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How SPACs Work

You probably heard all the buzz about the SPACs — the special purpose acquisition vehicles — and are curious to know what exactly they are.

Technically speaking — and according to TechCrunch — SPACs are “blank-check companies that are formed for the purpose of merging or acquiring other companies.”

Yes, it’s a mouthful of words. But what do SPACs actually do and, most importantly, what is all the buzz about?

Let’s explore.

First, think of the most traditional way of company growth and maturation: they raise money in venture capital and investment, grow and increase valuation and reach a point of maturity known as an IPO. But the thing is, the world is currently amidst a pandemic — and the global health crisis has seriously shaken most of the companies’ projections and hopes for successful exits. Some need a relatively frictionless way to get out the door, and there are plenty of investors who would like to give them that push.

Usually, SPACs are created through collaborations between investors and sponsors; the “founding members” of SPACs are normally experts in specific industries — and by forming a SPAC, they come together to seek deals in that particular business area. Oftentimes, the founders of the SPACs keep a minimum of one business acquisition in mind; however, they usually do not publicize what the target company is — there is a reason why SPACs are known as “blank check companies”: with this element of surprise, most IPO investors don’t initially know what company they will be investing their resources in.

The financial resources raised by SPACs are usually saved in a trust account designated only for either completing the acquisition or to return the funds back to the investors in case the SPAC ceases to exist. The deadline for SPACs is two years — if the acquisition deals are not complete, they are forced to be dispersed within the two years allocated to the “coalition.”

In short, as Forbes summarizes it, SPACs basically raise capital through an initial public offering and use the raised funds to acquire an existing company — all within two years.

The IPO process for SPACs is not that different from the usual IPO, however. It still involves the charade of meetings between the SPACs teams and other interested parties in the deal. The ultimate goal in both cases is to reach a conclusion in the form of an offer that’s in the interest of all the parties involved.

SPACs have existed for a long time, even though it seems like they have been discussed openly only recently. And over the years, SPACs have changed structurally. In the early stages of their existence, it was common practice to disclose the target company to the investors under strict NDAs, after which the investors would decide to either keep their investment or redeem their shares and not proceed with the deal.

But in this case scenario, investors would have the opportunity to “rebel” if they weren’t given the founder shares or other types of preferential treatment in the newly formed company. In modern SPACs, investors now have the right to redeem their shares regardless of their vote, making sure there are no interruptions in running the deals.

SPACs haven’t just undergone a structural transformation; they have also built a new reputation over the years, improving it and becoming an innovative solution rather than a “last resort” option for investment. According to Forbes, in the early 2000s, there were many “blank check” companies that did not succeed; however, there are more protections for investors today, and sellers are more informed about the process and the target companies.

While there is no maximum size for the target company a SPAC wants to buy, there is a minimum threshold SPACs have to meet for a smooth deal. Typically, the size of the target acquisition is supposed to be approximately 80% of the total funds in the SPAC’s trust account. Moreover, it has become almost routine for SPACs to keep an eye on target companies that are two to four times the funding they have.

A question may arise then, how can SPACs afford to partner with companies that are much bigger in size and valuation?

Well, here is also where the asymmetry in information and preferential treatment issues come in, too. SPACs are able to accept private investments from parties outside of the usual SPAC’s institutional investors; however, it’s the institutional investors that get the initial information about the target company for acquisition to decide if they would like to pull out or stay in the game, or if they should seek more external funding from private investments. The rest of the world, however, remains in the dark and guessing.

By all means, SPACs have been through a history of ups and downs, of successes and failures, of advantage and disadvantage. However, today, they remain to be yet another viable way to direct investments into industries and companies of choice for those who find the traditional venture capital path unsatisfactory.

Originally published on Medium


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