Special purpose acquisition companies (“SPACs”) have been around for decades, but over the last several years they have exploded in popularity. Virgin Galactic, DraftKings, Opendoor, Quantumscape and a host of other companies have all gone public by merging with special purpose acquisition companies rather than taking the traditional initial public offering (“IPO”) route to the public equity markets. Roughly 200 SPACs went public in 2020, raising about $64 billion in total funding, nearly as much as all 2020 traditional IPOs, according to Renaissance Capital.
History and Origin of SPACs
SPACs are descended from the “blank-check companies” of the 1980s which had questionable and negative reputations, to the point where a federal law was passed to crack down on them. Over time, the blank-check company model was adapted into the SPAC structure seen today with critical safeguards to protect investors. Blank-check companies are subject to Rule 419 of the Securities Act, but SPACs are not blank-check companies within the scope of Rule 419 because SPACs have charter restrictions prohibiting them from being “penny stock” issuers. The major differences between SPAC and blank-check companies are that SPAC equity may trade on an exchange prior to the SPAC’s business combination, brokers are not subject to heightened requirements on trades in SPAC securities, and SPACs have a longer time period to complete their business combinations.
What is a SPAC & how do they work?
A SPAC, also sometimes referred to as a shell company, is set up in corporate form, most commonly as Delaware or Cayman corporations. The SPAC is typically formed and launched by a sponsor, whether that be an individual or a firm, and that sponsor participates in the SPAC primarily through a SPAC Sponsor Entity, which is often a Delaware LLC or Cayman entity. Sponsors are typically business executives with deep experience in a particular industry, financial sponsors, such as private investment firms, or a combination. Many SPACs will disclose a particular industry of interest, while others will not place any limitations on the industries in which they may invest. The chart below reflects a very common SPAC organizational structure.
The SPAC is formed with the goal of conducting a traditional IPO for the purpose of (1) raising capital into the shell entity (the “SPAC IPO”) and (2) subsequently using that capital to acquire or merge with a business after the IPO (the “initial business combination” or “deSPAC” transaction). The acquisition cannot be identified, and inquiries from potential targets must be turned away, until after the IPO closes. The SPAC typically has up to 24 months to identify a company for acquisition.
Upon formation, the SPAC Sponsor Entity (or “SSE”) purchases founder shares in the SPAC for a nominal seed amount of, for example, $25,000. The founder shares initially amount to 20% of the total SPAC shares outstanding, or 25% of the common shares sold as part of the Class A unit sale to the IPO investors. The SSE also agrees to purchase warrants at the time of the IPO. The purchase price is typically designed as a function of the underwriter fees due to the investment bank conducting the IPO and may also include an amount needed for working capital. Notably, the purchase price for the warrants seems to have nothing to do with their theoretical value under any sort of standard valuation model, and everything to do with the capital needed to pay the investment bank and meet working capital requirements.
The capital proceeds from the SPAC IPO are held in a trust account during the searching period and then deployed if and when an acquisition is approved and consummated. If the SPAC does not make an acquisition within the 24-month period, all capital remaining in the trust (the IPO proceeds, plus interest income, net of relatively minor operating costs) must be returned to the shareholders. In the SPAC IPO, investors typically pay $10.00 for a “Class A Unit.” This unit is typically structured to include one share of common stock and a full or partial warrant with an exercise price of $11.50. Warrants typically become exercisable after the de-SPAC transaction and may expire after a defined number of years. The Class A Units generally trade by themselves until 52 days following the IPO, at which time they are split into the common shares and warrants. At that point, investors are able to purchase the Class A units, the common stock or the warrants.
As stated earlier, SPACs generally have two years to search for a company with which to merge or acquire, bringing the private company public in the process. When a SPAC identifies a company for acquisition, they make a public announcement and, generally, the acquisition will need to be put to a vote of the SPAC shareholders through a traditional proxy process. A separate feature available to SPAC shareholders is the ability to redeem (irrespective of whether they vote for or against the acquisition) their shares and receive in return their pro-rata share of the assets in the trust. This is an incredibly investor-friendly feature, in that the SPAC shareholders have the right to see the proposed deal and decide whether they find it prudent to stay invested or redeem, limiting downside during this part of the process. In addition, SPAC investors may retain the warrants even if they redeem the stock.
From the perspective of the SPAC sponsor, the redemption feature is a significant risk. If a large number of investors redeem, which is not uncommon, the trust could shrink to a point that makes the proposed merger difficult. There are typically features in the SPAC structure that limit the convertibility of the founder shares to no more than 20% of the total shares sold in the SPAC IPO, net of redeemed shares. As a way of mitigating the risk of the deal falling apart due to redemptions, sponsors have started to pre-arrange alternative sources of financing that can be tapped if needed. This is an attractive feature for sellers to SPACs, who want to be assured that the financing for the deal is in place.
In some cases, depending on the size of the acquisition, the SPAC may need to raise additional capital, regardless of the level of redemptions, via committed debt or equity financing via a private investment in public equity (“PIPE”) commitment.
If shareholder approval is received, the merger transaction closes, commencing the so-called de-SPAC process. The SPAC shareholders who elected to retain their shares will have their SPAC shares swapped into shares of the newly merged company.
