Nary a day goes by when we do not get an inquiry about SPACs. This primer provides you with an introduction to SPACs. Among other things, it explains what a SPAC is, lays out the economic terms of the equity offered in a SPAC IPO, introduces the players that inhabit the SPAC world and describes the benefits of going public in combination with a SPAC instead of through a traditional IPO.
After reading this primer, you will be able to answer the following question: what do Shaquille O’Neal, Bill Ackman, Serena Williams, former House Speaker Paul Ryan, Alex Rodriguez and Chamath Palihapitiya have in common? The answer is provided below.
Structure of a SPAC
What is a SPAC?
A SPAC is a special purpose acquisition company that raises a pool of cash in an initial public offering, or IPO, and deposits the cash proceeds from the IPO into a trust account. These funds are used solely to acquire an operating company, referred to as a target, in a business combination transaction. The SPAC is required to complete an initial business combination, referred to as a “de-SPAC” transaction, typically within 18 to 24 months following the SPAC IPO date. If the SPAC fails to complete a business combination within that period, the SPAC liquidates and the funds in the trust account are returned to the public shareholders.
What are the terms of the units offered by the SPAC in the IPO?
In its IPO, the SPAC offers units, with each unit comprising one share of common stock, typically designated as “class A” shares, and either a fraction of a warrant to purchase a share of common stock, or one warrant to purchase a fraction of one share of common stock. Each unit is customarily priced at $10.00 per unit, and the warrant is usually priced “out of the money,” with an exercise price greater than the per unit price offered in the IPO, typically $11.50 per share. The warrants become exercisable on the later of 30 days after the consummation of the business combination or 12 months from the IPO closing, and expire five years after the business combination.
Upon consummation of the IPO, the units begin to trade on the applicable stock exchange. However, within 52 days after the IPO, the units are severed, and the class A shares, often referred to as the public shares, and the warrants, often referred to as the public warrants, may be traded separately.
What is the “at-risk capital”?
The sponsor of the SPAC will purchase warrants in an amount equal to the 2.0% upfront underwriting discount of the IPO (see below), plus funds to cover the offering expenses and expenses to find a target, with the aggregate price of the purchased warrants in most recent deals hovering between 2.3% to 3.0% of the gross IPO proceeds. These warrants, which are referred to as the private placement warrants, have terms that are substantially identical to the warrants issued in the IPO, and are commonly purchased by the sponsor at around $1.00 or $1.50 per whole warrant in a private placement that closes concurrently with the closing of the IPO. Unlike the public warrants, which are registered in the IPO, the private placement warrants are restricted securities. In addition, the sponsor agrees not to transfer or sell the private placement warrants until 30 days after the completion of the business combination transaction with the target.
The sponsor’s investment in the private placement warrants is referred to as “at-risk capital” because if the SPAC does not complete a business combination, the amount of the “at-risk capital” will be lost.
As described above, the purpose of the at-risk capital is to provide additional funding for the trust account and to pay IPO expenses and the operating capital needs of the SPAC. A portion of the proceeds from the sale of the private placement warrants equal to or greater than the amount of the upfront underwriting discount will be deposited in the trust account, so that the aggregate amount of cash in the trust account equals 100% or more of the gross proceeds of the IPO. The balance of the proceeds from the private placement is retained by the SPAC to pay expenses, including expenses incurred to identify a suitable target for the business combination transaction. In addition to the private placement, most sponsors contemplate making working capital loans to the SPAC, of which typically up to $1.5 million in principal amount of such loans may be converted into warrants (identical to the private placement warrants) at the closing of the de-SPAC transaction.
