Special purpose acquisition companies (SPACs) are enjoying their moment in the sun. They’ve shot into prominence as a way for startups to make an initial public offering (IPO) and join public stock exchanges. They offer founders unprecedented speed. And for some investors — more on that later — they can provide unique advantages.
There were double the number of SPAC IPOs in 2020 than there were in 2019. And for an extended period last year, funds raised through SPAC deals exceeded traditional IPOs.
So, what are SPACs?
A SPAC is a shell company that almost anybody can start. It attracts institutional money based on the investing acumen and reputation of its founding team. When it goes public through IPO, it chooses a startup to merge with and negotiates a purchase price for that company. Then the SPAC raises more institutional money to meet that purchasing price before buying the startup. Only then does it resemble other listed companies. And only then can public investors assess the company based on traditional factors like growth and profit potential. If they like what they see, its shares go up. If not, they go down.
Sounds good? Well, at least fair and reasonable? Not so fast. There are many reasons for everyday investors to dislike SPACs. They have some major built-in advantages that favor institutional investors.
Much like traditional IPOs, everyday investors can’t invest before the company actually goes public. But institutional investors can. After the IPO, the shell company selects a startup to merge with — and institutional investors get to approve the choice. Everyday investors are shut out. If the SPAC’s pick is approved but institutional investors don’t like the choice — or they simply don’t think the share price is going to increase — they can get ALL their money back… no questions asked.
This “satisfaction guaranteed or your money back” offer does not extend to everyday investors. They can sell their shares… a right accorded to all public stock investors. But share prices might have dropped in the meantime — meaning everyday investors could lose money on a deal they didn’t get any say in.
There’s more. As an incentive to invest pre-IPO, institutional investors get warrants. Let’s say they bought a thousand shares at $10 a share. They can also get warrants to buy a thousand more at $11 a share. If the shares pop to $16, they can exercise their warrants and pocket the 60% gains not only on their original investment but on the extra thousand shares, doubling their profit.
And as you might have guessed, everyday investors don’t get to unwrap this nice little gift. Warrants are not an option for them.
Let’s review. Both everyday and institutional investors invest initially in the shell company based on the reputation and skill of the founding team. Pretty flimsy… and risky. While it still seems like risk is shared equally at this point, it’s an illusion. The institutional investors aren’t taking much of a risk after all. If they don’t like the startup chosen to merge with the shell company, they can opt out and get ALL their money back. If they choose to continue with their investment and prices pop, they can double down through warrants. The ability to significantly reduce risk and dramatically raise upside is theirs alone.
While there is upside to be had for everyday investors, it’s not nearly as much as for institutional investors. And while there is risk for institutional investors, it’s not nearly as much as there is for everyday investors. The risk-reward ratio just isn’t balanced between the two groups. SPACs are structured to benefit a specific segment of financial players — the wealthy and institutional investors.
Yet there is a silver lining. And it’s a pretty big one as far as early-stage investors are concerned. SPACs represent another path startups can take to reach liquidity. This is a big deal when you’re sitting on startup shares that have gone up 50X, 100X or 200X — but you can’t cash them out because they’re illiquid.
There are different types of liquidity events. The most common is a company buying the startup for cash. Traditional IPOs are another way companies can reach liquidity. And there are non-traditional IPO pathways like direct listings and SPACs. Companies that do Regulation A+ raises technically have the option of listing on public exchanges or Over-The-Counter markets. But this option is seldom used to date.
Illiquidity is the last hurdle before getting paid in cold cash. As flawed and unfair as SPACs are, if they allow more startups to reach liquidity, I suppose I can’t totally hate them.
Are there any circumstances under which I can imagine investing or recommending SPACs? I’ve learned never to say never. So I’ll leave the door ever so slightly ajar. If the SPAC is led by rock-star investors and they’re in a frontier space I don’t have easy access to (something like psychedelic drugs as a hypothetical), then maybe I might be tempted to invest… But that chance seems pretty unlikely right now.
Otherwise, I’m staying away from SPACs. They’re a sweet setup for institutional investors — but not for the likes of you and me. High risk should be taken on only if the upside is large and irresistible. But with SPACs it’s constrained and unknown. And that’s no way to succeed as an early investor.