Why have SPACs become increasingly popular?
For the owners of a privately held company thinking of going public, selling to a SPAC is far easier than conducting a traditional IPO. For the seller, the process of getting to the public markets is easier through a SPAC, takes less time, is less expensive, contains fewer regulatory hurdles, and contains more price certainty – the seller has greater influence on deal negotiations than they would otherwise have within a traditional IPO pricing process. The merger is conducted within the SEC’s S-4 process, rather than the S-1 process. The S-4 process allows for the parties to put forth financial projections, an aspect that is prohibited in the S-1 process and may make the SPAC route a better candidate for earlier stage companies.
In many cases, the owners see the opportunity to strategically partner with a financial sponsor or industry veteran to transition or scale the business.
For the individual investor buying into a SPAC, there is more certainty and security than buying into a traditional IPO because, as described earlier, they have the opportunity to review the proposed deal and redeem if they dislike it.
It is also reasonable to hypothesize that the COVID-19 pandemic has accelerated the evolution of the SPAC market. During the pandemic in 2020, traditional IPO road shows were simply not possible.
Estate Planning Considerations
It has become increasingly common for wealth, tax, and legal advisors to receive inquiries from clients that own interests in the SPAC organizational structure. Unique estate planning opportunities may exist for individuals that own equity in the SPAC Sponsor Entity before the SPAC IPO or before the de-SPAC transaction. Opportunities may also exist later in the process.
For those clients who are the founders and sponsors, and own equity in the SPAC Sponsor Entity, a significant estate planning opportunity may exist. This opportunity exists because at formation, the value of the SPAC Sponsor Entity is relatively low and is similar to an out-of-the-money call option or a private equity promote, in that there is no intrinsic value, but there is significant upside should the underlying SPAC successfully conduct an IPO, identify a target company, and consummate a merger. The result could be that the SPAC Sponsor owns up to 20% of the equity of the de-SPAC’d entity. Sponsors must consider that if they don’t engage in estate planning, their estate tax exposure may greatly increase should the SPAC succeed.
Since a significant number of events must occur between formation and the de-SPAC transaction, numerous risk adjustments and discounts apply when valuing the equity in the SPAC Sponsor. In addition to those risks already stated, risks include the ability for shareholders in the SPAC to redeem shares if they dislike the proposed acquisition, and uncertainty surrounding the terms of the merger. Recall that the target company will negotiate a merger transaction with the SPAC. In the context of that negotiation, it is not uncommon for the SPAC Sponsor to concede a restructuring of their equity position in the SPAC such that they end up with a lower ownership percentage in the merged company (lower than 20%). One can imagine that to the extent SPACs are competing for the same mergers, especially mergers where sellers are rolling equity into the deal, one form of competition is to restructure the SPAC Sponsor Equity to reduce the “equity allocation” to the SPAC Sponsor.
If wealth transfer planning is conducted early in the life of a SPAC, a natural topic of discussion will be valuation. If planning is conducted prior to the SPAC IPO, sponsors may question the need for an appraisal and may believe that their indirect interest in the founder shares and warrants held through the SSE are either worth the nominal $25,000 they capitalized the SSE with or are worthless. While this belief might be supportable for some sponsors, it will likely be untrue for many clients, especially those with lengthy track records of success in a particular industry or institutional-grade asset managers that have expanded into the SPAC arena. For many clients, it will be necessary to obtain a qualified appraisal from a credentialed appraiser to determine the value of the SSE for transfer tax purposes.
The valuation process can be categorized as an elaborate probability analysis combined with a discounted cash flow exercise. Discounts for lack of control and lack of marketability are likely to apply, especially for those transfer transactions conducted well in advance of the de-SPAC transaction. The result will be a determination of fair market value that is consistent with federal transfer tax laws and regulations. Attaching the qualified appraisal with a federal gift tax return should run the statute of limitations and be subject to scrutiny for a limited period of three years. The probability analysis can be likened to a decision tree approach, as shown below.
As indicated herein, once SPACs are formed, the public offering can be consummated relatively quickly. There are numerous milestones in the life of a SPAC, each milestone may change the valuation conclusion, and the milestones can come quickly. Thus, it is important to engage the client and all relevant advisors early in the process. This will allow for timely planning decisions, giving the client the best opportunity for the most effective and efficient plan. The longer a client waits in the lifespan of a SPAC before implementing a transaction, the more likely the effectiveness of a tax planning strategy will be dampened.
Close collaboration among a client’s advisors is advised when implementing any estate planning strategy. The professional team at MPI encourages you to leverage our resources and take advantage of our eight decades of institutional knowledge and our experience with SPACs as you contemplate wealth transfer planning and valuation matters.
MPI, a national consulting firm founded in 1939, specializes in business valuation, forensic accounting, litigation support and corporate advisory work. MPI conducts every project as if it is going to face the highest level of scrutiny, and its senior professionals have extensive experience presenting and defending work product in front of financial statement auditors, management teams, corporate boards and fiduciaries, the IRS, other government agencies, and in various courts. Contact us for more information on our valuation and advisory services.
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 Article – Harvard Law School Forum on Corporate Governance – Special Purpose Acquisition Companies: An Introduction – 7/6/18