The IPO Process and Stock Exchange Listing
IPO Process and SEC Review
A SPAC will file a registration statement on Form S-1 with the U.S. Securities and Exchange Commission to register the units, the public shares and the public warrants issued in its IPO. Since a SPAC is not operating a business, the SEC staff review can be more streamlined, and the SPAC’s registration statement will take considerably less time than an operating company’s registration statement to be declared effective. However, the SEC staff does focus on the structure of the sponsor and has increasingly commented on potential conflicts of interest. For example, the staff will ask about other SPACs that the sponsor has formed, particularly where they may compete for the selection of a target (see below), and about the percentage of shares in the SPAC that the sponsor controls and the influence the sponsor and other private investors will have on the vote to approve the business combination transaction with a target. (See KL Alert: SEC Provides Disclosure Guidance on SPAC IPO and Subsequent Business Combination Transactions (January 6, 2021).)
Importantly, a SPAC cannot have identified a target for a business combination at the time of the IPO. If the SPAC had a target in mind, the SEC would require disclosure of the name of the target and information (financial and otherwise) about the target. Accordingly, SPACs expressly state in their registration statements that they have not identified a target. They do, however, disclose the industry or geographic focus of the target business(es) they will pursue and the experience of their management in the relevant industry.
Most SPACs initially file their registration statement confidentially. While the staff of the SEC is reviewing and providing its initial comments on the registration statement, the sponsor selects its underwriter, its management team and board members, and investors in the at-risk capital. (See below.) The sponsor files the registration statement publicly at the time it addresses the comments of the SEC staff. After the staff has signed off on the public filing, the sponsor can move quickly to have the registration statement declared effective, most often with limited amendments. SPACs typically file as emerging growth companies, which allows for confidential submission and review of the IPO registration statement, reduces financial statement audit and disclosure requirements and offers the ability to test the waters with certain qualified investors.
Stock Exchange Listing
Most SPACs list on the Nasdaq Capital Market, but there are those that list on the New York Stock Exchange. SPACs must meet the relevant initial listing standards of Nasdaq or the NYSE applicable to all companies, and must also comply with specific SPAC-related requirements. These latter requirements include, among others, that (i) within 36 months of the effective date of its IPO, the SPAC must complete one or more business combinations having an aggregate fair market of at least 80% of the value of the SPAC’s trust account, (ii) if the SPAC holds a shareholder vote on the business combination, the business combination must be approved by a majority of votes cast by public shareholders, with the NYSE excluding votes of shareholders who are officers, directors or hold more than 10% of the SPAC’s outstanding shares, and Nasdaq requiring approval by a majority of the SPAC’s independent directors, and (iii) holders of the public shares must have the right to redeem their public shares for a pro rata share of the aggregate amount held in the SPAC’s trust account if the business combination is consummated, regardless of whether such shareholders previously voted to approve the business combination. Both the Nasdaq and the NYSE require as well that independent directors comprise a majority of the board, and that the SPAC have an audit committee and compensation committee made up of independent directors.
Where are SPACs organized?
Most SPACs seek domestic targets, and those that do are organized in Delaware. SPACs intending to seek an offshore target are organized mainly in the Cayman Islands, although a few SPACs have been formed in the British Virgin Islands and the Marshall Islands. Being an offshore SPAC may allow for a more efficient structure following the de-SPAC transaction, if foreign assets are acquired. If a SPAC organized offshore decides to acquire a domestic target, the SPAC may have to redomicile in the United States. This will result in a more involved transaction structure and may introduce complex tax issues.
The SPAC Players
SPACs are formed by sophisticated financial practitioners, alternatively referred to as sponsors or founders. The sponsor pays a minimal amount, typically $25,000, for founder shares, referred to as the promote. The founder shares are usually designated as “class B” shares. They will convert into class A shares at the time of the initial business combination transaction, on a one-for-one basis, subject to adjustment for stock splits, stock dividends and the like. At the closing of the IPO, the founder shares will represent about 20% of the SPAC’s outstanding shares. Unlike the public shares, the founder shares are subject to contractual transfer restrictions, and their resale would either need to be registered under the Securities Act or be made in reliance on an exemption from registration.
