SPACS: 8 Key Issues To Consider For Issuers and Investors.
Excellent platforms for liquidity and fundraising – potentially. Many are solid, but be careful and pay attention to their structure.
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Steve Ogunro, CrossWork.us, firstname.lastname@example.org, 213-327-5920
The following article is neither financial, investment nor legal advice and by reading it you agree not to construe it as such. Investing in public or private companies involves many risks and no performance guarantees. Engage an attorney and financial adviser to thoroughly evaluate any investment decisions that you make.
A SPAC is a special purpose acquisition company. It is a publicly traded company set up with the primary goal of acquiring an operating company or other entity. SPACs have several key advantages that are connected with the liquidity and status of their publicly traded stock, including: a means of shareholder value realization/shareholder liquidity, an option to use public stock as acquisition currency, a tool for compensation and incentive, a means to provide liquidity to shareholders, access to broader financing options and more. And of course, prestige! For full disclosure, we may or may not launch a SPAC in the coming months.
In January alone, SPACs completed around $26 billion in share sales, helping fuel $63 billion of IPO proceeds worldwide this year, more than five times the proceeds from January last year. SoftBank Group, Social Capital, The Gores Group, PE firm Thoma Bravo and many others have all raised money through SPACs in the past few weeks, capitalizing on last year’s record fundraising. Over 200 companies completed IPOs in January.
However, not all SPACs are equal, and their structures must be considered carefully given the wide range of parties with a potential interest in the equity of any SPAC, including investors, investment bankers, sponsors, acquisition teams, acquisition targets, acquisition target shareholders, institutional funds, hedge funds, speculators, offshore (or even onshore) short sellers, attorneys, potential lenders and more.
Critical items to consider when evaluating a SPAC at any time include:
- Stock options or warrant overhang
- Stock research coverage
- Volume and liquidity
- Shareholder base strength
- Classes of stock and class power
- Credible institutional holders
- Debt and debt power
- Need for future financings
- Stock Options or Warrant Overhang
A strong stock price exists when a relatively broad range of shareholders believes that the stock’s price will appreciate in the future. Thus, when a shareholder chooses to sell his position in the company, many other shareholders are interested in buying the stock. Over the long term, if large, professional institutional shareholders (such as Fidelity, Capital Group Companies, Vanguard, etc.) are unwilling to or uninterested in buying a company’s stock, its price is likely to crumble over time. Some companies with global consumer name recognition and powerful brands are able to get away with minimal institutional shareholdings, but they are few and far between.
Company issued stock options, generally speaking, can be dilutive to stock value. In some cases, such as incentivizing key employees, the power of an incented workforce might be reflected in a strong stock price. On the other hand, a large number of outstanding warrants and options presents two key issues for stock price: (1) The dilutive power of an excessive number of options cannot be overstated. Excessive stock option issuance can cause downward pressure on stock price. (2) Many professional and institutional funds as a matter of policy will simply not purchase the stocks of publicly traded companies that have excessive warrant or option “overhang.” This means that this critical investor base is potentially excluded as a core and strong part of the company’s shareholder base.
Ira Kay, a prominent compensation consulting professional, puts it this way: “Extremely high levels of overhang are bad in bull or bear markets.” A percentage of more than 20 is considered high while 1 to 2 percent is rather low, he says. A good balance is around 10 to 15 percent. However, there are industry variations. The sweet spot for utility or consumer goods companies is 6 percent, but it’s 15 percent for tech and health care, which includes the biotech sector.
SPACs are, generally speaking, completing or contemplating larger acquisitions, in part, in order to reduce the impact of risks associated with warrant overhang issues.
That being said, it is important to consider these issues in conjunction with other factors when making evaluations of SPAC equity. Some companies with larger overhang may perform well, especially when they have had a depth of institutional and retail investors across multiple markets or when they have had a smart PE backer.
Potential Solutions: “Potential” solutions are all subject to regulatory requirements in their respective jurisdictions as well as financial implications that should be reviewed with an investment banker and equity professionals. Completing a large acquisition can be very helpful. Other solutions include providing the issuer with the ability to purchase excessive options, potentially prior to initial issuance. Over time, issuers might also consider the use of excessive balance sheet cash or debt to repurchase overhang options. Issuers can potentially, and subject to regulatory hurdles, work on financial structures that offset excess stock option issuance such as potentially issuing offsetting securities subject to regulatory and other considerations. Of course, merging with another public company or going private may be potential options, particularly for those companies that may struggle to raise further rounds of equity. All of these considerations are financially delicate and subject to regulatory obligations in the jurisdiction of the stock market, and thus require strategic consultation with experienced and sophisticated bankers, financial advisers and lawyers.
