SPAC: Guide To Buying Company Shares

May 3, 2023
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Many people dream of buying shares of a firm before they are released to the public in an initial public offering (IPO). However, institutional investors such as pension funds and professionals often go in first, leaving regular investors to pick up the pieces after the offering has closed, often at a premium. However, modest investors may get in on the ground floor by using a back-door, formerly unpopular IPO strategy known as a SPAC.

What is a SPAC?

SPAC is a business founded only to acquire or merge with another firm and generate funds via an initial public offering (IPO). At the time of their IPO, SPACs had neither established operations nor identified acquisition prospects. Each SPAC share has a par value of $10 and is issued in the form of a trust unit. SPACs attract a diverse set of investors, from well-known private equity firms and celebrities to regular people. A special purpose acquisition company (SPAC) has two years to make a purchase or repay investment money.

Perceiving the concept of SPAC

Investors, commonly known as sponsors with extensive experience in a certain field, often get together to create a SPAC. They pool their resources with those of other investors to purchase a privately owned firm and then take it public through an initial public offering (IPO). In order to avoid the substantial paperwork and disclosures required by the Securities and Exchange Commission (SEC), SPAC sponsors often don't have a precise aim in mind when they establish the corporation.

In most cases, the sponsors' plans for the money are a mystery to the early underwriters, financial institutions, and individual investors who normally participate later. Therefore, early investors are putting their faith in the track records of the sponsors in the hopes of securing a profitable investment. However, they should expect to have to wait. It may take a SPAC up to two years after it goes public to choose and publicly disclose the firm it intends to purchase (or, more accurately, merge with; the precise time range is specified in the corporate charter in accordance with SEC requirements). If it doesn't, the SPAC will be dissolved, and the money it obtained from investors will be returned to them.

Because of this uncertainty, the average trading price of a SPAC is just $10. Assuming they are successful in acquiring a firm and bringing it public, share values will naturally skyrocket. Investors now have the option of taking profits or holding on for future growth.

The evolution of SPACs

If the SPAC system seems like it may be exploited, that's because it did. In the 1980s, blank check firms were plagued by widespread fraud. Many of these businesses were only fronts for the sale of unreliable "pink sheets" or penny stocks. Many investors lost money because these companies either disappeared with their money or made overpriced transactions with insiders

There has been more than just a change in nomenclature since then, as the blank check firm has transformed into a special purpose acquisition company (SPAC). The SEC has instituted strict rules and procedures for such endeavours. For instance, until the target firm is made public, a SPAC must typically hold investor funds in a trust or impound account. Investors may get their money back if they decide they don't like the offer after that. However tiny a SPAC may be (in the IPO world, this would imply having less than $1 million in assets), it must nevertheless file for SEC registration.

Who are the parties involved in SPAC?

Sponsors, investors, and intended beneficiaries (target) are the three primary parties involved in SPACs. Their worries, requirements, and points of view are all different.

1. Sponsors

It is the sponsors who kick off the SPAC procedure. Risk capital is invested in the form of non-refundable payments to professionals like bankers, attorneys, and auditors. Sponsors are required to disband the SPAC and repay all investor monies if they are unable to form a combination within two years. The sponsors lose not only the funds at stake but also their own time, which is not trivial. If the merger goes well, however, the sponsors will give the employees a stake in the new company equal to as much as 20% of the stock collected from the first investors.

That figure has drawn criticism from several quarters. Remember, however, that sponsors can reap these advantages only if they craft a compelling plan, attract investors, locate a suitable target, and persuade that company to enter into a business combination. They have to steer the target and the SPAC through the intricate merger procedure without losing investors while negotiating competitive acquisition terms. That's quite the challenge. With so many SPACs on the market, competition for targets and investors is fierce, increasing the danger that a sponsor would lose the money it risked and the time it spent on the deal.

2. Investors

So far, institutional investors like hedge funds with a narrow focus have made up the bulk of SPAC investors. Initial investors in a SPAC purchase shares before the target firm is known, putting their faith in the SPAC's sponsors, who are not required to restrict their targets to those that meet the size, value, industry, or geographic criteria they established in their IPO documents. Common stock (usually priced at $10 per share) and warrants (allowing the holder to purchase more shares at a later date) are issued to investors. The risk-alignment arrangement between SPAC sponsors and investors relies heavily on warrants. For every share of common stock acquired, a warrant may be issued by certain SPACs, whereas no warrants may be issued by others. Since warrants, which give early investors more of a chance to profit, are incentives to subscribe, more warrants issued means more uncertainty about the SPAC's future.

The original investors decide whether to proceed with the transaction when the sponsor announces an agreement with a target or whether to withdraw and get their initial investment plus interest. They are free to walk away from the deal while still holding on to their warrants. They may assess an investment in a private firm via the SPAC without taking any financial risks.

Even if they are interested in the company combination, not all SPAC investors are chasing sky-high profits. While looking into the merger, some investors use the structure on a leveraged basis to earn a guaranteed return from interest on invested income and the sale of warrants, often at a higher yield than Treasury and AAA corporate bonds offer. Because of the structure's intricacy, investors may tailor their investment to their preferred rate of return, level of risk, and time horizon.