The sponsor manages the IPO process, including the selection of the lead underwriters to conduct the IPO, the auditors for the SPAC and counsel to prepare and file the Form S-1 registration statement with the SEC.
The sponsor team will consist of the sponsor, a management team and the directors of the SPAC. To attract capital, the sponsor must be a sophisticated and experienced investor that is well known in private equity circles and the financial markets. The directors will be chosen on the basis of their experience in M&A transactions and deal sourcing. Many have been chief executive officers of public companies, M&A dealmakers and industry experts. On the roadshow for the IPO, the sponsor team will highlight its experience, particularly the track record of the team in building value for shareholders. The team will also discuss the industry in which the SPAC intends to seek a target and the growth potential of companies in the industry.
Many SPAC sponsors are serial SPAC sponsors, and their track record will include the success of their prior business combinations. In fact, there have been instances where a sponsor has multiple SPACs that are simultaneously seeking a business combination. In these instances, the SEC staff will be especially keen on disclosure of any conflicts of interest that may arise in the sponsor’s identification and pursuit of potential targets for the various SPACs. (See above regarding SEC review.)
Investors in the IPO
The primary capital pool for SPAC investments comes from institutional investors. IPO investors focus on the track record of the sponsor, the experience of the management team and the industry in which the SPAC proposes to identify a target.
A SPAC investment has certain attractions for these investors. Unlike an investment in the IPO of a typical operating company in which the IPO stock price may rise or fall after the IPO, an investment in a SPAC IPO benefits from downside protection through the closing of the business combination. Until the SPAC effects a business combination transaction, virtually all the IPO proceeds are held in the trust account, and investors can exit through a redemption of their shares for cost plus accrued interest, if for any reason they disapprove of the transaction, while retaining or selling their public warrants. Prior to consummation of a business combination, after the public shares and the public warrants separate, investors will have separate liquidity opportunities in their public shares and their public warrants. If the business combination transaction closes, investors choosing to remain with their investment will enjoy potential upside both in their shares and their warrants.
In a traditional IPO for an operating company, the underwriters typically receive a discount of around 6% to 7% of the gross proceeds, which is paid at the closing of the IPO. In a SPAC IPO, the underwriters will receive a discount of 5.5% of the gross proceeds, but only 2% of the discount will be paid at the closing of the IPO. The balance of the discount is deposited in the SPAC’s trust account and is deferred and payable to the underwriters at the closing of the business combination. If a business combination is not consummated, the deferred 3.5% is not paid to the underwriters, and instead, that amount is used with the rest of the funds in the SPAC’s trust account to redeem the public shares.
A sponsor will want to select lead underwriters with experience in SPACs. The sponsor will be looking to the underwriters to fill their book with investors who have a long-term investment horizon and/or a strong interest in the industry in which the sponsor will seek a target. The underwriter will play an additional, critical role in gauging the amount of redemptions by investors, and in arranging for the replacement of redeeming investors with others who support and are sanguine about the success of the proposed business combination transaction. Too many investors heading for the exits will jeopardize the success of the transaction.
The underwriters also have another role to play. In order to consummate a business combination transaction with an operating target, the SPAC will usually require additional equity capital. Typically, this capital is raised in the form of either a forward purchase arrangement or a so-called “private investment in public equity,” or PIPE, transaction. (See below.) The underwriters will be instrumental in identifying and arranging for the sale of the equity to investors to participate in this follow-on capital raise.
Institutional investors invest in the at-risk capital
Since the offering size of most SPAC IPOs exceeds $200 million, the amount of at-risk capital that sponsors are expected to contribute will exceed $4 million. Sponsors may reduce their exposure by having institutional investors purchase a portion of the at-risk capital. These institutional investors, called anchor investors, will purchase private placement warrants from the SPAC or the sponsor, and will also have an opportunity to purchase founder shares at a nominal value from the SPAC or the sponsor.
Institutional PIPE Investors
A SPAC typically needs to raise additional capital to complete the de-SPAC business combination transaction. These follow-on equity raises customarily take the form of a forward purchase agreement or a PIPE commitment.