- Equity Research Coverage
Stock research is an important informative or suggestive tool in helping stock investors form opinions on stock price potential. Equity research reports are also an important tool in helping a broad group of investors develop interest in and ultimately purchase a stock, assuming they agree with potentially positive analyst recommendations. Importantly, good stock research attracts long-term institutional investors, one of the bedrocks of strong, long-term stock price performance. Stock analysts thus play a critical role in stock liquidity and ultimately stock price. Companies that have no research coverage might be perceived as risky since they might have more limited shareholder bases and more limited liquidity. To use an example that will be deliberately repeated throughout this writing, imagine watching the 10,000 shares that you owned yesterday at $10 each have a price today of $5 because another shareholder sold his 10,000 shares for $5 and not a single institutional investor stepped in to buy at the higher price. What if they did not step in because no equity analysts write research on the company?
Potential Solutions: Companies that do not have good research coverage should proactively engage the financial community with timely and well thought out communications that explain their strengths (and risks) in a way that is compelling to investors in general, and equity research analysts in particular. Solid investor relations efforts combined with seasoned and experienced CFOs can be very helpful in this regard.
- Trading Volume and Liquidity
While a separate issue from shareholder distribution, trading volume/liquidity and shareholder distribution are closely intertwined. Many smaller SPACs suffer from a lack of liquidity and trading volume because of the lack of well-distributed public ownership of their shareholdings and/or a lack of a strong institutional shareholder base. Stocks with significant volume and liquidity, generally speaking, have better price stability than stocks with limited volume and liquidity. The lack of liquidity might potentially be a reflection of a lack of interest in the stock or fears about its stock price. Stocks with limited trading volume and liquidity are thus potentially subject to very significant price swings, and this is the case with some smaller SPACs. This presents the same challenge as the equity research challenge: imagine watching the 10,000 shares that you owned yesterday at $10 each have a price today of $5 because another shareholder sold his 10,000 shares for $5 and not a single “buyer” stepped in to buy at the higher price.
Potential Solutions: Solid investor relations, good management communication (of business activities and expectations) and equity research coverage from respected, expert research analysts can all help drive liquidity. Secondary issuances, if on the table as an option, that are professionally managed and broadly distributed might be very helpful in promoting share liquidity and trading volume.
- Shareholder Base Strength (Distribution)
A well-distributed shareholder base is a fundamental underpinning of the shares of many of the world’s leading publicly traded companies. What this means is that, generally speaking, a good mix of large institutional investors/fund managers, small and medium sized fund managers, as well as retail investors should form the shareholder base. (There are some exceptions to this, such as some Dutch auctions and some higher profile SPACS with significant name recognition/branding, but they are few and far between.) These investors ultimately ensure that there is a significant supply and demand for a stock, which produces a reasonably “trustable” stock price. Research firms and professional investors, through the laws of pricing and economics, help support or establish stock prices that are reflective of widely attainable information.
Small shareholder distributions have the potential to impact stock prices negatively because of the probability of a lack of liquidity. Imagine watching the 10,000 shares that you owned yesterday at $10 each have a price today of $5 because another shareholder sold his 10,000 shares for $5 and not a single “buying investor” was available to step in to buy at the higher price. Having a broader shareholder base would increase the likelihood of an investor stepping in and buying based on available information. Global investment banks like Goldman Sachs (a former employer of mine) and Morgan Stanley coined the term “global initial public offering” to refer to offerings whose stockholders were diverse and global with trading at times on multiple stock markets in multiple regions to maximize liquidity, price trust and price transparency. Many publicly traded companies, not only SPACs, do not have the benefit of global listings, but many do have well-distributed national or regional shareholder bases. This is harder for SPACs, but the good news is that there are ways to build out and develop well-distributed shareholder bases.
