What’s a SPAC, part 2: Is going public this way really a good idea for your firm?

Editor’s note: Jim Verdonik and Benji Jones, cofounders of Innovate Capital Law discuss Special Purpose Acquisition Companies (SPACs) – the hottest trend in capital raising. But their focus is on the business implications of SPACs, not the legal.

Article I published Thursday describes the 600% growth of SPACs in 2020. Article 2 describes how to determine whether a SPAC deal is right for your business. Article 3 describes how to choose the right SPAC for your business. Article 4 describes the steps, time schedule and cost for doing a SPAC deal.

JIM: In our last discussion, we discussed the explosive 600% growth of SPACS during 2020 that caused SPAC dry powder to equal or exceed the entire U. S VC industry.

Now let’s talk about what types of companies merged with SPACs to become publicly traded.

BENJI: The explosive growth of SPACs has opened the door to many types of businesses.

JIM: What about start-up companies?

BENJI: Over dozen SPAC deals in 2020 were with pre-revenue companies.

JIM: So, now you can go public without revenue?

BENJI: Well, I didn’t say it was a good idea. I just said that in 2020 the SPAC market was so hot that it included pre-revenue companies that were in hot industries. These included: Richard Branson’s space tourism company Virgin Galactic Holdings Inc. and electric vehicle makers Nikola Motors, Hylliion and Fisker Automotive. Investors are buying pieces of the industry, rather than focusing on company specifics. So, I think a pre-revenue company has to be in a VERY hot space to pull off a SPAC deal.

JIM: I understand biotechnology may be an exception, because biotech companies often become public with little or no revenue based on the progress they are making in clinical trials. Biotech companies need so much capital that public markets are often a better way to lower dilution than doing a big late-stage venture capital round.

But putting aside biotech and the hot electric vehicle industry why wouldn’t it be a good idea for most pre-revenue businesses?

What’s a SPAC? And why are they the hottest deals going on Wall Street?

BENJI: Going public isn’t a problem, but operating a pre-revenue public company creates many problems. How long will investors wait for you to generate revenue or become profitable before they sell their shares and the market price of your shares crashes?

JIM: That’s the big question: Is your business prepared to be successful in public markets? What can you do to prepare your business?

BENJI: Yes. And do you want to invest the effort into creating public market success.

JIM: Public market success sounds great. You get top read about yourself in prestigious business publications. But a lot of people would rather work on business solutions than worrying how to please the market every quarter. And the financial media will magnify every failure in bigger print than your successes.

BENJI: To be, or not to be, public (THAT) is the question. Whether to go public thorough a traditional IPO, a direct listing, a shell company merger of a SPAC merger is secondary.

JIM: We’ve both taken businesses public and we’ve both represented public companies. Yes, being public is expensive and time consuming, but people decide to do it every year. Let’s talk about specific goals you might have for doing a SPAC merger.

What are the goals?

BENJI: Building your brand and reassuring your customers that you are a reliable supplier are reasons businesses become public. Being able to use your stock or to obtain cheap financing to buy other companies is also a benefit of being public, if you are successful in maintaining a high market price for your stock

JIM: Another potential goal is to exit with a pile of cash. If you sell your shares for cash, you don’t have to deal with the challenges of running a public company. Or at least, all your assets aren’t tied up in the stock.

BENJI: Can you sell for cash in a SPAC deal?

JIM: I think of SPACs like the public version of a Private Equity deal. There are four basic pieces.

How much is paid at the merger closing to buy out existing owners
How much cash remains in the post-merger company to operate and grow the business (it’s no fun being a public company that is low on cash),
How much equity of existing target company owners is rolled over into publicly traded equity
when is each player allowed to resell stock after the merger

Most of the negotiation is usually around these four issues.

BENJI: How much of the cash is used to pay owners of the private company?

JIM: That varies from one deal to another. But SPACs are rolling in cash these days. So, often the amount of cash isn’t the biggest issue. You may be able to do an all cash buyout when a lot of cash is chasing a limited number of good deals. Often, the real issue is how much of the cash in the deal is paid to investors in the private company and how much is paid to the target company’s management team.

BENJI: That depends in part on what the venture capital or other investment documents from prior deals provide. Do the VC and other investors have large preference rights to take cash off the top?

JIM: That’s right. But it also depends on market perception. The merger has to be sold to public investors in a way that they think the post-merger company will increase in market value above its current trading price. That’s a tougher sell if they are told that the management team has cashed out.

BENJI: The SPAC market was so hot last year that many of the deals allowed management to take home a lot of cash with very low liability risk, because you aren’t selling to public traders. It will be more difficult if the SPAC market cools off. Then, investors will be more concerned that the management team lacks faith in their business.

JIM: But for several reasons, I like it when the management team gets a nice cash payout at the time of the merger closing. First, it has the benefit of relieving the pressure on management to sell a lot of shares into the post-merger public market after their lock-up agreements expire. That selloff, or the risk that it may occur, often depresses market price in the other ways to go public – traditional IPOs, direct listings or public shell mergers. Another upside is that post-merger sales by management into the market creates potential liability for insider trading. Cash that management receives in the merger has much less liability risk, which makes SPAC deals a safer for management teams to diversify their assets. So, as long as management retains a sufficient number of shares after the merger to incentivize them to grow the business, management getting a nice chunk of cash at the time of the merger closing is a good idea in my book.

BENJI: Another big reason to go public is that raising growth capital from private sources is no picnic. It’s expensive and you often give up control of your company to your financial backers. Public investors pay higher valuations than Venture Capital Investors and Private Equity Funds and the public’s voting control usually isn’t as concentrated as VCs and PE funds. If that wasn’t true, most businesses would remain private. So, SPACs are competing with venture capital funds and private equity funds.

JIM: Competing and collaborating.

Many SPACs are sponsored by people in the Private Equity industry. That’s one reason SPACs have grown so much so quickly. VCs and PE firms make money by buying at private company valuations and reselling at public company valuations.

Private companies are flocking to SPACs to capture the profits VCs and PE firms make in that arbitrage. But PE firms that start SPACs are tapping into new capital sources that want liquidity that traditional PE firms can’t offer. Investors will pay more for a liquid investment than one where their capital is tied up for ten years. I think of SPACs as a more liquid version of Private Equity.

SPACs are also a way for venture capital and private equity funds to achieve profitable exits. The same VC that bemoans losing a good investment opportunity when a company does a SPAC deal is thrilled when a SPAC buys one of its portfolio companies. So, the three types of capital sources sometimes compete with one another and sometimes support one another.

BENJI: OK, that explains how you decide whether doing a SPAC deal is right for your business. So, let’s take a break and discuss in future articles: