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Why IPO 2.0 is a go

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Today’s post is the second of a series on special purpose acquisition companies (SPACs). Find part one here. 

I am extending this series beyond its original two parts. Lots of cool stuff here!

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The IPO as we know it is dying.

Whenever we see a traditional IPO, the stock price pops. It gets us tweeting. It gives us FOMO. Most importantly for the bank, it makes their clients (that bought the pre-IPO stock) richer.

Banks intentionally design this to happen. I imagine them celebrating the wealth arbitrage like this:

Yet this arbitrage is daylight robbery of the very companies that go public. As lead anti-IPO crusader (and prolific tech investor), Bill Gurley, points out: 

Bill Gurley @bgurley

Everyone needs to realize this unneeded wealth transfer comes straight out of the pockets of employees, founders, & investors. That "pop" you hear is money going out of your pocket and into the hands of the bank's best brokerage clients. Market pricing & open access solve this.

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Today we are going to learn why are SPACs becoming a thing?

We know SPAC IPOs are beginning to rival traditional ones.

But why? 

It comes down to the experience and incentives.

All three stakeholders of a SPAC IPO (companies, lead investors, banks) can have equal or better experiences with a SPAC than a traditional IPO.

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We’ll get into each of them, but first, a SPAC fun fact:

Blank check’s checkered past

Blank check companies aren’t new, they were just laying low. They have a checkered past (ba dum tss). In the 1980s they were used used in thousands of penny stock fraud schemes.

The government clamped down hard with legislation: the Penny Stock Reform Act of 1990 and SEC rule 419. In the early 1990s, there were fewer than fifteen blank check offerings.

In 1992, a new form of blank check company was developed. The aim was to have enough investor protections to be approved by the Securities and Exchange Commission (SEC). This new entity was the SPAC.

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All major stakeholders benefit from a SPAC. Let’s dig in:

Clear expectations for companies 

Companies are the main beneficiaries of a SPAC IPO. Compared to a traditional IPO, SPACs provide companies:

• Security during volatile times (like today)

• Clear pricing

• Straightforward IPO process

In DJ Khaled speak, companies look at SPACs like this:

Security

Now these improvements happened 25+ years ago. Why are SPACs only taking off now? 

In bull markets, there’s no desire to seek better options. Let the good times roll.

The pandemic brought along a wave of uncertainty and the market got spooked!

SPACs provide a more secure, alternative route of going public. The Wall Street Journal explains why, with an added commentary from Nikola:

Getting an IPO done began to look uncertain as markets tumbled, recalled Nikola Chief Financial Officer Kim Brady. With a typical IPO, a company learns how much capital it is raising only after several months of wrangling with underwriters and investors. It can also fall through at the last minute, especially if markets slide. A SPAC deal [M&A] can take a similar time to complete, but the negotiations are simpler—involving the company and the SPAC—and the terms are determined earlier in the process.

Nikola unveiled its tie-up with VectoIQ in March and completed the deal last month. Its valuation has since soared to $19.5 billion.

“We chose the SPAC route because there was simply too much uncertainty in the market with the coronavirus,” Mr. Brady said in an interview. “If we had pursued the IPO path, we would not be a public company at this point.”

Clear pricing

The pricing process of traditional IPOs infuriates companies. Not only do they leave money on the table (the IPO pop), the whole process is a pain. As Nikola’s CFO noted above, SPACs provide companies more control and clarity on the price.

Bill Gurley @bgurley

Article misses the key issue. With IPOs being underpriced by 80% on average this year, the SPAC now offers a lower cost of capital. https://t.co/TdNJB29Ox0

The Wall Street Journal @WSJ

Fallout from the coronavirus has fueled interest in an investment vehicle with a shaky reputation: the blank-check company https://t.co/gsfeNywQNp

Straightforward process

SPAC IPOs are much simpler, quicker, and less stressful than traditional IPOs.

In a traditional IPO, a business undergoes a lot of scrutiny. The business has to file an S-1 that requires a host of detailed information: planned use of money, business model, how they are pricing their shares, etc.

With SPACs, it’s straightforward. The SPAC goes public with the ‘pool of money’ part only. This makes SPAC IPO nowhere near as scrutinized. How do you scrutinize cash?

Once the M&A is done, a less painful SEC disclosure is required.

Investor friendly

Major investors (sponsors) are incentivized to start SPACs. Namely, until the target company is M&A’d, sponsors can park their money in high upside, low downside ways.

Upside

There are two benefits for SPAC sponsors by going public. First, they get tons of leverage. Typically a SPAC sponsor funds 2% of the vehicle, and public investors fund 98%. This helps the sponsor buy bigger companies. 

Second, in exchange for running the SPAC, sponsors get 20% of the SPAC for almost free!

Downside

There’s minimal downside for sponsors. The money sits in a bank account while they search for a target. If they don’t find one, or the deal doesn’t go through, investors get their money back (minus bank fees). 

In a world of excess capital, what’s not to love?

Banks still make bank

Banks complete the SPAC stakeholder no-brainer trifecta.

To underwrite a traditional IPO, banks charge 3-7% of the amount up for sale. For example, if a company is selling $1B worth of equity, the bank can take in $30-70M. That’s a good chunk of money!

Fortunately for them, SPAC IPO bank fees are in the same range. According to Gig Capital, a SPAC expert:

The SPAC entity sponsors typically pay a 2% underwriting fee at the time of the SPAC IPO, with an additional 3.5% underwriting fee (i.e. based on the SPAC IPO size) paid by combined company at the completion of merger.

What’s next?

We have a great base on SPACs. We understand what they are, why we should care, and why they are popping off. 

There are a couple interesting questions to still explore. Specifically:

• What makes some SPACs succeed vs fail?

• How do SPACs differ from IPOs and direct listings?

• What’s the future of SPACs?

Are you still curious about SPACs? What more do you want me to explore? I’d love to hear from you! Simply reply to this email.

See you tomorrow,

Anuj

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If you made it this far - what did you think of this post? What else are you curious about SPACs? Did you enjoy the detail? Was it too detailed?

Note: This content is for informational purposes only. It should not be relied upon as legal, business, investment, or tax advice. Your use of the information contained here is at your own risk.