The dangers of SPACs, explained

The dangers of SPACs, explained
A street sign for Wall Street is seen outside the New York Stock Exchange (NYSE) in New York City, New York, U.S., July 19, 2021. REUTERS/Andrew Kelly
The life cycle of a SPAC is almost like the life cycle of a butterfly, just throw out all the beauty involved and add in a whole bunch of lawyers.

What are SPACs?

  • SPAC stands for “Special Purpose Acquisition Company,” and is essentially a public company that doesn’t sell anything or have any operations, but instead has been created to help a private company go public.
  • Then they merge with these private companies looking to go public and for the businesses that merge with these SPACs, called targets, this can be a big deal.
  • Targets don’t have to deal with such hefty fees, regulations, scrutiny and paperwork if they go public via a SPAC compared to if they wanted to go public via a traditional Initial Public Offering (IPO), so the whole process can be faster by around two to four months.

How do these things even get started though?

  • The life cycle of a SPAC is almost like the life cycle of a butterfly, just throw out all the beauty involved and add in a whole bunch of lawyers.
  • In its inception, the people who manage the SPAC (called “sponsors") put in some money to get the thing started. This is mostly used to pay for the people that actually work on the SPAC (like lawyers).
  • The SPAC’s aim, before merging with a private company, is to just raise money. And, the initial injection of money by the sponsors is typically about 20% of their overall funding goal.
  • Then the SPAC gets opened up to private investors, who also put money into it. And, once the SPAC is funded, it goes public.
  • It then looks for a target company to merge with and it has two years to find a target, otherwise, the SPAC is dissolved and all the money returned is returned to the original investors.
  • When a target is found, the shareholders in the SPAC get to vote on whether or not it will be merged. Around this time, shareholders usually have the option to sell their stake in the company if they don’t want to be involved with the company the SPAC is merging with.
  • If the majority votes yes, then the SPAC merges with the target, and the target goes public via the SPAC.

What are the dangers?

  • To understand one of the biggest risks for people investing in SPACs when they’re public, you first have to understand what benefits the private investors reap, the ones that the sponsors go to first.
  • Private investors like Wall Street insiders, usually get one free warrant with every share of the company they purchase. A warrant is issued by the company and is sort of like a share that can be bought at a later date at a set price if the investor chooses.
  • For example, most SPACs launch at a price of US$10 a share. If you were a private investor, for every share, you would also get a warrant that would stipulate you would, at a later date, be able to buy a share at US$11.50.
  • If the price of a share goes down from US$10, you never have to redeem your warrants, and you’re in the clear. But say the price of a share goes up to US$20; it only makes sense to buy your share at the price of the warrant (US$11.50), if for no other reason than to sell it quickly.
  • What this does for the investors on the public market though, the ones that got in after the private investors, is it opens up the risk of their shares being worth less – aka, diluted.
  • Why? Because these warrants are being issued by the company itself. Imagine if the company said everyone sitting at the dinner table (in this case investors) would get dinner on their plates – but then kept on introducing new people to the table? Unless they cook more food, the first people at the table will have to share some of the food on their plate with the new diners.
  • So, let’s just say the stock value did shoot up to US$20 a pop, if people with lots of warrants decide to redeem them, your share value will dilute.

So, is dilution the only danger?

  • Not at all, but it’s the most consistent one.
  • The other big danger of SPACs is that, at least in its recent frenzy, they tend to merge with capital-intensive startups that need funding fast to be able to build and develop what they’re trying to sell.
  • This can sometimes be a good thing; Richard Branson’s space-travel company Virgin Galactic famously went public with a SPAC. The company has hardly made any money from its services. But so far, it seems to be a company that can at least hold itself to some scrutiny and perform.
  • In other instances, like Tesla’s competitor Nikola Corp., the founder of the company was indicted on charges of fraud for lying to investors to boost the price of the stock with critics saying that if Nikola went through a traditional Initial Public Offering (IPO) and scrutinized more, he wouldn’t have been able to lie so much.
  • And also, because SPACs usually work on limited timelines, (they need to find a target within two years), sponsors are often quick to jump on the first company approached, regardless of how well the business might perform.

So, what’s next for SPACs?

  • No one really knows, but this is what we do know.
  • SPACs blew up in 2020, and there’s no telling if that was a one time occurrence, or if we might see a second SPAC explosion.
  • That said, there is some good news with them. Every time a SPAC goes through, good or bad, we learn something about the way these relatively new financial devices work.
  • And even the Securities Exchange Commission (SEC) has recently shifted the way it looks at SPACs, saying that companies going public via SPAC should go through the same regulatory standards seen by those going through a traditional IPO, and, this wasn’t always the case.

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