Throughout my CFO career, I worked on several transactions where a SPAC was a combination target for a life sciences company I worked for. For full disclosure, none of the transactions I worked on closed, and in retrospect, I came to view that as a blessing in disguise.
Post by Aleksey Krylov Photo by Kenny Eliason on Unsplash
While some businesses may ultimately benefit from a Nasdaq-listed SPAC combination, the track record for such deals has been less than stellar. When there is a meaningful imbalance between the supply and demand of SPACs and private companies, more risks emerge. In such disbalance situations, a lot of caution goes to the wind, and the short-term excitement of getting a deal done takes over the prudence of long-term planning. As such, my word to a life science CFO is, “Be careful! If no other options exist, proceed carefully. If you can avoid SPACs, do so.”
The reason for this cautionary tale is simple. SPACs inherently carry 3 fundamental risk factors that are likely to destroy shareholder value in the long-term.
First, SPAC IPO investors don’t have skin in the game and are not aligned with private company shareholders regarding long-term value creation.
Second, SPAC sponsors have an enormous agency issue where their motivation to get a de-SPAC-ing transaction done overshadows prudence in diligence and valuation discussions; this conflict is exacerbated if the bubble conditions emerge.
Third, SPAC’s sponsor’s fee (sponsor promote) creates such a material dilution that no sponsor’s value-add can overcome.
For these reasons, small private companies and their CFOs, especially in the life sciences space, should evaluate and opt for other alternatives to raising capital and going public rather than engaging in a merger transaction with a SPAC. This post will define SPAC, go over historical stats around SPAC fundraising, review the track record of SPAC in shareholder value destruction, and assess the agency problem associated with the SPAC as a fundraising or going-public vehicle. I will reiterate caution for life sciences CFOs while considering SPAC as a strategic alternative for their employers.
What is SPAC and How it Works?
A SPAC (special purpose acquisition company) functions as a corporate shell that aggregates funds from investors without a predetermined plan for their use except for the generic statement that the funds will be used to identify and merge with a promising company. Unlike traditional initial public offerings (IPOs), which often require extensive disclosure and can take more than a year to complete, SPACs rapidly go public within a matter of months due to their lack of operational history and “disclosure light” IPO prospectus, which is easy to prepare and contain very little information requiring serious review by the SEC.
After becoming publicly listed, the SPAC seeks out a suitable company interested in becoming publicly traded, leading to a merger known as the de-SPAC-ing transaction. Through this process, investors in the SPAC transition from owning shares in a shell company to holding equity in a tangible operating business.
SPAC is typically launched by sponsors, who may be private equity or hedge fund managers, or a team of accomplished operating executives. While these sponsors might have a particular target company in mind, they are prohibited from engaging in formal agreements or negotiations with potential targets until after the SPAC has gone public.
After the completion of the SPAC's IPO, the funds raised are not immediately allocated to the company. Instead, they are deposited into a trust account where they accrue nominal interest. After the IPO, the sponsor commences the process of identifying, assessing, and bargaining with potential acquisition targets. This marks the onset of the de-SPAC-ing phase, wherein the private operating company merges with the publicly traded SPAC (note a public company can also merge with a SPAC even though it is rare). Once the letter of intent and merger documents are finalized, the combined company may proceed to execute the merger, often utilizing funds from the trust account to finance the transaction.
However, it is customary for SPAC transactions to involve additional financing via private investment in public equity (PIPE) offerings. For instance, if the SPAC initially raised $100 million through its IPO but the target company requires $200 million in funding, the sponsor may seek the additional $100 million through a PIPE from institutional investors, typically at a discounted price.
Upon announcement of the target company, SPAC shareholders vote on whether to approve the acquisition. Those in favor of the transaction become shareholders in the merged entity while dissenting shareholders have the option to redeem their invested cash. If some SPAC investors opt out of the merger, the additional capital raised through PIPE financing may help bridge the funding gap for the target company.
