SPAC sponsors raised billions this year to bring U.S. private companies public. What might that mean for your business?
Steve Faulkner, Head of Private Business Advisory
Andrew Oshman, Executive Director, Private Business Advisory
The number of Special Purpose Acquisition Companies (SPACs) in the United States has increased rapidly—and the financial world is taking notice.
In the first quarter of this year alone, 291 SPACs (or “blank-check” companies) went public, collectively raising $95 billion. That’s more than the 231 SPACs raised in all of 2020, itself a record year with $81 billion in proceeds. By the end of the first quarter of 2021, another 241 SPACs were publicly on file. 1
Then the market ran into headwinds in the second quarter and the pace of SPAC IPOs dropped precipitously. Only 14 new SPACs have gone public, raising $4 billion, in the second quarter through May 7. Still, SPACs remain active today, with 407 SPACs representing $135 billion of capital looking for targets as of May 7. 2
In their race to find good targets, SPACs are widening their search beyond young, unprofitable companies and looking at closely held businesses (founder-led and family-owned) that have a record of strong earnings and good growth. 3
Could that target be your business?
If you’re seeking to capitalize on a SPAC opportunity, you’ll want the right advisors and insights.4 Here is a good start, with five things to consider when assessing a SPAC’s viability:
1. Be ready to move fast
SPAC targets go public at a speed that’s both an opportunity and a challenge. For example, targets do not have to go through Securities and Exchange Commission (SEC) review of an IPO registration statement. Though eventually you will have to file a proxy statement or Form S-4 (before shareholders vote), and a Form 8-K after closing. Your business will be more attractive to SPAC sponsors if you are prepared with:
- Audited financial statements—two or more years in accordance with Public Company Accounting Oversight Board (PCAOB) standards, plus interim financial statements. As most private companies don’t have PCAOB-compliant audits, this more comprehensive audit is a crucial first-step
- Management discussion and analysis (MD&A)—addressing financial projections (unique to SPACs), compliance, operating risks, personnel, future plans, as well as organic and inorganic growth strategies
- Robust governance—by an actively engaged board of directors and a culture of collaboration; SPACs often seek one to two board seats and help select the combined Company board
- Sophisticated advisors—including investment bankers, tax advisors and deal counsel who understand the requirements and complexities of the SPAC process
2. Know what SPAC sponsors want
Market terms and considerations are evolving quickly as the SPAC market gets more heated. Among qualities attractive to SPAC sponsors and investors:
- Valuation—The enterprise value of the business needs to be large enough to support a capital raise of between $200 million and $500 million; also, the ratio of enterprise value to SPAC IPO proceeds has been increasing, currently implying enterprise values of $1 billion to $3+ billion
- Sector—Higher-growth businesses in industries with perceived long-term value, such as tech, electric vehicle, healthcare and industrials, are the bulk of recently completed SPAC mergers.
- Management—SPACs look for a deep management bench capable of handling their company’s day-to-day operations, while simultaneously qualifying and selecting a SPAC partner; raising private investment in public equity (PIPE) capital; responding to SEC filing requirements; and participating in the de-SPACing process.5
- Controls—To operate as a public company, the business will need strong controls and internal reporting capabilities as well as a smooth-functioning investor relations effort
3. Stoke competition among SPAC sponsors
Increasingly, target companies and their advisors aim to spark competition among SPAC sponsors to reduce the sponsor’s dilutive impact on the IPO proceeds, negotiate the most accretive terms possible, find the best cultural fit and, importantly, increase the odds of a successful de-SPAC.
Signs that these so-called “SPAC-offs” are working:
- The shrinking number of warrants given as kickers to encourage sponsors and investors to invest in the SPAC
- Adding multi-year vesting schedules and/or requiring minimum share price targets for a portion of the sponsor’s incentive equity
- Offering earn-out shares to target shareholders, reducing dilution if the share price performs
While sponsors have earned mixed reviews on their additive value, there is now a flight to quality with market reputation, committed capital and prior industry expertise having a measurable effect on valuation and deal success.6
4. Understand why PIPEs are key
PIPE7 investments are included in almost every transaction to validate the valuation, generate additional committed proceeds and provide a more stable shareholder base.
