Special Purpose Acquisition Companies (SPACs): The IPO Alternative

Special Purpose Acquisition Companies (SPACs) are looked at as an alternative to IPOs but there are many details associated. How does it work? Can a regular investor gain exposure to them? Do the pros outweigh the cons? In today’s episode discuss all of that in more.

Summary – Cents of Security Podcasts Ep. 103

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement 

Welcome back to the Cents of Security Podcast. I’m Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers, and today I’m your host for the podcast. Our guest is Caleb Silver, Editor in Chief at Investopedia and host of Investopedia Express, a podcast that comes out every Monday. 

Special purpose acquisition companies, or SPACs, are looked at as an alternative to IPOs — but are there many details associated that differ from IPOs? How do they work? Can a regular investor gain exposure? What about the pros and cons? In today’s episode, we’re going to discuss all of that and more. Welcome back to the program, Caleb. 

Caleb Silver 

Nice to be with you. 

Cassidy Clement 

Yeah, so as always, we’re gonna delve into some of the core market hot topics, I guess you could say. So a lot of things that are happening lately — there are new IPOs entering the scene all the time, but now with many talks of inflation, different types of economic environments, and then of course people looking to other places to put their money. 

SPACs have come — I don’t want to say back into fashion — but back into the spotlight. So what exactly is a special purpose acquisition company, and how does it work? 

Caleb Silver 

You said it — it’s a special purpose acquisition company, but we often refer to them as blank check companies. These are companies that really have no commercial operations, but they’re formed strictly to raise capital through an initial public offering so that they can acquire or merge with another company. 

Sometimes that other company wants to go public — this is a vehicle for companies to hit the public markets without going through a traditional initial public offering. And they come and go in terms of popularity. They were super popular in 2021. They’ve come back into fashion a little bit, and some prominent companies have been formed through SPACs. 

That said, they are nowhere near the scale of initial public offerings that we usually see in the capital markets. 

Cassidy Clement 

So when it comes to their operation, somebody may think out of the definitions or just general research that it may operate almost like a shell company, or maybe similar to a VC firm where it’s injecting capital. What exactly are the dynamics or the structure of how these operate and how they go from a group to actually funding a company that then launches? 

Caleb Silver 

Yeah, there is a whole process that SPACs have to go through before they actually become public or acquire a company and then go public together. So they are a little bit like venture capital in that money is raised — but it’s raised for the sole purpose of acquiring another company and going public, versus venture capital, which can sometimes be offering investments to companies, whether it’s at the seed level or a much more mature level so that they can grow their business or expand — and not necessarily go public. 

But the whole point of a SPAC is to become a public company and do it in a much more efficient, cost-effective way than a traditional IPO — initial public offering — which generally requires what we call a roadshow: taking the investment book on the road to various investors to try to raise money to commit to buying shares before the company goes public. 

A SPAC doesn’t do that at all. It actually is a blank check company — it has the money it gathers from investors and then goes to seek a company to take public through the special acquisition vehicle. So the process is: the money is raised through a group of investors; they identify a potential target to acquire and go public with. But they have to spend that money usually within an 18- to 24-month period, or return it to investors if they don’t find a company and don’t take it public. That, usually again, is returned to investors. 

So it’s got that one sole purpose in life. It’s not there to necessarily grow the business. It’s not necessarily to spread its investments. It is there to enter the public markets through the special vehicle. So there are periods of time where investors are searching for the right company to acquire. Finally, when they do, they make their declaration that they’ll take it public, and then the public offering is very different from an initial public offering. 

Usually you see those at the high-profile exchanges like the New York Stock Exchange or the NASDAQ MarketSite. SPACs don’t necessarily have that at all. It acquires the company and goes public through that transition — without a bunch of hoopla — but then it becomes publicly available to investors. 

Cassidy Clement 

Yeah, it’s interesting because the way that the mission or the goals are accomplished — like you said — it’s a lot more, I don’t want to say stringent, but straightforward. The goal is: we’re going to find something that we’re going to eventually take public, and then at some point the actual public start to invest in it in more of the traditional sense. 

And when I was doing my research, there were a lot of companies that had come up that I had no idea were initially part of a SPAC. The first two that I recognized were DraftKings and Rover. As a dog owner, Rover’s a popular one if you’re looking for dog-sitting services or dog walkers. 

Are there other examples of SPACs that listeners may be familiar with — or actually surprised — that brought really well-known companies into business today? 