Potential Solutions: Developing a structurally diverse shareholder base can be an exercise in patience but is certainly both worthwhile and critical. Solutions to developing a shareholder base have overlap with solutions to lack of liquidity and trading volume in stocks. Roadshows and solid investor communication programs are essential. Solid investor relations, good management communication (of business activities and expectations) and equity research coverage from respected, expert research analysts can all help drive the growth and diversification of shareholder bases. Secondary issuances, if on the table and well-distributed, are potentially an excellent option. If secondary issuances are professionally managed to the highest standards and broadly distributed, they might be very helpful in increasing shareholdings among a broad range of institutional and retail investors. Depositary receipts may potentially provide value as well over time, if well marketed.
- Classes of Stock (Securities) and Class Power
Some SPACs issue multiple classes of securities. It is important to have a real understanding of key differences from an economic and possibly a control/voting perspective between the different classes of stock. Some classes of stock might produce returns far superior to others. It is also important to understand which classes of securities have stock options or warrants attached to them in order to understand overall options/warrant overhang and its long-term impact on stock price. Not to state the obvious, and in some cases, it might be necessary to read between the lines, but debt investors with a warrant interest have a significantly different position from equity investors that also have a warrant interest.
Potential Solutions: It is possible that issues can be addressed in a similar fashion to the potential solutions outlined above for stock and warrant overhang.
- Credible Institutional Holders
This has overlap with the issue described above pertaining to shareholder base distribution. The point of emphasis here relates to whether the biggest (possibly smartest) institutional investors (Fidelity, Vanguard, Goldman Sachs Asset Management, etc.) are shareholders in the SPAC. It is certainly not necessary to have them as shareholders in a SPAC, but it is an indication of a SPAC’s potential strengths. They are “reference investors.” From a shareholder perspective, just be cautious and do the math if you own a different class of securities from the class of securities that a large and smart institutional investor owns; you might have vastly different economic outcomes.
Potential Solutions: Similar to the solutions presented above for shareholder base distribution issues. Roadshows and solid investor communication programs are essential. Solid investor relations, good management communication (of business activities and expectations) and equity research coverage from respected, expert research analysts can all help attract large credible institutional investors. Secondary issuances, if on the table and well-distributed, are potentially an excellent option. If they are professionally managed and broadly distributed, they might be very helpful in attracting smart, strong institutional investors.
- Debt and Debt Power
While debt does not have the traditionally high return profile of equity, debt issuances in connection with SPACs often come with stock options, providing a significant upside to a lower risk position in the capital structure. Some hedge funds and other smart professional investors might thus view a debt position as a highly protected equity position. In situations where a SPAC’s equity structure is problematic and prevents it from raising further equity, it is of the essence that its cash flows are strong and well understood. The requirement for cash flow strength is thus further compounded for equity holders when the SPAC takes on any form of debt. No suggestion is being made to avoid debt, which is clearly a security that can substantially enhance returns. One should simply undertake diligence to ensure that a SPAC is appropriately capitalized from a debt perspective, and option/warrant overhang in connection with debt should be thoroughly examined.
Potential Solutions: Issues with debt can often be addressed by refinancings, if available, or intelligent, mutually agreeable renegotiations.
- Need for Future Financings
Well-structured SPACs with strong operations will likely have no issues with future equity financings. Poorly structured SPACs (sometimes even with good operations), on the other hand, might struggle to raise future financings, potentially causing a death spiral in stock price – especially if the SPAC is targeted by specialist short sellers. As part of a due diligence exercise in connection with SPACs, it is worthwhile to pay very close attention to the SPAC structure if the company is likely to have significant future needs for financing for operations.
Overall, SPACs are a great mechanism for capital raising and value realization. They must be structured carefully and thoughtfully in order to ensure that they grow as an important fundraising component of the global capital markets system and to ensure that confidence continues to grow among investors in SPACs.
CrossWork.us is a pre-IPO venture capital group consisting of:
- CrossWork Midas Pre-IPO Fund focuses on investments in traditional pre-IPO opportunities but enhances return with accelerator equity additions
- CrossWork Emerging Pre-IPO Fund focuses on multi-stage pre-IPO opportunities and provides equity enhancements if IRR falls below benchmarks
- CrossWork Late Stage Accelerator partners late stage companies with teams of senior executives with IPO / M&A experience, bankers and hedge fund managers to drive and support success