What in the World is a SPAC? — Diving Deep into the New/Old Way to Go Public and the Race to Raise Capital in the Electric Vehicle Industry
For most startups, going from idea to MVP to commercialization requires a strong and knowledgeable team, a product that resonates with the target market, a large TAM, and most importantly MONEY!
Entrepreneurs often go through several rounds of funding as described in the image below:
At some point in time, investors/founders/employees will look to receive a return on the capital and time invested in the form of a potential exit. Typical exits include acquisitions or traditional initial public offerings. Such accomplishments speak volumes about your company, product(s), team and overall strategy. Only the best companies can achieve such exits and doing so is akin to making it to the NFL, NBA, or playing professionally in the Premier League. I’ll touch upon the M&A and IPO topics in detail in a different article, but both are extremely difficult.
With all things in life — there are alternative ways to get things done even if they aren’t the most popular or straight forward path. Going public is exactly one of these examples.
Recently, there’s been a storm of articles in Barrons, FT, and WSJ talking about electric vehicle companies like NKLA, Fisker, Lordstown, and Canoo going public via a “new” method known as the De-SPAC process. SPACs are NOT new and have existed for a long time. According to Winston & Strawn, SPACs first appeared in the 1990s, but then disappeared until 2003. Between 2004 and 2006, 70 SPACs completed IPOs raising US$4.6bn. In 2007 alone, 66 SPACs completed IPOs raising a total of US$12.1bn. SPACs disappeared again during the Great Recession of 2008, but have come roaring back. Between 2016 and 2019, 152 SPACs completed IPOS raising US$37.9bn. This year alone, 80 SPACs have completed IPOs raising ~$32.2bn year-to-date. Yes, this is SPAC mania.
So, you might be wondering why everyone is talking about SPACs if they have been around for nearly three decades. SPACs are back in the spotlight because of record issuance particularly in the automotive industry. But what exactly is a SPAC?
SPACs, short for Special Purpose Acquisition Companies, are entities that have no operations. They serve as shell companies also referred to as “blank shell companies”. The primary goal of a SPAC is to serve as an investment vehicle to acquire a company at some defined point in the future — typically 24 months. Sometimes the defined length is longer such as 36 months. If the SPAC does not acquire a private company in the defined time frame, all capital must be returned to the investors who invested into the SPAC and the SPAC management team/sponsors will lose out on a significant pay day!
Now let’s get more detailed and understand how to form a SPAC, the benefits, and why private companies choose to go public through the SPAC process:
How Are SPACs Formed and Why Are Investors Interested?
SPACs are formed and led by a sponsor team of experienced operators and/or dealmakers/investors. These sponsors typically have a background that includes a long track record of value creation, access to a proprietary deal sourcing network, and managerial expertise post acquisition. Once a SPAC is formed, the founders invest an initial amount of capital at a nominal value. Typically, this initial investment is used to cover the costs for the investment banks underwriting the IPO (~2.0% of the offering size) and ~US$2.0mm to cover offering expenses and working capital post-IPO. After the initial investment, the sponsors follow a traditional IPO process to raise proceeds for the SPAC. Yes, this entity with no operations will file to go public with the SEC. So why would there be any interest by the public markets?
The typical pitch is that the SPAC structure allows investors to co-invest publicly side-by-side with a best in class sponsor (SPAC team) that has deep access to private market opportunities and a track record of successful execution. In layman’s terms, the SPAC team offers investors a higher probability of generating excess returns and value. In addition, all proceeds from the IPO are held in a trust account until closing of any acquisition. Thus, investors investing in the SPAC IPO have downside protection and immediate liquidity if a transaction does close.
Understanding Sponsor Economics and Motivations For Deal Making
The SPAC team itself is incentivized to find a company to acquire given the deal economics. Let’s understand how a sponsor is incentivized.
The sponsor economics are broken into two aspects:
1. Founders shares also known as the “promote”
2. Warrants from the sponsor’s initial investment (“at-risk capital”)
Prior to filing a registration statement with the SEC, the sponsor will purchase founder shares at a nominal value that equates to 20% of the SPACs fully diluted post IPO equity. Today, the sponsor typically receives founder shares for free which will vest at a pre-defined schedule but still will always equate to 20% of the total shares outstanding post IPO, inclusive of any green shoe exercise. The remaining 80% is owned by the public investors i.e. IPO investors.
SPAC sponsors also receive additional economics in the form of warrants based on their initial investment mentioned above. This initial investment, also known as the at-risk capital, is converted to an equivalent amount of warrants depending on the exercise ratio from warrants to common stock which are anywhere between 1, ½, 1/3, and ¼.
To give you an idea of a sponsor’s potential pay day, let’s assume a US$500mm IPO size. Typically, the IPO price per unit or per unit purchase price (consisting of one share of common stock and a fraction of the warrant to purchase a share of common stock in the future) for investors is nearly always US$10.00. US$500mm/US$10.00 per unit = 50mm units consisting of 1 share and the exercise ratio of the warrant. These 50mm shares are considered all public shares. To ensure the sponsor owns 20% of the company, the sponsor will then receive 12.5mm promote shares which is 20% of the total 62.5 proforma shares (50.0mm public shares + 12.5mm sponsor). At a price of US$10.00 per share, the sponsor’s shares will be valued at US$125mm, excluding any warrant exercise. This is a 10.4x multiple on invested capital (MOIC) return! For my visual friends:
Yes, that’s a home run return for the sponsor/SPAC team and potentially a grand slam for everyone involved depending on the future value of the company that is being acquired.
Besides being economically incentivized, there are several other motivating factors that are worth mentioning:
1. Track record/reputation — the goal for any money manager is to build a strong track record and deliver outsized returns. Reputation is important in the world of investing and similar to any money manager, having a track record allows you future opportunities. My argument here is that SPAC founders want to get a deal done not only for the economics of the deal, but to build up that track record.
2. Timing — Proceeds from the IPO are locked up in a trust account for a maximum of 24 months as the SPAC team finds a company to acquire. Imagine after 24 months no deal gets done. Those proceeds are then returned to the investors, but such investors could have been put their money to work elsewhere during this period. The thought process here is that if I gave a sponsor money for the last 24 months, and you did nothing with my money, then why will I ever give you money again? I won’t.
3. Swing for the fences — This is more of a subjective answer, but nobody likes to fail. Even if there are no strong companies to acquire, is a SPAC founder going to admit defeat and potentially harm his or her reputation or will they try swinging for the fences? It’s the old adage, “swing for the fences” which incentivizes sponsors to get a deal done rather than return capital.
In my opinion, such reasons are why you sometimes see deals which are clearly questionable and are contributing factors to a potential bubble.
Now that we’ve covered why SPACs are formed and the benefits for both investors and the SPAC team, let’s understand why companies choose to go public via the De-SPAC process.
Why Are Companies Interested in the De-SPAC Process?
As mentioned earlier, raising capital from seed to later stage rounds becomes increasingly difficult per round. Each industry is different, but typically a company goes from generating an idea (ppt), to product concept, to MVP (minimum viable product), to generating revenues and scaling your user-base. Funding is a major requirement to transition to each milestone. As you enter into later stage private rounds, investors will put significant emphasis on industry KPIs and will also focus on
1. Financial viability
2. Product readiness
3. Business due diligence
4. Financial targets
5. Revenue Growth
6. Customer acquisition / churn
Again, going public is a privilege and is reserved for the best companies, so later stage investors will be adamant on key metrics. If startups are not hitting their metrics and KPIs, there is lower probability of an exit in the future, causing investors to be very selective in which companies they invest in. I often refer to this as the chicken and egg dilemma. Companies need capital to scale and to hit those metrics, but can’t obtain funding without already scaling and meeting such metrics.
This is where SPACs offer an intriguing proposition. SPACs allow companies struggling to raise capital, especially in times of market instability, to raise capital and go public simultaneously. This process is called the “De-SPAC Process”. Remember, SPACs have already raised the capital via the IPO. The proceeds raised in the IPO are held in a trust account and the SPAC has ~24 months after being publicly listed to acquire a target private company. Also note, the funds in the trust account must equal 80% of the value of the target private company. Whether a company is struggling to raise a late stage funding round or struggling to IPO, the De-SPAC process offers a private company an alternative way to go public, raise immediate liquidity to fund operations/growth, and allows shareholders to cash out.
This is why so many electric vehicle companies are opting to go through the De-SPAC process. The cost required to build a car is nearly ~US$1.0bn and another ~US$1.0bn is required to build a manufacturing plant if a company is looking to scale and produce significant volume. Then on top of this one has to add the retail and distribution costs. My point here is that it takes significant capital to produce the product, in this case an electric vehicle, before customers even get to try it. Therefore, many investors will desire to see vehicles on the road and clear demand before committing to fund in later rounds. We are back to the chicken and egg dilemma. I’ve heard a similar statement from some of the most well-known institutional investors, “You can fund over 20 AI companies with the same amount of capital it takes to fund an electric vehicle company.” True so what does a company dreaming to be the next Tesla do? They either raise enough capital in private rounds to produce their product (Rivian) or they go the De-SPAC route.
In some cases, private companies that are going through the De-SPAC process still require additional proceeds that are greater than the amount of cash reserved in the SPAC IPO. In these cases, SPAC sponsors, with the help of underwriters/investment banks, will help raise additional capital in what’s known as a PIPE (private investment in public equity). The PIPE serves as a conduit for incremental capital and signals validation for the transaction given the additional support. These PIPE investors are typically blue chip, long only investors that will help support a public stock (typically not hedge funds).
In summary, the benefits of a De-SPAC process for private companies include:
1. Immediate capital and liquidity with upfront proceeds that can be up-sized via a PIPE
2. Timing — De-SPAC transaction can take 3–4 months from beginning to close (faster than the traditional IPO process which takes 6+ months)
3. Exit for current shareholders with flexible structures for earn outs not available in IPO
4. Upfront price discovery to pre-sound the transaction with SPAC/PIPE investors prior to any public announcement
5. Investor base is typically made up of top investors with leading SPAC sponsors also coming from top institutional investors; PIPEs include top blue-chip investors
6. Receiving credit today for financial projections several years in the future
#6 is an important point to highlight. SPACs will provide valuation flexibility by giving private companies credit today several years in the future. What do I mean by this? Let’s look at recent SPACs in the automotive sector:
All of these recently announced SPACs in the automotive sector are being valued off of 2023–2025 revenue multiples and are getting credit today for their future and much later projections, than a private company would going through a traditional IPO. While a greater discount is given to those forecasted years, a company going through a traditional IPO will typically be valued off of 1-year forward multiples. This is where the SPAC structure really differentiates itself as business targets can include pro forma financial projections in the merger proxy statement unlike the IPO prospectus. Such projections help provide comfort to sponsors and investors and explain the willingness to value such companies off later year financials.
Wrap Up: Are SPACs The Holy Grail?
Now that we’ve covered the De-SPAC process in detail, the motivations for getting a deal done, and the benefits to the sponsors, SPAC investors, and private companies, I’d be remiss if I did not mention the simple fact that many companies going through the De-SPAC process are not ready to be public companies yet. Going public via the De-SPAC process requires the same disclosures as a company that goes public in a traditional IPO including required filings with the SEC such as Form 10-Ks, Form 10-Qs, Form 8-Ks and proxy statements.
If we look at many of the recently announced SPAC mergers in the electric vehicle industry, almost all of these companies have no product yet, limited customers in the form of reservations with minimal deposits, and little to no revenue. These EV companies will now be public entities, assuming such transactions close, and be closely scrutinized and penalized by the market for every misstep. However, the need for funding and survival today outweighs the future risks. SPAC mergers are giving such EV companies the opportunity to live and fight another day. How bout them apples?
If you’d like to learn more about SPACs or have any questions on the dilution impact, please reach out to me on LinkedIn at www.linkedin.com/in/sujoy-sarkar-1b584519
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