What are SPACs?
A special purpose acquisition company, or SPAC, is fundamentally a “blank check” company formed by existing corporations, or even private investor syndicates for the purpose of raising capital through public markets (IPOs and secondary offerings) so that they can make acquisitions in a specialized sector.
Global macroeconomic conditions which forged during the COVID-19 pandemic, including the relative rise of speculative investor sentiment among traders, in addition to the increase of direct investments from global family offices in technology have very suddenly accelerated M&A activity among SPACs in 2020, particularly in Western capital markets such as in the United States and Canada.
Accessibility to a cornucopia of inexpensive leverage capital has led a growing number of public and private firms to raise private funds for investment in syndication of themed acquisition target groups specific to sectors characterized by high returns, yet subject to tangible momentum for consolidation. These SPACs form management teams under singular holdings groups, overseeing the independent operations of acquired firms.
Due to the recent boom in their usage, similar to the ICO (initial coin offering) boom of 2017, founders considering strategic partnerships, alternatives to raising capital, or exiting their businesses are very likely to encounter plenty of buzz in the news portraying these investment vehicles as optimal or even fool-proof solutions to each.
As a precaution, entrepreneurs and investors alike ought to guard themselves against hearsay, illusion, and the "irrational exuberance" carried by both. The SPAC Hack, as Buttonwood puts it, carries with it a number of spectacular benefits, as well as significant risks.
This is just an endeavour to shed light on some of relative advantages and risks for founders entertaining either M&A or raising capital as paths to growth, or divestment, via the SPAC route.
MAXIMIZING YOUR EXIT
As a company founder, to understand how merging with a SPAC maximizes your exit multiple, all entrepreneurs need do is revisit some very basic principles of corporate finance for public companies, and how initial and secondary public financings work.
Remember that a SPAC is already a public listed acquisitions firm. It retains shares individually priced as a factor of total market capitalization. When you merge with a SPAC, the management team’s intent is to later convert these privately owned shares of your business which they purchased from you into public shares through a secondary or follow-on offering.
Any publicly listed company can technically raise as much public financing as it desires through follow-on share offerings, obviously subsequent to IPO. When private acquisitions take place, publicly listed SPACs sell the private shares which they acquired from you to the general public at a multiple of this private cost, per share. Price per share for this offering is usually set at a rate influenced by a number of factors.
The present market capitalization of the SPAC, and the expected demand for new shares, based on a combination of the stock's trading history and the expected increase in earnings per share which the SPAC will experience due to acquisition of your firm, are two major factors which influence the size of the ratio between the pre-offering price per share, and the same metric post-offering.
A compelling corporate narrative, driven by the SPAC’s marketing of opportunities for its newly acquired holdings through investor relations and PR campaigns, also contributes to a higher offering valuation expressed as price per share.
Following your private sale to the SPAC, but prior to the secondary offering, private shares that you retain or hold in the form of a certificate can be secured under private placement. Think of this private placement as a lockdown of shares at a guaranteed price in line with the private purchase price of your business, which serves as a debt instrument that you own against the SPAC as a security against a fall in public share price post-offering. When the public offering takes place, these shares need not immediately be sold to the public, however.
Alternatively, if your confidence in the offering is great enough, you can simply issue your private shares along with the schedule of the offering on an option basis. Either way, the SPAC sells, or offers the majority of its acquired shares to public investors at a price per share many times greater than that same price prior to the conversion.
In the event of a successful offering, hinging on accurately estimated public demand for shares and consequent pricing on behalf of the investment bank handling the transaction, in which the converted shares are monetized at the intended multiple to their original price under private placement, founders can realize a net gain on their retained shares at least several times greater than the value of the once privately owned shares. The proceeds of these privately owned shares being sold to the general public then line the pockets of the SPAC's shareholders with cash.
Sometimes, SPACs will only use capital raised from an offering to purchase a company. This, however, is generally more difficult to pull off the fewer holdings the SPAC has under management.
When the lockdown period ends, you will be able to sell your privately owned shares back to the SPAC at the increased price of its public shares or 2) direct to public investors, allowing the present market price at the time to dictate the multiple of your delayed cash out.
The monetization multiple realized upon a successful secondary offering essentially compounds to a final sale price at which the founder has sold his privately owned business to the SPAC.
For example, imagine that a founder generating $1MM per year in revenue has exited his business at a 10X revenue multiple through a SPAC, retaining 35% of the business in equity. This translates to an original exit price of $6.5MM.
The 35% of shares retained and secured under private placement are eligible to be sold at public price following the offering. This $3.5MM worth of shares, depending on the growth of the public share price carried by the valuation set by the company at offering, and the public investors' relative concurrence with that valuation, has the potential to balloon into at least several times its value, or more.
In some cases, for businesses in verticals with high net margins and strong growth opportunities, such as tech and SaaS, post-offering to pre-offering share price ratios are set as high as 30:1 by the SPAC. If investors concur with this valuation based on the information made publicly available by the SPAC, in addition to the other aforementioned public valuation factors, this original $3.5MM in equity could be worth over $100MM through a successful offering.
This results in a “final exit multiple” of over 90X the revenue of the selling firm. Obviously, these situations are more rare, but typically entrepreneurs who merge with a strong SPAC with excellent trading history, an engaged investor base, and profitable current holdings, a baseline post-offering to pre-offering valuation ratio hovers around 10:1.
Even if this were the case, in the same scenario, this $3.5MM in equity carried over from the initial acquisition would be optimally monetized at around $35MM: resulting in an over 40X final multiple.
“This sounds too good to be true” is the right response. Hence, why SPACs remain so secretive in their engagements with privately selling firms; it's better for their returns that fewer prospective acquisition targets understand the massive profit potential in the strategy.
APPROACHING SPACs
Because most SPACs, which are essentially publicly traded holdings companies, often employ a private management entity owned by the SPAC to acquire new firms, the selling firm generally remains unaware that the acquiring team intends to monetize the acquisition at a significant return through a public share offering. In fact, most SPACs would prefer to keep things this way, so that they can scoop up strong companies at relatively low multiples compared to their public valuations post-acquisition. This also makes it more likely that a selling firm is referred to such a buyer through an advisor or an investment banker, or is engaged directly by a shareholder. Since SPACs aim to maximize an almost immediate return on their investments, they may first conglomerate a number of privately funded acquisitions before leveraging public funds, increasing the revenue driven multiple for each company under the managed group.
Positive speculative sentiment of short term traders, bolstered by the SPAC’s release of press and other public announcements of acquisitions leading up to public offering, drives these higher returns for SPACs through secondary transactions, potentially unbeknownst to the selling firm until the initial process of private placement. For this reason, selling firms who wish to take advantage of these returns as well, however, must know how to approach and negotiate with SPACs, who largely keep their M&A strategy hidden from sight.
In order to potentially secure a higher overall multiple for the business, a prospective selling firm and its founders must develop connections to investment banking firms who have access to these SPAC shareholders and know their investment criteria. While this step is crucial, founders also require a financial advisor or partner who is capable of engaging a SPAC appropriately and negotiating means by which the founder can benefit from the secondary transaction (the public offering) while maintaining the acquirer’s interest.
If you're an entrepreneur seeking a strategic partner, capital, divestment from day-to-day management, or exit, I'm happy to take any questions you might have and help you develop a strategy which may incorporate engaging a SPAC partner in my network.
Feel free to book a strategy call with me here: https://calendly.com/torro-discovery/b2b_call
Happy Capitalism!
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