Special purpose acquisition companies (SPACs) have been one of the highest-flying tech industry corporate finance tools over the past year. As of November, over 200 SPAC IPOs have raised $69 billion, up from 59 that raised $14 billion last year. Additionally, more than 40 SPACs have merged with another business this year, up from 28 in 2019.
A big selling point for management is the lower cost of doing a SPAC when compared to an initial public offering (IPO). But a recent paper by academics from New York University and Stanford University says that not all the benefits of SPACs are clear, and that sponsors, and investors may be getting a little drunk over the amount of capital pouring into the structures.
FEI Daily spoke with one of the authors of the paper, NYU assistant professor of law Michael Ohlrogge, about how the SPAC phenomenon has grown and why the tech industry is riding the wave of optimism.
FEI Daily: Why is there such a perception that SPACs have lower regulatory hurdles than traditional IPO why is that not the case?
Michael Ohlrogge: I would say that with all great misunderstandings, there's a germ of truth to this notion of lower regulatory hurdles for SPACs.
There are certain advantages. It's easier to make the forward-looking statements if you're going public with a SPAC, as well as include projections and estimates of future earnings. And there is a lower Section 11 liability. So there's sort of a germ of truth to it, but we're skeptical that those advantages are all that big and can fully explain the popularity of SPACs. And certainly, there are many assertions about SPAC regulatory advantages that go well beyond those two issues.
Why are there those misperceptions? I think it's a couple of reasons.
If you think about a SPAC, one of our points in our research is that it's a very expensive way to go public. We've got a sponsor that's taking an initial 20% of the value in the SPAC, but really it ends up being more like 30% given redemptions. We've got warrant holders who are getting another 10% or 12% of the value. And then we've got these underwriting fees, which are paid not just on shares that are sold at the IPO, but then also when those shares get redeemed. And you still have the underwriting fees.
So, it's a very expensive structure to go publicly as SPAC. And if you're running one of these SPACs and you're approaching a company and saying, ‘Hey, you should merge with us.’ The natural question is, well, what is the SPAC doing to justify these really high costs? What's the SPAC doing to justify the sponsor taking 30% of the funds? It starts out as 20%, but it goes up to 30 by the time you account for redemptions.
And that's even net of PIPES, you've got these warrants that are outstanding that are going to come on to the capital structure of a company that goes public via SPAC. You've got these underwriting fees that are paid, not just for money that's actually delivered, but also for shares that just get redeemed. So, it's very expensive.
If you're thinking about it from the perspective of a SPAC sponsor, trying to sell the deal to a company that might go public via SPAC, how do you justify these really high fees? How do you justify the fact that the sponsor is going to walk away with $50 million or $80 million?
One way you can try to say is ‘Well, I'm delivering a really valuable service. I'm giving you this favorable regulatory treatment.’ I think that's one perspective. Now, if you think about it from the perspective of the company that is going public, many times the appeal of a SPAC is that sponsors are good at getting investors to pay more for a slice of a company than investors will not pay in any other settings.
And it's understandable why that's appealing to companies going public, but it's a little awkward when the someone asks you, ‘Why are you choosing to go public via SPAC?’ It's a little awkward to say, ‘Well, we're choosing to go public via SPAC because the SPAC will get investors to pay more for our shares than anyone else will.’ It makes a much better quote to the newspaper reporter to say, ‘Well, I'm choosing to go public SPAC because it's more efficient and it saves on regulatory burdens.’
I think our paper shows that they're even more expensive than people recognize, that people recognize they're expensive, people have seen that they've historically not had good performance. A lot of people are asking, ‘Well, why do they keep existing if they have all of these strange features, all these expenses, all this bad performance?’ And a natural supposition is well, maybe they have great regulatory benefits. And that somehow explains why people would be willing to do something seemingly as odd as go public via SPAC.
FEI Daily: It seems like the tech industry is particularly focused on SPACs. Why do you think that is?
