Private companies usually go public through an initial public offering (IPO). In an IPO, the private company raises funds from public investors, and the company’s stock is listed in an exchange. But this is not the only way for companies to go public. Private Companies can equally go public through a business combination with a Special Purpose Acquisition Company (SPAC).

What are SPACs?

A Special purpose acquisition company is a company that is formed solely to raise funds through an IPO to acquire a private company and take it public. SPACs are regarded as blank-check companies because investors in the firm give a blank check to the sponsors of the SPAC to make a deal for them within 24 months. The money raised is placed in an interest-bearing trust account. If the sponsors fail to acquire a public company within the period, the investor’s money is returned. SPACs are regarded as shell company as there is no underlying business beyond the money that is raised and the reputation of the sponsors or the management team.

SPACs have become very popular in recent times. It was reported by SPACs research that 248 SPACs IPO raised $83.4 billion in the US in 2020. Thus far, 330 have been done in 2021. Virgin Galactic, Nikola Motor Co. & DraftKings are few examples of companies that have gone public through a deal with a SPAC. WeWork is also planning to go public through a merger with a SPAC after its IPO failed last year.

How do SPACs work?

SPACs could be sponsored by influential figures, private equity firms, venture capitalist, hedge funds, banks and sometimes entrepreneurs. The story begins with their formation. After that, investors are pursued to back the SPAC before performing its IPO. A target company is identified for a merger deal. If shareholders approve the merger, the process ends with the acquired company being publicly traded – this process is called de-SPAC-ing.

What is in it for an Investor?

When a SPAC is successful, the investors’ benefits lie in his early investment as they become shareholders of the acquired company. SPACs are not without risks. The risks include uncertainty as to the kind of acquisition that will be made. And suppose the company is unable to make an acquisition. In that case, the company is dissolved, and the money is returned to investors at the book value of the stock. Therefore if the SPAC is trading at a valuation higher than book value at the time of dissolution, investors will take the premium as a loss. The whole arrangement favours the sponsors as they bought their shares at a nominal price and are paid management fees whether or not an acquisition is completed.

Conclusion

Does investing in SPACs make sense? It depends on who is sponsoring or backing the SPAC. If the sponsor finally makes a good deal with the target company, investors would benefit if they bought the shares early at the offer price or a little above it. Knowledge of the stock market is indispensable to be a successful retail investor.