For more details see Thinking of Using a SPAC to Go Public? Here's What to Consider.
SPAC from Historical Perspective – Why are We Talking About SPACs?
In the 1980s, SPACs earned a dubious reputation for their association with investor scams. However, over time, SPACs have implemented various measures aimed at safeguarding investor interests, such as allowing investors to withdraw their support if they disapprove of the proposed merger. This enhanced level of investor protection, coupled with growing frustration among venture capitalists (VCs) with the traditional initial public offering (IPO) process, has attracted notable figures – celebrities – to sponsor SPACs.
For example, in October 2019, Virgin Galactic (founded in 2004 by British entrepreneur Sir Richard Branson, who had previously founded the Virgin Group and the Virgin Atlantic airline), chose to merge with a SPAC backed by a VC, Chamath Palihapitiya. This marked one of the initial instances of a reputable company, as recognized by Wall Street, opting to go public through a SPAC. Subsequently, numerous success stories have emerged, including DraftKings, which went public via a SPAC IPO and has since achieved a remarkable stock run (at some point in March 2021 touching $71.98 and producing a return of 770%+ from the SPAC IPO).
The publicity and successes of the early stages of the SPAC wave taking place in 2019 through 2021 gave rise to a floodgate of the SPAC vehicles going public. As the charts below indicate, between 2020 and 2021, more than 860 SPACs with approximately $250 billion in capital went public and were looking for acquisition targets. This coincided with only 263 de-SPAC-ing transactions over the same period, leaving approximately 600 sponsors actively looking for deals.
Side note: the SPAC transaction value of approximately $560 billion that occurred between 2020 and 2021 exceeds the $250 billion raised throughout the same period. Because $560 billion includes the enterprise value of the private companies being merged into SPACs, this M&A statistic does not mean that the SPAC dry powder was tapped out. In fact, the reality was likely completely the opposite: There was a lot of liquidity available for more details. NASDAQ rules dictate that SPAC cannot acquire a company whose enterprise value is less than 80% of the SPAC cash in the trust account, but there is no cap on how valuable the private company can be when it is merging with SPAC.
I have not done the data analysis. However, the back-of-the-envelope calculations suggest that in an extreme scenario, where all de-SPAC-ing transactions follow the 80% enterprise value limitation, the $560 billion of SPAC-related M&A would tie up about $311 billion of SPAC capital. It is more than what was raised during the same 2020 and 2021. This extreme scenario is highly unrealistic. What is more realistic, however, is that SPAC managers go after significantly higher enterprise-value private companies seeking IPOs than the cash held by SPAC. The fee optics of such deals appear much better than in scenarios where the SPAC is roughly the same size as the company it acquires.
Starting sometime in 2019, SPACs emerged as a compelling IPO vehicle that offered private companies ample capital to strengthen their balance sheets and quickly get into public capital markets. It became a force impossible to ignore if you are a private company CFO.
Source: SPACResearch.com, data as of December 31, 2023.
Billions in Shareholder Value Demolished through SPACs
Naturally, this wave of successful SPAC IPOs in 2020 and 2021 gave rise to SPAC capital chasing private companies for the merger. When enough managers chase a limited universe of private companies, this dynamic creates disbalances and drives up the targets’ valuations. Smaller and, perhaps, less desirable tier 2 and 3 private targets also enjoy the same benefit.
Clearly, the disbalances of 2020 and 2021 in the SPAC marketplace led to excesses. Some even called it a bubble. A recent piece from Fortune describes the consequences of such excesses: SPAC companies accounted for at least 21 bankruptcies this year and a staggering $46 billion in lost investor value.
While this is not a complete list, here are some major reasons behind the shareholder value destruction.
Companies not ready for prime time.
Preparing to be a public company is at least an 18-month or longer exercise. The company should operate as if it was public way before it is public in order to avoid trip-ups. Examples of operating maturation may include how companies are approaching internal record keeping, disclosure, and reporting.
