A SPAC, or special purpose acquisition company, is a “blank cheque company.” It exists solely to acquire private companies and complete their initial public offerings (IPO).
To be clear, a SPAC doesn’t have any commercial operations. That is, SPACs don’t sell products or services, nor do they have business plans. They exist solely to acquire private companies and bring them to public investors.
Why would you invest in a SPAC and what are the risks in doing so? Let’s take a closer look at SPACs and see if they’re worth your investment.
What is a special purpose acquisition company (SPAC)?
A SPAC is a “shell” company that raises money in order to bring private companies to the public market. SPACs typically target companies with massive future potential, helping accelerate their growth by raising capital.
SPACs are formed by a team of investors or, in some cases, by popular celebrities. Once a SPAC is formed, it has 36 months to complete an acquisition. Whatever capital the SPAC raises is placed in an interest-bearing trust account. These funds can only be used to complete the acquisition. Should the SPAC fail to acquire a company, the funds are returned to investors.
How does a SPAC work?
SPACs typically have two phases: the SPAC’s own IPO and the announcement of the company it wants to acquire.
1. The SPAC’s IPO
In the first phase, a management team comes together and creates a shell company, the SPAC. This team will usually have some capital to start with, though they’ll need to raise more money if they’re going to acquire companies. They might have a company in mind, though they don’t often reveal this target company until later. They’ll file a prospectus with a securities regulator, then apply for listing on a stock exchange.
When approved, the SPAC will then begin raising capital through its IPO. Unlike a traditional IPO, however, in which common stock is based on the valuation of an underlying company, a SPAC’s IPO is usually priced at a flat $10 per unit.
Each unit consists of two things: one share of common stock and a warrant. Common stock is simply the stock that makes you a shareholder of a company. Warrants are contracts that give you the right (but not the obligation) to buy a certain number of common stock for a fixed price on a specific date in the future. When this date arrives, you can choose to exercise your right to buy more shares at the agreed-upon price. If the company isn’t performing as you expected, you may decide not to.
As far as buying a SPAC’s IPO, you can do so on an exchange, as you would any other stock. However, whereas with common stocks you invest because you believe in the underlying company, with SPACs you invest because you believe in the SPAC’s management team.
The acquisition of a company is only as successful as the SPAC’s management. If they’re skilled enough, you can expect them to persuade a company to be acquired.
2. The SPAC announces the acquisition
A SPAC launches its second phase when it reveals to investors the company (or companies) it is targeting. At this point, new investors will no longer invest for the management team alone. Now, they’ll invest for the company to be acquired.
Now, before the SPAC can actually acquire the company, should it come to that, one condition must be met: shareholders of the SPAC must agree on the acquisition. If the majority of shareholders agree, then the acquisition can proceed. The shareholders who disagree can convert their shares into a pro rata share of the funds in trust, usually the IPO price plus some interest.
After the announcement, you’ll notice a change in the $10 share price. That’s because once investors know what company the SPAC wants to acquire, the market price will adjust accordingly.
Once the terms of a deal are announced, as well as a launch date, the “de-SPAC” transition begins. As long as investors vote in favour of the transition, the SPAC will merge into the acquired company, using its capital to launch it on an exchange.
What are the risks of SPACs?
A SPAC can present investors with a chance to buy common shares of a young company before it grows larger. That said, because SPACs are steeped in speculation, they are fraught with risks that investors should be aware of.
1. You’re putting all your trust in the SPAC’s management team
The first risk is in the SPAC’s management. In the initial phases, you’re placing your trust in a management team’s ability to pick the right company for a good price, with little input from you. You typically won’t know the SPAC’s choice until after you buy your units. If you don’t like the company they choose to acquire, you could be disappointed if the majority of shareholders vote in favour of the acquisition.
2. More focus on future potential rather than past performance
Now, in regards to the acquisition, an IPO via a SPAC can also be a risky investment. In a traditional IPO, a company has to disclose its past performance at length. They typically describe its financial conditions, as well as the market sector in which they operate.
But with a SPAC merger, most companies don’t disclose their past performance. Instead, they focus on their future potential, which may or may not come to pass. This could present significant risks to investors who don’t know exactly what they’re buying into.
3. The merger could be over-hyped
This leads to another major risk: a SPAC merger could be over-hyped. You might think your initial investment ($10 per unit) will lead to major returns when the SPAC merger is finished. The company could seem promising. But if there’s little past performance to base your investment on, you’re taking a leap of faith.
Should you invest in a SPAC?
A SPAC could be a lucrative opportunity for investors. For one, they can help you get in on the ground floor of a great company. If the SPAC’s management team chooses their target company wisely, the payoff can be immense, especially if the new company reaches its full potential.
With greater upside, however, comes greater risks. In general, IPO stocks present more risks to investors, and SPAC mergers can be even riskier. The acquired company could be over-hyped, or the SPAC itself could fail to find a target. If the SPAC does fail to merge with a company, you’ll at least get money back. If it succeeds, however, but the acquired company fails, you could end up losing a large portion of your initial investment.
For new investors, you’re better off investing in well-established companies whose business models you understand. If you’re looking for significant returns, you might also want to try your hand at growth stocks or value stocks. Both could help you realize immense gains.