In the past, PIPEs were frequently raised after the SPAC and target agreed on transaction terms. Increasingly, these investments are being negotiated concurrently and improve the odds of a successful de-SPAC. Because most target shareholders roll equity forward and own 60% to 80% of the resulting company, these structural changes have inured to their benefit. It also demonstrates why careful selection of partners and alignment of interests are key to minimizing risk and preserving value.
5. Proceed with caution
If you decide to move forward, proceed with care as the devil is in the details, for example:
- Exclusivity—SPACs typically seek a 30–60 day exclusivity period to negotiate definitive agreements and raise the PIPE. The exclusivity should be mutual to ensure the SPAC is not negotiating with another target
- Stock performance—In many instances, target shareholders roll 100% of their equity into the public company, and don’t receive cash proceeds at closing. Targets are subject to a lock-up of at least 180 days; sponsors, typically for one year. Ideally, sponsors should be locked-up for the same or longer period than target sellers. PIPE investors are free to trade following the effectiveness of a registration statement covering their shares. Some SPACs feature an early release of a portion of the shares if the stock price hits certain milestones
- Earn-out provisions—Similar to earn-outs in other transactions, the share price of the public company’s stock must trade above a threshold for a specified period of time or you forfeit shares. 45% of recent de-SPACs included a seller earn-out, representing 7% of shares outstanding on average8
- SPAC pops—The decline in one-day price reactions for deals announced in 2021 (modestly positive) vs. 2020 (up 30%+) has made PIPE investors more sensitive to valuations, often causing purchase price re-negotiations prior to deal announcements
- Careful planning—Stay focused on the end game and retain seasoned tax advisors to guide you so that you arrive at a desired outcome:
Consideration of the seller’s entity tax status and the form of the proposed merger structure is necessary to negotiate a tax-free merger that defers gains on any rollover equity until disposition
Targets organized as a partnership or LLC may want to explore a Tax Receivable Agreement, in which the target shareholders typically receive 85% of the tax benefits from the step-up in basis of operating company assets when shares of the target are converted into shares of the new public entity
A SPAC is not a qualified small business. So, where applicable, only the gain accrued before the SPAC merger took place is eligible for Qualified Small Business Stock (QSBS) treatment when the gain is later realized. Target shareholders eligible under Section 1202 of the Internal Revenue Code should consult with their advisors about the impact of a SPAC compared to other alternatives and evaluate pre-transaction wealth transfer stacking opportunities to maximize QSBS savings
- Evaluate the risks and costs—Sellers incur substantial deal expenses in preparing for a SPAC transaction. Additionally, information that previously was private, including revenues, margins and projections, will be disclosed during due diligence and in regulatory filings
We can help
SPAC IPOs are only one avenue to greater liquidity and capital. A multitude of factors are driving the current M&A frenzy: low interest rates, high multiples, record levels of accumulated capital in search of assets, and a recognition that higher U.S. tax rates, both corporate and personal, are likely to increase in 2022. In addition, the pandemic has heightened business owners’ awareness of their exposure to known and unknown risks.
With the right advisors and careful preparation, business owners should feel confident assessing the viability of a SPAC if and when the opportunity presents. Your J.P. Morgan team is here to help.
2 These headwinds were likely a result of regulatory concerns, as well as the broader market pullback in growth stocks and longer-duration risk assets since SPACs are typically highly correlated with these assets.
3 While past performance is no guarantee of future results, and recognizing that SPACs as an asset class have traditionally underperformed other IPOs and the Russell 2000 Growth Index, the current SPAC boom is being fueled by higher quality sponsors and targets, with strong post-announcement performance.
4 JP Morgan’s Corporate Investment Bank and Private Bank work closely with target businesses and their owners to investigate the opportunity and guide them through a potential SPAC process.
5 The stage after the execution of a definitive agreement and before the actual combination of the public entity with the target operating company.
7 In PIPE transactions, institutional or accredited investors buy stock directly from a public company at a discount to the fully distributed market price.
8 Sources: Company filings, Dealogic and J.P. Morgan SPAC database.