Q: Whats a SPAC stock?
A: SPAC stocks are companies that have merged with SPAC companies versus going through the long IPO process.
Q: Whats a good price for a SPAC stock?
A: Typically, SPAC stocks are priced at $10 a share with a warrant that allows you to buy more shares later.
Q: Whats a SPAC warrant?
A: A SPAC warrant gives the investor the right to purchase the stock at a predetermined price.
Q: What happens after a merger?
A: The shares of stock will convert to the new business automatically. Investors will have the opportunity to either exercise their warrants or cash out.
Q: What if the SPAC merger isnt completed?
A: The SPAC has 2 years to complete it, but investors will get their money back from the trust account if it isnt done.
Q: Whats a SPAC sponsor?
A: SPAC companies can typically be formed by sponsors or investors with a specific specialty in an industry to find deals in that sector.
Q: How are SPACs managed?
A: The management team, which can include directors, sponsors, and officers, decides what companies to acquire. They raise funds and hold them in escrow for potential mergers or acquisitions and receive a percentage of the value of a deal.
Q: How do SPACs raise capital?
A: They raise money from the IPO for a merger or acquisition, and if it doesnt go through, which is rare, the investors get their money back.
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The bottom line
Investing in SPACs may not be for everyone, but they can be an option for those who enjoy being part of an upcoming new company without the hoops of an IPO.
They are, like all investments, risky. As long as you do your homework and understand the risks, youll be able to make better decisions about whether they fit your goals, investment personality, and strategy. To learn more about how stocks work, download the Public app today!