3. Targets

Startups that have already received venture funding are the typical targets of SPACs. At this juncture, companies often weigh their choices, which may include going public via an IPO, going public through a direct IPO listing, selling the company to another company or a private equity firm, or obtaining financing from investors like PE firms, hedge funds, and other institutional investors. SPACs are a viable substitute for these choices at the eleventh hour. They're adaptable to your needs and work with a wide range of permutations. Sponsors may utilize the structure to roll up several targets, even though targets are typically a single private firm. Companies that are currently publicly traded in other countries may be taken public in the United States via SPACs.

Advantages and disadvantages of SPACs

Pros

  1. They have a relatively low price. Many SPACs may be purchased for about $10 per share, making them accessible to even casual investors.
  2. Due to the short window of opportunity to initiate a transaction, the target company's owners may be able to negotiate a higher price when selling to a SPAC.
  3. Companies considering an IPO may benefit from SPACs. SPACs may shorten the time it takes to go public by several months compared to six months or more than a traditional IPO can take.
  4. They welcome investments from private parties. Smaller investors may get in on the action because of the enormous number of shares offered in SPAC offerings, even though institutional investors often have first dibs.
  5. The target firm has access to more resources and more seasoned leadership by merging or being bought by a SPAC backed by well-known investors and business leaders.
  6. They put their money into promising industries. The new generation of SPACs is laser-focused on glamour industries like technology and consumer goods.

Cons

  • SPAC IPO investors bet on the promoters' ability to acquire or merge with a suitable target firm. Due to inadequate data provided by the SPAC and less regulatory control, ordinary investors run the danger of losing money on what they think is a promising investment opportunity.
  • Investment without any kind of due diligence. Oftentimes, both the SPAC's sponsors and its investors are in the dark about the target firm of the SPAC they've invested in. The transaction cannot be assessed.
  • Time lag. Investors in a SPAC may have to wait a while before the business makes its first acquisition and begins operating. The escrow period might last up to two years. If no acquisition occurs, your money will be refunded, although it might be difficult to let it stay there unused.
  • Poor returns. It is possible that the returns from SPACs won't live up to the promises made during their advertising. A Renaissance Capital analyst estimates that as many as 70% of SPACs that went public in 2021 were trading below their $10 offer price by the end of that year. Some market analysts have projected that the recent downward trend in SPAC shares is a sign that the SPAC bubble is about to burst.
  • Broken Agreements. An investor in a SPAC runs the risk that the firm it plans to purchase could back out at the last minute. Industry estimates indicate that in 2022, more than 55 purported SPAC transactions totaling tens of billions of dollars were scrapped, and another 65 SPAC sponsors went out of business.

A SPAC transaction may fail for a variety of reasons:

  • The management of the SPAC may not be able to strike a good bargain on the acquisition, either in terms of price or structure.
  • The SPAC's IPO could not generate enough cash flow to cover the purchase price of the target. This may occur if there is insufficient demand for the SPAC among investors or if the market environment is adverse.
  • The SPAC could miss the opportunity to make a purchase. When the management team of the SPAC is unable to find a private firm that meets the investment requirements stipulated in the SPAC's prospectus, or when the private company is not interested in being purchased by the SPAC, the SPAC may be unable to fulfill its acquisition.
  • If the SPAC's shareholders and/or regulators do not approve of the purchase, the transaction will fall through.

The structure of SPACs ensures that investors get their whole investment back (generally $10 per share), but investors who acquire shares at higher prices in anticipation of a transaction completing may incur losses. The market price at which SPAC shares are purchased has no bearing on the investors' right to a pro rata part of the trust account.

  • Possibility of scams. Since April 2021, SPACs have been subject to new accounting standards released by the U.S. Securities and Exchange Commission (SEC), which has led to a precipitous drop in new SPAC filings from the historically high levels seen in the first quarter of 2021. In March 2021, The SEC issued an Investor Alert warning investors not to rely on investment choices based on the participation of celebrities since many celebrities, including entertainers and professional sports, had become so strongly involved in SPACs. Because of stricter regulations and underwhelming results, SPACs fell out of favor by early 2022.

Who may invest in SPAC, and how can they do it?

Privately owned firms often have better opportunities, but most investors can't get in. However, SPACs allow regular people to team up with Wall Street bankers and Silicon Valley startups. There are now exchange-traded funds (ETFs) dedicated to investing in special-purpose acquisition companies (SPACs). These funds often hold a variety of SPACs, from those that have just gone public via a merger with a SPAC to those that are still looking for a suitable acquisition target. The degree of risk associated with an investment in a SPAC will vary, as it does with any investment, based on the specifics of the deal at hand.

What would happen if a SPAC did not merge?

There is a deadline by which a SPAC must complete a merger with another corporation. In most cases, this ranges from 18 to 24 months. If a SPAC fails to combine within the specified period, it will be forced to dissolve, and all investor money will be refunded.

Conclusion

When a private firm wants to go public, it might form a special purpose acquisition company (SPAC) to do so via an initial public offering (IPO). SPACs are, at times, typically referred to as "blank check companies" since they are established without a predetermined acquisition objective in mind. After the SPAC has collected enough money from the IPO, it will look for and purchase a private firm to go public through a reverse merger. Without going through the typical IPO procedure, the private firm may now enter the public markets and obtain extra funds. SPACs were once a hot investment option, but the market has turned against them in recent years.