Relaxed compliance, paperwork, and projections standards.
The Fortune article mentions Lordstown-SPAC merger and allegations that the operating company exaggerated the demand for the company's Endurance truck. In the lead-up to Lordstown's public listing in 2020, the company boasted of a backlog of 38,000 pre-orders for its vehicles. However, unlike its competitors such as Tesla, Lordstown did not mandate a deposit for these orders. At least on the surface, Lordstown appeared to look inexperienced or unsophisticated; perhaps, the company was not getting proper advice from their financial advisors and auditors about the quality of their sales pipeline.
Bubble suggests unreasonably high valuations.
The Fortune article makes references to the “bubble” implying unreasonably high valuations. They offer WeWork’s valuation approaching $10 billion at its peak. I can’t help but draw parallels to the go-go dot-com era, where valuations of companies going public were disconnected from the fundamentals.
Undercapitalized operating businesses.
The article draws attention to data gathered by Bloomberg in mid-December 2023, estimating a company's cash requirements and suggesting that approximately 140 former SPACs may require additional financing within the next 12 months to remain operational (i.e., going concern issues). To paraphrase Fortune, SPAC companies are more inclined than their corporate counterparts to express uncertainty about their future. Hudson Labs reported that nearly 44% of SPAC companies that submitted annual reports in 2023 issued warnings about their ability to continue as a going concern, whereas only about 22% of non-SPAC companies did so.
3 Fundamental Misalignments that Lead to SPAC Murdering Shareholder Value
SPAC IPO Investors Don’t Have Skin in the Game
Not all but many SPAC IPOs are structured with investors receiving units consisting of common stock and warrants. The warrants are often detachable, which means that when the investors vote to surrender their shares and get their money back immediately prior to the de-SPAC-ing transaction, those investors still have the upside benefit of warrants while having no principal cash invested in the vehicle. In short, investors can control the lever managing their skin in the game.
A natural tendency in these circumstances for investors is to take no risk with their capital. Therefore, the private company going through the merger with a SPAC is likely to receive less capital than it was originally expecting. In some cases, the shortage of capital may result in missed performance targets (e.g., sales orders, revenue targets, execution timelines, etc.).
One may argue that the capital shortage is normally addressed by a PIPE financing typically accompanying the de-SPAC-ing transaction. I agree. However, the PIPE may have very different valuation and/or transaction structures from those negotiated in the merger agreement with the SPAC.
A PIPE tends to be investor-friendly(ier), and the private company going public is not getting the benefit of the capital priced in the SPAC IPO. PIPEs offer pricing discounts for common stock deals to incentivize investors to participate and get compensated for a lack of immediate liquidity (normally shares sold in a PIPE don’t get registered and are not available for resale for 45-90 days). PIPEs may offer additional warrants to investors. Convertible structures may carry other investor-friendly elements such as floating conversion prices and/or resets in addition to warrants.
In short, in my opinion, many investors who come into stock by way of a PIPE financing transaction are not as aligned with the long-term company success and stock price appreciation as if they were investors in a traditional common stock IPO underwritten by the investment bankers.
SPAC Sponsor Agency Issues
We discussed previously how many SPAC sponsors were actively soliciting private companies to incite them into a de-SPAC-ing transaction. We discussed how many managers chasing the same deals may lead to bid-up valuations among private companies and their peers. What exacerbates the situation is that many sponsors do not have a lot of skin in the game either. Of course, one would argue that holding shares in their SPAC would align Sponsor interests much more effectively with the long-term success of the company they seek to acquire. While some sponsors do invest cash and hold shares in their SPACs, many are compensated through sponsor promote.
A sponsor promote may include as much as 20% of SPAC shares outstanding via warrants, priced at or slightly above the money. 20% of the SPAC market capitalization is a lot of value, and it tends to eclipse the dollar value associated with sponsor investment in the SPAC. In short, the sponsors, generally, make their money from the sponsor promote and not through the return on invested capital they deploy into the vehicle.
