SPACs: What They Are and How They Work

by Josh Biggs in Business on 8th July 2021

Special purpose acquisition companies (SPACs) have sky-rocketed in popularity over the past four years and are now popping up all over the place. 

But what exactly is a SPAC? How is it formed, and how does it work? And what do you need to know before investing in or launching one? 

What Is a SPAC?

A special purpose acquisition company refers to a company that is formed to raise capital with the sole intention of taking an existing private company public. The main difference between a SPAC and other companies that go public through a traditional IPO is that a SPAC has no operations or assets (apart from cash and limited investments). 

A SPAC is sometimes also known as a “blank check company.”

Why Have SPACs Risen in Popularity?

In 2017, entrepreneur and venture capitalist Chamath Palihapitiya raised roughly $800 million for his SPAC, which was used to purchase a 49% stake in Richard Branson’s Virgin Galactic. Because of the high-profile nature of the deal, SPACs rose in popularity in the years after.  

The number of SPACs on the market quadrupled from 2019 to 2020. According to SPAC Insider data, there has already been a record number set for 2021, with over $97 billion raised so far.

This article about Yieldstreet confirms the rise in popularity as the online investment firm reportedly explores establishing a special purpose acquisition company of its own rather than merging with an existing SPAC.

Celebrities also want a piece of the pie, with Shaquille O’Neal, Tony Hawk, and Jay-Z all launching their own SPACs. This, coupled with interest from investors, has seen the growth of special-purpose acquisition companies soar, with no sign of slowing down anytime soon. 

How Does a SPAC work? 

A SPAC is no different from any other startup at the beginning. Anyone can form a SPAC. However, they are generally created by investors or sponsors who have accumulated a great deal of expertise in a particular industry and intend to pursue deals in that area. 

Once the team is established, they create an LLC known as the “sponsor.” The sponsor then creates the SPAC before going public.    

Usually, the founders will have a company in mind that they want to take public, but this isn’t disclosed during the IPO process. This means that IPO investors are investing in a company blind. Apart from this, the process is the same as a traditional IPO. 

The SPAC then needs funding money (known as “risk capital”), either put up by the team or other financial investors. 

According to James Graf (an industry veteran) and Harvard Law, a $200 million SPAC will require funding of about $7.5 million to account for various fees, including underwriters, lawyers, insurance, and directors and officers. However, as demand rises, so do prices.   

This risk capital enables the team to receive an incentive of 20% of the shares when the SPAC eventually goes public in exchange for a fixed price (usually around $25,000). These shares are in addition to the shares issued during the IPO. However, these shares will only be of value once the SPAC merges with a private company. 

What Happens When a SPAC Goes Public?

A SPAC must gain approval before it can be listed on the Nasdaq or New York Stock Exchange. Once this happens, it becomes like any other IPO. However, investors are not buying shares in the company; they are buying “units.” Each unit is usually sold for $10 and comprises a share plus a warrant or a fraction of a warrant. The warrant essentially means that the investor can buy more units at a fixed price in the future and acts as an incentive to encourage investors. 

What Happens After the IPO?

The raised capital is placed into a blind interest-bearing trust until a decision is made on which company the SPAC wants to acquire. A SPAC usually has two years to do a deal or will ultimately face liquidation. When a company is selected, the capital is used to merge with that company. 

Should You Invest in a SPAC?

As an investor, you have no idea what company the SPAC is looking to purchase, so it comes down to whether you are willing to bet on the SPAC team. It is best practice to know who they are along with their sponsors. Be sure to read the SPACs IPO prospectus as well as any reports filed with the SEC before going ahead so that you understand the terms of your investment. 

If the SPAC doesn’t manage an acquisition, you’ll get your original investment back along with any interest accrued while held in the trust. So as far as risk goes when investing in a SPAC, it’s minimal. 

Categories: Business