Caleb Silver 

Yeah, one that they might be very familiar with is the Trump Media and Technology Company that is principally controlled by President Donald Trump. That actually went public through a SPAC, and that was announced back a couple of years ago — 2021 — merging with Truth Social to take it public. 

That is a classic example of a SPAC company still out there today. It is the parent company of Truth Social. It’s also spinning off some other companies within that, including a decentralized finance company. 

But Virgin Galactic — another company that was taken public through a SPAC — through venture capitalist, actually, Chamath Palihapitiya’s SPAC, Social Capital Hedosophia. SoFi Holdings bought a 49% stake in Virgin Galactic and then eventually took it public through a special purpose acquisition vehicle. 

You mentioned DraftKings, the popular gaming company. Those are companies your listeners may have heard of in the past. 

Cassidy Clement 

It’s interesting because you recognize — at least I’ll speak for everyone here — you hear those names and you think, “Oh, okay, I’m familiar with their service or their products,” and I’m familiar with maybe their tickers or their financial performance as they get spoken about all the time in financial commentary. 

But there can be some confusion with how people could invest in them once they are out on the market, versus when they are acquired by a SPAC. So how exactly does that work? Are there people behind it funding that SPAC to then buy something else? Or is it a collective group of funds? 

How exactly does it get there from investor on the private side to investor on the public side? 

Caleb Silver 

Yeah, in the initial stages, it’s only the internal investors behind the special purpose acquisition company — behind what we call the shell company — that have access to the investment. They raise a certain amount of money — call it a hundred million dollars — to go out and acquire a company and take it public through their SPAC. 

So that’s the insiders only, right? Outside investors are not typically invited into that until the company goes public. And once it becomes public and is traded on a public exchange, then we all have access to it. We can look at the ticker every day, we can track the price, we can access it. But it’s very different in that it’s not necessarily backed by the same sort of ruthlessness and scrutiny that IPOs generally go through. 

It’s a much faster, more efficient way of going public — but there are oftentimes, and I mentioned a couple of companies, that are being taken public that have really poor financial performance, and this is one way to get them to the public markets and avoid that scrutiny. But what happens when they become public is in the hands of public investors. 

Cassidy Clement 

When we’re thinking about SPACs and the actual makeup of a company, I guess the first thing that most people would think of is, okay, it’s a little bit quicker, and there could be a little bit more of a liquidity injection or additional capital at the fingertips of those at the company. But what exactly are the pros and cons of actually doing this as a company? 

Because it is more of an accelerated process than a standard-issue IPO that then eventually will yield some type of capital to help your company grow. 

Caleb Silver 

Yeah, the difference is that sometimes these companies couldn’t get public through traditional means, and it’s because either they have poor financial performance, they don’t have a long track record necessarily, or they’re in a super competitive market. Or the initial public offering market just might be closed for one reason or another — maybe it’s a time of volatility in the stock market. Not usually a great time to go public. Investors are not willing to take risk. 

So this is a way to avoid risk concerns that generally surround IPOs and take a company public. But again, once you’re public, then you are at the mercy of public investors and public shareholders. 

Also, pricing in IPOs — or pricing for SPACs, I should say — is very different than IPOs. In an initial public offering, investors are taking that company and its books out onto the road — what we call a roadshow — presenting it to investors. They’re trying to gather a commitment of investors who will be a part of the initial public offering. And in doing so, they set what they think is the right share price target or range in which to price their shares the day that company goes public. 

That’s an initial public offering. That’s all based on demand. 

In a SPAC, you don’t have all that demand. You haven’t built that demand through a roadshow. You have your money, you’ve acquired the company that you want to go public with, and then units or shares are typically priced at $10 a share out of the gate. Then they’re set public — and what happens after that, again, is in the hands of public investors who want to either buy or sell that stock, or hold it. 

So you have a set share price — typically around $10 a share, or a “unit” as they call it for a SPAC — versus an IPO, which could have a range. And you’ve probably heard about initial public offerings where a company might price above the range that investors had expected because demand for that stock, once it goes public, is so strong. 

You don’t get that with SPACs necessarily. They come to the public markets, and they can be bought through simple market orders or stop or limit orders just like any other stock. But they don’t have that pent-up demand like a lot of the IPOs generally have. 

