Dec 30, 2022
We agree with the naysayers that not all SPACs will uncover high-performing targets and that some will fail. There will be many disappointed investors. Despite this, SPACs will stick around and may even be suitable for the financial system. Why? Because they provide an alternative source of funding for investors and targets, challenging later-stage VC, private equity, direct listings, and the traditional IPO route. They infuse funds into a broader range of startups and other businesses, promoting new ideas and expansion.
Using SPACs, several businesses have been able to raise more money than they would have been able to otherwise, boosting innovation across various sectors. We are writing from the perspective of actual practitioners. In 2020, Paresh co-founded the Special Purpose Acquisition Company (SPAC) Natural Order Acquisition Corporation with Sebastiano Cossia Castiglioni to advance the plant-based food industry.
Max is a member of the board. Using our extensive knowledge in the investment industry (Paresh) and our skills in negotiation and decision-making, we hope to shed light on the strengths and weaknesses of SPACs in this essay (Max). In particular, we will explain why some companies prefer to raise money through SPACs rather than through a typical IPO and what benefits this structure offers both savvy investors and ambitious business owners.
There is no denying the fact that SPACs are dramatically altering the public and private financing sectors. As a result, managers and leaders must be up-to-date on the game's rules. However, it is necessary to stress that the opinions expressed here do not always support SPACs as a whole. This is merely a primer for companies considering expanding into this dynamic (and, for many, uncharted) markets.
Since their inception as blank-check businesses in the 1980s, prominent purpose acquisition corporations (SPACs) have been plagued by penny-stock fraud, costing investors over $2 billion annually as recently as the early 1990s. Congress stepped in to provide much-needed regulation, such as mandating the use of regulated escrow accounts to hold the proceeds of blank-check IPOs until mergers are finalized. To conform to the new rules, blank-check companies became exceptional purpose acquisition companies (SPACs).
The decades that followed saw the emergence of a cottage industry supporting SPACs, with specialized law firms, auditing firms, and investment banks providing services to sponsor groups that were otherwise lacking in blue-chip public and private investment expertise. The investing opportunities of the time inspired them to zero in on troubled businesses or specialized fields. After 2020, however, a dramatic increase in SPAC offerings from serious investors occurred.
Increased number of startups looking for either liquidity or growth capital and legislative improvements that standardized SPAC products attracted established hedge funds, private-equity, venture companies, and top operations executives to SPACs.
Even if they are interested in the merger, not all SPAC investors are chasing sky-high returns. The framework accommodates a wide range of risk tolerances and time horizons.
The current gold rush can be attributed to the fact that seasoned professionals like those mentioned above helped establish the sector's legitimacy and attract the attention of less savvy investors. But nowadays, SPAC sponsors are more trustworthy than ever, which has led to a rise in the caliber of their targets and a corresponding boost in their investment returns.
Target companies can benefit from SPACs in several ways that aren't possible with traditional funding or liquidity strategies. Higher valuations, less dilution, faster access to financing, greater certainty and transparency, lower fees, and fewer regulatory obligations are all benefits of SPACs compared to traditional IPOs.
As before, SPACs can provide a higher valuation than a standard IPO. The target company and the SPAC's other participants, including the investors, negotiate a capital commitment and a binding valuation several months before the merger is finalized (although the valuation is subject to approval by PIPE investors). On the other hand, when conducting a conventional initial public offering (IPO), targets typically hand over valuation authority to the underwriters who handle investor relations on their behalf.
Take the sponsor-target discussion for example. If you look at it as a simple two-party process, you'll notice that the target has a lot of power, especially at the end of the 24 months, when the sponsor has the most to lose. However, the calculus shifts when the original investors are considered; they can still reject transactions even after they've been made public. Deals that have unreasonable terms that benefit targets are unlikely to make it through the PIPE process or to avoid substantial investor redemptions.