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Special Purpose Acquisition Companies (SPACs)

Special Purpose Acquisition Companies (SPACs)

Part 1: Is SPAC a better alternative to seek the benefits of public listing - at a lower price, and at a faster pace?

SPAC that, I got you a floor!

Imagine you are a start-up founder, who has crossed the valley of death.
You have successfully managed to turn your first idea into an MVP, with -



icon

A steady annual
recurring revenue

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A well-defined
customer set

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Sufficient cash
in the bank





You were funded into your early stages by venture capital firms that have a reputation for spotting the right ideas and hand-holding you through that phase in your growth when the risks of your firm dying are the highest.

Partly due to their networks and partly due to your own charisma, you have attracted an unassailable talent pool that has come on board at affordable cash costs but with significant ESOPs.

All in all, you are at the inflection point of your growth โ€“ that early bend upward of the Hockey Stick curve.



The next challenge is to grow to a size where you can enjoy the efficiencies of scale and scope.

You want to increase the standardization of some processes which were ad-hoc in the early part of your growth story, like:


As your core revenue stream stabilizes, you are also at a stage where you can take bigger bets on the industry in which you are functioning, like -

  • Exploring foreign markets
  • Trying to add greater value and stickiness by exploring adjacencies
  • Bets on new technologies/business models of the future

All these endeavors require capital

The next challenge is to grow to a size where you can enjoy the efficiencies of scale and scope.
And for most startups at this stage, the best bet to raise funds at this scale is an IPO.

But why are IPOs the best bet?

1. IPOs provide a bigger and more diversified base of investors to raise money from

1

As per Preqin, despite having a 7X growth since 2002, the amount of funds managed by private equity managers (including VC + PE) was about US$6.3 trillion as of 2021 (McKinsey).

2

As per Bloomberg, we can contrast the same with the global public equity market capitalization of US$122 trillion over the same period.

2. Better liquidity for investors and employees

1

A public stock means that a security is frequently traded and there is a dynamic price discovery on it.

2

This gives both early employees and investors an opportunity to time when they wish to cash out and at what level.

3. A currency for future acquisitions

1

A publicly traded stock acts, to a large extent, as a currency to acquire targets with high synergies through all-stock or part-stock deals.

2

Offering a publicly traded stock to a potential acquisition target becomes especially lucrative when multiple competitors are:

  • interested in the same company (Salesforceโ€™s acquisition of Tableau) or
  • when similar-sized companies want to merge to acquire a larger share of the market.
3

Essentially it is a signal by the company that they are offering the target company:

  • a stake at the table, and
  • a transparent price discovery mechanism.

4. Risk aversion by Limited Partners to VC/PE Funds

1

Institutional investors to VC and PE funds have an internal limit to what share of their total AUMs can they offer to such funds.

2

As per McKinsey and Statista, as of 2021, a little under 6% of total AUMs with institutional investors were allocated to private equity and venture capital. This share, however, is expected to largely remain stable by 2023, as per BNP Paribas.

3

Given that dispersion of returns under PE/VC funds is almost 3x that of public equities, it is reasonable for large institutional investors not to risk greater amounts of capital towards such investments.

4

Hence, even though institutional investors may still believe in a start-upโ€™s story, they will tend to push it towards a public listing when it grows to an appreciable size in order to manage their own risk.

Challenges of an IPO:

As lucrative as this may sound, IPOs come with their own set of challenges for the investors and management of a startup.


This is especially true when:

1. Your company has a revolutionary technology and a product, but still needs deep pools of capital to hit a scale to become profitable on a sustained basis.

1

Virgin Galactic, which aims to promote space tourism; or

2

MP Materials โ€“ a mining and refining company that wishes to become one of the largest producers of rare earth minerals outside of China.

Note: Rare earth minerals are critical to the supply chains of microchips, EVs, and electronic devices.

These two companies become important in a later context in this essay.


2. Markets are volatile both ways, as they are currently.

1

Investment bankers could price your equity too conservatively when your employees and your investors cash out.

2

Once listed, the stock could possibly go up in the market by up to 30-40%, allowing retail and public equity market investors to benefit at your expense.

3

This is especially true when the equity markets are at their whipsawing worst since 2008.


3. Your company could have been valued by private markets and VC investors on the basis of a different story

Remember Uber, Lyft, and WeWork?
which public markets are not willing to buy.
The result โ€“ a steep decline in stock price post listing that leaves a stampede of investors and key talent in its wake.


4. IPO process too overbearing

You need capital, but a traditional IPO process could take as much as 12-18 months, locking in the time of senior management and key investors who have to suspend their core deliverables to tour around the world with the bankers on a roadshow.


5. The risks of pricing failure

Finally, while investment bankers do their best to provide insurance to your start-up for such risks, that comes at a high price.

1

Especially so when there is a lot of uncertainty โ€“ either in the overall market or about your startup specifically.

Indeed, there isnโ€™t an exact convergence -by design- between your interests and that of your bankers in the IPO process.

2

They are helping you determine a fair price for your stock, which is based on the future prospects of your company.

At the same time, they are also trying to leave some money on the table for institutional investors.

This is important because these institutional investors in public markets are the repeat clients who could subscribe to future IPOs that these banks sponsor.

3

Apart from conservatively trying to price your stock below its fair price, there are additional ways in which Investment banks insure themselves against the risks of failures in pricing.

4

There are lock-ins to prevent current investors from selling off their shares immediately upon listing (in case they suspect that share prices post-listing could sharply fall off).

And then there are the famous Green shoe options that allow the investment bank to stabilize prices by buying or selling up to 15% of the floated shares.

5

All of this is important because investment banks in essence work in the interests of the overall IPO market.

Therefore charge a price for providing these services when the volatility or uncertainty around the companyโ€™s pre-IPO valuation is high.

The greater the volatility, the greater the price.


We, hence, circle back to the same question โ€“
Are there alternative structures, especially for startups, that allow them to enjoy the benefits of public listing, at a lower price and at a faster pace, and is the answer SPAC?

The answer is -

Special Purpose Acquisition Companies (SPACs)
seem to be a strong alternative. That said, expert opinions about them tend to be very polar. Which is what makes them an interesting subject for this essay.

But hey, What exactly is a SPAC?

  • A SPAC or a blank check company is basically a corporate shell company that is sponsored by a well-known investor.
  • A SPAC is almost always a publicly listed entity, with a single purpose โ€“ to find a private company and merge with it.
  • When a SPAC merges with a target company, the shares of the two companies become one; therefore, the merger immediately makes the target company public. As a result, the private company goes public without an IPO.

Interested to know more about SPACs?
Stay tuned for our next article โ€˜PART 2 - SPAC: A fortune cookie with a unicorn in itโ€™, where we discuss and cover every facet of SPACs in detail!

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By

Kristal Private Markets

September 13, 2022

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