Ohlrogge: A necessary component to get a SPAC deal done is a lot of optimism about the value of the target company. In order for the deal to be a winner for everyone around. For the company going public and the SPAC investors who are going to hold through the merger, you need to have a very optimistic view about a company's future profitability. If it's a pretty predictable company with a set income stream, it's harder to build that really cheerful, hopeful story in one's mind.
It would be my supposition that you need a lot of optimism and the tech company is a place where you can have that optimism. The technology is unproven, but maybe in five years, it'll turn out to be really valuable. It's hard to disprove it in the short run. It seems to work well for the SPAC transaction.
FEI Daily: Do you think the tech industry understands the drawbacks of a SPAC?
Ohlrogge: We find in our papers is we find evidence that companies going public via SPAC tend to get a pretty good deal. I think they're generally aware of what's going on. They understand that if they merge with a SPAC, for instance, that it's going to usually come with tens of millions of warrants. They understand that those are expensive and those aren't free. And they're going to ask, ‘What kind of evaluation are you going to give me for my company that's going to make it palatable for me to take on this many warrants onto my capital structure?’ They're going to ask what kind of valuation are you going to give me for my company that's going to make it palatable to give all of these shares away to the sponsor without the sponsor putting in cash?
Our belief is that that in general the companies going public via SPAC are relatively aware of their costs and they're negotiating deals, and they're negotiating merger agreements and pricing in those merger agreements, such that the companies going public are getting a pretty good deal.
FEI Daily:Your paper states that SPACs have slight disadvantages regarding Sarbanes-Oxley compliance when compared to other firms going public. Could you describe why that is?
Ohlrogge The SEC gives a gradual phasing period for newly public companies before they are subject to all of the Sarbanes-Oxley compliance and reporting requirements. And for SPACs the SEC currently starts that phasing period when the SPAC does its IPO, rather than when the SPAC completes its merger. So, what that means is you get a longer grace period if you go public via IPO before you're subject to full Sarbanes-Oxley requirements, rather than if you go public via SPAC, it's a shorter grace period.
FEI Daily: You argue the advantage of SPAC is that companies are regulated under merger rules and not public offering rules. This includes exemptions from safe harbor, financial projection of forward-looking statements requirements. Why is that important?
Ohlrogge: I was in a webinar recently promoting SPACs, and there was a banker that works on a lot of SPACs. He said ‘The great thing about SPACs is they let you go public on a dream.’
I think projections are important for that. We see companies going public via SPAC, and they haven't sold any products yet, but they've got projections that say that in four years they're going to be selling $10 billion a year. And it seems to be that it's easier to raise money if you say, ‘I have no revenue now, but in four years, I'm going to be selling $10 billion a year,’ versus if you just say, ‘I have no revenue now.’
FEI Daily: You talked about Section 11 liability, misstatements and omissions. How has that played out in SPAC disclosures that you've seen? And does it offer much protection as sponsors and companies presume?
Ohlrogge: As far as we've been able to tell, it has not impacted the content of disclosures. It's hard to really do a perfect analysis of that, but we haven't seen any evidence that companies are saying, ‘Oh, we can leave stuff out of our disclosures or be vague or incorrect or anything like that because we don't have Section 11 liability’. So, we haven't seen any evidence of that. And it would be a silly sort of thing to do because there are other ways that you can still be liable for material misstatements and omissions.
As far as we're aware, it's not affecting the content of the disclosures, but there is the question of then what kind of litigation is going to follow a company going public via an IPO or via a SPAC. And it seems to be that there is less litigation against firms that have gone public via SPAC than against firms that have gone public via IPO. And that may well be, at least in part, because of the Section 11 liability issue. There's the potential damages that can be claimed are going to tend to be lower. And it's going to be harder to meet the standards of proof in terms of the action elements for bringing a suit against a company that went public via SPAC versus IPO.
It seems to be a little less litigation, even though the disclosures are about the same. We'll see if that stays in theory. I mean, judges have started pushing back a little bit for companies going public via direct listing and saying maybe they ought to have a Section 11 liability more comparable to IPOs. It's sometimes hard to know exactly how that squares with the statutory wording, but for the time being, it does seem to be that there's materially lower litigation risk.