SPACs as the Symptom to Reform the IPO process

Special purpose acquisition companies or short SPACs have risen dramatically in popularity. CNBC calls them “one of Wall Street’s hottest trends” CNBC, 2021 But what is a SPAC, and what makes them so popular at all? Furthermore, how can we improve the IPO process due to the SPAC mania?

What is a SPAC?

A SPAC or special purpose acquisition company is seen as an alternative to going public via the common IPO or initial public offering. A SPAC is basically an empty publicly traded company. It is usually set up by reputable investors with the main purpose of raising money through an IPO. By going public, the SPAC is collecting a bolster of cash which then enables it to acquire another company and by doing so, taking the target company public. But other than that, the SPAC company itself has no operations, no products, and no assets. 2020, U.S. Securities and Exchange Commission

This SPAC method of taking companies public through the back-door has existed for a long time. However, it has been rather unpopular – until recently. It gained momentum again through venture capital investors from Silicon Valley who see in it a cheaper and less bureaucratic way to take startups public.

As of writing this in March 2021, companies like Virgin Galactic, DraftKings, Opendoor, Nikola Motor Co. went public through a SPAC in recent months. In fact, nearly 250 SPACs went public in 2020 – a record which has already been beaten 3 months into 2021.

SPACs are backed and initiated by all kind of investors, venture capital funds, hedge funds and even private equity giants.

While there are SPACs with top management teams like Chamath Palihapitiya – who got the SPAC mania going or Bill Ackman – who raised a $4bn SPAC in July 2020 there are also management teams who “don’t know the first thing about the businesses they are dealing with” – as the Economist puts it. This makes a SPAC potentially an efficient and attractive investment opportunity or a complete rip-off.

IPOs are “Expensive and Inefficient”

SPACs are gaining in popularity because the only alternative – the traditional IPO – is a pain in the ass. Roelof Botha, a partner at Sequoia Capital, calls the IPO process as “chicanery and grand larceny” while asking: “So many things have become cheaper and more efficient. Why are IPOs as expensive and inefficient as ever?” The Economist, 2021: What the SPAC craze means for tech investing

While a SPAC is utilizing an IPO as well, it does so with less bureaucracy and fewer costs than a traditional IPO. Traditionally, a company is formed and is slowly building and scaling its business. At one stage it may decide that it has the resources in place to raise capital from the public markets. It then has to comply with all processes and reporting requirements of the regulators. The traditional IPO process includes many bureaucratic and complex steps, which all come with fees:

  1. Choosing an investment bank to advise the company and offer underwriting services,
  2. Due diligence and regulatory filings,
  3. Setting the offer price and the precise number of shares to be sold,
  4. After-market stabilization through the underwriter,
  5. Transition to market competition. CFI, 2021: What is the IPO Process?

The IPO Tax

All previous mentioned steps come with fees: underwriting fees (around 6.8% with a $100m deal), legal fees, accounting costs, printing costs, SEC registration fees ($129.80 per $1 million), FINRA costs, exchange listing fees ($150,000 to $295,000 + $25,000 application fee + $46,000 to $159,000 annual fee for a $100m deal), and other miscellaneous fees. PwC: Considering an IPO? First, understand the costs All those costs are often referred to by Silicon Valley investors as the IPO tax.

Let’s calculate an example. For a company with $250m – $499m in revenue and a deal value of $100m to $249m, the IPO cost calculator of PwC estimated the costs of going public to around $9.6M up to$21.9M. That is roughly 20% of the total deal value.

With SPACs, most of these costs are kept to the absolute minimum as a SPAC is an empty shell company. There is no considerable due diligence necessary, no negotiations required, and so on. This makes SPACs cheaper, less bureaucratic and as a result, deals can close faster.

Making The Problems of IPOs Clear

SPACs are making the problems of IPOs clear. They are expensive, bureaucratic and therefore unattractive for small or medium-sized companies. This makes it oftentimes a no-brainer when smaller companies and startups decides between being acquired by a larger organization or going public through an IPO.

But this hasn’t always been the case. “During 1980–2000, an average of 310 companies per year went public in the United States. Since 2000, the average has been only 99 initial public offerings (IPOs) per year, with the drop especially precipitous among small firms.” Xiaohui Gao,Jay R. Ritter and Zhongyan Zhu, 2014: Where Have All the IPOs Gone?

Investors who initiate SPACs are trying to fill this gap by offering smaller companies a real alternative to private equity. For entrepreneurs, selling to a SPAC is as easy as selling the company to another private company. An IPO is out of question anyway.

Takeaway 1: IPOs are too expensive, too burocreatic and realistically impossible for small and mediums sized companies, SPACs try to circumvent this problem.

IPOs are not for Long-Term Investments

Traditional IPOs are unattractive to some entrepreneurs for one other reason. IPOs value the company to what it is worth today, not what it may become in the future. With a SPAC, this must not be the case. The terms of the deal are negotiated directly between the SPAC and the target company. Valuations can therefore be based on the hopes and dreams of tomorrow. Furthermore, going public is less about profitability today and more about profitability in the future.

Especially “deep tech” companies – such as those involved in autonomous vehicles, biotech, quantum computing, and more – can profit from the fresh perspective of going public through a SPAC merger.

Going public does still mean that executives are accountable and measured against short-term metrics. Which means a focus on quarterly earnings instead of the progress made in developing technologies for the long term.

Takeaway 2: IPOs are short-term focussed and don’t provide incentives for long-term developments.

Making the Public Market Accessible

All in all, SPACs try to make the public market accessible for companies who would not consider a traditional IPO. At the same time, SPACs are “are the closest thing a retail investor can get to a venture investment”, says Nirav Tolia The Economist, 2021: What the SPAC craze means for tech investing.

Resumée: Even if two thirds of SPACs will crash and burn, the idea behind them is reason enough to reform and improve the IPO process. Going public must become the norm again. Private companies – no matter their size – must get the ability to go public in a straight-forwarded process. This means: less bureaucracy, minimal fees, and a clear valuation of the company. This should come along with other reforms such as yearly instead of quarterly reports and more.

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