One of the less familiar terms to enter the language of investing in the past couple of years is SPAC (pronounced “spack”) – an acronym for Special Purpose Acquisition Company.

SPACs are potentially hazardous; they require substantial study before buying shares. They aren’t new, they’ve been around – though used infrequently – for the past 40 years. SPACs are simply cash-rich, publicly owned companies, meaning their shares trade on public exchanges, that exist for only one reason, to buy a single other company, usually a privately owned company.  Some refer to SPACs as shell companies or blank check vehicles.

 

Here’s how  SPACs work.

A group of investors – often called “founders” – pools a large amount of cash and registers the SPAC with the Securities and Exchange Commission. The founders might be experienced business executives, sports figures, hedge fund managers, entertainment personalities, entrepreneurs, etc., all coming together for one purpose. The founders’ goal, once the SEC approves the SPAC, is to acquire a company that is then absorbed into the publicly traded entity (i.e. the SPAC), sometimes with a new name.

 

SPACs Advantages and Disadvantages

SPACs offer advantages and disadvantages for the ordinary investor and for the founders of the SPAC. As an ordinary investor, you may be buying a company “blind,” without knowing much about it or its prospects for growth. You (and your money) could be waiting for up to two years for the SPAC to absorb a private company. On the other hand, you might be getting in on the ground floor of a unique investment opportunity that otherwise would be hard to accomplish via an ordinary IPO, whose shares are grabbed quickly when they’re cheap and often rise in price swiftly.

In a sense, SPACs allow ordinary investors to participate in an activity mainly conducted by private equity funds. Private equity funds specialize in raising money from usually well-heeled investors; then they identify and acquire private companies with great growth potential.

Any private company that wishes to raise money in public markets can apply to the SEC for an initial public offering (IPO) of common stock. The IPO process – in contrast to SPACs – tends to be time-consuming, costly and requires substantial documentation and copious legal and accounting opinions verifying the IPO’s credibility and fairness to potential investors. On the other hand, you the investor know what you’re buying up front.

Becoming a SPAC is much quicker, cheaper and simpler than the IPO route – as well as being disproportionately reliant on the reputation and skills of the founders. The founders simply must disclose their intention to use the proceeds of the SPAC shares sold to the public to buy a company and operate the merged entity as a publicly traded company.

 

SEC rule for SPACs

Under the terms set down by the SEC, the SPAC must buy a company within two years or return the SPAC’s cash to shareholders. Most frequently, SPAC shares are priced arbitrarily at $10 a share. Accordingly, if the SPAC is capitalized with $300 million, 30 million shares, more or less, will be created. Typically, founders will hold 20% of the SPAC’s shares with the rest offered to outside investors.

In 2020, a year marked by the flourishing of SPACs, more than $80 billion was used to create more than 200 SPACs, which sometimes are called “blank check” companies.

Once the SPAC becomes a public company, the company’s shares, as well as warrants awarded to founders to buy additional shares, begin trading on public markets. But the SPAC doesn’t yet have financial results since it won’t become an operating company unless and until it buys a company.

Trading in warrants can be significant and holders of common shares should monitor this closely. If, for example, a warrant allowed a founder to buy additional common shares at, say, $12.50 each, they might become extremely important if the price of common shares rose to, say, $20 – with additional shares adding to the dilution of the common stock.

Under SPAC rules, a company bought by the SPAC must have a fair market value of at least 80% of the money deposited with the SPAC at its founding. Thus, a SPAC founded with $300 million must buy a company whose value is at least $240 million.

 

SPAC investing can be very risky – or very rewarding.

What it requires is close study and sharpening of the financial skills already in use if you are a committed and knowledgeable investor in equities.

Learn More About BetterInvesting
 

Doron Levin is the Editor of BetterInvesting Magazine.  His lengthy career includes writing about business and economic subjects for The Wall Street Journal, New York Times, Detroit Free Press and Bloomberg. He is the author of two books and an acknowledged expert on the world automotive industry.

Sample Our Resources Open House Get Your Resources