In a forward purchase agreement, affiliates of the sponsor or institutional investors either commit or have the option to purchase equity in connection with the de-SPAC transaction. Alternatively and/or in addition to the forward purchase arrangements, an investment bank, often another division of the IPO underwriter, acts as a placement agent in conducting a private placement of debt and/or equity securities of the SPAC in the form of a PIPE transaction. The PIPE transaction is committed and announced publicly at the same time as the acquisition agreement with the target. PIPE transactions have ranged from $100 million to billions of dollars, and are funded at the closing of the business combination with the target. As is typical in PIPE transactions, the SPAC agrees to register for resale the SPAC securities acquired in the PIPE by the investors. Often, existing investors in the SPAC will invest in the PIPE transaction, demonstrating their support for the de-SPAC business combination.
The proceeds of the forward purchase arrangement and/or the PIPE transaction are used to finance a portion of the purchase price for the business combination, meet minimum cash conditions required to consummate the business combination (including by compensating for redemptions of public shares by exiting investors) and fund the working capital needs of the surviving entity.
Business Combination or de-SPACing Transaction
Finding a target
Once a SPAC has completed its IPO, the sponsor will begin its search for an operating entity to combine with the SPAC. The criteria that will inform the search include:
- Industry/geographic focus. In its IPO prospectus, a SPAC typically specifies an industry or geographic focus of the operating company that it will be seeking to acquire. The most common industries have been the tech sector, fintech, travel and entertainment, media, electric vehicles and enterprise software.
- Size of the target. As noted above, both the Nasdaq and the NYSE require, and the SPAC's charter provides, that the business combination must be with one or more targets that have an aggregate fair market value of at least 80% of the value in the SPAC’s trust account. To mitigate the dilutive effect of the 20% represented by the founder shares, SPACs typically seek a business combination with a target priced at four to eight times the amount of the proceeds from the IPO, with the balance of the acquisition price being funded through debt, forward purchase arrangements, PIPE investments in the form of debt or equity or a significant rollover of equity by the target’s equity holders.
- Is the target ready to be a public company? It is critical that the target have appropriate internal financial controls so that the de-SPAC company is able to comply with the reporting requirements of a public company.
- Financial statements. The SPAC will be required to file a proxy statement to solicit shareholder approval for the business combination, or a registration statement to issue unrestricted rollover shares to the target equity holders. (See below.) Under the SEC’s proxy rules, two or three years of audited financial statements of the target and interim financial statements will be required. If the SPAC lacks audited financial statements, the timing of the filing of the proxy statement or registration statement, the vote and the closing of the de-SPAC transaction could be significantly delayed.
From the target’s perspective: IPO vs. SPAC merger
For founders or investors in a pre-IPO company, an initial public offering has traditionally been regarded as one exit strategy of choice. A private equity fund considering a public company exit from a portfolio company would also be looking to an IPO. Today, consideration must also be given to a de-SPAC transaction in lieu of an IPO.
There are certain advantages to pursuing a de-SPAC transaction as opposed to an IPO. It provides greater pricing certainty earlier in the process. In a traditional IPO, the issuance price is determined at the time of the IPO after a lengthy SEC review process and roadshow, and is subject to full market risk during this process. In a de-SPAC transaction, price is determined early on through negotiation. Pricing is complete once agreements are executed for the business combination transaction and the PIPE, which can occur within four to six weeks after signing of a letter of intent. Only after pricing is determined does the SPAC file a proxy or registration statement and undergo SEC review with respect to the target company information.
A de-SPAC transaction will ordinarily take less time overall to consummate than an IPO. The time horizon for a typical de-SPAC transaction is three to four months, while a traditional IPO often requires six to nine months from commencement to completion. In part, this is attributable to the SEC staff’s typically lengthy review of an IPO registration statement. In a de-SPAC transaction, the transit time through the SEC — involving a review of either a proxy statement for a shareholder vote on the de-SPAC transaction or a registration statement to register shares received by the target equity holders in the transaction — is usually significantly shorter, and, as noted above, this review process takes place during the pricing.
