I know that SPACs are the new darling for investors. Lots of rich and famous celebrities have gone all-in on SPACs, and tech entrepreneurs think that SPACs are a golden-egg-laying goose. But I need to be really clear up front: I am not a fan of this investment option. They are shell companies that exist solely to invest in potential unicorns — targets — and get richer quickly after the IPO. So what’s the problem with that? The rush to invest is so out of control right now that SPACs are buying start-ups that don’t have the governance or operational track record to manage their own IPO. So there’s a lot of due diligence that’s not happening.
Why is this bad? I’m ranting way ahead of myself. So let’s go back and look at what a SPAC is and how it works. This is the first article in a new series on SPACs — a Special Purpose Acquisition Company — and how they impact clean energy investing.
What’s a SPAC?
SPACs have been around the investment fringes since the mid-1990s. But they burst onto the scene in the past year or so with a mania usually reserved for pet rocks and Pokémon cards. In the before times — before the pandemic in 2020 — there were 200 SPACs registered in the US, four times the 2019 numbers. In the first six weeks of 2021, newly registered SPACs are at 70% of the 2020 numbers.
Why the boom? During COVID-19, investors needed a place to park a lot of cash while ideally — because they are big-time players — waiting for the right big-return opportunity to pop up. Clean energy entrepreneurs may have noticed an equally crazy uptick in investing in renewables. This sets the stage for a meeting of the manias. It’s like a money game of Rock Paper Scissors — does the pet rock beat out the Pokémon card?
This ain’t the SEC’s first rodeo with paper investment companies. SPACS are the latest iteration of the notorious “blank check” companies that raged across boiler rooms in the 1980s — the penny and microcap stocks that Congress negated with the Penny Stock Reform Act in 1990. Speculative investors abhor a vacuum, so the SPAC was introduced in 1993 — a shell company with a limited lifespan whose sole goal was to find and fund the next Uber.
SPACs buy a position in a promising start-up in what’s basically a reverse merger since the extant stockholders maintain the majority interest in the new company. As part of this de-SPAC transaction, the start-up goes public.
‘I’m Not Seeing the Downside of a SPAC’
Then you’re not paying attention. Right now, you’re thinking, ‘Your surfboard hit you on the head one time too many, and you’re nuts. This sounds like a great way to bring companies through the last fundraising slog and to the market.’
There are two ways a SPAC can bleed an investor or entrepreneur dry:
- The way the SPAC itself is set up
- The freewheeling approach they can take to forecasting
The carnival barkers/sponsors who run SPACs — Gary Cohn, Reid Hoffman, Mark Pincus, Shaq, A-Rod — are the biggest names in investing and celebrity, so what’s the problem? These guys are working with house money, and the deals are structured so they can’t lose. You, on the other hand, are just so much chum. If the deal falls apart, the others take the write-off and move on.
Here’s how a SPAC deal looks, but don’t skim through to the end. Savvy investors know that the devil is in the details. The fine print in a business combination (SPAC-speak for merger) term sheet does not favor the little guy or the investor in the secondary markets.
SPACs Are Weighted Towards the Deep-Pocketed Investor
First, the SPAC’s required pound of flesh is usually 25% of the deal. If the SPAC brings in $100 million, the initial deal bumps up to $125 million, and the SPAC walks out with their first cut. The banks that market the deal and bring it to that magic IPO day don’t work for future earnings (they’re not stupid), so they take another 5.5% as their fees (the Hamptons don’t come cheap). The new company typically opens at $10.
So far, so good, right? Only if you’re an early-stage investor in the IPO. Then you typically get a free warrant with every share you buy. This is basically a free call option to buy another share at a predetermined price; the standard is $11.50 for SPACs that go public at $10.
When you buy open-market shares in a SPAC, you don’t get that warrant. The sponsor investors can sell their shares and get that initial investment back, but they still have the free warrants to hold or sell in the secondary markets. And if they’re selling, it’s not because those warrants are worth anything.
Another SPAC Problem to Consider
The next gotcha is when a SPAC does find a solid company with good fundamentals and the merger is a huge success. Sponsor investors exercise their warrants, so the stock is diluted at least 100% for retail investors. How can it dilute more than is there? I told you: SPACs are a carnival game, and the house makes the rules. There’s a special rule for SPACs that allows investors to sell their stake any time between the announcement of the merger and the finalized sale.
Let’s say that Shaq and A-Rod have invested $10 million each in a SPAC that’s worth $80 million. The two of them and a couple of other equal investors have the chance to invest in another SPAC. So they sell their shares and warrants. This is half the investment pool, but the same number of warrants are outstanding. With a one-to-one share to warrant ratio, the stock dilution is well over 100%. These redemptions happen a lot in the SPAC world. It’s not exactly a pump and dump, but with an average of 73% of IPO proceeds returning to shareholders via redemption in 2019, you can see how the deep-pocketed investors are playing the system.
But wait, there’s more.
Strike Three for SPACs
Shaq and A-Rod’s selloff exacerbates the sponsorship and banking fees. Those numbers don’t change, but the SPAC has a lot less cash, and the share price has already dropped. In that 50% redemption move, the original 5.5% fee doubles to 11% in real money when you have that much dilution. Sponsors aren’t all that altruistic, and they will take their money off the top. Sure, the SPAC can sell additional shares to raise more cash and thereby reduce the dilution. But at this point, they’re just playing catch-up. By the way, that capital raise isn’t free — 7.5% goes straight back to the banks.
Oh, and one more thing. Those celebrity investors? It’s entirely possible that they get compensation for their participation in the SPAC — it’s high-class catfishing.
Wild West Forecasting
Although it would appear that the big investors are the bad guy here, some start-ups are pretty good at playing the SPACs. The built-in deadline for finding that magic investment makes some SPACs easy targets themselves and susceptible to buying into the marketing hype.
The traditional path to an IPO is littered with reams of documentation — like proxy statements, financial disclosures, and registration statements — but not a whole lot of touting the financial glories that await investors. There’s a good reason for this: the liability risks for misleading investors are tremendous. A SPAC doesn’t care about such minor details. Unscrupulous or desperate entrepreneurs can vastly inflate their financials, marketing success, and other factors that appeal to SPACs.
The short version? A SPAC is free to communicate financial projections to its investors while the target company is not. So far, they have not carried any liability for litigation. The SEC is cracking down on SPACs using the Private Securities Litigation Reform Act (PSLRA) safe harbor provision to avoid litigation for their forward-looking statements that may have overstated the rosy future of their target investment. Per the PSLRA, those predictions are directly related to the IPOs and are not covered under safe harbor rules, allowing for litigation against some companies to move forward.
At the moment, the SEC is thought to have at least four SPAC mergers under investigation for defrauding investors via unrealistic projections.
SPACs and the Clean Energy Sector
Now that I’ve scared the hell out of you about SPAC investing, let’s look at the one upside. Yes, there is one. One.
Let’s say you are an energy entrepreneur running a company with solid fundamentals. (This obviously includes strong financials backed by successful early rounds of fundraising.) SPACs looking at clean energy targets are flooding the market right now. A couple of billion dollars are looking for placement. Time is on your side; if you’ve been pursuing a traditional IPO, you’ve settled in for the long haul. You are okay with waiting several years for the IPO to happen.
A SPAC, on the other hand, is under the gun to find that investment that will make them even richer. It also needs a quick investment to give the sponsors the street cred to keep up with this particular version of the three-card monte. In this scenario, you have the upper hand and can negotiate a better deal. This means you can whittle down that 25% off the top down to something more palatable.
Next time I’ll talk in more detail about the risks of SPACs.