Sponsors have a limited time horizon over which they can merge the SPAC with a private company. Most often, this is 2 years. There are ways to secure extensions through structuring and executing a shareholder vote. However, these votes normally lead to sponsors giving up certain privileges and/or upsides, and sponsors are not incentivized to conduct such votes. They may have a limited number of times during which they conduct such a vote. And ultimately, without an M&A, they must return the SPAC capital to investors, which will completely eliminate any upside from their warrant-based sponsor promote.
Because the promote is through warrants, sponsors don’t have the skin in the game. They are not as sensitive about the valuation which they agree to when merging with the private company. In fact, I argue, they are inclined to offer rich(er) valuations to incentivize the merger agreement execution because they are playing with the “house money,” and their downside is in not getting a deal done vs. inappropriately pricing the private company’s enterprise value. The mispricing of the private company may lead to steeper discounts during the PIPE financing.
Value Destruction Through Dilution
The most fundamental problem I see with SPAC vehicles is the dilution that the sponsor fees and warrants introduce into the economics calculus related to the SPAC going-public transactions. When a private company is very large relative to the SPAC trust account, the sponsor promote and fees may get to be “spread” over a larger amount of the combined enterprise value. However, if the private company is small and is approaching the size of the SPAC cash trust account, the SPAC sponsor fees are, in my opinion, truly destructive of the private company’s shareholder value.
Consider two scenarios. In Scenario 1, the SPAC trust account is valued at $100 million and the private company is valued at $100 million. If we ignore the fees and keep other factors out of the calculus (e.g., warrant exercise provisions), the sponsor promote will equal to approximately 9% of the combined company market capitalization. In Scenario 2, the SPAC account is valued at $100 million, and the private company is valued at $1 billion. The Sponsor promote, in this case, will be around 1.8% of the combined company market capitalization. Meaningfully lower.
Life Sciences CFO: Exercise Caution
I can’t think of “value add” that sponsors bring to the table to replace the dilution that their involvement creates. This is especially true for smaller operating companies.
I am not convinced that for a private company that grows at a healthy pace, continues to deliver on its milestones, and enjoys the support of its shareholders, the SPAC method of going public is the most optimal path forward.
While you must check out the CFO’s Scope of Responsibilities, for now, let me mention that CFOs are responsible for preparing companies to operate in the public capital markets, they are responsible for projections (to be disclosed to investors or not), they are keeping a pulse on the enterprise value of the business, and they are ultimately accountable for proper capitalization of the business. If you are interested in exploring strategies for CFOs in the life sciences sector, read 'A CFO’s Roadmap to Tech Agility in Life Sciences' which provides valuable insights into navigating the unique challenges faced by CFOs in this industry.
In life sciences, CFOs must adjust their analytical calculus for an inherent value in the ability to access public capital markets. It is hard to quantify and “plug” into a spreadsheet.
While some businesses may get SPAC-ed into sustainable profitability, life sciences companies are likely to rely on SPACs as a stepping stone to the subsequent fundraise. Their CFO must think through valuation and a reasonable step-up it may offer to the investors when the next round of funding is around the corner. With purchase orders or sales targets beyond the projection horizon, the valuation discussions with SPAC sponsors and investors are even harder to tie to fundamentals such as revenue and EBITDA. CFOs must prioritize how far the SPAC dollars can take the company and what milestones can be achieved until the next round of capital may be available to the organization.
Lastly, smaller companies and their shareholders are likely to be hurt disproportionately more by the association with SPACs (than their larger comparables). Because of all these factors, I would caution a life sciences CFO to explore all other alternatives to raising capital and going public rather than engaging in a SPAC merger.
Author Bio
Aleksey Krylov is a strategic Chief Financial Officer to life sciences and medical technology companies with a background in venture investing and M&A.
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