After the de-SPAC, the capital structure from the perspective of the target equity holders will oftentimes be similar to what it would have been had the target conducted an IPO. The equity holders of the target will typically roll most, or even all, of their equity in the target into the surviving company in the de-SPAC transaction. As a result, they will collectively own a significant stake in the surviving company, as they would if the target had conducted an IPO. If the target holders cash out a portion of their equity in the de-SPAC transaction, this would be the equivalent of a secondary offering in conjunction with an IPO. Also, the target’s management team will likely continue in their roles in the surviving company, while benefiting from a new partnership with a well known sponsor team.
There are certain tradeoffs to choosing a de-SPAC over an IPO. For one, the target equity holders will suffer a measure of dilution on account of the founder shares and private placement warrants in the surviving company held by the sponsor and any PIPE investors, and on account of the warrants issued to the SPAC IPO investors. There is also inherent uncertainty as a result of the SPAC investors' redemption rights, which could result in the surviving company having insufficient cash to fund its operational needs of the surviving company or a shortfall in the cash consideration, if any, owed to the selling stockholders. The target stockholders’ rights to seek monetary damages for breaches by the SPAC or any financing failures are limited. Since the funds in the trust account are to be used solely to redeem the public shares, counterparties typically waive their rights to seek recourse against the trust account in the absence of a business combination closing. In determining to pursue a de-SPAC transaction, target equity holders will have to weigh these factors against the benefits of taking the de-SPAC route.
Proxy process and the shareholder vote
In most cases, a vote of the shareholders of the SPAC will be solicited to approve the business combination transaction with the target. This will require the preparation, SEC review and dissemination to the SPAC shareholders of a proxy statement. The de-SPAC transaction may also require registration under the Securities Act if the business combination transaction is structured as a share exchange and if new securities are required to be registered. Registration would be on a Form S-4, and the registration statement would include a combined proxy statement-prospectus.
The proxy statement or registration statement will ordinarily be drafted while negotiations over the business combination transaction agreement are being conducted between the SPAC and the target. Shortly after announcing the transaction, the SPAC will file a preliminary proxy statement, or a registration statement including a preliminary proxy statement-prospectus, with the SEC for review and comment on the filing. The process can take three to five months from the date the business combination agreement is signed to complete, but in most cases is still shorter than the corresponding review of an IPO registration statement.
When the SEC staff clears the proxy statement or the registration statement, the SPAC will schedule a shareholder meeting to vote on the business combination with the target and will deliver a final proxy statement to its shareholders and/or a proxy statement-prospectus to the target equity holders. Following shareholder approval, the SPAC and the target will complete the business combination, and both the target equity holders and the SPAC investors will become shareholders in the surviving company. Post-closing, the surviving company will file with the SEC a “Super 8-K,” to put into the public record any information that was not contained in the proxy statement but that is required to allow affiliates to sell their shares under Rule 144.
For successful SPACs and suitable targets, the SPAC model provides benefits all around. Sponsors and their investors get the opportunity to invest in a growth stage company or other attractive target, carefully selected to match their investment criteria, with substantial upside opportunity. Sponsors may earn a substantial return on their at-risk capital and promote, in return for identifying suitable operating business combination targets. At least for the period while the search for the target is ongoing and prior to its acquisition, investors enjoy downside risk mitigation. On the other side of the ledger, SPACs offer founders and equity investors in growth stage private companies a viable alternative to a traditional IPO, with a shorter, more definitive and simpler runway to completion.
According to reports in the financial press, the current SPAC market could not be more active. The features of the SPAC world described in this primer give some insight into why this may be so.
Answer to Introductory Question
Each is a sponsor or a member of the sponsor team of a SPAC.