Why are SPACs gaining popularity and what are the risks?
A crucial precursor to Virgin Galactic’s “billionaires in space” operation dominating the news this summer is the company’s 2019 merger with SPAC Social Capital Hedosophia Holdings. One might even argue that, had Virgin Galactic not combined forces with this SPAC (Special Purpose Acquisition Company), founder Richard Branson’s “new space age” dream would have stayed just that.
As an entity type, the SPAC is gaining popularity today as an easier alternative to a traditional initial public offering (IPO). The SPAC does have its risks, however, and newer SPACs attract litigation claims. Here is what you need to know about SPACs and how to navigate them correctly.
What is a SPAC?
A SPAC is a shell company that produces no goods or services but raises capital and funds through an IPO to acquire another company. The SPAC may focus on acquiring one particular company or pursue multiple options. Since there is no disclosure on the acquisition target or the amount of capital needed for purchase, the SPAC is commonly called a “blank check company.”
The advantage of a SPAC over a standard operating company IPO has to do with paperwork. Since SPACs are new companies, they have fewer disclosure requirements. There are no historical financial reports to show or assets to describe. SPACs also contain no known business risks at the time they open. Their IPO registration statements merely include boilerplate language and officer biographies. The Securities and Exchange Commission (SEC) has less information to work with, so their comments tend to be short and manageable.
How does a SPAC work?
A SPAC starts with corporate registration and then begins fundraising activities. Investors who fund the SPAC may be individuals or companies. The people who solicit investors to fund the SPAC are called promoters. A SPAC development has three growth phases including:
- IPO Phase;
- Target Search and Negotiation Phase; and
- Approving/Closing Phase
During the IPO phase, promoters and brokers hire legal counsel and start registration. Steps in the IPO phase include:
- Selling founder shares
- Filing the S-1 form with the Securities and Exchange Commission (SEC)
- Depending on SEC feedback, investors may file amendments to the S-1.
Unlike a traditional IPO, investors do not know the acquisition target. Investors rely on the reputations of the promoters in the IPO rather than a company’s track record. The general thought is that if the promoters involved in the SPAC have a history of making good acquisition choices, that SPAC is a less risky investment than one using inexperienced promoters. Therefore, the promoters with the best reputations usually have the best-funded SPACs.
Once the SPAC collects the needed funds, it searches for an acquisition target. Usually, experienced promoters will have started negotiating with a target company or at least have a list of candidates. As negotiations with the target company develop, promoters file more SEC documents and conduct due diligence.
The final phase (approval and closing) happens when the parties agree to the acquisition. Closing the acquisition deal takes about three to five months. It involves meeting with SPAC investors and securing shareholder approval of the transaction. If everyone reaches an agreement and closes the deal, the SPAC redeems public shares of electing holders. If not, the SPAC may seek another acquisition and start at the beginning. Once concluded, parties file their Form 8-K with the SEC. The SPAC and acquired company merge to become a new publicly traded operating company.
Why are SPACs becoming more popular?
SPACs are not new; they’ve been around for decades but only in recent years have they seen such unprecedented growth. Here are a few reasons for the surge in SPAC popularity:
- Industry insiders claim that recent market volatility makes them a better option today than in the past.
- Smaller companies have an easier time going public through a SPAC. In SPAC mergers, the acquired company has more leeway to negotiate terms, and it often goes public more quickly and with more capital influx than with traditional methods.
- A SPAC transaction closes within a few months as opposed to the longer (six to twelve-month) process with the usual IPO.
- Selling to a SPAC adds up to 20 percent to the sale price as compared to traditional IPOs.
- SPACs are now attracting prominent underwriters, including Credit Suisse, Goldman Sachs, and Deutsche Bank, as well as retired or semi-retired senior executives looking for shorter-term opportunities. (In 2019, SPAC IPO fundraising hit a record $13.6 billion, four times higher than the $3.2 billion raised in 2016.)
Examples of Recent High-Profile SPAC Transactions
- Virgin Galactic. The top story about this wishful space travel company is Richard Branson’s recent flight. However, Virgin Galactic entered the public scene through a SPAC. Social Capital Hedosophia Holdings Corp. invested around $800 million into Virgin Galactic and made Virgin Galactic the first publicly traded human spaceflight company.
- WeWork. WeWork is better known for what didn’t work; when it attempted to go public in 2019, it imploded and investors scrutinized its management. Now, rumor has it that WeWork will take a different approach–and go public through a SPAC.
- Draft Kings. The fantasy sports company went public in 2020. Its strategy included a merger with Diamond Eagle Acquisition Corp., a SPAC and SBTech. Draft Kings’ business expanded after more states legalized sports gambling, and it took the SPAC approach to enjoy a quicker IPO.
Special Purpose Acquisition Companies and Litigation
While SPACs have become popular, there are still risks, some of which lead directly to litigation. As investors enter these transactions with nothing more than assurances, the legal side of SPACs can become challenging if reality does not match the claims made during the fundraising step.
General SPAC risks include:
- shareholders rejecting acquisition plans;
- promoters failing to find an acquisition target within the two-year deadline; and
- paying more than the target company’s perceived value.
The primary criticism of SPACs is the pressure on promoters to do something – anything – with the investors’ money, and within a relatively short timeframe. That pressure can lead to poor decision-making when choosing target companies. If the ultimate investment fails, investors and shareholders may have grounds to sue.
From 2019 to 2020, 17 percent of SPAC deals faced lawsuits. (And directors, officers, and promoters now face increasing liability insurance premiums as a result.)
Many companies pursue the SPAC route so they don’t have to submit the same records to the SEC as they would with a traditional IPO. However, that also limits disclosures to investors. When investors pledge cash or capital to a SPAC, they rely on the promoters to choose a viable acquisition target. That reliance can lead to fraud claims (e.g., claims that the promoters exaggerated the acquisition target’s success or potential) or lack of disclosure claims (e.g., failure to describe the SPAC directors’ involvement with the newly public company).
SPACs may have lower disclosure requirements than traditional IPOs, but that does not mean SPAC promoters can keep investors in the dark. Doing so risks lawsuits and SEC investigations. SPAC promoters must prepare to answer more questions. At the very least, promoters and their attorneys should be ready to explain:
- Future corporate governance structures;
- Names and qualifications of management team members;
- Names, qualifications, diversity of and number of board members;
- Executive compensation packages; and
- Company operation details, including offered goods and services.
In early 2021, the SEC opened investigations into at least four SPACs. One of them, Ability, an Israel-based intelligence communications company, faces fraud charges for lying to shareholders to gain their approval of a SPAC merger. The claim is that the merger approval lined pockets of insiders to the detriment of investors.
The SEC also sent open inquiries to investment banks known for handling SPACs. These letters request information and explanations on how the banks manage risks in their SPAC deals. The SEC may also place more stringent requirements on SPACs or issue new rules regarding disclosures to investors.
The SEC is continually evaluating the issues surrounding SPACs and is expected to issue further guidance in the future. Meanwhile, the agency has stepped up scrutiny of SPACs in response to the increase in SPAC usage and investor complaints.
Stay in the loop—we can help.
If you are involved in forming or promoting SPACs, the heightened attention from the SEC cannot be ignored. At BIA, we can assist you with due diligence on target companies. These services may include:
- Information gathering & analysis
- Digital investigations
- Social media investigations & reviews
- Legal document reviews
- Expert services
We offer customized solutions that are cost-effective for any budget. Contact our experts today and make your SPAC experience as stress-free as possible.