Cassidy Clement 

There seems to be a little bit more of a narrower scope when it comes to the financial due diligence or the statement creations — more the financial reporting — within that time for a SPAC that has merged to actually take into the public. Are there certain types of business valuations or metrics that are looked at a little bit more intensely when it comes to SPACs as opposed to IPOs, just because it’s a bit more of an accelerated path? 

Caleb Silver 

Yeah, you often find companies that are pre-profit. Maybe they have revenue, but they haven’t necessarily made a profit. Those are classic examples of companies that might be wrapped up into a SPAC to go public, just ’cause they don’t have the financial performance that an investor in an IPO might want to see over time. 

So sometimes it’s a newer company. Sometimes it’s a company in an emerging space where the market hasn’t really been defined so much for that type of business. 

Also, when you think about sports betting — DraftKings entered the public markets through a SPAC at a time where a lot of the betting sites and betting service sites were starting to become more popular with sports bets. And that was right during the pandemic when we were all locked down. So sometimes a company emerges from a space or a market that is just taking off. Sports betting is a good example of that — so are EVs — and you see a lot of companies go public through that type of SPAC in those types of environments. 

So there’s that. And there’s also the fact that you get a lot of dilution in SPACs. The investors who brought the company public through the SPAC take a big percentage of the shares when they take that company public. So as an investor in the public markets trying to buy into a SPAC after it goes public, you’re buying a stock that has been heavily diluted by its original investors. 

Cassidy Clement 

So since you have a lot of the original investors from the SPAC perspective gaining a lot of those shares, is there any type of shortfalls that may come from potential redemptions or from larger forces — like quicker sell-offs — when it comes to these types of things? 

The only reason I’m asking is I’m thinking about some of these — you mentioned sports betting — but because a lot of these areas are emerging markets, not from the potential of a country, but new, let’s say, AI or something like that… something along those lines where it’s newer. 

Is there something that needs to be considered — a little bit more of the details — that people should really look into when they’re considering one of these companies that came out of a SPAC, because it’s such an emerging area? Or concerns about larger amounts of people getting in just buying the trend? 

Caleb Silver 

Yeah, and investors should be doing their due diligence on any company they buy — whether it came through an initial public offering, whether it’s been on the market for 50 years, or whether it comes public through a SPAC. But as it relates to SPACs, you want to pay attention to the following: 

Who are the investors taking this company public, forming the SPAC? Who are they? What is their track record? Are there other companies that they have taken public through a SPAC or through an initial public offering, and how have those done over time? So what’s their track record, so to speak? 

Because ultimately, you’re betting on management — on that investor’s ability to identify the right company to buy. 

You want to study the industry in which they are making that investment and trying to take the company public through the SPAC. Is there a moat around some of the companies? Do they have a competitive advantage or a disadvantage, given the fact that there might already be big players in the space? 

I mentioned EVs — that’s a super competitive marketplace right now — and going public through a SPAC into that industry can be very challenging. 

But also know that the lock-up period — typically with an initial public offering, a lock-up period where the inside investors can’t sell their stock — can range anywhere from six months to 12 months. In a SPAC, it’s much shorter. It could be three to six months, sometimes even shorter than that. So the investors that brought that company public — the SPAC — might want to get out and cash in on their investment sooner. You may lose a lot of the shareholder base once that happens. So that’s something to pay attention to as well. 

And then, ultimately, you want to look at the general trend with SPACs and their performance. And the reality is: most SPACs don’t trade higher than their initial public offering price six months out, 12 months out — even two to three years. Performance in the public markets is generally not that good. So you want to make that decision as an investor by looking at the overall track record for companies coming public through this method. 

Cassidy Clement 

That’s a really good point about the management perspective, because it’s like looking at a coach with a team — they move from one team to another. What was their performance on the last team? How did they guide people? What type of staff are they bringing in with them? Things of that nature. 

Because with a lot of these — as you said, whether it’s new markets, a new product, something that is pre-profit — there are so many elements that are a little bit unknown. It’s important to look to those guiding the ship to see what the potential track record was — or is going to be — when you’re looking at the pros and cons of the potential investment. 

But you brought up some awesome points today. Thanks for joining us, Caleb. 

Caleb Silver 

Always. 

Cassidy Clement 

Yep. So as always, listeners can learn more about an array of financial topics for free at interactivebrokers.com/campus. Follow us on your favorite podcast network, and feel free to leave us a rating or review. 

Thanks for listening, everyone.